[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

candy increases. Now he can buy fewer candy bars; but the number of
CDs he can buy, were he to spend all of his income on CDs, is unchanged.
Thus, his budget constraint becomes flatter; it is now line B 2 C. While
Jeremy originally chose point E 0 on the indifference curve I 0 , now he
chooses E 1 on the lower indifference curve I 1 .
The price change has moved Jeremy’s choice from E 0 to E 1 for two
reasons: the substitution effect and the income effect. To see how this
has happened, let’s isolate the two effects. First, we focus on the substitution
effect by asking what would happen to Jeremy’s consumption
if we changed relative prices but did not change how well-off he
was. To keep him just as well-off as before the price change, we must
keep him on the same indifference curve, I 0 . Thus, the substitution
effect is a movement along an indifference curve. As the price of candy
rises, Jeremy, moving down the indifference curve, buys more CDs
and fewer candy bars. The movement from E 0 to E 2 is the substitution
effect. The budget constraint B 1 C 1 represents the new prices, but
it does not account for the income effect, by definition, since Jeremy
is on the same indifference curve that he was on before.
To keep Jeremy on the same indifference curve when we increase
the price of candy requires giving Jeremy more income. The line B 1 C 1
is the budget constraint with the new prices that would leave Jeremy
on the same indifference curve. Because prices are the same, the
budget constraint B 1 C 1 is parallel to B 2 C. We now need to take away the
income that left Jeremy on the same indifference curve. We keep prices
the same (at the new levels), and we take away income until we arrive
at the new budget constraint B 2 C, and the corresponding new equilibrium
E 1 . The movement from E 2 to E 1 is called the income effect,
since only income is changed. We have thus broken down the movement
from the old equilibrium, E 0 , to the new one, E 1 , into the movement
from E 0 to E 2 , the substitution effect, and the movement from E 2
to E 1 , the income effect.
CANDY BARS
B
B 1
B 2
I 0
I 1
Budget
constraints
E 0
Indifference
curves
E 1
I 0
I 1
C C 1
CDs
Figure 5.15
SUBSTITUTION AND INCOME EFFECTS
WITH INDIFFERENCE CURVES
As the price of candy bars increases, the budget constraint
rotates down. The change of Jeremy’s choice from
E 0 to E 1 can be broken down into an income and a substitution
effect. The line B 1 C 1 shows the substitution
effect, the change in the budget constraint that would
occur if relative prices shifted but the level of utility
remained the same. (Notice that Jeremy stays on the
same indifference curve in this scenario.) The substitution
effect alone causes a shift from E 0 to E 2 . The shift in the
budget constraint from B 1 C 1 to B 2 C shows the income
effect, the change that results from changing the amount
of income but leaving relative prices unchanged. The
income effect alone causes a shift from E 2 to E 1 .
E 2
APPENDIX: INDIFFERENCE CURVES AND THE CONSUMPTION DECISION ∂ 129