Normal Goods: Income & Substitution Effects

Income & Substitution Effects of Normal Goods

As we know that a change in the price of a good causes a change in the demand for the good, ceteris paribus, and is known as the price effect. Further, this price effect is divided into the income effect and substitution effect for the consumer to make his choices wisely.

The income effect arises because of a change in a consumer’s real income or purchasing power, which is caused by the change in its price, i.e. a rise in the price, reduces, and a fall in price increases a consumer’s real income. Furthermore, a change in the real income leads to a change in the consumer’s consumption basket, which is also known as the income effect of price change.

On the other hand, when the price of one commodity decreases, it becomes relatively cheaper than the other, and the consumer substitutes cheaper goods for relatively costlier ones. This is known as the substitution effect.

The total of these two effects (income effect and substitution effect) is known as the price effect. There are two methods to evaluate the price effect:

• Hicksian Method to Evaluate Price Effect
• Slutskian Method to Evaluate Price Effect

Hicksian Approach: To Evaluate Price Effect

Income and Substitution Effect for a Fall in the Price of X

Let the consumer is initially in the equilibrium at point P on IC₁ with the MN budget line, where he consumes PX₁ of Y and OX₁ of X. Now, if the price of X falls, and then the budget line will pivot to MN”. On this new budget line the consumer will be at equilibrium at point Q as IC₂ is tangent on MN” at point Q.

Now since the price of X has fallen and correspondingly, the consumer I also moves to point Q as his equilibrium, so now he will consume more of X compared to his previously selected basket of goods. At this point, he will buy an additional X₁X₃ of X. Thus, the total price effect on the consumption of X is X₁X₃.

The next step is to split this price effect into substitution and income effect.

According to Hicks, first measure the income effect, then the residue would be the substitution effect. For this, he reduced the income of the consumer (by way of taxation) so that the consumer would again reach back to his original IC1 in accordance with the new price ratio.

Hicks calls it an “income compensation approach” as when the price of X falls, the purchasing power of the consumer increases for X, so in order to bring the consumer back to his original IC, Hicks suggested to reduce his level of income (in order to show the income effect). This is done by drawing an imaginary budget line, M’N’, which is also tangent to IC₁ at point R.

Thus R is the consumer’s new equilibrium point after eliminating the real income effect, which in turn means that, after income adjustment, the consumer will move from point Q to R. This will lead to a reduction in X by X2X3, which is also known as the income effect.

Now as per hicks, the substitution effect can be derived by subtracting this income effect from the total price effect. In other words,

SE = PE – IE

SE = X₁X₃ – X₂X₃ = X₁X₂

Income and Substitution Effect for an Increase in the Price of X

Suppose that the consumer’s initial budget line is given by AB and the consumer is in equilibrium at point E₂ on the indifference curve IC₂ where he consumes OX₃of commodity X. When the price of X increases, the budget line shifts from AB to AD and the consumer moves to a new equilibrium point E₁ on a lower indifference curve IC₁. This decrease in consumption of X, that is, OX₃ − OX₁ = X₁X₃, is the price effect.

Now as per the Hicksian method, i.e. the ‘income compensation approach’, let us suppose that the government grants ‘dearness allowance’ (DA) to the consumer, which is just sufficient to compensate him for the loss of his real income due to the rise in the price of X so that he could move on to his original indifference curve, IC₂.

This will also shift the consumer’s budget line AD to HC, which will be tangent to the original indifference curve IC₂ at point E₃, which is the consumer’s equilibrium point after income compensation. The consumer’s movement from point E₁ to point E₃ shows a rise by X₁X₂ in the consumption of X. This rise in consumption of commodity X is the result of a rise in the real income after the grant of compensatory DA. Therefore, X₁X₂ is the income effect.

Now since, PE = X₁X₃ and IE = X₁X₂, SE = X₁X₃ − X₁X₂ = X₂X₃. The consumer moves (after the grant of DA) from equilibrium point E₂ to E₃. This movement indicates a decrease in the consumption of commodity X by X₂X₃. This means that the consumer reduces the consumption of commodity X when its price rises. Thus, X₂X₃ is the substitution effect.

Slutskian Approach: To Evaluate Price Effect

In contrast to the Hicksian approach, Slutsky suggested that consumer’s income should be so adjusted that the consumer returns not only to their original indifference curve but also to the original point of equilibrium; that is, they are able to buy the original combination of the two goods after the change in the price ratio.

In other words, the consumer’s income-adjusted budget line must pass through the initial equilibrium point on the original indifference curve.

Suppose that the consumer, given an income and the prices of commodities X and Y, is initially in equilibrium at point P on the indifference curve IC₁, where he consumes OX₁ of commodity X. When the price of X falls, other factors remain the same, the consumer moves to a new equilibrium point Q on the indifference curve IC₃, which in turn increases the consumer’s purchase of X by X₁X₃. This is the price effect caused by the fall in the price of X.

Now in order to split this price effect into substitution and income effect, as per Slutsky, the consumer’s real income must be reduced to the level to make them capable of purchasing the original bundle of both goods at a new price ratio.

This can be done by drawing an imaginary budget line M′N′ through point P, and is tangent to IC₂ at point R. Point R is the consumer’s equilibrium after income adjustment, which shows a decrease by X₂X₃ in the consumption of X. The quantity X₂X₃ is, therefore, the income effect. The SE, thus, would be X₁X₃ – X₂X₃ = X₁X₂.

Read More- Microeconomics

1. Microeconomics: Definition, Meaning and Scope
2. Methods of Analysis in Economics
3. Problem of Choice & Production Possibility Curve
4. Concept of Market & Market Mechanism in Economics
5. Concept of Demand and Supply in Economics
6. Concept of Equilibrium & Dis-equilibrium in Economics
7. Cardinal Utility Theory: Concept, Assumptions, Equilibrium & Drawbacks
8. Ordinal Utility Theory: Meaning & Assumptions
9. Indifference Curve: Concept, Properties & Shapes
10. Budget Line: Concept & Explanation
11. Consumer Equilibrium: Ordinal Approach, Income & Price Consumption Curve
12. Applications of Indifference Curve
13. Measuring Effects of Income & Excise Taxes and Income & Excise Subsidies
14. Normal Goods: Income & Substitution Effects
15. Inferior Goods: Income & Substitution Effects
16. Giffen Paradox or Giffen Goods: Income & Substitution Effects
17. Concept of Elasticity: Demand & Supply
18. Demand Elasticity: Price Elasticity, Income Elasticity & Cross Elasticity
19. Determinants of Price Elasticity of Demand
20. Measuring Price Elasticity of Demand
21. Price Elasticity of Supply and Its Determinants
22. Revealed Preference Theory of Samuelson: Concept, Assumptions & Explanation
23. Hicks’s Revision of Demand Theory
24. Choice Involving Risk and Uncertainty
25. Inter Temporal Choice: Budget Constraint & Consumer Preferences
26. Theories in Demand Analysis
27. Elementary Theory of Price Determination: Demand, Supply & Equilibrium Price
28. Cobweb Model: Concept, Theorem and Lagged Adjustments in Interrelated Markets
29. Production Function: Concept, Assumptions & Law of Diminishing Return
30. Isoquant: Assumptions and Properties
31. Isoquant Map and Economic Region of Production
32. Elasticity of Technical Substitution
33. Law of Returns to Scale
34. Production Function and Returns to Scale
35. Euler’s Theorem and Product Exhaustion Theorem
36. Technical Progress (Production Function)
37. Multi-Product Firm and Production Possibility Curve
38. Concept of Production Function
39. Cobb Douglas Production Function
40. CES Production Function
41. VES Production Function
42. Translog Production Function
43. Concepts of Costs: Private, Social, Explicit, Implicit and Opportunity
44. Traditional Theory of Costs: Short Run
45. Traditional Theory of Costs: Long Run
46. Modern Theory Of Cost: Short-run and Long-run
47. Modern Theory Of Cost: Short Run
48. Modern Theory Of Cost: Long Run
49. Empirical Evidences on the Shape of Cost Curves
50. Derivation of Short-Run Average and Marginal Cost Curves From Total Cost Curves
51. Cost Curves In The Long-Run: LRAC and LRMC
52. Economies of Scope
53. The Learning Curve
54. Perfect Competition: Meaning and Assumptions
55. Perfect Competition: Pricing and Output Decisions
56. Perfect Competition: Demand Curve
57. Perfect Competition Equilibrium: Short Run and Long Run
58. Monopoly: Meaning, Characteristics and Equilibrium (Short-run & Long-run)
59. Multi-Plant Monopoly
60. Deadweight Loss in Monopoly
61. Welfare Aspects of Monopoly
62. Price Discrimination under Monopoly: Types, Degree and Equilibrium
63. Monopolistic Competition: Concept, Characteristics and Criticism
64. Excess Capacity: Concept and Explanation
65. Difference Between Perfect Competition and Monopolistic Competition
66. Oligopoly Market: Concept, Types and Characteristics
67. Difference Between Oligopoly Market and Monopolistic Market
68. Oligopoly: Collusive Models- Cartel & Price Leadership
69. Oligopoly: Non-Collusive Models- Cournot, Stackelberg, Bertrand, Sweezy or Kinked Demand Curve
70. Monopsony Market Structure
71. Bilateral Monopoly Market Structure
72. Workable Competition in Market: Meaning and Explanation
73. Baumol’s Sales Revenue Maximization Model
74. Williamson’s Model of Managerial Discretion
75. Robin Marris Model of Managerial Enterprise
76. Hall and Hitch Full Cost Pricing Theory
77. Andrew’s Full Cost Pricing Theory
78. Bain’s Model of Limit Pricing
79. Sylos Labini’s Model of Limit Pricing
80. Behavioural Theory of Cyert and March
81. Game Theory: Concept, Application, and Example
82. Prisoner’s Dilemma: Concept and Example