1. Substitution Effect,
Income Effect
&
Price Effect

2. Substitution Effect (S.E.)
• Definition: It refers to the change in quantity demanded
for a good caused by a change in relative price, holding
real income constant.

3. Substitution Effect (S.E.)
• Definition: It refers to the change in quantity demanded
for a good caused by a change in relative price, holding
real income constant.
Qy
Px
Qx
0
Qx0
Qx1
Qx

4. Substitution Effect (S.E.)
• Definition: It refers to the change in quantity demanded
for a good caused by a change in relative price, holding
real income constant.
Qy
Px
Qx
0
Qx1
Qx0
Qx

5. Substitution Effect (S.E.)
Px
Qx
Px
Qx

6. Income Effect (I.E.)
• Definition: It refers to the change in quantity demanded
for a good caused by a change in real income, holding
relative price constant.

7. Income Effect (I.E.)
• Definition: It refers to the change in quantity demanded
for a good caused by a change in real income, holding
relative price constant.
Qy
I
Qx
0
Qx0 Qx1
Qx

8. Income Effect (I.E.)
• Definition: It refers to the change in quantity demanded
for a good caused by a change in real income, holding
relative price constant.
Qy
I
Qx
0
Qx1 Qx0
Qx

9. Income Effect (I.E.)
I
Qx
I
Qx
Normal Goods !!

10. Income Effect (I.E.)
I
Qx
I
Qx
Normal Goods !!

11. Income Effect (I.E.)
Inferior
Good
Normal Good
Qy
I
Qy
Qx
I
0
0
Qx0 Qx1
Qx
Qx1 Qx0
Qx
Qx

12. Income Effect (I.E.)
Inferior
Good
Normal Good
Qy
I
Qy
Qx
I
0
0
Qx1 Qx0
Qx
Qx0 Qx1
Qx
Qx

13. Income Effect (I.E.)
• Inferior Good:
I
Qx
I
• Normal Good:
Qx
I
Qx
I
Qx

14. Price Effect (P.E.)
• Definition: It refers to the change in quantity demanded
for a good caused by a change in relative price.

15. Price Effect (P.E.)
• Definition: It refers to the change in quantity demanded
for a good caused by a change in relative price.
Qy
Px
Qx
0
Qx0
Qx1
Qx

16. Price Effect (P.E.)
• Definition: It refers to the change in quantity demanded
for a good caused by a change in relative price.
Qy
Px
Qx
0
Qx1
Qx0
Qx

17. Relative price changes
(S.E.)
When price changes
(P.E.)
Real income changes
(I.E.)
P.E. = S.E. + I.E.

18. Relative price changes
(S.E.)
When price changes
(P.E.)
Real income changes
(I.E.)
P.E. = S.E. + I.E.

19. S.E.
P.E.
I.E.
-ve
Px ↓
Px ↑
Qx ↑
Qx ↓
I↓
I↑
Qx ↓
Qx ↑
inferior gd I ↓
-ve
I↑
Qx ↑
Qx ↓
normal gd
+ve

20. Case 1
Qx ↑
S.E. : Px ↓ Qx ↑
normal gd : I ↑ Qx ↑
+ve
P.E.
Assume Px ↓
I.E.
inferior gd : I ↑ Qx ↓
-ve

21. S.E. : Px ↓ Qx ↑
P.E.
normal gd : I ↑ Qx ↑
+ve
Px ↓
I.E.
inferior gd : I ↑ Qx ↓
-ve
Qx ?

22. S.E.
Px ↓ Qx ↑
S.E. > I.E.
I.E.
S.E. < I.E.
inferior gd
I ↑ Qx ↓
Qx ↑
Qx ↓
Case 2
Case 3

23. Summary
-ve S.E. & +ve I.E.
Qx ↑ & Qx ↑
Px ↓
-ve S.E. > -ve I.E.
Qx ↑ > Qx ↓
-ve S.E. < -ve I.E.
Qx ↑ < Qx ↓
Case 1
Qx ↑
normal gd
Case 2
Qx ↑
inferior gd
non-giffen case
Qx ↓
Case 3
inferior gd
giffen case

24. Graphically
Case 1 Normal good
Qy
S.E. Qx ↑
-ve
Px ↓
I.E. Qx ↑
+ve
0
Qx0
Qx0’ Qx1
Qx
Qx ↑

25. Graphically
Case 1 Normal good
Qy
S.E. Qx ↑
-ve
Px ↓
I.E. Qx ↑
+ve
0
Qx0 Qx0’
Qx1
Qx
Qx ↑

26. Graphically
Case 2
Inferior good, non-giffen case
Qy
S.E. Qx ↑
Px ↓
-ve
S.E.>I.E.
I.E. Qx ↓
-ve
0
Qx0 Qx1 Qx0’
Qx
Qx ↑

27. Graphically
Case 2
Inferior good, non-giffen case
Qy
S.E. Qx ↑
Px ↓
-ve
S.E.>I.E.
I.E. Qx ↓
-ve
0
Qx0 Qx1 Qx0’
Qx
Qx ↑

28. Graphically
Case 3
Inferior good, giffen case
Qy
S.E. Qx ↑
-ve
Px ↓
S.E.<I.E.
I.E. Qx ↓
-ve
0
Qx1 Qx0
Qx0’
Qx
Qx ↓

29. Graphically
Case 3
Inferior good, giffen case
Qy
S.E. Qx ↑
-ve
Px ↓
S.E.<I.E.
I.E. Qx ↓
-ve
0
Qx1 Qx0
Qx0’
Qx
Qx ↓