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Responses to price changes: substitution and income effects

A higher price for a good will cause the budget constraint to shift to the left, so that it is tangent to a lower indifference curve representing a reduced level of utility. Conversely, a lower price for a good will cause the opportunity set to shift to the right, so that it is tangent to a higher indifference curve representing an increased level of utility. Exactly how much a change in price will lead to the quantity demanded of each good will depend on personal preferences.

Anyone who faces a change in price will experience two interlinked motivations: a substitution effect and an income effect. The substitution effect is that when a good becomes more expensive, people seek out substitutes. If oranges become more expensive, fruit-lovers scale back on oranges and eat more apples, grapefruit, or raisins. Conversely, when a good becomes cheaper, people substitute toward consuming more. If oranges get cheaper, people fire up their juicing machines and ease off on other fruits and foods. The income effect refers to how a change in the price of a good alters the effective buying power of one’s income. If the price of a good that you have been buying falls, then in effect your buying power has risen—you are able to purchase more goods. Conversely, if the price of a good that you have been buying rises, then the buying power of a given amount of income is diminished. (One common source of confusion is that the “income effect” does not refer to a change in actual income. Instead, it refers to the situation in which the price of a good changes, and thus the quantities of goods that can be purchased with a fixed amount of income change. It might be more accurate to call the “income effect” a “buying power effect,” but the “income effect” terminology has been used for decades, and it is not going to change during this economics course.) Whenever a price changes, consumers feel the pull of both substitution and income effects at the same time.

Using indifference curves, you can illustrate the substitution and income effects on a graph. In [link] , Ogden faces a choice between two goods: haircuts or personal pizzas. Haircuts cost $20, personal pizzas cost $6, and he has $120 to spend.

Substitution and income effects

The graph shows two indifference curves with points A (10, 3) and B (10, 2) marked on the curves. Point C is also marked as the intersecting point of two dashed lines. The x-axis is marked pizza and shows an arrow next to “s” point to the right and an arrow next to “i” pointing to the left.The y-axis is market “haircuts” and sows downward pointing arrows for both “s” and “i.”
The original choice is A, the point of tangency between the original budget constraint and indifference curve. The new choice is B, the point of tangency between the new budget constraint and the lower indifference curve. Point C is the tangency between the dashed line, where the slope shows the new higher price of haircuts, and the original indifference curve. The substitution effect is the shift from A to C, which means getting fewer haircuts and more pizza. The income effect is the shift from C to B; that is, the reduction in buying power that causes a shift from the higher indifference curve to the lower indifference curve, with relative prices remaining unchanged. The income effect results in less consumed of both goods. Both substitution and income effects cause fewer haircuts to be consumed. For pizza, in this case, the substitution effect and income effect cancel out, leading to the same amount of pizza consumed.

Questions & Answers

where we get a research paper on Nano chemistry....?
Maira Reply
what are the products of Nano chemistry?
Maira Reply
There are lots of products of nano chemistry... Like nano coatings.....carbon fiber.. And lots of others..
Even nanotechnology is pretty much all about chemistry... Its the chemistry on quantum or atomic level
no nanotechnology is also a part of physics and maths it requires angle formulas and some pressure regarding concepts
Preparation and Applications of Nanomaterial for Drug Delivery
Hafiz Reply
Application of nanotechnology in medicine
what is variations in raman spectra for nanomaterials
Jyoti Reply
I only see partial conversation and what's the question here!
Crow Reply
what about nanotechnology for water purification
RAW Reply
please someone correct me if I'm wrong but I think one can use nanoparticles, specially silver nanoparticles for water treatment.
yes that's correct
I think
Nasa has use it in the 60's, copper as water purification in the moon travel.
nanocopper obvius
what is the stm
Brian Reply
is there industrial application of fullrenes. What is the method to prepare fullrene on large scale.?
industrial application...? mmm I think on the medical side as drug carrier, but you should go deeper on your research, I may be wrong
How we are making nano material?
what is a peer
What is meant by 'nano scale'?
What is STMs full form?
scanning tunneling microscope
how nano science is used for hydrophobicity
Do u think that Graphene and Fullrene fiber can be used to make Air Plane body structure the lightest and strongest. Rafiq
what is differents between GO and RGO?
what is simplest way to understand the applications of nano robots used to detect the cancer affected cell of human body.? How this robot is carried to required site of body cell.? what will be the carrier material and how can be detected that correct delivery of drug is done Rafiq
analytical skills graphene is prepared to kill any type viruses .
Any one who tell me about Preparation and application of Nanomaterial for drug Delivery
what is Nano technology ?
Bob Reply
write examples of Nano molecule?
The nanotechnology is as new science, to scale nanometric
nanotechnology is the study, desing, synthesis, manipulation and application of materials and functional systems through control of matter at nanoscale
Is there any normative that regulates the use of silver nanoparticles?
Damian Reply
what king of growth are you checking .?
What fields keep nano created devices from performing or assimulating ? Magnetic fields ? Are do they assimilate ?
Stoney Reply
why we need to study biomolecules, molecular biology in nanotechnology?
Adin Reply
yes I'm doing my masters in nanotechnology, we are being studying all these domains as well..
what school?
biomolecules are e building blocks of every organics and inorganic materials.
how did you get the value of 2000N.What calculations are needed to arrive at it
Smarajit Reply
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Equilibrium price is a stable price and it must stay.discuss
Elvis Reply
Card 14 / 21: What are the similarities between a consumer’s budget constraint and society’s production possibilities frontier, not just graphically but analytically?
Ali Reply

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Source:  OpenStax, Principles of macroeconomics for ap® courses. OpenStax CNX. Aug 24, 2015 Download for free at http://legacy.cnx.org/content/col11864/1.2
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