Page 71 - DECO401_MICROECONOMIC_THEORY_ENGLISH

Microeconomic Theory

Notes product increases when it costs less and the demand decreases when it costs more. Positive income
effect means the real income increases when the price of product decreases and it helps to increase the
quantity of products. In another words, income effect is always the proof of real income and demand of
quantity but it touches light of negative relation between price and demand of quantity. In other words,
positive income affect moves in the same direction as the negative substitution effect. In summary
the substitution effect and the income effect both represent the opposite relation between pricing and
demand of quantity. So the slope for general products is always moving downwards.

Fig. 4.24

Y Price Effect = SQ
Substitution Effect = TQ
R
Income Effect = ST

Oranges L C

B
IC
A
IC
1

O ST NQ P M X
Income
Apples
Effect
Substitution Effect
Price Effect

(a) Separation of Substitution and Income Effects for normal goods in case of Price Rise: The
division of substitution and income effect in respect of price rise for general product is defined
by Fig. 4.24
Figure 4.24 represents that LM is original price line. The consumer is in equilibrium in point B of
indifference curve IC. He bought the units OQ of apples. When the price of apples rises, then the price
line shifts inwards on LN. The consumer gets equilibrium on point A of the indifference curve IC . In
1
this point, he bought the units OS of apples. The price effect shows by movement point B to A.
Or the demand of quantity from OQ to OS represents price effects. In another words, price effect =
OQ – OS = SQ. The rise of price of apples represents the inclination of real income of consumer which
is shown by IC . If we increase the money income of consumer that he stood on primary indifference
1
curve IC then new price line would be RP. This indifference curve touches IC to point C. This is parallel
to price line LN which is the new pointer after increasing the demand of apples.
1. Substitution Effect: Substitution Effect comes by movement of Primary equilibrium point B to
C. Both the points are on same indifference curve. Due to this substitution effect, the demand
of apples would decrease from OQ to OT. In other words,

Substitution Effect = OQ – OT = TQ

2. Income Effect: Income effect comes by movement of point C to A. In another word, it would
be ST.
∴ Price Effect = SQ, Substitution Effect = TQ; Income Effect = ST
So, SQ (Price Effect) = TQ (Substitution Effect) + ST (Income Effect)

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