Recall that a consumer's budget line

• has the equation Y = M/P_Y - (P_X/P_Y)X.
• has a slope equal to -(P_X/P_Y), which must be negative.  (P_X/P_Y) is called the market rate of substitution of X for Y.  It must be positive.
• changes in income do not change the slope of the buget line, but cause parallel shifts of the budget line.

• show the level of utility (satisfaction) that a consumer will receive from a combination of X and Y.
• each (X,Y) combination along an indifference curve gives the same amount of utility.
• the slope of an indifference curve is -(MU_X/MU_Y), which must be negative.  (MU_X/MU_Y) is called the marginal rate of substitution of X for Y, MRS_XY, which must be positive.

Income and Substitution Effects of a price change.

Economists separate the effect of a price change on the quantity demanded into two components:
the income effect and the substitution effect.

The income effect refers to the fact that when the price of a good rises, the increase reduces the consumer's purchasing power and forces the consumer to purchase a different combination of goods.  The strength of the income effect depends on how much the price increase reduces the purchasing power of the consumer's income.  For most goods it is a weak effect, but a moderate percentage increase in items such as rent, car insurance premiums, or food in general could substantially reduce the consumer's purchasing power.

The substitution effect refers to the change in the relative prices of X and Y.  (Some economists call the substitution effect the "relative-price" effect.)  It has to do with how a consumer can trade a good for another good and how the consumer's utility changes as he or she makes the trade.  This is directly related to the condition that at the consumer's optimum, the MRS_XY = (P_X/P_Y).  For example, if (P_X = $20 and P_Y = $5 then the consumer can trade 1 X for 4 Y.  If each unit of X gives 15 units of (marginal) utility and each unit of Y gives 6 units of (marginal) utility, then the consumer would rather trade away X and receive the 4 units of Y.  But if the price of X falls to $10 each, then the consumer can only get 2 Y for each X.  In that case, the consumer would prefer to trade away 2 Y and receive 1 X.  This says nothing about how many X and Y the consumer has at the start, nor how much the total combination of X and Y costs.

To separate the income and substitution effects of a price increase, we need to think of an intermediate step as the consumer goes from the higher budget line to the lower budget line.  We imagine that we can keep the consumer on the original indifference curve after the price of X has increased.  Of course, to do this will mean augmenting the consumer's income.  The substitution effect is the effect of moving from one point on that indifference curve to a second point on the same indifference curve as the price ratio changes.  The income effect is the effect of moving from the intermediate budget line to the final budget line as the price ratio remains the same.  The income effect is what happens when we take away the income that we had just given the consumer when we measured the substitution effect.

In the diagram on page 131 of our text, the line IJ is the intermediate budget line.  The movement from point A to point B is the substitution effect.  The movement from point B to point C is the income effect.  Of course the net effect is the movement from point A to point C.  Notice that after the price of X rises, point A represents a combination of X and Y that the consumer cannot afford--it is above the budget line FH.  To let the consumer maintain the original level of utility (to reach indifference curve I), we had to give the consumer enough income that the intermediate budget line could reach point B.  When we removed the income that we just gave the consumer, the budget line falls from IJ to FH--a parallel shift.

[more later]