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MICROECONOMICS
| BREAKDOWN OF THE PRICE EFFECT |
| introduction |
In the section on the effect of price, we discussed how a consumer rearranges his optimal consumption mix to re-maximize the utility of his disposable income in response to a change in the price of a good. We also looked at consumer reactions to a price change for different types of goods.
| learning goals | |
| After reading this chapter, you should learn the following: I understand 1. 2. | |
| | 1. Importance of price effect decomposition |
The price effect is viewed as a combination of income and substitution effects. The replacement effect always works in one direction. A consumer is always enticed to buy more units of a cheaper good. On the other hand, the income effect can be positive, negative, or zero for normal, inferior (including Giffen goods), or neutral goods. See Graph 1 in the Income Effect section.
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Therefore, as the end result of the substitution and income effects, the price effect depends on their relative direction and magnitude. This is summarized in Diagram 1.
The substitution and income effects work in the same direction when good X is a normal good. The final price effect is then positive. The consumer tends to increase consumption of good X as the price falls.
If good X is an inferior good, substitution and income effects work in opposite directions. If the price of good X (Px) decreases, the consumer tends to increase the consumption of good X as a result of the substitution effect. However, the income effect is negative here. The price effect then depends on the relative magnitude of the two effects. The ultimate price effect is positive for inferior goods because the variation in consumption of good X is larger than the income effect due to the substitution effect.
If good X is a Giffen good, substitution and income effects also work in opposite directions. If the price of good X (Px) decreases, the consumer tends to increase the consumption of good X as a result of the substitution effect. However, the income effect is negative here. Furthermore, the magnitude of the change in units of good X is smaller than the income effect due to the substitution effect. The bottom line is that the price effect is negative.
Let us now examine the decomposition of the price effect into income and substitution effects using indifference curves.
| | 2. Price Effect Decomposition: Common Commodities |
We use the compensatory variant of the monetary income method to decompose the price effect into income and substitution effects. This is shown in Figure 1. It begins with the initial optimum consumption combination achieved at point and
If the price of good X falls, the consumer will buy X1Units of good X in the optimal combination of consumption and1about the budget constraint PL1and a higher indifference curve U1🇧🇷 The price-consumption curve (PCC) is obtained by connecting the dots and and and1Go up.
This price effect can be broken down into substitution and income effects. This is done using the method of offsetting changes in income from consumer funds. Suppose we reduce the consumer's monetary income in the optimal combination of consumption and1by the amount just enough to bring it back to the initial indifference curve U. This results in a downward shift in the budget constraint, as shown by the budget constraint AB, which runs parallel to the budget constraint PL1🇧🇷 Good X is relatively cheaper in budget constraint AB than in budget constraint PL. and2is the optimal consumption mix at which the consumer buys OX2Units of good X. Shows the consumer's preference for the cheaper good X even after reducing his monetary income.
Suppose the consumer recovers the cash income that was reduced by the compensating change in his cash income. The consumer then switches to the optimum combination of consumption and1🇧🇷 Such is the movement of2toe1represents the income effect. The income effect is positive here because good X is a normal good.
Thus, the price effect is the sum of the substitution effect and the income effect. Consumer movement from the optimal consumption combination and back and forth1, due to the price effect, can be broken down into two effects. Firstly, the substitution effect, i.e. the back and forth movement of the consumer2and then the income effect, that is, the movement of the consumer from the optimal combination of consumption and2toe1🇧🇷 This way,
Price Effect = Substitution Effect + Income Effect
Regarding the optimal consumption mix:
and to and1= and to and2+e2e1
Regarding the purchased units of good X:
XX1= XX2+X2x1
As shown in chart 1, the substitution and income effects work in the same direction. Good X becomes relatively cheaper when its price falls and consumers tend to increase their consumption. The income effect is also positive. The consumer tends to increase consumption of the good because it is a normal good. This shows the ascending income-consumption curve (ICC). So the final price effect is positive. Finally, the consumer tends to increase consumption of good X from OX to OX1with falling price (px).
| | 3. Decomposition of the price effect: inferior goods |
The decomposition of the price effect into substitution and income effects for an inferior good is shown in Figure 2, where good X is an inferior good. It begins with the initial optimum consumption combination achieved at point and
If the price of good X falls, the consumer will buy X1Units of good X in the optimal combination of consumption and1about the budget constraint PL1and a higher indifference curve U1🇧🇷 The price-consumption curve (PCC) is obtained by connecting the dots and and and1Go up. Shows positive price effect. If the price of good X falls, the consumer increases consumption of good X from OX to OX1.
As in Section 2, this price effect can be broken down into substitution and income effects using the method of offsetting consumers' monetary income changes. Suppose we reduce the consumer's monetary income at the optimal consumption mix point and1by the amount just enough to bring it back to the initial indifference curve U. This results in a downward shift in the budget constraint, as shown by the budget constraint AB, which runs parallel to the budget constraint PL1🇧🇷 Good X is relatively cheaper in budget constraint AB than in budget constraint PL. and2is the optimal consumption mix at which the consumer buys OX2Units of good X. Shows the consumer's preference for the cheaper good X even after reducing his monetary income.
Suppose the consumer recovers the cash income that was reduced by the compensating change in his cash income. The consumer then switches to the optimum combination of consumption and1🇧🇷 Such is the movement of2toe1represents the income effect. The income effect is negative here because good X is an inferior good.
Thus, the price effect is the sum of the substitution effect and the income effect. Consumer movement from the optimal consumption combination and back and forth1, due to the price effect, can be broken down into two effects. Firstly, the substitution effect, i.e. the back and forth movement of the consumer2and then the income effect, that is, the movement of the consumer from the optimal combination of consumption and2toe1🇧🇷 This way,
Price Effect = Substitution Effect + Income Effect
Regarding the optimal consumption mix:
and to and1= and to and2+e2e1
Regarding the purchased units of good X:
XX1= XX2+X2x1
As shown in chart 1, the substitution and income effects work in opposite directions. Good X becomes relatively cheaper when its price falls and consumers tend to increase their consumption. However, the income effect is negative. The consumer tends to reduce consumption of good X because it is an inferior good. This shows the income-consumption curve (ICC) which is rising but curved backwards. However, the final price effect is positive because the magnitude of the substitution effect is larger than the income effect. Finally, the consumer tends to increase consumption of good X from OX to OX1with falling price (px).
| | 4. Price Effect Decomposition: Giffen Goods |
The decomposition of the price effect into substitution and income effects for a Giffen good is shown in Figure 3, where good X is a Giffen good. It begins with the initial optimum consumption combination achieved at point and
If the price of good X falls, the consumer will buy X1Units of good X in the optimal combination of consumption and1about the budget constraint PL1and a higher indifference curve U1🇧🇷 The price-consumption curve (PCC) is obtained by connecting the dots and and and1rises but curves back to the Y-axis Shows negative price effect. If the price of good X falls, the consumer also reduces consumption of good X from OX to OX1.
As above, this price effect can be broken down into substitution and income effects using the method of compensatory changes in consumers' monetary income. Suppose we reduce the consumer's monetary income at the optimal consumption mix point and1by the amount just enough to bring it back to the initial indifference curve U. This results in a downward shift in the budget constraint, as shown by the budget constraint AB, which runs parallel to the budget constraint PL1🇧🇷 Good X is relatively cheaper in budget constraint AB than in budget constraint PL. and2is the optimal consumption mix at which the consumer buys OX2Units of good X. Shows the consumer's preference for the cheaper good X even after reducing his monetary income.
Suppose the consumer recovers the cash income that was reduced by the compensating change in his cash income. The consumer then switches to the optimum combination of consumption and1🇧🇷 Such is the movement of2toe1represents the income effect. The income effect is negative here because good X is a Giffen good.
Thus, the price effect is the sum of the substitution effect and the income effect. Consumer movement from the optimal consumption combination and back and forth1, due to the price effect, can be broken down into two effects. Firstly, the substitution effect, i.e. the back and forth movement of the consumer2and then the income effect, that is, the movement of the consumer from the optimal combination of consumption and2toe1🇧🇷 This way,
Price Effect = Substitution Effect + Income Effect
Regarding the optimal consumption mix:
and to and1= and to and2+e2e1
Regarding the purchased units of good X:
XX1= XX2+X2x1
As shown in chart 1, the substitution and income effects work in opposite directions. Good X becomes relatively cheaper when its price falls and consumers tend to increase their consumption. However, the income effect is negative. The consumer tends to reduce consumption of good X because it is an inferior good. This shows the income-consumption curve (ICC) which is rising but curved backwards. The final price effect is also negative because the magnitude of the substitution effect is smaller than the magnitude of the income effect. Finally, the consumer tends to reduce the consumption of good X from OX to OX1with falling price (px).