The Income and Substitution Effect of a Change in Price of a Good - Coursework Example

Microeconomics Name Institution Date Course Introduction Income effect and substitution effect are important aspects in economics that expresses changes in the market. The change has impacts on the consumption pattern for the consumer goods and services. In economics, the income effect expresses the impacts of increased purchasing power on consumption (Estrin, David & Dietrich, 2012).The substitution effect describes how changing relative prices impacts on consumption. The good and services in the market usually experience changes in several ways at one time or the other. The goods whose consumption decrease when the income increases are referred to as inferior goods. Higher purchasing power on the other hand leads to an increase in consumer spending and the consumption of the normal goods. This can be best described when dealing with the luxury goods. Higher income households usually spend more on the luxury goods as compared to the low income households. The changes in prices have direct effects on the consumer. A change in the consumption patter is usually witnessed when the price changes (Taussig, 2013). The changes in prices has effects on the consumer and this may lead to changes in consumption pattern as it may leads to substitute products being consumed. The paper thus discusses and distinguishes the income and substitution effect of a change in price of a good. Discussion Substitution effect The substitution effect in economics is the effect only due to the relative price change and control for the change in real income. A change in price has effects on the consumption of the product by the consumer. If the price of a commodity decreases, income would be freed if the consumer is maintain the same consumption bundle (Estrin, David & Dietrich, 2012). The consumer may therefore end up consuming more of the same product as compared to the time before the price of the product decreased. The situation is also the same when the price of the product increases. The substitution effects are mainly concerned with the changes in quantity demanded due to the changes in the price of a good. The effect usually results to the substitution of a relatively cheaper good for a dearer one while at the same time keeping constant the price of the other good and real income as well as the tastes. The substitution effect is independent of the income effect which can be attributed to the compensation in the variation in income. The substitution effects according to a theory developed by Hicks can be defined as increase in the quantity bought as the prices of the commodity falls (Stiglitz, et al., 2013). This is with an adjustment in the income in order to keep the purchasing power same as before the changes. The adjustment in income is what is referred to as compensating variations. Graphically, this is represented by a parallel shift of the new budget line until it is tangential to the initial indifference curve. On the basis of compensating variation, the substitution effects measures the effect of change in relative price of product while the income remains constant (Mankiw, 2014). The fall in the prices of the product increases the real income of the consumer, however due to the substitution effect; the consumer is neither better off nor worse off as compared to the period before the changes. The substitution effect can be explained through the use of the graph below in relation to goods Y and X. Figure 1: Substitution effect graph In the graph, line PQ represents the original budget line with point R being the equilibrium on the curve. At the equilibrium, the consumer purchases quantity OB of product X and BR of product Y. When the price of product X falls, the new budget line is represented by line. The fall in the price of product X therefore results to an increase in the real income. However, for the purpose of compensation variation in the income, the increase in income is taken away by product Y which is indicated by PM or N of product X. As a result of the changes, the budget line  shifts to the left and it is represented by MN. The line M in the graph is tangential to the original indifference curve which is The new quantity changes to OD of X and DH of Y. The PM of Y or N of X represents the compensating variation in income as highlighted in by line MN. The graph indicates that the changes leads to the substitution of product X for Y leading to changes from point R to H with a horizontal movement of B to D which is the substitution effect. In most cases, the substitution effect is usually negative when the prices of good falls or rises. This can be attributed to an increase or decrease in its purchase. The relationship between price and quantity demanded is inverse making the substitution effect negative (Estrin, David & Dietrich, 2012). Income effect The income effect is different from the substitution effect as it is mainly involve effects resulting from the changes in the real income. The income effect can either be positive or negative depending on the nature of the product. The effect is dependent on whether the product is normal, luxurious or inferior. The total effect of income and substitution usually results to the total effects of price change (Dayal, 2015). The income effect can also be defined as change in demand for certain goods and services induced by change in the discretionary income of the consumer. The change in discretionary income of the consumer may result to a higher or lower demand for the goods or services. An increase in free money may result to the decrease in prices of the commodity which in turn increases the income. This may lead to an increase in the purchase of the product. Unlike the substitution effect, the consumer may end up becoming worse off as a result of the decrease in income and an increase in the prices of the commodities in the market (Stiglitz, et al, 2013). The income effect therefore represents a change in the income of the individual. The change has direct impact on the quantity demanded of a good or service. The income change can result from one or two sources. The income effect can result from external sources or from freed up sources such as decrease or increase in price of goods. According to the consumer theory, the income effect is a phenomena associated with the purchasing power. In a graphical representation, an increase in the income of the consumer leads to an upward shift of the budget line. A fall in the income of the consumers leads to a shift of the budget line inwards to the left. The changes makes the budget lines parallel to each other as the prices remains the same despite the changes in income. The income consumption curve plays an important role in providing an explanation regarding the income effect. An increase in the income of the consumer increases the purchasing powers leading to increased purchase of a certain product (Taussig, 2013). However, when dealing with the normal goods, the purchase may reach a saturation point despite the increase in the income. Normal goods such as salt and sugar where the consumers only require a specific amount act as a good example. An increase in the income of the consumers may however see an increase in the consumption of the luxurious goods (Estrin, David & Dietrich, 2012). The process of the luxurious goods has no effects on consumption with an increase in income. This therefore explains why luxurious goods such as jewels are common with those who are financially stable. The following graph can be used for representing the income effect. Figure 2: Income effects curve In the diagram, the PQ is the budget line before any changes are made in the income. The equilibrium is represented by R and it is also the point that it touches the indifference curve represented by. A partial increase in the income of the consumer leads PQ to shift to the right. The new budget line can be represented by line. The new equilibrium point is S and the new indifference curve is. A further increase in the income of the consumer lead to the budget line shifting further to the right. The new budget line can be represented by  and the new equilibrium is represented by T and the indifference curve . The curve indicates that there are changes in the purchase of the two different goods X and Y. At the point of equilibrium R, the consumer purchases quantity RA of Y and OA of X. At the equilibrium point X, where the income of the consumer has increased, the consumer purchases SB of Y and OB of X. A further increase in the income where the equilibrium is T, the consumer purchases TC of Y and OC of X. The income consumption curve above is positive for both product X and Y which is attributed to an increase in the income of the consumer. The income curves may however be different depending on the changes in the income of the consumer (Taussig, 2013). Conditions for opposite direction of the income and substitution effects The income as well as the substitution effects can act in opposite directions based on various conditions. When dealing with the normal goods, the income affects moves to the right due to an increased income of the consumer. This forces the budget line to move to the right. This is also an indication that the purchasing powers of the consumer is on the increase. However, with substitution effect, the budget line moves to the left as a result of an increase in the prices of the commodity which decreases the purchasing powers of the consumer. The price in the income effect usually remains constant despite the changes in the income of the consumer (Estrin, David & Dietrich, 2012). The changes in the income of the consumer may increase or decrease. An increase in the income of the consumer and an increase in the price of the commodity lead to different direction between the income and substitution effect. In the income effect, the price of the product is a main factor that influences the quantity that the customer is able to purchase. The price in most cases is influenced by the market which is an indication that it is beyond the control of the consumer. The income as well as the substitution effect indicates that price and income has a direct impact on the budget of the consumers (Taussig, 2013). Conclusion In conclusion, it is evident from an economic point of view that the consumption of goods and services is affected by various factors. The substitution effect indicates that the fall in the prices of the commodity leads to an increase in the income of the consumers. It is evident that an increase in the income of the consumers increases their purchasing powers. The income effect indicates that the consumer may be able to purchase the more products with an increased income despite the price remaining constant. It is evident from the graphs that the income effect may be positive or negative while the substitution effect is only negative. It is evident that an inverse relationship between price and quantity demanded exists in the substitution effect. Bibliography Estrin, S., David, L., & Dietrich, M., 2012. Microeconomics. Pearson Education. Taussig, F. W., 2013, Principles of economics. Vol. 2. Cosimo, Inc. Stiglitz, J. E., et al., 2013, Principles of economics. John Wiley & Sons, New York. Mankiw, N. G., 2014. Principles of economics. Cengage Learning, London. Dayal, V., 2015. "Supply and Demand." An Introduction to R for Quantitative Economics, Springer India, 19-25. Read More