In the figure, OX and OY are the X- an d Y- Axes. X-axis measures good X and Y-axis measures good Y. Initially, the AB budget line is constructed, and an indifference curve (IC1) is drawn tangent to budget line AB. Thus, the consumer consumes Q1 quantity of good X. Suppose, the price of good X decreases. With the decrease in the price of good X, the consumer can purchase more units of good X that previous. So, the budget line AB swung outward and formed new budget line AE. The new indifference curve (IC2) is formed tangent to new budget line AE. Thus, the consumer consumes Q2 unit of good X. Thus, the increase in the
consumption of good X from Q1 to Q2 is called price effect.
Now, let us suppose that income of consumer that decreases, the budget line has shifted inward to CD. The new budget line CD is parallel to AE. The line CD is tangent to IC1 at point W. thus, a consumer consumers Q3 units of Good X. Hence, the shift of Consumption from Q1 to Q3 is called substitution effect because the consumer has substituted some amount of good Y to consume some extra amount of good X. It is substitution effect as combination V(QX,QY) and W(QX,QY) lies on same Indifference curve i.e. both the combinations gives same amount of utility.
Finally, the increase in the consumption of Good X from Q2 to Q3 is income effect. It is income effect because combination Z (QX, QY) is tangent to AE, and W (QX, QY) tangent to CD, AE is parallel to CD and AE is above CD represents the increase in income. Thus, shift of consumer’s choice from combination W (QX, QY) to Z (QX, QY) is an income effect.
So,
Price Effect = 0Q2 - 0Q1 = Q2Q1
Substition Effect = 0Q3-0Q1 = Q3Q1
Income Effect = 0Q3 - 0Q2 = Q3Q2
PRICE EFFECT = SUBSTITUTION EFFECT + INCOME EFFECT
PRICE EFFECT = Q3Q1 + Q3Q2
PRICE EFFECT = Q2Q1
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