Income and Substitution Effects

Whenever the price of a good change there are two effects:

1) Substitution effect
2) Income effect

Substitution effect: this is the change in consumption due to the change in relative prices. When
the price of good increases; the other good becomes relatively cheaper. Rational consumers will
substitute towards the cheaper good, i.e. they will buy the cheaper product, ceteris paribus
To separate the substitution effect we hold utility constant; consequently the substitution effect is
measured along the indifference curve.
The substitution effect is always negative i.e. opposite the price change meaning that as price
decreases quantity demanded increases.

Income Effect: This results from a change in purchasing power, that is, the fall in price in effect
leaves them more income to spend and so will buy more of the good if it’s a normal good and
less if it a giffen/inferior good. It can either be negative or positive; depending on whether the
good is normal of inferior.

There are Two approaches that are used to separate the income and substitution effect. These
are:
 The Hicksian Approach
 Slutsky Approach
There are just a couple differences between both approach which I will point out shortly. We
will also be examining the substitution and income effect for the different types of goods.

THE HICKSIAN APPROACH

Normal Goods
The diagram above shows the consumer’s budget and how income is allocated between two
normal goods (X and Y). The original budget line is labelled BL1, and the original indifference
curve is at IC1. The original consumer equilibrium is where BL1 is tangent to IC1at point ‘a’
and a quantity of X1. The graph shows the effect of a decrease in the price of Good X assuming
that both goods are normal goods. This decrease on price will cause the consumer’s budget line
to pivot outwards to BL2 and a new equilibrium will be established at point ‘c’ and a quantity of
X2, where BL2 is tangent to IC2. The change from X1 to X2 is known as the total change.

To separate the total change into substitution effect and income effect, an imaginary (fictious)
budget line, BL3, is drawn parallel to BL2 but tangent to IC1. This imaginary budget line is
inserted on the basis of two conditions:
 It is drawn parallel to BL2 in order to reflect the new ratio of prices after the fall in the
price of Good X.
 It is tangential to IC1 which passes through the initial equilibrium at point ‘a’. Therefore,
BL1 and BL3 share the same satisfaction but on different budget lines.
The point of tangency of the imaginary budget line is shown as ‘b’.
 The substitution effect is shown by the movement along the original indifference curve
(IC1) from points a – b as consumers substitute good Y for good X since good X is now
relatively cheaper. This is effect is from quantity X1 to X3.
 The income effect is shown by the movement from points b – c and a quantity X3 to X2.
A price reduction increases consumers’ relative income (purchasing power) and they feel
richer. Being normal goods, as relative income increases, the consumer will buy more of
the goods.

In conclusion, it follows that for a normal good, the income effect always reinforces the
substitution effect. The substitution effect for a normal good is always negative i.e., as price falls
quantity demanded of the good will always increase. while the income effect is positive i.e., an
increase in relative income also causes an increase in quantity demanded of the goods.
Inferior Goods

The diagram above shows the combination of two goods that consumers can afford. Good X is
assumed to be an inferior good. The original equilibrium is at point ‘a’ and at a quantity of X1.
If there is a fall in the price of good X, the budget line will pivot outwards to BL2 and a new
equilibrium will be established at point ‘c’ and a quantity of X3. We can separate the
substitution and the income effect by drawing an imaginary budget line tangent to IC1 but
parallel to BL2.
 The substitution effect is shown by the movement along IC1 from point a = b as the fall
in the price of good X makes it relatively cheaper than good Y. Therefore, the consumer
would want to purchase more of good X. the substitution effect is therefore negative to
the price change and as a result the total substitution effect is from X1 to X2.

 The income effect is shown by the movement to a new budget line (BL2). The reduction
in price of good X will cause relative income to increase. with good X being an inferior
good, consumers will buy less of good X and more of good Y as relative income
increases. The income effect is represented by a reduction from X2 to X3. The income
effect is therefore negative to the price change for an inferior good i.e., as income
increases quantity demanded of an inferior good decrease.

In conclusion, when there is a reduction in the price of an inferior good, the income effect offsets
some of the substitution effect.
Giffen goods

The diagram shows the combination of two goods, X and Y. it is assumed that Good X is a
giffen good and the price of good X has fallen.

 The substitution effect is shown by the movement along the indifference curve IC1 from
a – b and a quantity of X1 to X2. Consumers would increase their consumption of good
X since the decrease in price makes it relatively cheaper than good Y. they would
therefore substitute Y for X. the substitution effect is negative to the price change.

 The income effect is depicted by the new equilibrium on IC 2 and BL2. This is at point
‘c’ and a quantity of X3. Since the giffen good is an extreme case of an inferior good, an
increase in relative income will cause the consumers to purchase less of the giffen good
and more of the other good (the normal good (Y)). The income effect is shown from b –
c and a quantity X2 to X3. It is negative to the increase in relative income i.e., when
income increase demand for the giffen good decreases.

In conclusion, a fall in the price of a giffen good will cause the income effect to outweigh the
substitution effect.
SLUTSKY APPROACH

The Slutsky Approach states that the imaginary budget line should be drawn through the initial
consumer equilibrium (at point a). The imaginary budget line should be drawn parallel to budget
line 2 however, because it is drawn through the original equilibrium, we can now fit a different
indifference curve on it to show equilibrium (at point b).