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__Indifference Curve Analysis of Demand __173.
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Fig. 8.42. Price Consumption Curve with Varying Slopes
BREAKING UP PRICE EFFECT INTO INCOME AND
SUBSTITUTION E!
It has been explained above that 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 IC, moves to the point R
on indifference curve IC, when the price of good X falls and the budget line twists from PL., to
PLy. 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.
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. Slutsky uses cost-difference
method to decompose price effect into its two component parts. How the price effect can be
decom-posed into income effect and substitution effect by the Hicksian methods is explained
below, whereas Slutsky’s cost-difference method will be explained in an appendix to this chapter.
1, Breaking Up Price Effect: Compens:
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 of
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,
ing Variation in IncomeEconomic 7
Ad\ ory,
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.
Compensating
Variation
Substitution
Fig. 8.43. Price Effect Split up into Substitution and Income Effects through
Compensating Variation Method
When price of good X falls and as a result budget line shifts to PL, 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 PL, he is in equilibrium at point R on a higher indifference curve IC, 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 IC, 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'PLy. Now, with the reduction
in income by compensating variation, budget line shifts to AB which has been drawn parallel to
PL, so that it just touches the indifference curve IC, where he was before the fall in price of X.
Since the price line AB has got the same slope as PL», 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, wheri the consumer's money income is reduced by the compensating
variation in income (which is equal to PA in terms of Y or LB in terms of X), the consumer
moves along the same indifference curve IC, and substitutes X for Y. With price line AB, he is
in equilibrium at S on indifference curve IC, and is buying MK more of X in place of Y. This
movement from Q to S on the same indifference curve IC, 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 IC, to R ona higher indifference curve IC. The
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|Indifference Curve Analysis of Demand 175
movement from S on a lower in difference curve to R on a higher in difference curve is the
result of income effect. Thus the movement form 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 mainfest that price effect is the
combined result of a substitution effect and an income effect.
In Fig. 8.43 me various effects on the purchases of good X are:
Price effect MN
Substitution effect = MK
Income effect KN
MN = MK+KN
or 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. 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 tum 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. 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