SUBSTITUTION EFFECT

 MICROECONOMICS
The substituion effect measures how the optimal consumption combination of a consumer changes as a result of change in the relative price alone, real income of the consumer remaining unchanged.

We need to understand here the meaning of relative price change and real income remaining unchanged.

In relative price change, comparison is between prices of two goods. For example, between goods X and Y, good X becoms relatively cheaper (costlier) when price of good X (Px)decreases (increases)with price of good Y remaining unchanged.

The real income on the other hand shows purchasing power of the money income. For the given money income, whenever price of a good changes then the purchasing power of consumer's money income increases and so also her/his real income. For example suppose a consumer is spending her/his money income on good X. When the price of the good X decreases, the consumer's purchasing power increases and with same money income she/he is able to purchase more of good X.

Now, a substitution effect shows change in the consumer’s optimal consumption combination on account of change in the relative price alone and thereby changes in her/his quantity purchased of goods X and Y, real income of the consumer remaining unchanged.

Note that consumer's real income changes whenever there is a relative price change. Then, how do we study substitution effect which shows changes in consumer's purchases on account of relative price changes, consumer's real income remaining unchanged?

A compensatory variation in money income method is used to neutralize the real income change that takes place on account of the relative price change. The consumer's money income is sufficiently adjusted to compensate her/him for real income changes on account of change in the price of a good.

Solve the following activity to gain adequate clarity on the concepts just discussed, before we move on to understanding substitution effect with the help of indifference curves.

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