Splitting a Price Rise into Two Effects

Ogden has $120. Haircuts cost $20 and pizzas $6, and he chooses A, ten pizzas and three haircuts. Then haircuts rise to $30. His budget line pivots inward and he ends at B, ten pizzas and two haircuts.

The move from A to B is really two moves at once. The dashed line has the new, steeper price of haircuts but is placed to keep Ogden exactly as well off as before. Sliding along his original curve from A to the dashed line's tangency at C is the substitution effect: haircuts are dearer relative to pizza, so he takes fewer haircuts and more pizza. Dropping from C to B is the income effect: the price rise has made him poorer, which pulls both back down. The slider sets the new price of a haircut.