SUBSTITUTION AND INCOME EFFECTS OF A PRICE CHANGE

T. Koplin, Microeconomic Analysis, p.40).
             Substitution effect explaining the decreased consumption of a good when its price increases is an obvious one. If the price of salt rises while other prices do not, then sweater has become relatively more valuable. Therefore, it pays the consumer to substitute other good for salt in order to get the satisfaction as cheaply as possible. Salt becomes a relatively more valuable source of motivation. A particular amount of money spent on pepper buys the same quantity of pepper but, now, fewer quantity of salt. We can say that to keep buying the same quantity of salt, we have to willing to sacrifice of a greater amount of pepper. The behaviour of consumer in responding this substitution effect, is the same way as the business manager does when an increase in price of one productive factor causes an adjustment of the production method with substitution of other inputs for the dearer input. This process produces the same output with the least increase in the total cost. Consumers, to get the satisfaction, will choose those goods which provide that sort of satisfaction at least cost.
             Income effect is less obvious. Our income is fixed. An increase in the price of a good purchased decreases our purchasing power, that is, it has an effect of cutting in our income. This loss of real income, the income effect, will be more significant the more we had been spending on the dearer commodity. With a lower real income the consumer is able to buy less. Usually the income effect will reinforce the substitution effect in making the demand curve downward sloping.
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             Based on the Figure 1.1. above, we assume that an individual is in equilibrium at point E1, purchasing OA units of the good. A reduction of the price of the good causes him to move to a new equilibrium at point E2, consuming OC units of the good. To identify the income effect of this change in price we ask how his consumption of the product would have changed if its price had not changed, but his income had been increased enough to enable him to move to the higher indifference curve which is point E2.