Consumer Theory - Price Effect As Sum of Substitution and Income Effects

Price Effect As Sum of Substitution and Income Effects

Every price change can be decomposed into an income effect and a substitution effect; the price effect is the sum of substitution and income effects.

The substitution effect is a price change that alters the slope of the budget constraint but leaves the consumer on the same indifference curve. In other words, it illustrates the consumer's new consumption basket after the price change while being compensated as to allow the consumer to be as happy as he or she was previously. By this effect, the consumer is posited to substitute toward the good that becomes comparatively less expensive. In the illustration below this corresponds to an imaginary budget constraint denoted SC being tangent to the indifference curve I1.

If the good in question is a normal good, then the income effect from the rise in purchasing power from a price fall reinforces the substitution effect. If the good is an inferior good, then the income effect will offset in some degree the substitution effect. If the income effect for an inferior good is sufficiently strong, the consumer will buy less of the good when it becomes less expensive, a Giffen good (commonly believed to be a rarity).

In the figure, the substitution effect, is the change in the amount demanded for when the price of good falls from to (increasing purchasing power for ) and, at the same time, the money income falls from to to keep the consumer at the same level of utility on :

The substitution effect increases the amount demanded of good from to . In the example, the income effect of the price fall in partly offsets the substitution effect as the amount demanded of goes from to . Thus, the price effect is the algebraic sum of the substitution effect and the income effect.