Let’s now explore these two separate effects in a little more detail.
The Substitution Effect
To isolate the effect of the change in relative price when the price of ice
cream falls, we can consider what would happen if we also reduce
Tristan’s money income to restore the original purchasing power.
Suppose Tristan’s uncle sends him a monthly allowance for ice cream,
and when the price of ice cream falls, the allowance is reduced by $15 so
that Tristan can buy just as much ice cream—and everything else—as he
could before. Tristan’s purchasing power will be unchanged. If his
behaviour remains unchanged, however, he will no longer be maximizing
his utility. Recall that utility maximization requires that the ratio of
marginal utility to price be the same for all goods. In our example, with
no change in behaviour, the quantities (and hence marginal utilities) and
the prices of all goods other than ice cream are unchanged. The quantity
of ice cream is also unchanged, but the price has fallen. To maximize his
utility after the price of ice cream falls, Tristan must therefore increase his
consumption (reduce his marginal utility) of ice cream and reduce his
consumption of other goods. In other words, he must substitute away
from other goods and toward ice cream.
When purchasing power is held constant, the change in the quantity
demanded of a product whose relative price has changed is called the
substitution effect of the price change.^2