Dominick Salvatore Schaums Outline of Microeconomics, 4th edition Schaums Outline Series 2006

CHAP. 4] CONSUMER DEMAND THEORY 93
constant, and (d) explain how you derived the demand curve for commodity X along which real
income is kept constant.
(a) and (b)
Fig. 4-29
(c)
(d)
In panel A, the consumer moves from equilibrium point E (on budget line 2 and indifference curve II) to
equilibrium point J (on budget line 4 and indifference curve IV) as a result of the reduction of P x , ceteris
paribus. Thus, when P x ¼ $2, the consumer purchases 4X per time period (point E 0 on d x in panel B); when
P x ¼ $1, the consumer purchases 9X (point J 0 on d x ). Of the total increase in the quantity of X demanded,
part is due to the substitution effect and the remainder is due to the income effect. (Since in Problem 4.28 we
found that X is a normal good, both the substitution effect and the income effect work in the same direction.)
Thus, as P x falls (and we move along d x in a downward direction), the consumer’s money income remains
constant but real income increases. To be noted is that in this example, the income effect is greater than the
substitution effect. In the real world, the substitution effect is usually much stronger than the income effect.
Many economists prefer to keep the consumer’s real income constant in deriving a demand curve. One way
to keep real income constant is to reduce the consumer’s money income sufficiently to eliminate the income
effect of the price change. In the previous figure, this is accomplished by shifting budget line 4 (parallel to
itself) until it is tangent to indifference curve II. What we get is budget line 4 0 which reflects the same relative
prices as budget line 4, but $5 less of money income. The movement from E to K along indifference
curve II is then the substitution effect of the price change. The movement from K to J is the income effect of
the price change; dx 0 reflects only the substitution effect. Thus along dx, 0 the consumer’s real income is held
constant. Note that dx 0 is less price-elastic than d x .