Income & Substitution Effects
•
It will turn out to be very helpful to
decompose effects of price changes into 2
theoretical pieces
•
Income and Substitution effects are
hypothetical decomposition of price
changes

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Can decompose PRICE
changes into two components
•
Substitution effect:
change in
consumption of a good due to change in
relative price, holding utility constant
•
Income effect:
change in consumption of
a good due to a change in income, holding
relative prices constant

Why is there an INCOME effect
of a price change?
•
An increase in one (or more) prices means
that fewer units of goods can be
purchased.
•
Real income (as measured by purchasing
power) has fallen

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Graph
—
Income and
Substitution Effects
(decrease price of books)
CDs
Books
(old)
(new)
1
3