Derivation of the Price Effect of a Price Fall
The price effect refers to the change in the quantity demanded of a good or service when its price changes, holding all else constant. When the price of a good falls, the total change in the quantity demanded is due to two distinct effects: the substitution effect and the income effect. Let's break down these two effects, starting with a general understanding of the price effect.
1. The Price Effect
The price effect can be explained as the total change in the quantity demanded of a good resulting from a change in its price. When the price of a good falls, the law of demand suggests that the quantity demanded will increase, all else being equal. This relationship holds because consumers typically purchase more of a good when its price decreases, provided their income remains unchanged. However, this total change in quantity demanded is not solely due to the price change itself—it is influenced by two separate effects: the substitution effect and the income effect.
2. The Substitution Effect
The substitution effect refers to the change in the quantity demanded of a good due to a change in its price relative to other goods. When the price of a good falls, the good becomes relatively cheaper compared to other similar goods. As a result, consumers tend to substitute the now cheaper good for other goods that are relatively more expensive. This leads to an increase in the quantity demanded of the cheaper good.
For example, consider the case of two goods: tea and coffee. If the price of tea falls, consumers will buy more tea, substituting it for coffee, which has become relatively more expensive. The substitution effect isolates the change in demand due to the change in the good's price, without taking into account any changes in the consumer’s overall purchasing power (i.e., the income effect).
In graphical terms, the substitution effect can be visualized as the movement along the demand curve of the good itself. When the price falls, the consumer will move to a higher quantity on the demand curve, reflecting the substitution of other goods with the cheaper good.
3. The Income Effect
The income effect refers to the change in the quantity demanded of a good due to the change in the consumer’s real income or purchasing power caused by a price fall. When the price of a good decreases, the consumer can now afford to purchase more goods in general because the good has become less expensive, effectively increasing the consumer’s real income. This increase in purchasing power causes the consumer to buy more of the good in question, as well as possibly other goods.
The income effect is especially important for goods that are considered normal goods, as a decrease in price allows consumers to purchase more of the good and other goods as well. For example, if the price of bread falls, a consumer who previously could only afford 3 loaves of bread might now be able to afford 4 or 5 loaves, assuming their income remains unchanged.
In terms of the demand curve, the income effect causes a shift in the demand curve itself. As the consumer's purchasing power increases, the quantity demanded at each price level rises, shifting the demand curve to the right. However, it is important to note that the income effect is generally smaller than the substitution effect in cases where the price fall is not too large or when the good is a necessity.
4. Total Price Effect
The total price effect is the combination of both the substitution effect and the income effect. When the price of a good falls, the total change in the quantity demanded is the sum of the two effects. The substitution effect increases the quantity demanded because the good has become relatively cheaper, leading consumers to buy more of it instead of other goods. The income effect increases the quantity demanded because the consumer’s real income has increased, allowing them to afford more of the good.
For example, in the case of a price fall for tea, the substitution effect will lead to an increase in the quantity of tea demanded due to the lower price relative to other goods (like coffee). The income effect will further increase the demand for tea because the consumer's real income has increased as a result of the price fall.
5. Net Effect of a Price Fall
The net effect of a price fall can be expressed as the sum of the substitution and income effects:
In most cases, the substitution effect dominates the income effect, especially for small price changes. However, the income effect can be significant for goods that constitute a larger portion of a consumer’s budget, or for luxury items where price changes can significantly impact purchasing power.
6. Conclusion
In summary, the price effect of a fall in price consists of two key components: the substitution effect and the income effect. The substitution effect reflects how consumers respond to a change in relative prices, leading to a substitution of the good for other more expensive alternatives. The income effect reflects how the change in price increases the consumer’s real income, allowing for greater purchasing power and thus a higher quantity demanded. Together, these two effects combine to explain the total change in demand when the price of a good falls. The relative magnitude of each effect can vary depending on the type of good and the context of the price change.
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