Income And Substitution Effect Explained

A simplified explanation of the income and substitution effect.

Income and substitution effect explained. Let us assume there is a decrease in the price of a product. The decrease in quantity demanded due to increase in price of a product. Many studies have demonstrated that the price elasticity of labor supply is positive meaning that the substitution effect dominates more than the income effect in aggregate. In our discussion of substitution effect we explained that slutsky presented a slightly different version of the substitution and income effects of a price change from the hicksian one.

Consumer will prefer buying more of that good because it has become cheaper and he she will decrease the demand for those goods which are now comparatively more expensive. 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. This will have two effects. Income and substitution effects.

This is essential to a fundamental knowledge of labor market economics as we understand it today. How a higher price causes consumers to substitute other goods. The income effect expresses the impact of higher purchasing power on consumption. The substitution effect describes how consumption is impacted by changing relative income and prices.

Income effect and substitution effect are the components of price effect i e. In fact it was slutsky who first of all divided the price effect into income and.