INCOME AND SUBSTITUTION EFFECTS

The impact of a change in the price of a good on consumption can be decomposed into two effects an income effect and a substitution effect. To see what these two effects are, consider how our consumer might respond when he learns that the price of Pepsi has fallen. He might reason in the following ways

• “Great news! Now that Pepsi is cheaper, my income has greater purchasing power. I am, in effect, richer than I was. Because I am richer, I can buy both more Pepsi and more pizza.” (This is the income effect.)

• “Now that the price of Pepsi has fallen, I get more pints of Pepsi for every pizza that I give up. Because pizza is now relatively more expensive, I should buy less pizza and more Pepsi.” (This IS the substitution effect.) Which statement do you find more compelling?
In fact, be the)f these statements make sense. The decrease in the price of Pepsi makes the consumer better off. If Pepsi and pizza are both normal goods, the consumer will want to spread this improvement in his purchasing power over both goods. This income effect tends to make the consumer buy more pizza and more Pepsi. Yet at the same time, consumption of Pepsi has become less expensive relative to consumption of pizza. This substitution effect tends to make the consumer choose more Pepsi and less pizza Now consider the end result of these two effects. The more Pepsi because the income and substitution effects both act to raise purchases of Pepsi. But it is ambiguous whether consumer buys more pizza because the income and substitution effects work in opposite directions. This conclusion is summarized in Table 1.
4 We can interpret the income and substitution effects using indifference curves. The income effect is the change in consumption that results from the movement to a higher indifference curve. The substitution effect is the change in consumption that results from being at a point on an indifference curve with and different marginal rate of substitution.

Figure 10 shows graphically how to decompose the change in the consumer’s decision into the income effect and the substitution effect. When the price of Pepsi falls, the consumer moves from the initial optimum, point A, to the new optimum, point C. We can view this change as occurring in two steps. First, the consumer moves along the initial indifference curve, 1\, from point A to point B. The consumer is equally happy at these two points, but at point B, the marginal rate of substitution reflects the new relative price. (The dashed line through point B reflects the new relative price by being parallel to the new budget constraint.) Next, the consumer shifts to the higher indifference curve, 12, by moving from point B to

Figure 10 Income and Substitution Effects

The effect of a change in price can be broken down into an income effect and a substitution effect. The substitution effect-the movement along an indifference curve to a point with a different marginal rate of substitution-is shown here as the change from point A to point B along indifference curve II’ The income effect-the shift to a higher indifference curve-is shown here as the change from point B on indifference curve II to point Con indifference curve 12

point C. Even though point B and point C are on different indifference curves, they have the same marginal rate of substitution. That is, the slope of the indifference curve II at point B equals the slope of the indifference curve 12 at point C. Although the consumer never actually chooses point B, this hypothetical point is useful to clarify the two effects that determine the consumer’s decision. Notice that the change from point A to point B
represents a pure change in the marginal rate of substitution without any change in the consumer’s welfare. Similarly, the change from point B to point C represents a pure change in welfare without any change in the marginal rate of substitution. Thus, the movement from A to B shows the substitution effect, and the movement from B to C shows the income effect.

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