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.)

income effect the change in consumption that results when a price change moves the consumer to a higher or lower indifference curve substitution effect the change in consumption that results when a price change moves the consumer along a given indifference curve to a point with a new marginal rate of substitution

Which statement do you find more compelling?

In fact, both of 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 consumer certainly buys more Pepsi, because the income and substitution effects both act to raise purchases of Pepsi. But it is ambiguous whether the consumer buys more pizza, because the income and substitution effects work in opposite directions. This conclusion is summarized in Table 21-2.

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 a different marginal rate of substitution.

Figure 21-10 shows graphically how to decompose the change in the consumer's decision into the income effect and the substitution effect. When the price

Good

Income Effect

Substitution Effect

Total Effect

Pepsi Consumer is richer, so he buys more Pepsi.

Pizza Consumer is richer, so he buys more pizza.

Pepsi is relatively cheaper, so consumer buys more Pepsi.

Pizza is relatively more expensive, so consumer buys less pizza.

Income and substitution effects act in same direction, so consumer buys more Pepsi.

Income and substitution effects act in opposite directions, so the total effect on pizza consumption is ambiguous.

Table 21-2

Income and Substitution Effects When the Price of Pepsi Falls

Figure 21-10

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 i1. The income effect—the shift to a higher indifference curve—is shown here as the change from point B on indifference curve I1 to point C on indifference curve I2.

Quantity of Pepsi

Income effect

Substitution effect

Quantity of Pepsi

Income effect

Substitution effect

« Quantity

Substitution effect of Pizza

« Quantity

Substitution effect of Pizza

Income effect

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