Substitution Effect, Income Effect of Price Increase of a Commodity - Example

SUBSTITUTION EFFECT, INCOME EFFECT OF PRICE INCREASE OF A COMMODITY INTRDUCTION The market is a composition of consumers that have differing tastes as well as preferences. Consumers are over and over faced with the difficulty of deciding on the commodities to buy towards acquiring maximum utility. Such a dilemma is brought about by a budget which restrains a customer into buying commodities that maximize utility. The income that a consumer earns is a constraining factor when deciding on the commodities to buy. The various compositions of goods and services that a customer can afford using earned income are represented on the budget line. A consumer takes note of the constraining income and ensures that commodities picked are of maximum utility. The region that is below the budget line is the budget set. That region is a set of all goods and services that a consumer can obtain using the income level (Hanson & westman, 2004). A consumer that purchases goods within the budget set, below the budget line is said not to be maximizing his or her utility. On the other hand, a consumer cannot buy goods above the budget line since at that point resources are scarce; thus, commodities are not affordable. Thus, the consumer must stick at the budget line, where utility is maximized. However, not all points on the budget line signify the highest utility. It is the point where the resources line meets the highest indifference curve that demonstrates the best quantity. However, the budget line is subject to change. It is influenced by the customer’s income and commodity prices. Change in income and prices affects the position of the budget line. An alteration of income leads to shifting of the budget line (Carbaugh, 2013). Graph 1: the budget line Good Y M/b Budget line Optimal choice Budget set 0 M/b good X However, a change in price leads to a twist of the budget line. That results in the income effect and the substitution effect. According to Thomas and Azevedo (2013), given merchandise in the marketplace that a consumer considers best, any alteration in value of either of the good or service, or income of the customer will influence the level of buying of either of the merchandise. The two commodities complement each other. That is because the consumer will buy a given quantity of a commodity and another quantity of the other commodity, which will then add up to ensure total satisfaction of the consumer. This paper describes the substitution effect and income effect, which are caused by doubling of the price of a commodity, as other factors are held constant. The two goods are X and Y, of value a and b, respectively. The price of good X is doubled. Hence, the new price of good X is now 2a. SUBSTITUTION EFFECT Substitution effect refers to alteration in the amount of goods bought by a consumer given the variation in price. This concept can be clarified from the exact meaning of substitution. Substitution is the action of replacing one commodity with another. If the price of a commodity rises, the consumer is inclined to purchasing more of the commodities whose price has not risen and less of the goods whose price has heightened. Contrary to that, a decrease in price of a commodity leads to increased purchase of the good and less of the good whose price has not reduced is bought. A customer will forever react to the changes in prices of commodities, so as to maintain the initial optimal selection of consumption. The Slutsky compensation clearly illustrates this concept of substitution (Kulkarni, 2010). When the prices of a commodities change, consumers make some adjustments on their income. That is for the sole purposes of enabling them keep their purchasing power similar to the previous purchasing power. The adjustment is mainly making a decision on which good to buy in large quantities and which good to buy in less quantity. Based on the question, the best choice is the combination of goods X and Y. The prices of X and Y are, a and b in that order. The income of the customer is assumed to be M. Therefore, the original equation of consumption will be equal to: M=a×X+ b×Y. This equation implies that all income is used on good X and good Y. From the equation of income, deriving the amount of good X purchased and good Y purchased is feasible. Thus, X=M/a, whereas Y=M/b. M/a and M/b stand for the amounts of good X and Y correspondingly. By dividing income by prices of the commodities, one can arrive at the quantities bought. Given that the price of X becomes twofold, the price rises. Other factors are held constant. The initial price of X was a. however, after doubling, the new price of good X becomes 2a, i.e. 2×a= 2a. Therefore, the new capacity the customer will buy will be M/2a. This quantity is less than the initial quantity, M/a. The consumer still purchases the original quantity of good Y, M/b. Thus, the new optimal quantities of goods purchased are M/2a and M/b. The income is unchanged. Therefore, when the price of X increased, the consumer tends to buy good Y in huge quantities and good X in small quantities. Graph 2: The tilting of the original budget line (substitution effect (SE)). Good Y M/b new budget set New budget line Original budget line e1 original indifference curve e2 new indifference curve Shift 0 M/2a Good X M/a From the graph above, the original budget line was tangent to the original indifference curve at point e1. The original budget line tilts towards the left side, with the intercept of the budget line with the x-axis shifting. This demonstrates that the amount of X declines. However, the intercept on the y-axis is constant. A novel indifference curve is sketched, and should be tangent to the new budget line. The tangency point signifies the new optimal selection of goods, and is labeled e2. The substitution effect is shown by the change from e1 to e’. INCOME EFFECT Income effect implies the adjustment in consumption level in response to income modification. Increased income to a consumer pushes them to purchase more of a commodity. Moreover, an increase in income motivates a consumer into buying goods and services of the best quality. Given two commodities, a consumer will purchase more of the good with high quality, given an increase in income. However, if the income of the consumer is decreased, then the consumer responds to the decrease by reducing the consumption level of commodities. Hicksian compensation, illustrates clearly the income effect concept. The hicksian compensation demystifies that following a change in price, consumer’s income is subjected to some adjustments, for the purpose of preserving equivalent satisfaction level (Bhatia & Jain, 2013). Increase in prices of goods and services impact directly on the income of consumers. Though the income is constant, an increase in price of a commodity results in an impression of reduced income being formed in the minds of customers. Therefore, consumers, in trying to maintain the same level of satisfaction, will go for low priced goods and purchase less of the goods highly priced. When the price of a commodity is reduced, the same happens. The income remains regular. However, in the customer’s mind, an impression of raised income is created. Thus, the consumer will buy more of the commodities with high prices and less of the cheap commodities (Kumar, 2004). Before the increase in price of good X, the optimal consumption was at point e1, the point of tangency linking the initial budget line and the initial indifference curve. With the doubling price of commodity X, from a to 2a, the income will appear reduced since the consumer has to budget for the same income as before. Thereby, the customer will purchase good Y in huge quantities and good X in minimal quantities. Graph 3: Income effect (IE) and total effect (TE). Good Y M/b Original budget line New budget line Compensated budget line e’ new indifference curve e1 old indifference curve e2 Shift IE SE 0 TE M/2a M/a good X Diagrammatically, the original budget line tilts towards the left, thus forming a new budget line. A novel indifference curve must be drawn on the novel budget line, and the meeting point gives the new best amount of consumption. That point of tangency is labeled e2. A line that is known as compensated budget line is drawn, and should be corresponding to the new budget line, but meet the original indifference curve at its point of tangency. The compensated budget line illustrates the income effect. The meeting point of the compensated budget line and the initial indifference curve is labelled e’. Hence, the shift from e2 to e’ in the graph represents income effect. Finally, the income effect and the substitution effect, summed up together generate the total effect. The total price effect stipulates the impact of any modification on price of a good or service. In respect of the question, price increased leading to a reduction of the capacity of good X in demand. The total effect is given by the shift from e1 to e2. CONCLUSION In conclusion, tangency between the budget line and the indifference curve gives the best choice of all the bundles available. However, if the price of a commodity forming the optimal choice is increased, the consumer will tend to make some adjustments on the income available, so as to maintain the initial level of satisfaction. A consumer will buy the cheap goods in huge quantities, and the goods with heightened prices in minimal quantities. This illustrates the replacement of expensive goods with the cheap goods. The substitution effect and the income effect added together give the total effect. Even though sellers of goods and services may think that by increasing prices of their goods and services, they get to earn a lot, the reality is quite contrary to that. Increase in prices of goods leads to huge losses by the sellers of goods. That is because of the substitution mentality that customers have. Consumers of goods and services tend to act negatively on price increase. Consumers know how to complement their satisfaction. Once the price of a good is heightened, a consumer looks for another good that is of a low price and complements the other. Hence, by retracting from the highly priced good, the highly priced good sells less. Hence, the seller looses a lot, in the long run. References Bhatia, M, & Jain, A 2013, Green Marketing: A Study of Consumer Perception and Preferences in India, Electronic Green Journal, 1, 36, pp. 1-19, Academic Search Premier, EBSCOhost, viewed 4 June 2014. Carbaugh, R., 2013. International economics (14th ed.). Mason, OH: South-Western CENGAGE Learning. Hanson, F, & Westman, J 2004, Optimal Portfolio and Consumption Policies Subject to Rishels Important Jump Events Model: Computational Methods, IEEE Transactions On Automatic Control, 49, 3, pp. 326-337, Academic Search Premier, EBSCOhost, viewed 4 June 2014. Kulkarni, K., 2010. International economic development: theories, models & case studies of countries leading the change. New Delhi: Matrix Publishers. Kumar, R., 2004. Micro economics. New Delhi: Anmol Publications Pvt. Ltd. Noel, H., 2009. Consumer behaviour. Lausanne, Switzerland: AVA Academia. Thomas, B, & Azevedo, I 2013, Estimating direct and indirect rebound effects for U.S. households with input–output analysis Part 1: Theoretical framework, Ecological Economics, 86, pp. 199-210, Academic Search Premier, EBSCOhost, viewed 4 June 2014. Read More