INDIFFERENCE CURVES ANALYSIS:SUBSTITUTION EFFECT

MICROECONOMICS

SUBSTITUTION EFFECT |

Introduction

In the previous section on income effect we have discussed how a consumer rearranges her/his optimal consumption combination, to once again maximize utility of her/his spendable income, as a response to a change in her/his income. We have also seen consumer's responses to income changes in case of different types of goods.

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	Learning Objectives
After reading this chapter, you are expected to learn about: understand 1. How consumers arrive at optimal consumption in response to change in relative prices?

Substitution Effect: Related Concepts

In this section we are going to study substitution effect. In other words, understand how the optimal consumption combination 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 (P_x)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.

Activity

1.1 Select the correct answer from the options given- a. Smita's income is Rs. 1, 000/-. She wants to spend entire income on good X. Price of one unit of good X is Rs. 20. What is the purchasing power of Smita's income? i.Rs. 50 ii.50 units of good X iii.Rs. 1000/- b. Smita's income is same Rs. 1, 000/- which she wants to spend only on good X. Price of one unit of good X is now Rs. 50. What is change in the purchasing power of her income now? i.Purchasing Power of the income has increased ii.Purchasing Power of the income has decreased iii.Purchasing Power of the income has remained Unchanged c. Amman's income is Rs. 1, 000/-. He wants to spend entire income on good Y. Price of one unit of good Y is Rs. 25. What is Amman's real income? i.Rs. 40 ii.40 units of good X iii.Rs. 1000/- d. Amman's income is Rs. 5, 000/- He now wants to spend his income on two goods X and Y. Price of one unit of X is Rs.20 and Price of one unit of Y is Rs. 25. What is Amman's real income? i.Rs. 5, 000/- ii. 100X + 120Y iii. 200 Y d. The following table stats with Zoya's initial income Rs. 1, 000/-, price of good X (PX), Zoya's real income expressed in terms of good X. Complete the table given below by filling in correct options from the answer box given below - ANSWER BOX

Hicksian Substitution Effect

A substitution effect shows change in consumer's optimal consumption combination as a result of change in the relative price alone, real income of the consumer remaining unchanged. Substitution effect is shown in Figure 1. It starts with the initial optimal consumption combination attained at point e at which OX units of good X and OY units of good Y are purchased.

Figure 1.Substitution Effect

When the price of good X decreases, the budget constraint then becomes flatter, as the lower end point moves rightward. This is shown by budget constraint PL₁. The real income of the consumer also increases. This increase in real income will be neutralized through Compensatory Variation in Money Income so that the real income of the consumer remains unchanged. In other words we need to reduce consumer's money income to bring her/him at initial real income level. This adjustment in money income shifts the budget constraint backwards and it is a parallel shift as shown by the price line AB.

The relative prices of goods X and Y are different on budget constraint AB than on the budget constraint PL. Good X is relatively cheaper to good Y on budget constraint PL₁ than budget constraint PL. This is because budget constraint PL₁ is obtained when the price of good X decreases, price of good Y remaining unchanged. Similarly, good X is relatively cheaper to good Y on budget constraint AB, as it is parallel to PL₁.

Thus, good X is relatively cheaper to good Y on budget constraint AB than on budget constraint PL. However, Consumer's real income on budget constraint AB is same as her/his real income on budget constraint PL, as budget constraint AB is obtained through compensatory variation in consumer's money income.

Figure.1 shows that on the new budget constraint AB, obtained after compensatory variation in money income, the consumer attains optimal consumption combination at point e₁ which is on the same indifference curve U and purchases OX₁ units of good X and OY₁ units of good Y.

Thus, consumer's movement from optimal consumption combination e to e₁ shows substitution effect. Similarly, increase in her/his consumption of good X by XX₁ and decrease in consumption of good Y by YY₁ is on account of change in the relative price alone, real income of the consumer remaining unchanged.

Thus a substituion effect shows consumers preference for relatively cheaper goods. In the case of a substitution effect the consumer remains on the same indifference curve. Chart 1 presents a summary of Figure.1.

CHART 1

Slutsky Substitution Effect