# Discussion of Substitution and Income Effects in Consumption as Price Varies by Using the Compensating Variation Methods.

Discussion of Substitution and Income Effects in Consumption

as Price Varies by Using the Compensating Variation Methods

Tutor: Mr. Pedro E. Moncars

Microeconomics

Tian Ni Zhang

A change in price results in a change in quantity demanded, shifting the bundles of consumption from one equilibrium to another equilibrium. This effect is called total effect. Total effect includes two sections. One is called substitution effect; the other is called income effect. The definitions of the two effects will be discussed in the follows associated with their roles in consumption varies as price changes by using the compensating variation.

Substitution effect defines as the change in bundles that people can consume when the relative price changes caused by a change in price as holding real income constant. It uses the same indifference curve to show that when the price of a good increases, to what extent people would like to substitute other goods for it and vice versa. Income effect defines as the change in quantity demanded when the real income changes as a result of a change in price. It keeps relative price constant to show what happens to people’s consumption ability when the price of a good varies.

The changes in consumption are different for varieties of good. The situation of normal good, whose quantity demanded rises when its price falls down or income goes up, is shown in Figure 1. The original budget line BC1 tangents the indifference curve IC1 at point A. When price of good A falls down as other prices remain constant, the real income increases. BC1 rotates rightward to BC2, tangents the new indifference curve IC2 at point B, which means the quantity demanded of good A enlarges from Q1 to Q2. To disentangle substitution effect from income effect by using the ...