Income, Price and

Substitution Effects
And Demand Theory
 Income Effect (IC)
• The effect on consumer equilibrium
when income of the consumer changes
while prices remain the same
Y

e1
e0
X
 Price Effect (PE)
• The effect on consumer equilibrium when price of one
commodity changes while price (s) of other
commodity (ies) and income of the consumer remain
the same
Y

e0 e1

X
 Substitution Effect (SE)
• The effect on consumer's equilibrium when price of a
commodity falls/rises the consumer increases/decreases
the purchase of the commodity, but it is assumed that
there is no increase/decrease in his/her real income, so
he/she remain on the same indifference curve
Y

e0
e1

X
 Demand
• Scarcity is the consequence of the
mismatch between wants and ability
of the economy to meet the wants
• Unlimited wants (desire) Vs Demand
• Willingness and ability generate
demand
 Demand

The demand for a commodity is

the amount of the commodity that
consumers are prepared to buy at
a given price
 Demand Curve
• A consumer’s Demand Curve
demand curve
6
represents how
4
much of a
Price
2
commodity is
0
purchased at 0 20 40 60
different prices. Quntity Demanded
Why demand curve sloped down from
left to right?
• Diminishing Marginal Utility

• Price ↓ implies Real-income ↑(income effect)

• Cheaper commodity tends to be substituted for

other commodities (substitution effect)

• Price decrease leads to less urgent uses of the

commodities
 Law of Demand
• Holding other factors constant, there is a
negative relationship between the price of a
commodity and quantity demand
• Limitations
 Change in taste or Fashion
 Expectation about price
 Change in income
 Change in other price (s)
 Discover of the substitution
 Change in Quantity Demanded and
Change in Demand
• Change in Quantity Demanded (Qd)
∆Qd due to ∆P

• Change in Demand (D)

∆D (shift) is due to change in factors other
than price
(i.e. related good, income, preference,
expectation and number of buyers )
Contraction and Extension of Demand

• Contraction and Extension are associated with

Change in Quantity Demanded (Qd)

P1 a
P2 b
P3 c

dc

Q1 Q2 Q3
 Increase and Decrease in demand
• Increase (rise) and Decrease (fall) in demand are associated
with Change in Demand (D)

P a b c

dc3
dc1
dc2
Q2 Q1 Q3
 Elasticity of Demand
• Elasticity of demand is the measure of the
responsiveness of demand to changing prices
• A small change in price may lead to a great
change in quantity demanded, in such case we
shall say that the demand is elastic/sensitive or
responsive
• If a large change in price causes a small
change in quantity demanded, then the demand
is in elastic
 Five Cases of Elasticity
• Perfectly elastic/ infinite elasticity

p D

Qd
2) Perfectly inelastic or zero elasticity
p2
p1

Qd
3) Relatively elastic: ٪∆Qd > ∆٪p
p

Qd
4) Relatively inelastic: ∆٪p > ٪∆Qd
p

Qd
5) Unitary elastic: ∆٪p = ٪∆Qd
p

Qd
 Types of Elasticity
• Price Elasticity (PE): it is the ratio of
percentage changes in quantity demanded in
response to a percentage change in price
PE = ∆q/q ÷ ∆p/p
• Income Elasticity (PE): it shows how the
demand will change when the income of the
purchaser changes, the price of the commodity
remaining the same
IE = ∆q/q ÷ ∆I/I
 Types of Elasticity
• Cross Elasticity (CE): a change in the price of
one good cause a change in the demand for
another

∆qx/qx ÷ ∆Py/Py
 Measurement of Elasticity
• Total outlay method: in this method we
compare the total outlay of the purchaser before
and after the variations in price
Unity: the total amount spent remains the same
even though the price has changed
Greater than unity: with the fall in price, the
total amount spent increases or the total amount
spent decreases as the price rises
Less than unity: with the rise in price, the total
amount spent increases or the total amount
spent decreases with a fall in price
 Total outlay method
S.no P Qd Total
outlay
1 8 3 24

2 7 4 28

3 6 5 30

4 5 6 30

5 4 7 28

6 3 8 24
 Measurement of Elasticity
• Proportional method: the P Qd
elasticity is the ratio of the
percentage change in the 500 400
quantity demanded to the
400 600
percentage change in price
changed
PE = ∆Qd/Qd ÷ ∆p/p
PE = 200/400 ÷100/500
PE = 2.5
 Firm’s Behavior
• In the last few lectures, we focused on the
demand side of the market; the preferences
and behavior of the consumer
• Now we turn to the supply side and examine
the behavior of producers
Consumer behavior Demand
market
firm’s behavior supply
 Production function (PF)
• Production is the result of joint efforts of the
four factors of production
• Production function is the process of
transforming input into output
• Rojer. R. Millor defined PF as “it is a
mathematical equation that gives a maximum
quantity of output that can be produced from
specific sets of inputs while technique of
production are given”
• PF is the relationship between input and output
• The most efficient method of production
• Classical production function
Q = f(L)
where
Q= output
L= labor

while capital K is constant, there it is a short-run

production function
 Return to Factor of Production and
Return to scale
• The increase in total output that results from
increase in the employment of one factor of
production (generally labor), assuming that the
fixed input remains unchanged
Q = f(L)
• When firm changes both labor and capital, the
effects on production will be analyzed with the
name of “Return to Scale”
Q = f (L,K)
where L is labor and K is capital,
• Total production (TP= Q): total
output of a firm produced by
certain number of labor
• Average product (AP): we get Q L
average product when we divide
total product by the units of labor 50 10
AP = TP/L = 40/5 54 11
• Marginal product (MP): the
addition to total output that MP = 4
results from a unit increase in the
employment of labor, assuming
that the fixed input remains
unchanged