Question

As it relates to the law of demand, briefly describe the substitution effect. + B I v S IX E 5 E

Answer 1

The substitution effect in consumer theory refers to the change in the demand for a product when the price of the good changes in terms of the relative price of the good. The same has been explained with the help of the following graph.

UB - - - JE SE - - --- - - - - - - Net

The above graph shows the consumption of two goods X1 and X2.

The initial equilibrium is at point A where the Indifference curve UA is tangent to the budget line.

The Price of X1 falls, which implies that with the same income level, the consumer can buy more of X1. This rotates the budget line towards right on the X-axis.

The consumer equilibrium is at point B on the higher indifference curve UB.

The movement from point A to Point B involves both the substitution effect as well as the income.

A fall in income means that the consumer's purchasing power has increased. In order to measure the effect, we draw a hypothetical budget line passing through UA at point C. The movement from Point A to Point C is the substitution effect, which reflects the same price ratio as the new one (since this budget line is parallel to the new budget line). The movement from point C to point B is the income effect.