Income And Substitution Effect Of A Price Increase

It involves the change in demand for the goods due to an increase or decrease in the consumer s real income or purchasing power as a result of the price change.

Income and substitution effect of a price increase. 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. The income effect expresses the impact of higher purchasing power on consumption. The decrease in quantity demanded due to increase in price of a product. The sum of these two effects is often called the total effect of a price change or simply price effect.

Income effect and substitution effect are the components of price effect i e. Hicks has explained the substitution effect independent of the income effect through compensating variation in income. The substitution effect is the increase in the quantity bought as the price of the commodity falls after adjusting income so as to keep the real purchasing power of the consumer the same as before. The substitution effect and income effect of price increase for an inferior good.

If a good increases in price the good is relatively more expensive than alternative goods and therefore people will switch to other goods which are now relatively cheaper.