Question

Separate the impact of a price change into substitution and income effects.

Short answer

Consumer behaviour gets directly effected by the change in price of good.

Step-by-step solution

Introduction

Substitution effect:

The movement along a given indifference curve that result from a change in the relative prices of goods, holding real income constant.

Income effect:

The movement from one indifference curve to another that results from the change in real income caused by a price change.

Describe substitution and income effect

Plot the graph:

Suppose a consumer initially is in equilibrium at point $A$in, along the budget line connecting points $F$and$G.$

Here, the price of good $X$increases so that the budget line rotates clockwise and becomes the budget line connecting points $F$and $H$.

Since, the budget set is smaller due to the price increase; the consumer will be worse off after the price increase.

We can observe that the increase in the price of good X leads to a budget line with a steeper slope, reflecting a higher market rate of substitution between the two goods. These two factors lead the consumer to move from the initial consumer equilibrium (point$A$ ) to a new equilibrium (point$C$ ).

It is useful to isolate the two effects of a price change to see how each effect individually alters consumer choice. Here, not necessary the price increase leads to a lower indifference curve. Let us assume, that after the price increase, the consumer is given enough income to achieve the budget line connecting points$\mathrm{J}\text{andI}$ . This budget line has the same slope as budget line$\text{FH}$ , but it implies a higher income than budget line $\text{FH}$.

Given this budget line, the consumer will achieve equilibrium at point $B$, where less of good$X$ is consumed than in the initial situation, point$A$. The movement from A to B is called the substitution effect. This effect mainly reflects how a consumer will react to a different market rate of substitution.

The total effect of a price increase thus is composed of substitution and income effects.

The substitution effect reflects a movement along an indifference curve. The income effect results from a parallel shift in the budget line. It isolates the effect of reduced “real income” on consumption and is represented by the movement from $B$to $C$. The total effect of a price increase, which is what we observe in the market place, is the movement from $A$ to $C$.

The total effect of a change in consumer behavior results not only from the effect of a higher relative price of good X(the movement from$A$ to $B$) but also from the reduced real income of the consumer (the movement from $B$to$C$ ).