Chapter 1Figure It Out 5.3

To find the substitution effect, construct an “imaginary” budget constraint that is parallel to the new budget constraint but tangent to the original indifference curve. That budget constraint is shown as BC′, which is tangent to U₁ at A′. Then, compare the original bundle to the bundle at the point of tangency. Pavlo consumes 16 pies at A, and 12 pies at A′, so the substitution effect is -4 pies. Then, determine the income effect by comparing Pavlo’s consumption of pies at A′ to his consumption of pies at B. At A′ he consumes 12 pies; at B he consumes 4, so the income effect is -8 pies. For further review see section “Decomposing Consumer Responses to Price Changes into Income and Substitution Effects”.

The shift from BC′ to BC₁ represents a decrease in overall purchasing power, or income: Both goods are less affordable; there is a parallel shift of the budget constraint, so relative prices are unchanged. As purchasing power decreases, Pavlo’s pie consumption falls from 12 (at point A′) to 4 (at point B). Because the decrease in purchasing power causes a decrease in consumption of pies, pies must be a normal good. Cake consumption, however increases from 10 at point A′ to 12 at point B. Because cake consumption increases as purchasing power decreases, cake must be an inferior good. For further review see section “Decomposing Consumer Responses to Price Changes into Income and Substitution Effects”.