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Consumer optimisation, income and substitution effects
Published on July 31, 2019 18 min
Other Talks in the Series: Introduction to Microeconomics
Hi. I'm Dr. Sangaralingam Ramesh. Welcome to this Henry Stewart talk series Introduction of microeconomics talk Number 8. In this talk, we'll be looking at consumer optimization, income and substitution effects varying with the nature of the type of good. So in this talk, we'll actually be putting together many of the other things that we've learned in previous talks, where we've looked at the consumption optimization behavior, we've looked at income and substitution effects and we've also looked at the different types of goods.
So in the context of consumer optimization. Firstly, we need to consider the effect of the change in the price of the good and in this case, this can be analyzed using the diagram in the slide where we have the price of good X on the vertical y-axis and the quantity of good X on the horizontal x-axis. In this case, we see that the price of a good falls from P1 to P2 and as a result the quantity demanded increases from Q1 to Q2. As a result, there is a movement along the demand curve from point a to point B and this is the price effect. As we saw in one of the previous talks, the price effect is equal to the income effect plus the substitution effect, and the impact of the price change will have different consequences for the income effect and the substitution effect which means, that for different types of goods, the price effect will be different for a change in the price of a good.
So we've looked at the income effect on the substitution effect, but we can summarize these effects here again. So in case of an income effect, a change in the quantity demanded will result from a change in consumers real income, where real income is equal to nominal income divided by price. In this case, nominal income represents the wages paid by firms to workers and we assume that it remains unchanged. So this means that if the price of a good changes, the consumers real income which is equal to nominal income divided by price rules are changed and as a result, there is a change in the consumer's purchasing power. In other words, for a given level of nominal income, the consumer can either buy more or less depending on whether the price of the good that has either increased or decreased. The second effect is the substitution effect, which simply means the change in the relative price of the good in question, in contrast to the price of alternate goods which we assumed to be unchanged. So in this case, the price effect is simply equal to the income effect plus the substitution effect and as we've seen, the income effect on the substitution effect can work in opposite directions or can support each other, but this depends on the specific type of good.