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The Impact Of A Price Change Into Two Components

1789 words - 8 pages

Economists often separate the impact of a price change into two components, the substitution effect and the income effect. The substitution effect involves the substitution of good x1 for good x2 or vice-versa due to a change in relative prices of the two goods. The income effect results from an increase or decrease in the consumer’s real income or purchasing power as a result of the price change. The sums of these two effects are called the price effect.

Sir John Hicks (1904-1989) awarded the Nobel Laureate in Economics (with Kenneth J. Arrow) in 1972 for work on general equilibrium theory and welfare economics was the founder of the income compensated demand curve, we are going to look ...view middle of the document...

“what would the consumer’s optimal bundle be if s/he faced the new lower price for X1 but experienced no change in real income? “This amounts to returning the consumer to the original indifference curve (I1). The Hicksian demand function is downward sloping, but isolates the substitution effect by thinking the consumer is compensated enough to purchase some bundle on the same indifference curve. Hicksian demand illustrates the consumer's new consumption gap after the price change while being compensated as to allow the consumer to be as happy as previously (to stay at the same level of utility). If the Hicksian demand function is "steeper” the good is a normal good; otherwise, the good is inferior.

Figure

X2

Income Effect

Sub Effect

X1

I2

Eb

I1

Ec

Ea

xb

xc

xa

From figure two above, the new optimum price is On Eb on indiffrence curve two and the total price effect is at Xa and Xb, when a line is drawn parallel to the new budget line and tangent to the old indiffrence curve, the new optimum on indiffrence curve 1 isa at Ec. The movement from Ea to Ec shows(the increase in quantity demanded from Xa to Xc) which is soely in response to change in relative prices. Also.point Xa and Xc show the relative substitution effect.

To isolate the income effect, we look at the remainder of the tota price effect due to a change in real income, the increase in real income is evident from the movement of the indfrencce curve 1 to 2. To sumarise the hickian compensated demand curve, we have to note that these demand curves cannot be upward-sloping (i.e the substitution effect cannot be positive)

Marshallian price demand curve

Definition :The Marshallian demand curve shows the relationship between the price of a good and the quantity of that good purchased by an individual assuming that all other determinants of demand are held constant. Three factors are held constant when a demand curve is derived income; prices of other goods and the individual’s preferences, if any of these factors change, the demand curve will shift to a new position. The actual level of utility varies along the demand curve, as the price of x falls, the individual moves to higher indifference curves it is assumed that nominal income is held constant as the demand curve is derived this means that “real” income rises as the price of x falls. To understand this we have to first look at prices and consumer surplus.

A consumer surplus is the difference between what a consumer is willing to pay and what he has to pay. For example, if a consumer is willing to pay £2.40 for a packet of sugar and another consumer is willing to pay £2. The consumer who will have paid £2.40 for the sugar can be said to have obtained a consumer surplus of £0.40 .Compensating variation and equivalent variation show the welfare attained

Figure

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