Cambridge International as and a level Economics Ebook

Income and substitution 
eff ects of a price change using 
indiff erence curves
Th
e income and substitution eff ects of a price change were 
briefl y outlined earlier. Th
ese eff ects can now be interpreted 
using indiff erence curves. Th
is is shown in 
Figure 7.4
.
If the price of good A falls, then this means that the 
consumer has more spending power. Th
is is represented 
by the new budget constraint 
B
2
. Th
e price of good 
B
remains the same which is why 
B
2
pivots upwards to a 
new position. Th
e extent of change that occurs consists of 
two stages. Th
ese are:
1
A movement along the initial indiff erence curve I
1
to point 
E
2
. This is the substitution eff ect. It is so-called since the 
consumer buys less of good B as it is now relatively more 
expensive than good A.
2
A 
shift upwards to a higher indiff erence curve, moving from 
point 
E
2
to 
E
3
. This is the income eff ect. As the consumer 
has more spending power, it is positive in the case of both 
goods, resulting in an increase in consumption of good B as 
well as good A.
In the case of good A, the income and substitution eff ects 
are both positive, resulting in a substantial increase 
in consumption. For good B, the substitution eff ect is 
negative but the fall in consumption is to some extent 
off set by the positive income eff ect. So here, the income 
and substitution eff ects are pulling in opposite directions. 
In 
Figure 7.4
 there is a fall in consumption of good B as the 
substitution eff ect is stronger than the income eff ect.
In the case of inferior goods, as we saw in
 Chapter 2
, 
when incomes rise above a certain point consumers tend to 
substitute more expensive and better quality alternatives. 
Here, the income eff ect is negative. Whether this leads to 
a fall in consumption will depend on the relative strength 
of the substitution eff ect. If this is greater than the income 
eff ect, then more of the inferior good will be consumed.