The document discusses the concepts of income effect, substitution effect, and price effect. It explains: 1) When the price of a good changes, it leads to both a substitution effect as consumers switch to substitutes, as well as an income effect as the change in price impacts real income. 2) The Hicksian approach and Slutsky approach are two methods used to decompose the overall price effect into its substitution and income components by holding real income constant. 3) Under the Hicksian approach, money income is adjusted to keep real income constant, while the Slutsky approach assumes money income changes to maintain the original consumption quantities when prices change.

1. INCOME EFFECT,
SUBSTITUTION EFFECT
AND PRICE EFFECT
Dr Riyanka Baral

2. • The Marshallian utility analysis fails to break up the price effect into income effect
and substitution effect.It simply points out that a change in price produces an
opposite change in quantity demanded because of income and substitution effect.
• Marshall doesnot categorically explains as to how much of this change in quantity
demanded is due to income effect and substitution effect
• We have been concerned with consumer’s behavior under the assumption that
consumer’s income and market price of goods are given
• We will drop these assumptions and examine the consumers’ response to the
change in his income and price of goods.

3. Price Effect – Combination of
Substitution and Income Effect
• It refers to the change in the consumption of the commodities when the price of one of
the commodity changes, provided the price of other commodities and income of
consumers being the same.
• When the price of commodity changes, it has two effects :
• There is a change in the real income of the consumer, leading to a change in the
consumption of commodities. It is known as the Income Effect.
• The change in price results in the substitution of a relatively cheaper commodity for the
relatively dearer one. It is known as the Substitution Effect.
• The combination of these two effects is called the Price Effect.
• Price Effect as a combination explains the nature of the response in quantity purchased
due to change in price.
Price Effect = Substitute Effect + Income Effect

4. Substitution Effect
• Let us consider a two-commodity model.When the price of one commodity falls,
the consumer substitutes the cheaper commodity for the costlier commodity.This
is known as substitution effect.
• Eg: Coke andThums Up: Some people prefer to have coke while some other
people prefer to have thums Up ,now if the price of coke decreased then people
who were having coke will have it, also those people who were having thums Up
will also substitute to coke

5. Income effect
• Suppose the consumer’s money income is constant. Again, let us consider a two-
commodity model. Assume that the price of one commodity falls. This results in an
increase in the consumer’s real income, which raises his purchasing power. Due to an
increase in the real income, the consumer is now able to purchase more quantity of
commodities.This is known as income effect.
• Money in hand will not change.Eg: If the price of one bottle coke is Rs 20 and suppose
the price decreased to Rs 10.Now with reduced price if we spend Rs 20 we can take
two bottles of cokes. That means the consumers real income has increased. Earlier he
was able to purchase 1 bottle with Rs 20 now with Rs 20 he can purchase 2 bottles of
coke.
• Due to decrease in price the real income increased, so it is called as income effect

6. • In case of substitution effect when price of the
commodity decreased the consumer substituted to
other product
• Incase of income effect when the price of the
commodity decreased the consumers real income
increased
• Both these effect are due to price , so we call it as
price effect
• Now, can you tell how much increase in
consumption is due to income effect and how much
increase in consumption is due to substitution
effect?

7. Income Consumption Curve(ICC)
• When a consumers income increases the consumer would move
to a higher indifference curve along a new budget line obtaining
a higher level of satisfaction at a new equilibrium point.
• If the different equilibrium points of consumers resulting from
the change in income are added then we will get a curve called
income consumption curve(ICC).
• In the fig, X-axis shows the quantity of rasgulla and Y-axis shows
the quantity of Gulab Jamun. The income is shown by budget
line AB and E is the equilibrium point where the budget line is
tangent to an indifference curve. When the income of consumer
increases, the equilibrium point and budget line shifts to the
right i.e. E1 on the budget line CD. Similarly, with a fall in the
income, the consumer’s equilibrium and price or budget line
shift to E2 on EF.
• The line joining points E, E1 and E2, is called Income
Consumption Curve. Thus, ICC shows the quantities of rasgulla
and Gulab Jamun, the consumer buys at different levels of
income.

8. The slope of the Income Consumption
Curve
• The slope of the ICC curve varies with the type of goods involved. It can be classified as :
1. Positive Sloped ICC curve
2. Negative Sloped ICC curve

9. The slope of the Income Consumption
Curve
Positive Sloped ICC curve
• When both commodity 1 and 2 are normal goods
As income increases consumer increases the purchase
of goods (ICC)
• When Commodity 1 is necessity and Commodity 2 is
luxury
Consumer will spend more on luxury if income
increases as compared to necessity commodity (ICC2)
• When Commodity 1 is luxury and Commodity 2 is
necessity
Consumer will spend more on necessity if income
increases as compared to luxury commodity (ICC1)

10. The slope of the Income Consumption
Curve
Negative Sloped Income Consumption Curve :
• WhenY is inferior and X is normal (ICC1)
In the fig, ICC1 curve shows that commodity-Y is an
inferior commodity. This curve turns downwards. It
means that less of the commodity-Y will be purchased
when the income of consumer increases.
• When X is inferior andY is normal (ICC2)
ICC2 curve shows the inferior commodity-X. This curve
turns backwards which means that less of commodity-X
will be purchased when the income of consumer
increases.

11. Engel Curve
• The Engel curve, named after the German statistician Ernst Engel (1821-96), is a
relation between the demand for a good and the income of its buyers
• Engel curve is the locus of points showing equilibrium quantities of a commodity
at different levels of income of the consumer.
• It indicates, how much quantity of a commodity, a consumer will consume at
different levels of income in order to be in equilibrium.

12. Engel Curve
• In fig, X-axis shows the quantity of a
commodity and Y-axis shows the income
of the consumer.
• At the income level of OM, the quantity
demanded of the commodity is OP units.
• As the income level increases to ON, the
quantity demanded increased to OQ
units.
• Here, the points A and B indicate the
level of consumer equilibrium. By joining
these points, we get the EE curve, that is
known as the Engel Curve.

13. Derivation of Engel Curve from ICC:
• As the demand curve shows the relationship between price and quantity demanded, other
things remaining constant.
• Similarly, the Engel curve shows the relationship between quantity purchased and income
of consumer, other things like prices and preferences of consumers remaining constant.
• To derive the EC from Income Consumption Curve, firstly, we have to draw the ICC curve
at different income levels. Given the preferences of consumers and prices of commodities,
the ICC curve is drawn to show the equilibrium points. Then, by plotting income on Y-axis
and quantity of a commodity on X-axis, the relationship between income and quantity
purchased is shown by the Engel curve. Any point on the Engel curve corresponds to the
relevant point on the ICC curve.

14. • In Fig, (a) shows the ICC curve with
equilibrium points.
• Here, X-axis andY-axis represent the
quantity of cold-drinks Fanta and Slice
respectively.
• AB is the budget line with a budget of
Rs.300 and IC2 curve is the indifference
curve showing maximum satisfaction to
the consumer.
• There, the consumer is able to buy 2
units of Fanta and 4 units of Slice
represented by the equilibrium point P.
• Slope of engel curve is change in
income / change in quantity

15. • When the income of the consumer
increases to Rs.450, the CD is his
new budget line shifting to the
right from the previous one and IC
is a new indifference curve. Here,
he is able to buy 3 units of Fanta
and 5 units of Slice and Q is the new
equilibrium point of the consumer.
• When the income of the consumer
increases to Rs.600, the budget line
and indifference curve shift to EF
and IC1. Here, he is able to purchase
4 units of Fanta and 6 units of Slice
and consumer gets new equilibrium
point as R.
• ICC is the curve drawn by joining
the equilibrium points P, Q and R.

16. To derive the Engel curve from this ICC
curve
• We have to plot the quantity of one commodity (here, Fanta) on X-axis
and income onY-axis as shown in (b).
• At the income level of Rs.300, the quantity of Fanta purchased by the
consumer is 2 units. As shown in (a), with an increase in budget to Rs.450
results in an increase in the quantity of Fanta to 3 units. Thus, we will plot
3 units of Fanta at the income level of Rs.450. Similarly, by observing the
quantity of Fanta at an increased level of Rs.600, we will plot the 4 units
of Fanta corresponds to the income level of Rs.600.
• Thus, the equilibrium points on the ICC curve in indifference map have
been changed into the Engel curve showing the income-expenditure
relationship. Any point on this curve indicates corresponding relevant
points on the ICC curve. As, P’, Q’ and R’ points on the Engel curve
corresponds to P, Q and R point on ICC curve.
• Here, the slope of the Engel curve is upward sloping as it is assumed that
the commodity is a normal commodity and the quantity purchased is
increasing with an increase in income.
• The shape of Engel curve depends on the shape of ICC

17. Engel curve in case of luxury goods
• Engel curve is upward sloping but is concave. This implies
that slope of the Engel cuve (∆M/∆Q) is declining with
increase in income. The equal increments in income result in
successively larger increases in the quantity purchased of the
commodity.
• At income Rs 300 the consumer purchases OQ1 quantity of
the commodity. The increase in income by Rs 100 to Rs 400
results in increase in quantity purchased of the commodity
equal to Q1Q2.
• With the further increase in income by the same amount of
Rs 100 to Rs 500, the quantity purchased increases by
Q2Q3which is much larger than Q1Q2.This implies that as a
consumer becomes richer he purchases relatively more of
the commodity. Such commodities are called luxuries
• Eg:luxury cars

18. Engel cuve in case of inferior goods
Consumption of the commodity declines as
income increases.
Engel curve of an inferior good is backward
bending indicating a fall in the quantity
purchases of the goods as income increases.

19. • The splitting of the price effect into the substitution and income effects can be done by holding the
real income constant.
• When you hold the real income constant, you will be able to measure the change in quantity caused
due to substitution effect. Hence, the remaining change in quantity represents the change due to
income effect.
• The decomposition of the price effect into the income and substitution effect can be done in several
ways
Keeping the real income constant,There are two main methods,:
(i)The HicksianApproach
(ii)The Slutsky Approach
In accordance to these two approaches there are two methods of splitting up the price effect into its two
component parts
a. Income compensating variation method
b. Equivalent variation method

20. The Hicksian Method:
• Sir John R.Hicks (1904-1989)
• Awarded the Nobel Laureate in Economics (with Kenneth J. Arrrow) in 1972 for work on
general equilibrium theory and welfare economics.
• More scientific approach
• The money income of the consumer is so adjusted to the change in real income that he
is neither better off-nor worse off

21. The Hicksian Method:
• Suppose a consumer has Rs 50 (money income)which he spends on two
commodity X and Y. let us assume that he was spending Rs 30 on commodity X and
Rs 20 on commodityY.
• Now the price of commodity X decreased, so the consumer can now purchase
more units of commodity X with Rs 30 which means his purchasing power
increases (means his real income increased) but his money income is same i.e Rs
50

22. The Hicksian Method:
• Hicks has separated the substitution effect and the income effect from the price effect through
compensating variation in income by changing the money income of the consumer while keeping the real
income of the consumer constant.
• To keep the real income of the consumer constant we will decrease the money income of the consumer. If
we donot keep real income constant then consumer will purchase more of commodity X .Then he will move
to higher indifference curve(E3)
• But Hick said the consumer will maintain the same level of satisfaction. That means he has to remain on
IC1.When we have decreased his money income his budget line will shift parallelly inwards
• Now consumer will be in equilibrium at point E2 where he has increased the consumption of Good X and
decreased the consumption of goodY.This is called substitution effect

23. The Hicksian Method:
• The initial equilibrium of the consumer is E1, where
indifference curve IC1 is tangent to the budget line
AB1.
• At this equilibrium point, the consumer consumes
E1X1 quantity of commodity Y and OX1 quantity of
commodity X.
• Assume that the price of commodity X decreases
(income and the price of other commodity remain
constant).This result in the new budget line is AB2.
• Hence, the consumer moves to the new equilibrium
point E3, where new budget line AB2 is tangent to
IC2.
• Thus, there is an increase in the quantity demanded
of commodity X from X1 to X2.
X1 to X2: Price effect
X1 to X3:Substitution effect
X3 to X2:Income effect

24. The Hicksian Method:
• According to Hicks the real income of the consumer will remain same or constant
• Let us assume that money income of the consumer is Rs 50.He was spending Rs 30
on commodity X and Rs 20 on commodityY.
• When the price of commodity X decrease he increases the consumption of
commodity X and decreases the consumption of commodity Y and remains on the
same IC (IC1) i.e satisfaction remains the same but the equilibrium point shifts.
• Since we have decreased the money its called compensating variation in income
meaning to make the real income constant we have to decrease the money
income so that consumer cannot purchase more of commodity X and should not
go to a higher indifference curve.
• Substitution effect is negative (price of X decreased, demand of X increased)

25. Slutsky Substitution effect
• The concept of substitution effect was put forward by J.R. Hicks.There is another
important version of substitution effect put forward by E. Slutsky
• Slutsky substitution effect has an important empirical and practical use
• Here we will assume the real income of the consumer will remain constant while
money income will change
• Also we will look into 2 cases i.e decline in price and rise in price

26. Decline in price of commodity X
• Initial budget line was AB and consumer is at
equilibrium at point E1
• Suppose a consumer money income is Rs 50.
He used to purchase X commodity whose
price is Rs 15 and Y commodity whose price is
Rs 10.He used to purchase 2 units of
commodity X and 2 units of commodity Y to
spend Rs 50.
• Let us assume that price of commodity X has
reduced to Rs 10 and the price of commodity Y
is same. So now his real income has increased.
• Slutksy said the money income should be
decreased in such a way that he purchase the
same amount as earlier

27. Decline in price of commodity X
• Earlier he was buying 2 units of X for Rs 30 (1 unit=Rs 15) and 2 units of Y for Rs 20 (1Unit=Rs
10) and his entire Rs 50 is spent
• Now when the price of commodity X is reduced to Rs 10 he will buy the same amount of X
and Y i.e 2 units of X and 2 units of Y but he will now spend Rs 40 (2 units of X will cost him Rs
20 and 2 units ofY will cost him Rs 20).The different is Rs 10 which is called cost difference.
• We should reduce money income equal to cost difference so that he is able to buy same
amount of X andY which he was purchasing earlier.
• Now money income is reduced to Rs 10 in order to keep the real income constant, so the
budget line will shift inwards
• But IC1 is not tangent to the new budget line MN (that means it is not giving him maximum
satisfaction).Consumer know that price of X has decreased so he substituted X for Y and
moved to a higher IC i.e IC2

28. Rise in price of commodity X
• Since the price of X has increased ,the new budget line will shift inwards, so the
real income of the consumer decreases
• Let us assume that money income of the consumer is Rs 50.He would not be able
to buy the same amount of X commodity as earlier because the price has
increased.
• To keep the real income constant we will give him Rs 10 (cost difference) so that
his money income increases.
• If money income increases budget line will shift rightward (parallel to original
budget line) and consumer will move to new IC with new equilibrium and he will
purchase less of X and more ofY

29. Decline in price and rise in price
Decline in price Rise in price

30. Price consumption curve
• PCC is the locus of various equilibrium points obtained
when the price of anyone commodity changes.
• With the change in the price of a commodity, there is a
change in the consumer’s equilibrium point as well.
• If we join consumers’ equilibrium points established at
different prices, we get the curve and that is known as
the price consumption curve
• PCC is downward sloping if the commodity X is normal
good and commodityY is substitute good

31. Price consumption curve
If price of commodity X decrease budget line will shift
to rightwards AB1.
In this case the consumer needs both commodity X
and commodityY.
Let us assume he has money income of Rs 50 and he
was spending Rs 30 on X and Rs 20 onY
Now commodity X is available at Rs 20.The surplus of
Rs 10 he wants to spend on commodity X while the
consumption of commodityY will remain the same .
PCC is horizontal or parallel to X axis if the
commodity X is normal good and commodityY is
essential good

32. Price consumption curve
• In this case consumer like commodity X and
commodityY equally.
• Let us assume he has money income of Rs 50
and he was spending Rs 30 on X and Rs 20 onY.
• Now commodity X is available at Rs 20.The
surplus of Rs 10 he wants to spend on commodity
X and commodity Y equally (i.e. Rs 5 on both the
commodity).
• Consumer increases the consumption of
commodity X as well as commodityY.
• PCC is upward sloping if the commodity X is
normal good and commodity Y is complementary
good