Figure 6A-8 The Income and Substitution Effects of a Price Change
The price-consumption line in part (i) of Figure 6A-7 indicates that as
price decreases, the quantity of gasoline demanded increases, thus giving
rise to the negatively sloped demand curve in part (ii). As we saw in
Chapter 6 , the key to understanding the negative slope of the demand
curve is to distinguish between the income effect and the substitution
effect of a change in price. We can make this distinction more precisely,
and somewhat differently, by using indifference curves.
In Chapter 6 , we examined the substitution effect of a reduction in price
by eliminating the income effect. We did this by reducing money income
until the consumer could just purchase the original bundle of goods. We
then examined how the change in relative prices affected the consumer’s
choices. In indifference theory, however, the income effect is removed by
changing money income until the original level of utility—the original
indifference curve—can just be achieved. This method results in a slightly
different measure of the income effect, but the principle involved in
separating the total change into an income effect and a substitution effect
is exactly the same as in Chapter 6.
The separation of the two effects according to indifference theory is
shown in Figure 6A-8. The figure shows in greater detail part of the
price-consumption line first drawn in Figure 6A-7. Points and
on the price-consumption line for gasoline; is the consumer’s utility-
maximizing point at the initial price, whereas is the consumer’s utility-
maximizing point at the new price.
A 0 A
A 0
A 2