PRICE EFFECT, SUBSTITUTION EFFECT

AND INCOME EFFECT

The Secrets of the Perfect Diagram

Nb: In this guide, we will only consider changes in the price of Good X. Use a ruler to
draw straight lines (both solid and dash).

CASE 1: GOOD X IS A NORMAL GOOD

CASE 1.1: INCREASE IN THE PRICE OF GOOD X

1) Draw the axes. Make sure your diagram is large enough (use the entire page width).
The x-axis may be longer than the y-axis. Label the x-axis “Quantity of Good X” and the
y-axis “Quantity of Good Y”.
2) Draw the initial budget line. Label it BL1. The vertical intercept should be high and the
horizontal intercept should be far to the right.

3) Choose a point on BL1 and label it “A”. You may use a cross to locate it precisely. Ideally,
it should be slightly below the mid-point of BL1. Use a dash line to identify the quantity
of Good X demanded at point A and label it “xA”.
4) Draw the initial indifference that is tangent to BL1 at point A and label it IC1. Make sure
the slope of IC1 does not suddenly change around point A. That is, IC1 should NOT be
very steep to the left of A and then suddenly very flat to the right of A. The slope of IC1
should decrease gradually. Also, make sure IC1 is decreasing and convex over its entire
range.

5) Draw the new budget line and label it BL2. It should have the same vertical intercept
but it should be steeper. Make sure you do NOT draw 2 budget lines that have almost
the same slope… Careful though, BL2 should not be steeper than the top section of IC1.
Do not forget to add an arrow to emphasize the direction of the shift.
6) Choose a point on BL2 and label it “B”. You may use a cross to locate it precisely. Ideally,
it should be around the mid-point of BL2. Use a dash line to identify the quantity of
Good X demanded at point B and label it “xB”. It is very important to ensure that xB is
substantially smaller than xA (i.e. do not pick a point B such that xB is just slightly smaller
than xA).

7) Draw the final indifference that is tangent to BL2 at point B and label it IC2. Make sure
that it is decreasing and convex over its entire range. IC2 must not cut IC1.
8) Draw an arrow below the horizontal axis that goes from xA to xB and label it “PE” for
“Price Effect”. Make sure the arrow point to the left.

9) Take you ruler and align it until it is parallel with BL2. Make it slide outward without
changing its angle until it becomes tangent with IC1. The tangency point should be
labelled “Z”.
10) Use a dash line to identify the quantity of Good X demanded at point Z and label it
“xZ”. xZ must be in between xB and xA.
11) Draw 2 arrows below the “PE arrow” and at the same level. One from xA to xZ that
you will label “SE” for “Substitution Effect” and one from xZ to xB that you will label “IE”
for “Income Effect”. Both arrows should be pointed to the right.