Introduction
In the indifference curve analysis of demand, the response of quantity demanded of a commodity to a change in its own price is analysed in terms of three closely related concepts: price effect, substitution effect and income effect. T.R. Jain and V.K. Ohri treat these as the core of the modern theory of demand for B.Com (Semester I), Panjab University. In this question we concentrate on price effect and substitution effect, explaining their meaning, measurement and graphical representation.
Broadly, price effect refers to the total change in quantity demanded due to a change in the price of the commodity, while substitution effect reflects that part of the change in quantity which is caused purely by the change in relative price, keeping the consumer’s real income (or level of satisfaction) constant.
1. Meaning of Price Effect
When the price of a good changes, ceteris paribus (other things like money income, prices of other goods and tastes remaining the same), the consumer will generally buy a different quantity of that good. The price effect is defined as:
The price effect is the total change in quantity demanded of a commodity resulting from a change in its own price, other things remaining the same. It is the movement from one equilibrium point to another on the indifference map when the budget line rotates due to a change in the commodity’s price.
Thus, when the price of X falls, the consumer’s budget line becomes flatter, allowing him to purchase more X with the same income. The consumer moves to a new equilibrium on a higher indifference curve. The resulting change in quantity of X is called the price effect of a fall in price.
Algebraic Expression (Informal)
If the initial equilibrium quantity of X is Q0 at price P0 and new equilibrium quantity is Q1 at price P1, then:
Price Effect (PE) = Q1 − Q0
When price falls and quantity demanded rises, the price effect is positive (for quantity). When price rises and quantity demanded falls, the price effect is negative.
Types of Price Effect (by Nature of the Good)
In terms of direction, price effect may be:
- Negative price effect: Price falls → quantity demanded rises (normal case).
- Positive price effect: Price falls → quantity demanded falls (Giffen case).
- Zero price effect: Price change → no change in quantity demanded (perfectly inelastic demand; rare theoretical case).
Diagram for Price Effect (Normal Good)
Consider a normal good X and a composite good Y (representing “all other goods”) on the vertical axis. In the following diagram, the consumer’s initial budget line is BL₁ and his equilibrium is at point E₁ on indifference curve IC₁. When the price of X falls, the budget line rotates outwards to BL₂, and the new equilibrium is at E₂ on a higher indifference curve IC₂. The movement from E₁ to E₂ represents the price effect of a fall in the price of X.
In the case of a normal good, a fall in price of X enables the consumer to reach a higher indifference curve and buy more of X, so the price effect is negative (price and quantity move in opposite directions).
2. Meaning of Substitution Effect
The substitution effect isolates that part of the price effect which is caused solely by the change in the relative price of the good, keeping the consumer’s real income or level of satisfaction constant.
The substitution effect of a change in the price of a good is the change in quantity demanded of that good when its price changes and the consumer’s real income or utility is kept constant, so that he remains on the same indifference curve and merely substitutes the relatively cheaper good for the relatively dearer one.
When the price of X falls, it becomes cheaper relative to Y. Even if the consumer were somehow compensated so that his level of satisfaction remained unchanged, he would still rearrange his consumption in favour of X and against Y, because X has become relatively cheaper. This tendency to substitute the cheaper good for the dearer one is called the substitution effect.
Key Features of Substitution Effect
- It is concerned with relative prices, not with absolute real income.
- The consumer is kept on the same indifference curve (same satisfaction level).
- For a fall in price of X, the substitution effect for X is always positive (more of X is demanded).
- For a rise in price of X, the substitution effect for X is always negative.
- In the Hicksian version (followed in standard textbooks), the consumer is compensated so that after the price change he can just reach his original indifference curve.
Diagram for Substitution Effect (Hicksian Approach)
The substitution effect is diagrammatically measured using a compensated budget line. Starting from the initial equilibrium E₁ on IC₁ with budget line BL₁, suppose the price of X falls. The new budget line is BL₂. To keep the consumer on the same indifference curve IC₁ (same satisfaction), income is reduced (if price falls) so that a new budget line BL* is drawn parallel to BL₂ but tangent to IC₁ at a new point E*. The movement from E₁ to E* along IC₁ represents the substitution effect.
In the diagram:
- E₁ is the initial equilibrium on IC₁ with budget line BL₁ (quantity Q₀ of X).
- After the fall in price of X and compensation of income, the consumer moves to E* on IC₁ with budget line BL* (quantity Q′ of X).
- The movement E₁ → E* (Q₀ to Q′) is the substitution effect.
- Without compensation, the actual new equilibrium is at E₂ on the higher IC₂ with BL₂ (quantity Q₁ of X).
Thus, the total price effect E₁ → E₂ (Q₀ to Q₁) is decomposed into a substitution effect (E₁ → E*) and an income effect (E* → E₂). Detailed discussion of income effect is usually taken up in the next question, but the basic relationship is important to mention here.
3. Relationship between Price Effect and Substitution Effect
Conceptually, the price effect of a change in the price of a commodity can be broken into two components:
Price Effect = Substitution Effect + Income Effect
For a fall in the price of a normal good X:
- Substitution effect is always positive for X (consumer buys more X because it is relatively cheaper).
- Income effect is also positive for a normal good (fall in price makes consumer effectively richer; he buys more X).
- Therefore, price effect is strongly positive (quantity demanded increases when price falls).
For an inferior good, substitution effect remains positive but income effect is negative. In extreme Giffen cases, negative income effect may outweigh the positive substitution effect, leading to a positive price effect (price falls, quantity demanded falls). This detailed classification is examined more sharply when studying income effect and Giffen goods.
4. Distinction between Price Effect and Substitution Effect
| Basis | Price Effect | Substitution Effect |
|---|---|---|
| Meaning | Total change in quantity demanded due to a change in the commodity’s own price, other things constant. | That part of the change in quantity demanded which is due solely to change in relative price, keeping real income/utility constant. |
| Income Position | Effective real income of the consumer changes (real purchasing power changes). | Consumer is kept on the same indifference curve; real income or utility is held constant by compensation. |
| Components | Includes both substitution effect and income effect. | Excludes income effect, isolates pure substitution response. |
| Sign | May be negative (normal), positive (Giffen) or zero. | Always negative for price and quantity of the same good (for a fall in price, demand for that good increases). |
| Graphical Representation | Movement from initial equilibrium to new equilibrium when price changes, along actual budget line. | Movement along original indifference curve from initial equilibrium to compensated equilibrium on BL* parallel to new budget line. |
| Role in Demand Theory | Explains the overall inverse or direct relation between price and quantity demanded. | Provides the basic negative slope of the demand curve; income effect only modifies its strength. |
5. Importance of Substitution Effect in Price–Demand Relationship
The substitution effect has a central role in modern demand theory:
Even if income effect were absent (for example, compensated demand), the substitution effect alone ensures that the individual demand curve slopes downwards. When price of X falls, X becomes cheaper relative to Y, and the consumer substitutes X for Y, increasing quantity of X demanded.
The sign and magnitude of income effect combined with the always negative substitution effect explains the behaviour of normal, inferior and Giffen goods. Thus, the decomposition of price effect into its components is crucial for classification of goods.
By considering only substitution effect (keeping utility constant), economists derive the compensated demand curve, which has important theoretical uses in welfare economics and analysis of consumer surplus.
Understanding how much of the response to a price change is due to substitution and how much to income helps in evaluating the welfare impact of taxes, subsidies and price controls. This is further developed in advanced microeconomics.
Conclusion
To conclude, the price effect measures the overall impact of a change in the price of a good on its quantity demanded, while the substitution effect isolates the pure effect of the change in relative price, holding the consumer’s utility constant. In the indifference curve framework, price effect is represented by the movement from one equilibrium point to another as the budget line rotates, whereas substitution effect is shown by movement along the same indifference curve from the initial equilibrium to a compensated equilibrium. This decomposition, as presented in your prescribed text by T.R. Jain & V.K. Ohri, provides a deeper understanding of the demand behaviour of consumers and lays the foundation for the analysis of income effect and Giffen goods in the subsequent questions.