Price effect

economic-dictionary

The price effect is the change in the quantity demanded of a good (or service) when its price changes, while the rest of the variables remain constant (other prices, income or consumer preferences, among others).

When the price of a good changes, the conditions under which a certain consumption basket was chosen change. Given the above, the user will have to reevaluate his choice and will probably have to vary the quantity demanded of the goods that make up his basket.

Thus, for example, if the price of one of the goods falls, the consumer will see his budget constraint modified and will be able to search for a new optimum in a higher indifference curve.

On the contrary, if the price of one of the goods increases, the budget line changes, but now the consumer can only aspire to a lower indifference curve. Furthermore, in the face of a price change, the relative prices of goods also change.

Components of the price effect

The price effect is made up of two effects: the substitution effect and the income effect. The first refers to the change in the quantity demanded caused exclusively by the relative change in the prices of goods.

Likewise, the income effect refers to the change in the quantity demanded due to the change in purchasing power due to the change in price.

Price effect graph

We can see the price effect in the following graph. Suppose there are two goods 1 and 2, both are normal goods. The price of good 1 falls while the price of good 2 remains constant. So, the quantity that a consumer can now buy is M / P1 ′, because with the same money supply (M) he can buy more products if the price of the good falls.

The initial basket of the consumer is A, but after the reduction in the price of good 1, the basket changes to C. As we can see, the consumer reaches a consumption basket in a higher indifference curve. In this basket, the quantity of good 1 consumed increases, which reflects that it is a normal good.

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