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Unit-4: Ordinal Utility Theory: Indifference Curve Approach

(b) Separation of Substitution Effect and Income Effect in case of a normal goods for a price fall: Notes
separation of Substitution Effect and Income Effect in case of a normal goods for a price fall can
be described as:
The Separation of Substitution Effect and Income Effect can be represented by Fig. 4.25.
Let’s assume AB is primary budget line and IC is primary indifference curve. The consumer is in
equilibrium on point E. When the price of apples decreases and the income as well as the price of
orange remains constant then the new budget line starts from AB to AC. The new budget line touches
indifference curve IC to point E which is the new equilibrium for consumer. The movement of point E to
1 1
E represents the price effect of apples. The consumption of apples defines the price effect difference from
1
OT to OM and is equal to MT. The price fall of apples indicates the increase of real income of consumer.
If the income of consumer decreases until he stood on primary indifference curve, or his real income
remains constant, then new budget line would be PH and the new equilibrium point would be E .
2

Fig. 4.25

Y
Price Effect = MT
Substitution Effect = MN
Income Effect = NT
I
A

P
E
1
IC
1
IC
O X
Substitution Effect MN BT H C
Income Effect Apples
Price Effect

1. Substitution Effect: This represents the movement from initial equilibrium point E to E because
2
the point is in parallel to indifference curve IC.
2. Income Effect: It is represented by point NT (from point E to point E ). The main reason to buy
1
2
point E is however, the income of consumer is stable but he gives priority to lesser value of apples
2
rather than costly oranges. The movement from equilibrium point E to new equilibrium point E
2
represents the effect of the prices of oranges and apples. The effect occurs on apples as MN and this
is called Substitution Effect.
In other words, the consumer bought many oranges
due to its less price and this is called Price Effect. In the The income effect represents by the movement from
figure, consumer bought more units of apples MT. He one indifference curve to another indifference curve.
bought MN units for substitution effect and NT units Due to this, the effect of change in income is with
for income effect. It means the demand of apples: having stable direct price.
Price effect = MT; Substitution effect = MN; Income effect = NT
So MT (Price Effect) = MN (Substitution Effect) = NT (Income Effect)

In summary, due to the negative substitution effect, the change in demand is opposite to change in
price. If price falls then due to substitution effect, demand of product increases. On the other hand, if
price rises then due to substitution effect, demand of product decreases.

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