6.2 Income and Substitution Effects

of Price Changes

We have just seen the relationship between the law of diminishing
marginal utility and the slope of the consumer’s demand curve for some
product. Here we consider an alternative method for understanding the
slope of an individual’s demand curve.

Let’s consider Tristan, a student who loves to eat—and especially loves to
eat ice cream. A fall in the price of ice cream affects Tristan in two ways.
First, it provides an incentive to buy more ice cream (and less of other
things) because eating ice cream is now a cheaper way to satisfy his
desire to eat. Thus, a reduction in the price of ice cream—which, with all
other prices constant, means a fall in the relative price of ice cream—leads
Tristan to substitute away from other products toward ice cream.

Second, because the price of ice cream has fallen, Tristan has more
purchasing power or real income available to spend on all products.
Suppose the price of premium ice cream fell from $5 to $4 per litre and
Tristan was in the habit of eating half a litre of ice cream a day. In the
course of a 30-day month, Tristan could keep his ice cream habit
unchanged but save $15, money that would be available for any purpose
—more ice cream, blueberry muffins, rounds of mini golf, or photocopies
of your economics notes.

