We have reached a point in chapter 2 which most students find a hard time understanding but the only reason for this is all the technical terms and jargon used in the notes and textbooks. So let’s go through some of these terms first, shall we?
The 2 terms which are the more confusing ones are in the title of this post itself. What is the substitution and income effects? Believe it or not, assuming that you maximize the utility of your money income and buy a set of 2 goods, you make a decision to change the quantity of your purchase in 2 steps.
Assuming you live on bread and cabbage; and the price of bread has fallen. You now have to make a new choice as to how much bread and cabbage you will buy. You now notice that bread is relatively cheaper than cabbage. How much cabbage will you SUBSTITUTE to buy more bread? The keyword here is substitute, which implies that you have not bothered about the change in your real income YET.
This brings us to the Hicksian definition of real income. As you can see from the word SUBSTITUTE, it should remind you of a certain MARGINAL RATE OF SUBSTITUTION, ie. the slope of the indifference curve. So that’s a little hint of what to take note when you watch the video.
So you have successfully experienced the substitution effect, which is a consumer’s reaction to a relative price change. We now go on to the income effect.
Since the price of Bread has decrease, you will be able to buy more bread and thus, your real income has increased. Would you be enticed to buy more goods? A rational being would. So the income effect captures what happens to the consumer’s decision due to a change in real income.
At the end of the video, you should be able to:
Some important notes: