With higher income, the consumer can afford more of both goods. The increase in income, therefore, shifts the budget constraints outward. Because the relative price of the two goods has not changed, the slope of the new budget constraint is the same way as the slope of the initial budget constraint. That is, an increase in income leads to a parallel shift in the budget constraint.
The expanded budget constraint allows the consumer to choose a better combination of his purchases. Given the shift in the budget constraint and the consumer’s preferences as represented by his indifferences curves, the consumer’s optimum moves from the point labelled new optimum.
The consumer chooses to consume more Pepsi and more pizza (example). Although the logic of the model does not require increased consumption of both goods in response to increased income, this situation is the most common one. If a consumer wants more of a good when his income rises, economists call it a normal good. The indifferent curves are drawn under the assumption that both Pepsi and pizza are normal goods.
An example in which an increase in income induces the consumer to buy more of a costly item but less of cheaper variety. If a consumer buys less of a good when his incomes rise, economists call it an inferior good.
Although most goods are normal goods, there are some inferior goods in the world. One example is bus rides. High income consumers are more likely to own cars and less likely to ride a bus than low income consumers. Bus rides, therefore, are an inferior good.
Let’s now use this model of consumer choice to consider how a change in the price of one of the goods alters the consumer’s choices. Suppose, in particular, that the price of Pepsi falls from $2 to $1 a pint. It is no surprise that the lower price expands the consumer’s set of buying opportunities. In other words, a fall in the price of any good shifts the budget constraint outward.
More specifically, how the fall in price affects the budget constraint. If the consumer spends his entire $1,000 income on pizza, then the price of Pepsi is irrelevant. Yet if the consumer spends his entire income of $1,000 on Pepsi he can buy 1,000 rather than only 500 pints.
Notice that in this case the outward shift in the budget constraint changes its slope. (This differs from what happened previously when prices stayed the same but the consumer’s income changed). As we have discussed, the slope of the budget constraint reflects the relative price of Pepsi and pizza. Because the price of Pepsi has fallen to $1 from $2 while the price of pizza has remained $10, the consumer can now trade a pizza for 10 rather than 5 pints of Pepsi. As a result, the new budget constraint is more steeply sloped.
How such a change in the budget constraint alters the consumptions of both goods depends on the consumer’s preferences.
The impact of a change in the price of a good on consumption can be decomposed into two effects: an income effect and a substitution effect. To see what these effects are, consider how our consumer might respond when he learns that the price of Pepsi has fallen.
He might reason in the following ways:
*Great news! Now that Pepsi is cheaper, my income has greater purchasing power. I am , in effect richer than I was. Because I am richer I can buy both more Pepsi and more Pizza. (This is the income effect).
*Now that the price of Pepsi has fallen, I get more pints of Pepsi for every pizza that I give up. Because pizza is now relatively more expensive, I should buy less pizza and more Pepsi. (This is the substitution effect).
Which statement do you find more compelling?
In fact, both of those statements make sense. The decrease in the price of Pepsi makes the consumer better off. If Pepsi and pizza are both normal goods, the consumer will want to spread this improvement in his purchasing power over both goods. This income effect tends to make the consumer buy more pizza and more Pepsi. Yet at the same time, consumption of Pepsi has become less expensive relative to the consumption of pizza. This substitution effect tends to make the consumer choose more of Pepsi and less of pizza.