Q- Price effect is combination of income effect and substitution effect. Explain and illustrate.
Price Effect = Income Effect + Substitution Effect
As we known that, when ever prices of good decreases then two effects are incurred on its demand that is income effect and substitution effect. Due to decrease in prices of good, purchasing power of a consumer increases which is called “INCOME EFFECT”. While on the other hand consumer will substitute cheaper good for expensive good, this is called the Substitution Effect.
Explanation With The Help Of Diagram:
In the above diagram the basic equilibrium on point E1. Where consumer purchases 3 units of X good on budget line “AA”.
When prices of X falls then new budget line will be “AB”. New equilibrium will be on point E3 and consumer purchasing will be 9 units. In this condition price effect is:
Price Effect or Total Effect = x3 – x1
= 9 – 3
Price Effect or Total Effect = 6
The Substitution Effect:
To determine substitution effect we draw an imaginary budget constraint “CC” which is parallel to AB budget line, and touches to IC1. The consumer will not stay on point E1 because X good is cheaper than Y so, consumer will move from E1 to E2 to purchase more units of good X, this shows the substitution effect.
In this case substitution effect will be: x2 – x1
= 5 – 3 = 2
The change in income is due to the change in price of X, which allows a consumer to buy more with in the same budget. Now the equilibrium of a consumer will move from 32 to E3 and consumer increase the purchasing of X good from 5 to 9 as that increase in income. So income effect will
x3 – x2
= 9 – 5 = 4
Price Effect = Substitution Effect + Income Effect
6 = 2 + 4
6 = 6