Effect of Change in in Commodity Price on Consumer's Equilibrium Consumer's equilibrium is,affected by changéin his income, change inthe price of substitutes and change in the pie of googconsumed, The effect of changes in consumer’s jmcome, the price of substitutes or the price of the good consumed on consumer’s equilibrium are known as (i) Income effect (ii) Substitution effect and (iii) Price effect, respectively. Income Effect: The income effect may be defined as the effect on the purchases of the consumer or consumer’s equilibrium caused by changes in his income if relative prices remain constant. (2) Substitution Effect:The substitution effect may be defined as the effect on the purchases of the consumer or consumer's equilibrium caused by changes in relative prices ifreal income remains constant. § 95% “Wee ice Effect: The price effect may be defined as the effect on the purchases of the consumer or consumer’s equilibrium caused by the change in the price of any one of the two goods if the price of the other good and the income of the consumer remain constant. come Effect, [The income effect may be defined as the effect orrthe purchases of the consumer or consumer’s equilibrium caused by change in his income, if relative prices remain constant. income effect can be studied under the following two types goods, )Figure 23 2 Substitution Effect Jy this prices oby doldias! soot yc thou.g, * (the substitution effect may be defined as the change in the purchases of ie er or consumer's equilibrium caused by changes in relative prices ne remains constant If change in the relative prices of the goods is followed by chaage. peibe monetary income of the consumer in such a way that his real incom: mains i Pastant, then the consumer will substitute cheaper good for the deatér\good.-¢. sequently, it will affect the quantity purchased of both the goods. This effect is knownas 4 — In the words of Ferguson} “Substitution effect refers to change in the amount of the goods purchased due to change in their relative prices se alenie, while realincomeFC he a Usfuch RUC oF Rasen " c3pricg effect -~ ¢ 2S an Aa oer A ad Price of et ght tow wee whee the Price effect may be defined as the change in the consumption of goods «‘ the ine’ Price of either of the two goods changes while the price ofthe other good and | ea ebas. B) < pa temir Wrpirg: 26! ect.. fe \ M7. Separation of Substitution Effect and Income Effect ag foe oe (We know that when the price of a commodity changes, it has two effects:) (There isa change in the real“income of the ténsunier leading to change in the consumption of the consumer. It is called income effect, (2) Secondly, due to change in relative price, the Sine: substitutes relatively cl good for relatively expensive good) Ut is Called ut ffect, fries mee efted ‘he combination of this income and substitution effect is calledwer" ic; L Price Effect= Income Effect + Substitution wa | fo qhere are two different approaches relating to the separation of substitution effect A geome effect given the price effect. These are: ant {@) Hicksian Approach, and (b) Slutsky’s Approachncn = _ "SQ (Price Etlect) = TQ (Substitution ewe ™ Separation of Substitution Effect and * incolae Effect in case of & Normal Good for a Price Fall: ; itcan be explained-as under with the help of Fig. 28. he separation of substitution Fig, 28 explains effect and income effect, as contem- plated by LR. Hicks. AB is the original budget-line and IC, is in Ql MME T MH sprees Zapposing the onginal indifference curve. Consumer fapples falls while Subsugen stag < pe Prostret #0 “0745 equilibrum at point E, When price o! the price of oranges and the income of the consumer remains constant then the new budget-line shifts from AB to AC, he new budget-line touches higher indifference carve IC, at point E, which is the new equilibrium of the consumer. Moveme: from equilibrium point E to new equilibrium point E signifies the effect of changes the price of apples a terms of the consumption of apples, price effect is equal to MT as difference betwee’ OT and OM. Fall in the price of apples means increase in the inco: = of the consumer. If the monetary income of the consumer is reduced to such that he remains on his original indifference curve IC or that his real income remail as before, in that case, new budget line will be PH and new equilibrium point Ep.serene Curve Analysis or see (1) Substitution Effect is represented by the movement from original equilibrium je 10 By both points being situated on the same indifference curve {a) Income Effect is represented by the NT. Sire main reason for buying. the combination indicated by Eis that despite the real the consumer being constant he substitutes relatively cheaper apples for searer oranges, Thus movement from equilibrium point B to new equilibrium ects the effect ofa change in the price ofapplesin relation tothe price oforanges, pint poi fect on the demand for apples is equal to MN which is called substitution effect. inother words due to fall in the price of apples when a consumer buys more units of called price effect. In Fig, 28 above, consumer buys MT more units of apples. buys MN units more on account of substitution effect and NT units more on come effect. It means, with regard to demand for apples: Price Effect is from OM to OT =MT Substitution Effect is from OM to ON = MN Income Effect is from MN toMT = NT ‘Thus, MT (Price effect) = MN (Substitution effect) + NT (Income effect). Itis due to negative substitution effect that the change in demand is opposite to the ie in price. If the price falls, the demand for the good due to the substitution effect ‘creases. On the other hand, if the price rises the demand for the good due to the jubstitution effect decreases. Note: Income effect is reflected as a movement from one IC to the other which is consonance with change in income, relative prices remaining constant. 8. Giffen's Paradox Based on his personal observations on the behaviour of price of wheat and quantity, 1anded of bread by low paid British wage earners early in the nineteenth century, Sir Giffen discovered an important exception to the law of demand that came to be ristened as Giffen paradox.(It states that in case of inferior good which is an sportant food item of the poor people and on which a large percentage of household come la speni/(auch as bread in England in 19th century and bajra in the desert at of Rajasthan in the present days{ )Ancom¢ ofa price change is negative (ti) negative income effect is stronger than the substitution effect so that the law, demand does not hold good. Such goods are called as Giffen gooda)fin other words O7" goods are those goods where a fallin the price of the good causes a fall in its atz4| Demand for such goods tends to increase when their price increases and decrease petite the decrease in their pric€JNote that Giflens’ paradox is not'a simple case of “iat #ods, showing negative income effector in the case of which quantity demanded 's¢s following increase in the inconie of the consumer; Rather, this is a special case ‘lot goods with the two characteristics noted above. It is the inferior goods with racteristics that are called Giffen Goods. |ze @! // Note: Giffen’s paradox points to the failure of law of demand. I femand curve tends to slope upwards implying greater purchase at a higher price q, lower purchase at a lower price. 8.1 Income and Substitution Effects in case of Giffen Goods. rs i goods- normal goods infer, ubstitution effect is alwnys negative in ease ofall goods- norm sd Ki : ‘implies that, more of X TUst be coud Fa ten andGeynne saon ect imple {We have already noted that in the case of inferior goods, income effect. is negative Negative income effect implica that quantity demanded of a commodity is reduced when towing fallin the price ofthe commodity, rea incomeof the consumer rises. Increased rea ame Tnduces te consumer to shift onto the consumption of superior substitutes Go However, whilelincome effect ig negative in, the case of inferior goods it need not necessarily be sronger than the substitution effect/2o that the net effect or price effect {Substitution effect = Income effect) continues tobe dominated by substitution effect. In fucha case the lav ofdemand is not violated Itcontinues to hold good, despite the fact that income effect is negative aw) ce * However inte case of life Goods; < )g “Jah icome elect is negative and : ; (b) Negative income effet is stronger than the substitution effect —Roikie inf reVetiect (Substitution effect - Income effect) is dominated by negative income effec which implies positive relationship between price of the commodity and its quantity demanded Ie is only when the net effect is dominated by negative income effect (-ve income income effectis stronger than substitution effect thatthe law of demand breaks down. Thy separation of subsitution effect and income effect in ease of Giffen goods is explained a follows: Fig. 29 shows the status of substitution effect and income effect in case of Giffen Goods. 7 In Fig. 29, Q, is the point of initial equilibrium he» * where the consumer demands OL units of commodity X A which is a Giffen’s goods. Assuming that price of picommodity-X falls, budget line, ‘AB’ stretches to the right to become ‘AC’, Q, indicates the new equilibrium »,, Point of the consumer. We know switching from Q, toQ, * is the net effect of substitution effect and income effect. (> “By drawinga lineTT parallel to ACand tangent to Cy, (ato point Q,) we find out the Substitution effect = LR.wl 99 ora gatition El (RL) RK) = (KL) | rece Elect Net effect dominated by negative income effect implies that in response to the refuced price of commodity-X the quanity demanded of commodity-X also reduces from OL, to OK. This is what Giffen Paradox means. In short, a price reduction for a Giffen goods nolves a substitution effect that encourages more consumption but an income effect that pot only works in the opposite direction (less consumption) but is also larger than the substitution effect, Consequently the total effect of price reduction is fall in demand. The Jemand curve Will have positive slope. Note: Even in the case of Giffen goods, substitution effect reflects greater hase of the commodity which is relatively cheaper. But income effect tends tobe strongly negative that it oversadows the substitution effect. Hence only less is urchased even if price of the commodity happens to reduce. VR y es ai 9, Difference Between Inferior Goods and Giffen-Goods ne =! (1 Giffen Goods: Giffen goods are those inferior goods on which alarge peFeentage Of ene In the case of which Se pe whe Taeéme effect is negative. So that when real income of the consumer inefeases, (/ owing to fallin the price of Giffen good-X, less of the commodity is demanded. {il_Negative income effect mist be stronger than the substitution elec, So that the net effect or price effect is alwaya positive implying a tise in quantity demanded of X in response to rise in the price of X. (iiL_the law of demand does not apply in case of Giffen goods. lilsfetier Good: inferior reds oer than ifn gpode are those godin the cave ic () Income effect is negative «°* oi =! (i) Negative income effect is lve stronger than negative substitution fect, yo, 6. the price effect may be negative. vn — debe (i) Law 8 ‘of demand applies KI J