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DECOMPOSITION OF PRICE EFFECT

The change in the price of a good and the resulting change in the quantity demanded
is called as price effect. The law of demand accounts for the price effect using the
concepts of substitution effect and income effect. The substitution effect involves the
substitution of good X for good Y or vice-versa due to a change in relative prices of
the two goods. The income effect results from an increase or decrease in the
consumer’s real income or purchasing power as a result of the price change. The sum
of these two effects is called the price effect. However the law of demand does not
tell us how much of the price effect is due to substitution effect and how much is due
to income effect. In order to know the magnitudes of the two effects it is necessary to
decompose the price effect into income and substitution effect.
The decomposition of the price effect into the income and substitution effect can
be done in several ways
There are two main methods:
(i) The Hicksian method; and
(ii) The Slutsky method
A change in the price of a good alters the slope of the budget constraint and it also
changes the MRS at the consumer’s utility-maximizing choices.
The substitution effect:
• . Even if the individual remained on the same indifference curve when the price
changes, his optimal choice will change because the MRS must equal the new
price ratio. If the price of good X changes the rate at which the consumer can
exchange good Y for X also changes. The trade of between the two good that the
market presents the consumer has changed. This is the effect of substitution
effect.
The income effect
• The price change alters the individual’s “real” income. That is even though his
money income remains the same, the purchasing power of the consumer’s money
income following a change in the price of good X. So the amount purchased of X
changes and therefore he must move to a new indifference curve. This is the
income effect.
The following figure illustrates income effect and substitution effect.
Suppose the consumer is maximizing utility at point E1. If the price of good X falls,
the consumer will maximize utility at point E2. To isolate the substitution effect, we
hold “real” income constant but allow the relative price of good X to change. The
substitution effect is the movement from point E1 to point E’. The individual
substitutes good X for good Y because it is now relatively cheaper. The income
effect occurs because the individual’s “real” income changes when the price of good
X changes. The income effect is the movement from point E’ to point E 2. Since X is
a normal good, the individual buys more because of the increase in real income.
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Hicksian Method of Isolating Income Effect from Price Effect
The change in the price of a good and the resulting change in the quantity demanded
is called as price effect. The law of demand accounts for the price effect using the
concepts of substitution effect and income effect. The substitution effect involves the
substitution of good X for good Y or vice-versa due to a change in relative prices of
the two goods. The income effect results from an increase or decrease in the
consumer’s real income or purchasing power as a result of the price change. The sum
of these two effects is called the price effect. However the law of demand does not
tell us how much of the price effect is due to substitution effect and how much is due
to income effect. In order to know the magnitudes of the two effects it is necessary to
decompose the price effect into income and substitution effect.
The decomposition of the price effect into the income and substitution effect can
be done in several ways
There are two main methods:
(i) The Hicksian method; and
(ii) The Slutsky method
A change in the price of a good alters the slope of the budget constraint and it also
changes the MRS at the consumer’s utility-maximizing choices.
The substitution effect:
• . Even if the individual remained on the same indifference curve when the price
changes, his optimal choice will change because the MRS must equal the new
price ratio. If the price of good X changes the rate at which the consumer can
exchange good Y for X also changes. The trade of between the two good that the
market presents the consumer has changed. This is the effect of substitution
effect.
The income effect
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• The price change alters the individual’s “real” income. That is even though his
money income remains the same, the purchasing power of the consumer’s money
income following a change in the price of good X. So the amount purchased of X
changes and therefore he must move to a new indifference curve. This is the
income effect.
In order to find out the magnitude of substitution effect, Slutsky and Hicks have used
the indifference curves. However the methodology of isolating income effect from
price effect differs in the two analysis. In the Hicksian method, the income effect is
nullified to arrive at the substitution effect, retaining the consumer on the original
indifference curve. In Slutsky’s method, the criterion for isolating the income effect is
that the original basket of goods should be available to the consumer after the income
effect has been cancelled out.
The following diagram explains the Hicksian method decomposition of price effect.

In the diagram the original price line is AB on which the consumer’s equilibrium is at E1.
With a fall in the price of X, the slope of the budget line changes and the new budget line
is AB’, The consumer ‘s equilibrium after the price fall is on AB’at E2. The change in
quantity demanded as a result of the movement from E 1 to E2 following a fall in the price
of X is X1X2, which includes a substitution effect and income effect. To separate the two
effects, that is , to find out how much of the change in quantity demanded is due to
income effect and how much is due to substitution effect, a simple exercise may be
performed that cancels out the income effect.
Since a price fall increases the real income of the consumer, the money income of the
consumer is decreased to cancel out the income effect. By how much should the money
income of the consumer be reduced? To this question the answer given by Hicks is, that,
the amount to be removed to cancel out the income effect is that amount which will retain
the original level of welfare to the consumer. Such an amount is Rs AC in the figure, the
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removal of this amount generates the new budget line CD, parallel to AB’. The
consumer ‘s equilibrium on CD is at E’. The canceling out of the income effect has
resulted in decrease in the quantity demanded by X2X’.The balance of the price effect,
namely, X,X1 is the substitution effect. Following susbtituion effect the consumer moves
from point E1 to E’ on indifference curve I1. Having identified the magnitude of the
substitution effect and income effect, the money income removed from the consumer
may be returned to the consumer; this will put the consumer back on AB’ at E 2 on
indifference curve I2.
Slutsky’s Method:
In Slutsky’s method, with the removal of the income effect, the original basket of good
must be available to the consumer. This means that the compensation variation line
should pass through the original equilibrium as shown in the following diagram.

In the diagram the budget line after the cancelling out of the income effect is CD whaich
passes through the original equilibrium E1. This implies that the original basket of goods
is still available to the consumer after the removal of money income to cancel out the real
income effect. However the consumer buys a different basket of goods at E’, establishing
clear preference for E’ over E1. Hence E’ is on a higher indifference curve. The
movement from E1 to E’ is substitution effect. Clearly substitution effect takes consumer
to a higher indifference curve from I0 to I1. Restoration of income effect takes the
consumer to I2.
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DECOMPOSITION OF PRICE EFFECT


COMPARISON OF HICKSIAN METHOD WITH SLUTSKY’S METHOD

The change in the price of a good and the resulting change in the quantity demanded
is called as price effect. The law of demand accounts for the price effect using the
concepts of substitution effect and income effect. The substitution effect involves the
substitution of good X for good Y or vice-versa due to a change in relative prices of
the two goods. The income effect results from an increase or decrease in the
consumer’s real income or purchasing power as a result of the price change. The sum
of these two effects is called the price effect. However the law of demand does not
tell us how much of the price effect is due to substitution effect and how much is due
to income effect. In order to know the magnitudes of the two effects it is necessary to
decompose the price effect into income and substitution effect.
The decomposition of the price effect into the income and substitution effect can
be done in several ways
There are two main methods:
(i) The Hicksian method; and
(ii) The Slutsky method
A change in the price of a good alters the slope of the budget constraint and it also
changes the MRS at the consumer’s utility-maximizing choices.
The substitution effect:
• . Even if the individual remained on the same indifference curve when the price
changes, his optimal choice will change because the MRS must equal the new
price ratio. If the price of good X changes the rate at which the consumer can
exchange good Y for X also changes. The trade of between the two good that the
market presents the consumer has changed. This is the effect of substitution
effect.
The income effect
• The price change alters the individual’s “real” income. That is even though his
money income remains the same, the purchasing power of the consumer’s money
income following a change in the price of good X. So the amount purchased of X
changes and therefore he must move to a new indifference curve. This is the
income effect.
In order to find out the magnitude of substitution effect, Slutsky and Hicks have used the
indifference curves. However the methodology of isolating income effect from price
effect differs in the two analysis. In the Hicksian method, the income effect is nullified to
arrive at the substitution effect, retaining the consumer on the original indifference
curve. In Slutsky’s method, the criterion for isolating the income effect is that the original
basket of goods should be available to the consumer after the income effect has been
cancelled out.
The two methods to decompose Price effect are compared in the following diagram.
In the diagram AB is the original budget line. AB’ is the budget line after the fall in
price. The consumer is in equilibrium on AB at E 1. With a fall in the price of X he buys
more of X due to substitution effect and income effect. As a result his new equilibrium is
at E2. and he buys X1X2 more of X. To determine the magnitude of income effect and
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substitution effect and income effect. The income effect may be isolated through the
removal of appropriate sum of money income from the consumer.

For this hypothetical exercise two methods have been suggested. The one suggested by
Hicks requires that after the removal of the money income the consumer should be able
to retain the original level of welfare. Following this we construct the budget line CHDH
which is tangent to the original indifference curve at EH. The new budget line CHDH is
parallel to AB’ since the consumer buys at the new price ratio but has less income now
than at E2 and hence CHDH is below AB’. The movement from E1 to EH is the substitution
effect. If the income effect is restored the consumer moves back to E2 on and movement
from EH to E2 is income effect.
The method suggested by Hicks requires that after the removal of the money income the
consumer should be able to buy the original basket of goods. Following this we construct
the budget line CsDs which is tangent to the original indifference curve at Es. The new
budget line CsDs is parallel to AB’ since the consumer buys at the new price ratio but has
less income now than at E2 and hence CsDs is below AB’. The movement from E1 to Es
is the substitution effect. If the income effect is restored the consumer moves back to E2
on and movement from Es to E2 is income effect.
It is clear from the diagram the substitution effect for a price fall is higher when Slutsky’s
method is applied than the Hicksian method. The substitution effect using Slutsky’s
method is X1Xs. SE using Hicksian method is X1XH. X1XS > X1XH in the diagram. Also it
can be seen in the diagram that SE and IE move in the same direction. This is so because
X is a normal good.