Income And Substitution Effect With Diagram

The income effect is the change in the consumption of goods by consumers based on their income.

Income and substitution effect with diagram. 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 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. Hicks has explained the substitution effect independent of the income effect through compensating variation in income. In the diagram above after w1 the income effect dominates.

Thus in hicksian type of substitution effect income is changed by the magnitude of the compensating variation in income. If the substitution effect is greater than income effect people will work more up to w1 q1. Hicksian substitution effect is illustrated in fig. Thus the movement form q to r due to price effect can be regarded as having been taken place into two steps first from q to s as a result of substitution effect and second from s to r as a result of income effect.

It is important to note that we are only concerned with relative income i e income in terms of market prices. The movement from s on a lower indifference curve to r on a higher indifference curve is the result of income effect. The left hand side of the equation represents the change in demand for commodity x as a result of a change in the price of commodity i. The decrease in quantity demanded due to increase in price of a product.

Income effect for a good is said to be positive when with the increase in income of the consumer his consumption of the good also increases. This is essential to a fundamental knowledge of labor market economics as we understand it today. The first term on the right hand side represents the substitution effect. With a given money income and given prices of the two goods as represented by the budget line pl the consumer is in equilibrium at point q on the indifference curve.

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. Income effect and substitution effect are the components of price effect i e. In the diagram shown here the substitution effect is larger than the income effect so the quantity of x consumed rises when the price of x falls. When the income effect of both the goods represented on the two axes of the figure is positive the income consumption curve icq will slope upward to the right as in fig.

However we may get to a certain hourly wage where we can afford to work fewer hours. This is the normal good case.