Hicksian Decomposition Effect

• Meaning of Decomposition of Price Effect

• The price effect is viewed as a combination of
income and substitution effects. The
substitution effect always works in one
direction. A consumer is always induced to buy
more units of a cheaper good. Income effect
on the other hand could be positive, negative
or zero in case of normal, inferior (including
Giffen goods) or neutral goods respectively.
Refer chart of the section on income effect.
• Therefore, the price effect, as the final
outcome of the substitution and income
effects, depends on their relative direction
and magnitude
• The substitution and income effects work in the same direction when good
X is a normal good. The final price effect is then positive. The consumer
tends to increase consumption of Good X with fall in its price.
• When good X is an inferior good, then the substitution and income effects
work in opposite directions. When price of good X (P x)falls, the consumer
tends to increase consumption of good X as a result of substitution effect.
However, income effect here is negative. The price effect then depends on
relative magnitude of the two effects. The final price effect is positive for
inferior goods, as change in the consumption of good X as a result of the
substitution effect is greater than the income effect.
• When good X is a Giffen good then also substitution and income effects
work in opposite directions. When price of good X (P x)falls, the consumer
tends to increase consumption of good X as a result of substitution effect.
However, income effect here is negative. Further, the magnitude of change
in units of good X on account of the substitution effect is less than the
income effect. The price effect, the final outcome, is therefore negative.
• Decomposition of Price Effect: Normal Goods
We use the method of compensatory variation
in money income in order to decompose the
price effect into the income and substitution
effects. This is shown in Figure. It starts with
the initial optimal consumption combination
attained at point e
• When the price of good X falls, the consumer buys OX1 units of good X
at the optimal consumption combination e1 on the budget constraint
PL1 and a higher indifference curve U1. The price consumption curve
(PCC) obtained by joining points e and e1 rises upwards.
•
This price effect can be decomposed into the substitution and income
effects. This is done by using the method of compensatory variation in
consumer's money income. Suppose, we reduce consumer's money
income at optimal consumption combination e1 by the amount that is
just sufficient to bring her/him back on the initial indifference curve U.
This will lead to a downward shift in the budget constraint as shown
by budget constraint AB which is parallel to budget constraint PL1.
Commodity X is relatively cheaper on budget constraint AB than on PL.
e2 is the optimal consumption combination at which the consumer is
buying OX2 units of good X. It shows consumer's preference for
cheaper good X even after reduction in her/his money income.
• Suppose the consumer is given back the money income that
was reduced under compensatory variation in her/his money
income. The consumer then shifts to optimal consumption
combination e1. Thus movement from e2 to e1 represents
income effect. Income effect here is positive as good X is a
normal good.
•
Thus, price effect is the net total of substitution effect and
income effect. Consumer's movement from optimal
consumption combination e to e1, as a result of price effect,
can be decomposed into two effects. First the substitution
effect, i.e., consumer's movement from e to e2 and then the
income effect, i.e., consumer's movement from optimal
consumption combination e2 to e1. Thus,
• Price Effect = Substitution Effect + Income Effect
• In terms of optimal consumption combination:
• e to e1 = e to e2 + e2 e1
• In terms of units of good X purchased:
• XX1 = XX2 + X2 X1
• Here, as shown in chart, the substitution and income effects are working
in same direction. Good X becomes relatively cheaper with fall in its price
and the consumer tends to increase its consumption. The income effect is
also positive. The consumer tends to increase consumption of good as it
is a normal good. This is shown by the Income Consumption Curve (ICC)
which is rising upwards The final price effect is, therefore, positive. The
consumer finally tends to increase consumption of good X from OX to
OX1 with a fall in its price (Px).
• Decomposition of Price Effect: Inferior Goods
Decomposition of the price effect into
substitution and income effects in the case of
an inferior good is shown in Figure in which
good X is an inferior good. It starts with the
initial optimal consumption combination
attained at point e
• When the price of good X falls, the consumer buys OX1 units of good X at the
optimal consumption combination e1 on the budget constraint PL1 and a higher
indifference curve U1. The price consumption curve (PCC) obtained by joining points
e and e1 rises upwards. It shows positive price effect. When price of good X falls the
consumer increases consumption of good X from OX to OX1.
• Same as section 2, this price effect can be decomposed into the substitution and
income effects by using the method of compensatory variation in consumer's
money income. Suppose, we reduce consumer's money income at optimal
consumption combination point e1 by the amount that is just sufficient to bring
her/him back on the initial indifference curve U. This will lead to a downward shift
in the budget constraint as shown by budget constraint AB which is parallel to
budget constraint PL1. Commodity X is relatively cheaper on budget constraint AB
than on PL. e2 is the optimal consumption combination at which the consumer is
buying OX2 units of good X. It shows consumer's preference for cheaper good X
even after reduction in her/his money income.
• Suppose the consumer is given back the money income that was reduced under
compensatory variation in her/his money income. The consumer then shifts to
optimal consumption combination e1. Thus movement from e2 to e1 represents
income effect. Income effect here is negative as good X is an inferior good.
• Thus, price effect is the net total of substitution effect and income effect.
Consumer's movement from optimal consumption combination e to e1, as a result
of price effect, can be decomposed into two effects. First the substitution effect,
i.e., consumer's movement from e to e2 and then the income effect, i.e.,
consumer's movement from optimal consumption combination e2 to e1. Thus,
• Price Effect = Substitution Effect + Income Effect
• In terms of optimal consumption combination:
• e to e1 = e to e2 + e2 e1
• In terms of units of good X purchased:
• XX1 = XX2 + X2 X1
• Here, as shown in chart, the substitution and income effects are working in
opposite direction. Good X becomes relatively cheaper with fall in its price and the
consumer tends to increase its consumption. However the income effect is
negative. The consumer tends to reduce consumption of good X as it is an inferior
good. This is shown by the Income Consumption Curve (ICC) which is rising
upwards but bending backwards. The final price effect is, however, positive as the
magnitude of substitution effect is greater than the income effect. The consumer
finally tends to increase consumption of good X from OX to OX1 with a fall in its
price (Px).
• Decomposition of Price Effect: Giffen Goods
Decomposition of the price effect into
substitution and income effects in the case of
a Giffen good is shown in Figure.3 in which
good X is a Giffen good. It starts with the initial
optimal consumption combination attained at
point e