Income And Substitution Effect Diagram For An Increase In The Price Of X

B3 is parallel to b2 because it represents the higher price for x.

Income and substitution effect diagram for an increase in the price of x. It must be tangent to the original indifference curve u1. The total effect is the substitution effect plus the income effect. In the graph above this is point c. When price of good x falls and as a result budget line shifts to pl 2 the real income of the consumer rises i e he can buy more of both the goods with his given money income.

Income effect arises because a price change changes a consumer s real income and substitution effect occurs when consumers opt for the product s substitutes. To separate the substitution effect from the total effect first draw a new budget line b3. Suppose the price of x falls so that his new budget line is pq 1. Income effect and substitution effect are the components of price effect i e.

At r the consumer is buying ob of x and br of y. The decrease in quantity demanded due to increase in price of a product. It is thus clear that as a result of substitution effect the con sumer remains on the same indifference curve. How the price effect is decomposed into substitution effect and income effect is illustrated in fig.

He is however in equilibrium at a different point from that at which he was. When the price of good x falls and as a result budget line shifts to pl 2 the real income of the consumer rises i e he can buy more of both the goods with his given money income. With the fall in the price of x the real income of the consumer increases. The substitution effect is explained in figure 12 17 where the original budget line is pq with equilibrium at point r on the indifference curve i 1.