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Income & Substitution Effect

# Income & Substitution Effect - How To Find Income and...

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Unformatted text preview: How To Find Income and Substitution Effects from a Price Change Joseph Guse * October 7, 2003 1 Example: price increase from p x to p x 1 1. Make note of starting point. Start by drawing the original budget line generated by income level m and prices p = ( p x ,p y ). Your picture should make note of the budget line intercepts m p x and m p y . Next identify the original consumption bundle which maximizes the consumer’s happiness given his income and the original prices. This is the point ( x ,y ). 2. Draw the new budget line. In this case draw the budget line generated by prices ( p x 1 ,p y ). Note that in this example the price of y does not change. Therefore we see a pivot of the budget line around the y intercept. The picture makes note of the new intercept m p x 1 . 3. Identify the New Consumption Bundle and the Total Effect. Before trying to break out income and substitution effects, it is important to keep a grasp on the actual changes in behavior effected by the price change. In this example, the consumer wouldchanges in behavior effected by the price change....
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Income & Substitution Effect - How To Find Income and...

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