Breaking up Price Effect into

Income and Substitution Effect

(with diagram)
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As price of a good X falls, other things remaining the same,

consumer would move to a new equilibrium position at a higher
indifference curve and would buy more of good X at the lower price
unless it is a Giffen good.

Thus, in the Fig. 8.43 the consumer who is initially in equilibrium at

Q on indifference curve IC1 moves to the point R on indifference
curve IC2 when the price of good X falls and the budget line twists
from PL1 to PL2.
The movement from Q to R represents the price effect. It is now
highly important to understand that this price effect is the net result
of two distinct forces, namely substitution effect and income effect.
In other words, price effect can be split up into two different parts,
one being the substitution effect and the other income effect.

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There are two approaches for decomposing price effect into its two
parts, substitution effect and income effect. They are the Hicksian
approach and Slutsky approach.

Further, Hicksian approach uses two methods of splitting

the price effect, namely:
(i) Compensating variation in income

(ii) Equivalent variation in income.

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Slutsky uses cost-difference method to decompose price effect into

its two component parts. How the price effect can be decomposed
into income effect and substitution effect by the Hicksian methods is
explained below.

1. Breaking up Price Effect: Compensating Variation in

Income:
In the method of breaking up price effect by compensating variation
we adjust the income of the consumer so as to offset the change in
satisfaction resulting from the change in price o a good and bring
the consumer back to his original indifference curve, that is, his
initial level of satisfaction which he was obtaining before the change
in price occurred. For instance, when the price of a commodity falls
and consumer moves to a new equilibrium position at a higher
indifference curve his satisfaction increases.

To offset this gain in satisfaction resulting from a fall in price of the

good we must take away from the consumer enough income to force
him to come back to his original indifference curve. This required
reduction in income (say, through levying a lump sum tax) to cancel
out the gain in satisfaction or welfare occurred by reduction in price
of a good is called compensating variation in income.

This is so called because It compensates (in a negative way) for the

gain in satisfaction resulting from a price reduction of the
commodity. How the price effect is broken up into substitution
effect and income effect through the method of compensating
variation in income is illustrated in Fig 8.43.
 When price of
good X falls and as a result budget line shifts to PL2, the real income
of the consumer rises, i.e., he can buy more of both the goods with
his given money income. That is, price reduction enlarges
consumer’s opportunity set of the two goods. With the new budget
line PL2 he is in equilibrium at point R on a higher indifference
curve IC2 and thus gains in satisfaction as a result of fall in price of
good X.
Now, if his money income is reduced by the compensating variation
in income so that he is forced to come back to the original
indifference curve IC1 he would buy more of X since X has now
become relatively cheaper than before. In Fig. 8.43 as result of the
fall in price of X, price line switches to PL2. Now, with the reduction
in income by compensating variation, budget line shifts to AB which
has been drawn parallel to PL2 so that it just touches the
indifference curve IC1 where he was before the fall in price of X.
Since the price line AB has got the same slope as Pig, it represents
the changed relative prices with X being relatively cheaper than
before. Now, X being relatively cheaper than before, the consumer
in order to maximise his satisfaction in the new price income
situation substitutes X for Y.
Thus, when the consumer’s money income is reduced by the
compensating variation in income (which is equal to PA in terms of
Y or L2B in terms of X), the consumer moves along the same
indifference curve IC1 and substitutes X for Y. With price line AB, he
is in equilibrium at S on indifference curve IC1 and is buying MK
more of X in place of Y. This movement from Q to S on the same
indifference curve IC1 represents the substitution effect since it
occurs due to the change in relative prices alone, real income
remaining constant.
If the amount of money income which was taken away from him is
now given back to him, he would move from S on indifference curve
IC1 to R on a higher indifference curve IC2. The movement from Son
a lower in difference curve to R on a higher in difference curve is the
result of income effect. Thus the movement from Q to R due to price
effect can be regarded as having been taken place into two steps first
from Q to S as a result of substitution effect and second from S to R
as a result of income effect. In is thus manifest that price effect is the
combined result of a substitution effect and an income effect.
In Fig. 8.43 the various effects on the purchases of good X
are:
Price effect = MN

Substitution effect = MK

Income effect = K/V

MN = MK+KN or

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Price effect = Substitution effect + Income effect

From the above analysis, it is thus clear that price effect is the sum
of income and substitution effects.

2. Breaking up Price Effect: Equivalent Variation in

Income:
As mentioned above, price effect can be split up into substitution
and income effects” through an alternative method of equivalent
variation in income. The reduction in price of a commodity
increases consumer’s satisfaction as it enables him to reach a higher
indifference curve. Now, the same increase in satisfaction can be
achieved through bringing about an increase in his income, prices
remaining constant.

The increase in income of the consumer prices of goods remaining

the same, so as to enable him to move to a higher subsequent
indifference curve at which he in fact reaches with reduction in price
of a good is called equivalent variation in income because it
represents the variation in income that is equivalent in terms of gain
in satisfaction to a reduction in price of the good.

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Thus, in this equivalent income-variation method substitution effect

is shown along the subsequent indifference curve rather than the
original one. How this price effect is decomposed into income and
substitution effects through equivalent variation in income is shown
in Fig. 8.44.

When price of good X falls, the consumer can purchase more of both
the goods, that is, the purchasing power of his given money income
rises. It means that after the fall in price of X if the consumer buys
the same quantities of goods as before, then some amount of money
will be left over. In other words, the fall in price of good X will
release some amount of money. Money thus released can be spent
on purchasing more of both the goods.

It therefore follows that a change in price of the good produces an

income effect. When the power to purchase goods rises due to the
income effect of the price change, the consumer has to decide how
this increase in his purchasing power is to be spread over the two
goods he is buying. How he will spread the released purchasing
power over the two goods depends upon the nature of his income
consumption curve which in turn is determined by his preferences
about the two goods.

From above it follows, that, as a result of the increase in his

purchasing power (or real income) due to the fall in price, the
consumer will move to a higher indifference curve and will become
better off than before. It is as if price had remained the same but his
money income was increased. In other words, a fall in price of good
X does to the consumer what an equivalent rise in money income
would have done to him.

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As a result of fall in price of X, the consumer can therefore be

imagined as moving up to a higher indifference curve along the
income consumption curve as if his money income had been
increased, prices of X and Y remaining unchanged. Thus, a given
change in price can be thought of as an equivalent to an appropriate
change in income.
It will be seen from Fig. 8.44 that with price line PL1, the consumer
is in equilibrium at Q on indifference curve IC1. Suppose price of
good X falls, price of Y and his money income remaining unaltered,
so that budget line is now PL2. With budget line PL2, he is in
equilibrium at R on indifference curve IC2. Now, a line AB is drawn
parallel to PL1 so that it touches the indifference curve IC2 at S.
It means that the increase in real income or purchasing power of the
consumer as a result of the fall in price of X is equal to PA in terms
of Y or L1B in terms of X Movement of the consumer from Q on
indifference curve IC1 to S on the higher indifference curve IC2 along
the income consumption curve is the result of income effect of the
price change. But the consumer will not be finally in equilibrium at
S.
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This is because now that X is relatively cheaper than Y, he will

substitute X, which has become relatively cheaper, for good Y, which
has become relatively dearer. It will be gainful for the consumer to
do so. Thus the consumer will move along the indifference curve
IC2 from S to R. This movement from S to R has taken place because
of the change in relative prices alone and therefore represents
substitution effect. Thus the price effect can be broken up into
income and substitution effects, showing in this case substitution
along the subsequent indifference curve.
In Fig 8.44 the magnitudes of the various effects are:
Price effect = MN

Income effect = MH

Substitution effect = HN

In Fig. 8.44 effect = MMH + HN

Price effect = Income Effect + Substitution Effect

Conclusion:
The Slutsky theorem is a good approximation to keep real income
constant and is superior to Hicks’ method. The Slutsky substitution
effect provides the consumer greater satisfaction by bringing him on
a higher indifference curve, while the Hicksian substitution effect
brings him back to the initial level of satisfaction on the original
indifference curve.

Conclusion:
The Hicksian method of decomposing the price effect into the
substitution and income effects is defective in that it lacks practical
applicability because it is not possible to know exactly how much
real income of the consumer should be changed in order to keep
him on the original indifference curve. The Slutsky method tries to
solve it by taking the apparent real income of the consumer.