Wednesday, March 30, 2011

Theory of Consumption - Indifference Curve Analysis - Substitution Effect

Meaning: When there is a change in the price of one commodity, and when the price of another commodity remains unchanged or constant, the income of the consumer must be changed in such a way that the consumer is neither better off nor worse off. He remains at the same old position. Under that circumstance, if there is a change in the consumption, that would be due to the Substitution Effect.

Equilibrium: We can find out the equilibrium position of the consumer in the following diagram.

In the above diagram AB is the original price or budget line. T is the original equilibrium position. There is a fall in the price of X. So the new budget line is AC. To put the consumer at the same old position we draw another budget or price line DE, which will meet the indifference curve at the point T1. So the movement from T to T1 on the indifference curve IC shows the substitution effect. Here the consumer substitutes n->n1 of Y to get m->m1 more of X because the price of X is now comparatively cheaper than the price of Y.

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