9.4 Graphical Analysis of Income and Substitution Effects

Having derived the Hicks bundle, we can use it to decompose the overall effect of the price change $(A \rightarrow C)$ into the substitution effect ($A \rightarrow B$) and the income effect ($B \rightarrow C$).

The substitution effect is caused by a shift of the IOC as the price ratio adjusts. It is a movement along the original indifference curve $U_1$, because we’re holding the level of utility constant.

The income effect is compares the bundle the consumer actually buys at the new prices ($C$) with the bundle they would buy if they had just enough money to afford their initial utility at the new prices ($B$). Since the price ratio is the same for each of these cases, this represented by a movement along the IOC corresponding to the new price ratio: