Substitution effect

a brief on substitution effect ....

1. Substitution Effect Presented by Pavan Gautam

2. THE IMPACT OF A PRICE CHANGE Economists often separate the impact of a price change into two components: – the substitution effect; – the income effect.

3. What is substitution Effect ? The substitution effect involves the substitution of good x for good y or viceversa due to a change in relative prices of the two goods.

4. Methods of substitution Effect Substitution effect can be done in several ways There are two main methods: ( i ) The Hicksian method; and (ii) The Slutsky method.

5. THE HICKSIAN METHOD About the author:- Sir John R.Hicks (1904-1989) Awarded the Nobel Laureate in Economics (with Kenneth J. Arrrow ) in 1972 for work on general equilibrium theory and welfare economics.

6. The Hicksian Method 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 IC and is purchasing OM of good X and ON of good Y.

7. The hicksian Method Suppose that the price of good X falls (price of Y remaining unchanged) so that the budget line now shifts to PL’. With this fall in price of X, the consumer’s real income or purchasing power would increase.

8. The Hicksian Method When some money is taken away from the consumer to cancel out the gain in real income, then the budget line which shifted to position PL’ will now shift downward but will be parallel to PL’.

9. The hicksian method   A budget line AB parallel to PL’ has been drawn at such a distance from PL’ that it touches the indifference curve IC.

10. The hicksian method PA or L’B is thus just sufficient to cancel out the gain in the real income which occurred due to the fall in the price of X. PA or L’B is therefore compensating variation in income.

11. The hicksian method Budget line AB represents the new relative prices of goods X and Y since it is parallel to the budget line PL’ which was obtained when the price of good X had fallen.

12. The hicksian method It can be seen from Figure that with budget line AB the consumer is in equilibrium at point T and is now buying OM’ of X and ON’ of Y. Thus in orders to buy X more he moves on the same indifference curve IC from point Q to point T.

13. The hicksian method Therefore, movement from Q to T represents the substitution effect . Thus, this is the concept of substitution effect.  

14. Substitution Effect example

15. Uses of substitution effect The  substitution effect  is meant to represent the change in macroeconomic consumption patterns that arise due to a change in the relative price of goods. Consumers have the tendency to replace, or  substitute , luxury items with cheaper alternatives when  income  decreases or prices increase.

16. thankyou