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Income and Substitution Effects with Indifference Curves

New to the Cambridge International Exams A Level Economics syllabus is indifference curve analysis. This was part of the old Oxford and Cambridge A Level Economics course back in the 1990’s. Below are some notes which might be of assistance to those teaching this course.

Income and Substitution Effects with Indifference Curves

Any price change can be conveniently analysed into two separate effects – the income effect and the substitution effect.

Income effect of a price change: when there is a fall in the price of a product, the consumer receives a real income effect and is able to buy more of this and other products in spite of the fact that nominal income is unchanged. If the consumer buys more of the good when the price falls it is a normal good. If the consumer buys less of the good when the price falls it is seen as an inferior good.

Substitution effect of a price change: when there is a rise or fall in the price of a product, the consumer receives a decrease or an increase in the utility derived from each unit of money spent on the product and therefore rearranges demand to maximise utility. This is distinct from the income effect of a price change.  For all products, the substitution effect is always positive so a fall in price leads to an increase in demand as consumers realise an increase in the satisfaction they derive from each unit of money spent on the product.

Note for normal goods, both the income and substitution effects are positive. But the income effect can be negative; if a negative income effect outweighs the positive substitution effect, this means that less is bought at a lower price and vice-versa. This good is known as a giffen good.

Showing income and substitution effects on a diagram

A Normal Good

Indiff Curves - Noraml Good

The graph above shows the effect of a fall in the price of Good B that increases the amount that can be purchased to 70. Hence the budget line moves from: 45 A – 37 B to: 45 A – 70 B.

To find the substitution effect, you must find a point where the new level of prices is effective but the consumer is no better or worse off than before. Therefore a line ZZ is drawn parallel to the new budget line (45A – 70B) and therefore has the same slope. This line then gives the same relative prices as implied by the new budget line. The consumer will be no better or worse off if he is consuming on his original indifference curve I1. Drawing the line ZZ at a tangent to the indifference curve I1, the consumer would consume at point K if prices had changed but income had not. The movement from point J to point K is therefore the substitution effect of the price change.

To find the income effect you have to find the movement between two points where income has changed but the same relative prices are effective. The movement from point K to point L is the income effect of the price change.

Summary

  • Good B falls in price – hence budget line moves from: 45 A – 37 B to: 45 A – 70 B.
  • The move from point J to point K is the substitution effect which = +13
  • The move from point K to point L is the income effect which = +10
  • These make up an overall move from point J to point L is the price effect (substitution effect + income effect) = +23
  • As both effects are positive Good B is a Normal good

Go to eLearn Economics for more notes on Indifference Curves.

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