INCOME EFFECT & SUBSTITUTION EFFECT Fall in prices of consumer goods has two effects. 1. Income Effect 2.

Substitution Effect INCOME EFFECT When prices fall, consumers enjoy an increased purchasing power; since they can buy the same amount of product with less money and thus have money left over for additional purchases. This is called the income effect of variation of prices. SUBSTITUTION EFFECT Again with the fall in prices people usually opt for goods that have become cheaper and give lesser preference to those products which are still expensive. This increase in consumption of a particular good (when level of utility is held constant) is called the substitution effect of variation of prices. Here it should be kept in mind that income effect and substitution effect occur simultaneously with the variation of prices. These two effects can be understood from the following illustrations:

Normal Goods
Suppose the initial budget line is RS and there are two goods food and clothing; the consumer maximizes utility by choosing the market basket at A, thereby obtaining the level of utility associated with the indifference curve U1.The consumer is initially at A on budget line RS. When food price falls, then the budget line rotates outward and RT is the new budget line. The consumer now chooses the market basket at B on indifference curve U2 though the option of choosing A is available. Thus reduction in price allows the consumer to increase in his utility level as his purchasing power increases and hence resulting in an increase in food consumption. This rise is represented by F1F2 in the figure given below. Here the increase in consumption of food (i.e F1F2) has two parts, one is F1E (due to substitution effect) and the other is EF2 (due to income effect). The substitution effect can be found out by drawing a line parallel with RT and tangential to the indifference curve U1 (since substitution effect is determined by keeping the utility level constant). The new budget line touches the indifference curve U1 at D. So the consumer under the new circumstances will choose the market basket D provided the utility levels are kept constant. At this point the consumer consumes OE units of food which is F1E more than the initial consumption.

The income effect can be realized from the fact that the fall in food price has resulted in an increase in utility level (i.e new utility level is U2) and thus the consumer has a preferential option of choosing market basket B ahead of A. So EF2 unit of food is consumed in excess because of income effect.

Inferior Goods
The effect of a decrease in the price of food is again broken down into a substitution effect FIE and an income effect EF2. In this case, food is an inferior good, because the income effect is negative. However, the substitution effect exceeds the income effect, so the decrease in the price of food leads to an increase in the quantity of food demanded.

Griffen Goods A Special Case

In case of a Griffen good the demand curve slopes upwards so as to cause a higher income effect. That means with fall in food prices instead of more food consumption more clothes will be purchased since at that point clothes will be available at a relatively higher price. In case of Griffen goods income effect is negative and the substitution effect is positive. But here the income effect is more than the substitution effect. This causes decrease in food consumption. Example 4.2 THE EFFECTS OF A GASOLINE TAX For years, following the Arab oil crisis of 1973-1974, the U.S. government considered increasing the federal tax on gasoline. In 1993, a modest 7 percent tax increase was enacted as part of a larger budget reform package. This increase was much less than the $1 to $2 tax increase that would have been necessary to put U.S. gasoline prices on a par with those in Europe. Because an important goal of higher gasoline taxes has been to discourage the consumption of gasoline (and not to raise revenue), the government has also considered ways of passing the resulting income back to consumers. One popular suggestion is a rebate program in which the tax revenues would be returned to households on an equal per capita basis. What would be the effect of such a program?