a brief on substitution effect ....

1. Presented by Pavan Gautam

2. Economists often separate the
impact of a price change into
two components:
– the substitution effect;
– the income effect.

3. The substitution effect
involves the substitution of
good x for good y or viceversa
due to a change in relative
prices of the two goods.

4. Substitution effect can be done
in several ways There are two
main methods:
(i) The Hicksian method; and
(ii) The Slutsky method.

5. About the author:-
Sir John R.Hicks (1904-1989)
Awarded the Nobel Laureate in
Economics (with Kenneth J. Arrrow)
in 1972 for work on general
equilibrium theory and welfare
economics.

6.  With a given money
income and given
prices of the two
goods as represented
by the budget line PL,
the consumer is in
equilibrium at point Q
on the indifference
curve IC and is
purchasing OM of
good X and ON of
good Y.

7.  Suppose that the price
of good X falls (price
of Y remaining
unchanged) so that
the budget line now
shifts to PL’. With
this fall in price of X,
the consumer’s real
income or purchasing
power would
increase.

8.  When some money
is taken away from
the consumer to
cancel out the gain in
real income, then the
budget line which
shifted to position
PL’ will now shift
downward but will
be parallel to PL’.

9.  A budget line AB
parallel to PL’ has
been drawn at
such a distance
from PL’ that it
touches the
indifference curve
IC.

10.  PA or L’B is thus just
sufficient to cancel
out the gain in the
real income which
occurred due to the
fall in the price of X.
PA or L’B is
therefore
compensating
variation in income.

11.  Budget line AB
represents the new
relative prices of
goods X and Y since
it is parallel to the
budget line PL’
which was obtained
when the price of
good X had fallen.

12.  It can be seen from
Figure that with
budget line AB the
consumer is in
equilibrium at point T
and is now buying
OM’ of X and ON’ of
Y. Thus in orders to
buy X more he moves
on the same
indifference curve IC
from point Q to point
T.

13. Therefore,
movement from Q
to T represents the
substitution effect.
Thus, this is the
concept of
substitution
effect.

15. The substitution effect is meant to
represent the change in macroeconomic
consumption patterns that arise due to a
change in the relative price of goods.
Consumers have the tendency to replace,
or substitute, luxury items with cheaper
alternatives when income decreases or
prices increase.