Price Effect

Price Effect

The price effect analyses the effect of a price change on the amount of a product bought by the consumer.  It explains, for example, why most people buy more units of a product as the price falls. It can also explain the abnormal situation in which less of a certain product is purchased when the price is reduced. The total price effect is the eventual outcome of a price change. The total price effect is the sum of the substitution and income effects. The substitution effect involves replacing a good with a comparatively cheap good. In other words, the consumer buys more units of the cheaper good and fewer of the relatively expensive good. The income effect is the effect of a change in purchasing power or real income as a result of a rise or fall in the price of a product. It is worthy of note that the substitution effect of a price change is the same for all types of products while the income effect for a normal good is different from that of an inferior good.

Substitution and income effects of a fall in the price of a normal good
The quantity of a normal good demanded is directly proportional to income. The amount bought increases as income increases and decreases as income decreases.  When the price of a normal good falls, it becomes relatively cheaper, thereby encouraging consumers to buy more of it at the expense of another product.  This is the substitution effect of a fall in price.  The original budget line touches the first indifference curve IC1 and gives quantity X1 of good X (Figure 1 below). The budget line rotates anticlockwise due to a decrease in the price of good X. A straight line is drawn parallel to the second budget line but touches the first indifference curve at a different point which is traced to the good X  axis producing quantity X3. The substitution effect SE is from X1 to X3.  It is on the first indifference curve IC1.  A fall in price means that the consumer’s real income (or purchasing power) has increased, prompting the consumer to increase the quantity purchased. This is the income effect which is from X3 to X2 . The substitution effect and income effect reinforce each other as both increase the quantity bought due to a price fall. The total price effect is, therefore, an overall increase from X1 to X2. As the price of a normal good falls, more quantity is bought, this is the normal price-quantity relationship in economics. Figure 2 below shows that as the price of good X falls from P1 to P2, the quantity purchased increases from X1 to X2.

Figure 1: Price effect of a fall in the price of a normal good

Figure 2: Demand curve showing a fall in the price of a normal good

Substitution and income effects of a fall in the price of a non-Giffen inferior good

An inferior good by definition is a good whose quantity is inversely related to income. That is to say quantity bought decreases as income rises while quantity increases as income falls. For most inferior goods, the substitution effect is moving in the opposite direction to the income effect but the substitution effect is stronger than the income effect. When the price of good X falls, people substitute the relatively cheap good X for the more expensive good Y. The substitution effect SE is from X1 to X3 in Figure 3 below. Besides, a fall in price means the consumer has more purchasing power or real income. As real income increases quantity bought of non-Giffen inferior good decreases. Therefore, the  income effect from X3 to X2 is in the opposite direction to the substitution effect. But the substitution effect is more, leading to an overall rise in quantity purchased from X1 to X2. There is a normal inverse relationship between quantity demanded and the price (see Figure 4 below).

Figure 3: Price effect of a fall in the price of a non-Giffen inferior good

Figure 4: Demand curve showing a fall in the price of a non-Giffen inferior good

Substitution and income effects of a fall in the price of a Giffen inferior good
A Giffen good is a special and rare type of inferior good for which the income effect is stronger than the substitution effect, leading to a direct relationship between price and the quantity demanded. A fall in price leads to an increase in the amount bought from X1 to X3 which is the substitution effect (Figure 5 below). The income effect moves in the opposite direction from X3 to X2. The consumer ends up buying fewer units of good X from X1 to X2 (the net effect of the two effects) since the income effect is more than the substitution effect. The demand curve for a Giffen good is upward sloping because a rise in price increases the quantity demanded and a drop in price decreases the quantity demanded (Figure 6 below).

Figure 5: Price effect of a fall in the price of a Giffen inferior good

Figure 6: Demand curve showing a fall in the price of a Giffen inferior good

Demand curve for a Giffen good