Question

What is the difference between the substitution and the income effect of a price increase? Explain in detail

Answer 1

Suppose the initial budget line is MN which is tangent to the initial indifference curve IC1 at point a with respect to which the initial quantity of good X is Q1. Now when the price of good X increases, the budget line rotates inward from MN to MO which becomes tangent to the new indifference curve IC2 at point c with respect to which the final quantity of good X is Q3. Hence the total decline in quantity demanded of good x from Q1 to Q3 can be decomposed into a substitution effect and an income effect.

To understand the substitution effect, we will consider real income as constant, hence the consumer will stay on the initial indifference curve IC1, but as the price of good X increases, slope of budget line(PX/PY) will change and hence consumer will stay on the budget line with its slope equal to the slope of the new budget line. Hence we draw a hypothetical budget line PQ which is tangent to IC1 at point b and is parallel to the new budget line MO. Hence the movement from point a to b with respect to which the quantity demanded of X falls from Q1 to Q2 is due to the substitution effect.

To understand the income effect, we will consider real income as variable. Now as price of X increases, Consumer's real income M/PX falls and hence consumer will feel poorer and the budget line will shift leftward from PQ to MO which becomes tangent to the new indifference curve IC2 at point c. Hence the movement from point b to c with respect to which the quantity demanded of good X falls from Q2 to Q3 is due to the income effect.