In economic theory , and in particular in the theory of consumer choice , the “ substitution effect ” is one of the types of influence of changes in the price of a product on the amount of demand for this product from the consumer. The second of these phenomena is called the income effect .
If we make the assumption that the consumer set is unchanged, then a decrease in the price of a product leads to the release of a part of the income that can be used to consume more of each product in this consumer basket. As a result, a new consumer set compared to the previous one would reflect the effect of a change in the relative prices of two goods (a unit of one product can now be exchanged for another quantity of the second product, since the ratio of their prices has changed), as well as the effect of the released income. The effect of relative price changes is called the substitution effect , while the effect of the release of income is called the income effect .
If the income changes depending on the price change in such a way that the new budget line passes through the original consumer set, but the angle of inclination is determined on the basis of new prices, and the optimal consumer choice lies on the budget line, then the resulting change in consumption is name of the Slutsky substitution effect . It describes changes in consumer choice when a consumer has enough income necessary for him to purchase an initial (or initial) set of goods at current (new, unlike previous) prices.
However, if the slope of the new budget line is formed on the basis of new (current) prices, while the tangent to the indifference curve passes through the initial set of consumers, then the difference between the new point of contact and the original set of products describes the Hicks substitution effect . It represents a change in consumer choice, when the consumer has enough income necessary to achieve his initial level of utility at current prices.
The same effects explain situations when the price of a product, instead of falling, rises, while the substitution effect reflects a change in relative prices, while the income effect reflects a situation where income is used to consume a constant supported set of more expensive goods.
Content
Definition
According to K.R. McConnell and S.L. I’ll substitute the substitution effect - 1) the effect of a change in the price of a product exerted on its relative high cost and on its quantity, which the consumer will acquire at a constant income; 2) the impact when changing the price of a resource, exerted on its quantity, which the company uses with a constant volume of its production [1] .
Due to the limited budget of the economic entity, this means that a cheaper product replaces a certain amount of consumption of the product that has not changed in price. If a drop in the price of one of the products entails an increase in the consumption of both products, we are talking about the effect of income .
Example
Someone eats meat and fish . After a fall in the price of meat, he decides that by sacrificing a certain amount of fish, he can buy himself relatively more meat. As a result, fish consumption is reduced, and meat consumption is increasing in excess of the proportion of the price decrease.
Graphical Analysis
Suppose that the initial situation is set by a graph (with product Y shown on the horizontal axis) with an (unchanged) indifference curve and budget constraint BC1, as well as a consumer choice at point A, since it is it that brings it to the highest level of indifference curve corresponding to BC1. The budget constraint is based on the income of the consumer and the prices of two goods X and Y. If the price of goods Y falls, the budget line shifts to BC2, which implies a larger quantity of goods Y, since if all income were used to consume goods Y, then it can be It was purchased in large quantities at a relatively low price. The cumulative effect of price changes is that the consumer now selects the consumer set at point C.
But the transition from A to C can be explained from two sides. The substitution effect is the change that occurs when the fighter retains the original indifference curve (shift from A to B). The income effect is a simultaneous transition from B to C, which occurs due to the fact that the lower price of one product actually allows you to move to a higher indifference curve. (In this graph, Y is of little value)
See also
- Slutsky equation
- Misconception about the "constant amount of work"