Substitution Effect,

Income Effect
&
Price Effect
 Substitution Effect (S.E.)
• Definition: It refers to the change in quantity demanded
for a good caused by a change in relative price, holding
real income constant.
 Substitution Effect (S.E.)
• Definition: It refers to the change in quantity demanded
for a good caused by a change in relative price, holding
real income constant.
Qy
Px
Qx

0 Qx
Qx0 Qx1
 Substitution Effect (S.E.)
• Definition: It refers to the change in quantity demanded
for a good caused by a change in relative price, holding
real income constant.
Qy
Px
Qx

0 Qx
Qx1 Qx0
Substitution Effect (S.E.)

Px Qx

Px Qx
 Income Effect (I.E.)
• Definition: It refers to the change in quantity demanded
for a good caused by a change in real income, holding
relative price constant.
 Income Effect (I.E.)
• Definition: It refers to the change in quantity demanded
for a good caused by a change in real income, holding
relative price constant.
Qy
I
Qx

0 Qx
Qx0 Qx1
 Income Effect (I.E.)
• Definition: It refers to the change in quantity demanded
for a good caused by a change in real income, holding
relative price constant.
Qy
I
Qx

0 Qx
Qx1 Qx0
Income Effect (I.E.)

I Qx

I Qx

Normal Goods !!
Income Effect (I.E.)

I Qx

I Qx

Normal Goods !!
 Income Effect (I.E.)
Inferior
Normal Good
Good

I Qx I Qx
Qy Qy

Qx Qx
0
0

Qx0 Qx1 Qx1 Qx0

 Income Effect (I.E.)
Inferior
Normal Good
Good

I Qx I Qx
Qy Qy

Qx Qx
0
0

Qx1 Qx0 Qx0 Qx1

 Income Effect (I.E.)

• Normal Good: I Qx

I Qx

• Inferior Good: I Qx

I Qx
 Price Effect (P.E.)
• Definition: It refers to the change in quantity demanded
for a good caused by a change in relative price.
 Price Effect (P.E.)
• Definition: It refers to the change in quantity demanded
for a good caused by a change in relative price.

Qy
Px
Qx

0 Qx
Qx0 Qx1
 Price Effect (P.E.)
• Definition: It refers to the change in quantity demanded
for a good caused by a change in relative price.

Qy
Px
Qx

0 Qx
Qx1 Qx0
 Relative price changes
(S.E.)
When price changes
(P.E.)
Real income changes
(I.E.)

P.E. = S.E. + I.E.

 Relative price changes
(S.E.)
When price changes
(P.E.)
Real income changes
(I.E.)

P.E. = S.E. + I.E.

 Px ↓ Qx ↑
S.E. -ve Px ↑ Qx ↓

P.E.
normal gd I ↓ Qx ↓
I.E. +ve I↑ Qx ↑

inferior gd I ↓ Qx ↑
-ve I↑ Qx ↓
 Case 1 Qx ↑
S.E. : Px ↓ Qx ↑

P.E. normal gd : I ↑ Qx ↑
Assume Px +ve
↓

I.E.
inferior gd : I ↑ Qx ↓
-ve
 S.E. : Px ↓ Qx ↑ Qx ?

P.E. normal gd : I ↑ Qx ↑
Px ↓ +ve

I.E.

inferior gd : I ↑ Qx ↓
-ve
 S.E.
Px ↓ Qx ↑ S.E. > I.E. Qx ↑ Case 2

I.E. S.E. < I.E. Qx ↓ Case 3

inferior gd
I ↑ Qx ↓
 Summary
-ve S.E. & +ve I.E. Case 1
Qx ↑
Qx ↑& Qx ↑ normal gd

Case 2
-ve S.E. > -ve I.E. Qx ↑ inferior gd
Px ↓
Qx ↑ > Qx ↓ non-giffen case

-ve S.E. < -ve I.E. Case 3

Qx ↓
Qx ↑ < Qx ↓ inferior gd
giffen case
 Graphically
Case 1 Normal good
Qy
S.E. Qx ↑
-ve
Qx ↑
Px ↓

I.E. Qx ↑
+ve

0 Qx
Qx0 Qx0’ Qx1
 Graphically
Case 1 Normal good
Qy
S.E. Qx ↑
-ve
Qx ↑
Px ↓

I.E. Qx ↑
+ve

0 Qx
Qx0 Qx0’ Qx1
 Graphically
Case 2 Inferior good, non-giffen case
Qy
S.E.Qx ↑
-ve
S.E.>I.E. Qx ↑
Px ↓
I.E.Qx ↓
-ve

0 Qx
Qx0 Qx1 Qx0’
 Graphically
Case 2 Inferior good, non-giffen case
Qy
S.E.Qx ↑
-ve
S.E.>I.E. Qx ↑
Px ↓
I.E.Qx ↓
-ve

0 Qx
Qx0 Qx1 Qx0’
 Graphically
Case 3 Inferior good, giffen case
Qy
S.E.Qx ↑
-ve
S.E.<I.E. Qx ↓
Px ↓
I.E.Qx ↓
-ve

0 Qx
Qx1 Qx0 Qx0’
 Graphically
Case 3 Inferior good, giffen case
Qy
S.E.Qx ↑
-ve
S.E.<I.E. Qx ↓
Px ↓
I.E.Qx ↓
-ve

0 Qx
Qx1 Qx0 Qx0’