Income and substitution effect

Definition of income effect: An increase in price reduces a consumer’s buying power, effectively reducing the consumer’s income and causing the consumer to buy less of at least some goods.

Income effect describes the effects of changes in prices on consumption. According to the income effect, an increase in price causes a buyer to demand the lower quantity of the commodity and vice versa. Although the buyer's actual income hasn't changed, the change in price makes the buyer feel as it has because his real income has decreased.

With the increase in the price of B , budget line has shifted from B1 to B2. And the quantity demanded has also decreased Q1 to Q2., also shifting the consumer optimum point from IC1 to IC2. We know IC2 is a lower indifference curve and hence will impart lower utility to the consumer.Deacrease in quantity demaded due to increase in price, leading to fall in real income) is called income effect.

(eg. If a consumer has an income of 100 Rs and with this income he can buy 10 pens worth 10 Rs each. And Suppose, the price of the pen has increased from 10 to 20 Rs. . Now with the same income, consumer can buy only 5 units of the commodity. So, his real income has decreased causing the consumer to demand low.)

The substitution effect

Due to the price of good x increasing, the budget line has pivoted from B1 to B2 and the consumption point has moved.

Definition of Substitution effect: If utility held constant, as the price of the good increases, consumers substitute other, now relatively cheaper goods for that one.