Page 465 - The Principle of Economics

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 475
D
New budget constraint
New optimum
A
1. A fall in the price of Pepsi rotates the budget constraint outward . . .
B
Initial optimum
I2 I1
Initial budget constraint
Quantity of Pepsi
1,000
500
0 100
2. . . . reducing pizza consumption . . .
Figure 21-9
A CHANGE IN PRICE. When the price of Pepsi falls, the consumer’s budget constraint shifts outward and changes slope. The consumer moves from the initial optimum to the new optimum, which changes his purchases of both Pepsi and pizza. In this case, the quantity of Pepsi consumed rises, and the quantity of pizza consumed falls.
3. . . . and raising Pepsi consumption.
Quantity of Pizza
INCOME AND SUBSTITUTION EFFECTS
The impact of a change in the price of a good on consumption can be decomposed into two effects: an income effect and a substitution effect. To see what these two effects are, consider how our consumer might respond when he learns that the price of Pepsi has fallen. He might reason in the following ways:
N “Great news! Now that Pepsi is cheaper, my income has greater purchasing power. I am, in effect, richer than I was. Because I am richer, I can buy both more Pepsi and more pizza.” (This is the income effect.)
N “Now that the price of Pepsi has fallen, I get more pints of Pepsi for every pizza that I give up. Because pizza is now relatively more expensive, I should buy less pizza and more Pepsi.” (This is the substitution effect.)
Which statement do you find more compelling?
In fact, both of these statements make sense. The decrease in the price of Pepsi
makes the consumer better off. If Pepsi and pizza are both normal goods, the con- sumer will want to spread this improvement in his purchasing power over both goods. This income effect tends to make the consumer buy more pizza and more Pepsi. Yet, at the same time, consumption of Pepsi has become less expensive rela- tive to consumption of pizza. This substitution effect tends to make the consumer choose more Pepsi and less pizza.
Now consider the end result of these two effects. The consumer certainly buys more Pepsi, because the income and substitution effects both act to raise purchases of Pepsi. But it is ambiguous whether the consumer buys more pizza, because the
income effect
the change in consumption that results when a price change moves the consumer to a higher or lower indifference curve
substitution effect
the change in consumption that results when a price change moves the consumer along a given indifference curve to a point with a new marginal rate of substitution