In economics, assume that the money income remaining constant, every pricechange can be decomposed into an income and substitution effect.1.
The substitution effect is when the price changes effect with the changesin relative price, because the customers to substitute one good to insteadof another.2.
In come effect is when the price of good changes affect the real moneyincome of consumer, also their purchasing power.However, the income and substitution effect also depends upon the good isnormal or inferior. Frist part
see what happens if the price of normal goodfall.
Income and substitution effects: normal good
See the diagram, OX1 and OX2 is the quantity of two goods and OX1 is a normalgood. Before the price X1 decrease, the maximizing consumer satisfactionequilibrium point is a. At this point, the budget line AB and indifference curve I1are tangent. There is no higher level of satisfaction can be attained at this case,because I1 is the slope describes how a consumer is willing to substitute foranother and at maximizing point a, the MRS=Pf/Pc, between the two goods X1and X2 are equals the price ratio.As the price of X1 falls, the equilibrium point shifts from a to b. so the newmaximizing equilibrium point becomes b, the new budget line shifts from AB toAB1, which are tangent with utility I2 (I2>I1). Due to the decrease in price, thedemand quantity increase and move to the right from Q1 to Q3.This is the to total effect of price decrease. We can separate the total effect toincome and the substitution effect.