Substitution and income effects decompose price changes into relative price shifts and purchasing power shifts.
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Reference material from consumer choice economic theory establishes that price changes can be decomposed into an income effect and a substitution effect.
Every price change can be decomposed into an income effect and a substitution effect; the price effect is the sum of substitution and income effects. The
The theory of consumer choice is the branch of microeconomics that relates preferences to consumption expenditures and to consumer demand curves. It analyzes how consumers maximize the desirability of their consumption (as measured by their preferences subject to limitations on their expenditures), by maximizing utility subject to a consumer budget constraint.
Factors influencing consumers' evalua
Every price change can be decomposed into an income effect and a substitution effect; the price effect is the sum of substitution and income effects.
The substitution effect is the change in demands resulting from a price change that alters the slope of the budget constraint but leaves the consumer on the same indifference curve. In other words, it illustrates the consumer's new consumption basket after the price change while being compensated as to allow the consumer to be as satisfied as he or she was previously. By this effect, the consumer is posited to substitute toward the good that becomes comparatively less expensive. In the illustration below this corresponds to an imaginary budget constraint denoted SC being tangent to the indifference curve I1. Then the income effect from the rise in purchasing power from a price fall reinforces the substitution effect. If the good is an inferior good, then the income effect will offset in some degree the substitution effect. If the income effect for an inferior good is sufficiently strong, the consumer will buy less of the good when it becomes less expensive. This is also known as a Giffen good (commonly believed to be a rarity).
The substitution effect,
Δ
y
1
s
{\displaystyle \Delta y_{1}^{s}}
, is the change in the amount demanded for
Y
{\displaystyle \ Y}
when the price of good
Y
{\displaystyle \ Y}
falls from
p
1
{\displaystyle \ p_{1}}
to
p
1
′
{\displaystyle \ p_{1}'}
(represented by the budget constraint shifting from
B
C
1
{\displaystyle BC1}
to
B
C
2
{\displaystyle BC2}
and thus increasing purchasing power) and, at the same…
The…