The substitution effect and income effect of a price increase for an inferior good.
C
A
sub
U1
B
inc
B1
B3
total
U2
B2
x3 x3 x1
The price of x increases causing the budget line to shift from B1 to B2. The consumer changes his consumption from the bundle of x and y represented by point A to the bundle represented by point B. The movement from A to B represents the total effect of the price change. Consumption of x goes down from x1 to x2 for two reasons. The substitution effect occurs because x is now more expensive relative to y (B2 is steeper than B1). The income effect of the price change occurs because real income (I/Px) has decreased. B is on a lower indifference curve than A. The total effect is the substitution effect plus the income effect.
To separate the substitution effect from the total effect, first draw a new budget line, B3. B3 is parallel to B2 because it represents the higher price for x. It must be tangent to the **original **indifference curve U1. In the graph above this is point C. Point C shows us how much x the consumer would buy if the price of x were increased and at the same time he was given more income so that he was no worse off than he was before the price went up. The movement from A to C is the substitution effect. The income effect is what is left when the substitution effect (A to C) is subtracted from the total effect (A to B), which is B to C in the graph above. X is an inferior good because when then the budget line shifts from B3 to B2 (income decreases), consumption of X increases from x3 to x2. The demand for x is downward sloping because when price increases consumption of x goes down from x1 to x2. |