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I’m currently reading the core economics textbook, and I’m confused by the description of income and substitution effects.

The income effect is defined as the effect on the point where marginal rate of transformation (wage) equals marginal rate of substitution from an increase in income but not a change in marginal rate of transformation (wage).

The substitution effect is defined as the effect on the point where marginal rate of transformation (wage) equals marginal rate of substitution due to a change in the marginal rate of transformation (wage).

The following diagram is then used to explore this: enter image description here

I understand that the income effect is the move from A to C. And the substitution effect, changing the marginal rate of transformation (wage) gives the move from A to D.

But I don’t understand what this overall effect is in this context, nor why it is not simply the move from A to D.

(Note: I have assumed that the presentation and definitions here are standard. If that’s not the case I can provide more detail).

Thanks for any help,

hmmm16

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1 Answer 1

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So I think I can answer my own question here.

The income effect is the impact of of fixed increase in income without any change in wage/marginal rate of transformation.

But the substitution effect is defined incorrectly. It’s the impact of the increase in wage/marginal rate of transformation assuming that you are already at that level of utility/on the same indifference curve.

So the income effect is given by the move from A to C. But the substitution effect is given by the move from C to D.

The overall effect is given by the move from A to C and is the sum of the income effect and substitution effect.

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