Meaning Of Price, Income And Substitution Effects

Price effect:
The price effect is the consumer's reaction to a change in the price of a commodity, holding other factors
constant. It is measured along the Price Consumption Curve (PCC), which represents the equilibrium
points corresponding to the changing slope of the price line due to changes in the relative prices of two
goods, with the consumer’s money income remaining constant.
components:
Substitution Effect: The change in consumption resulting from a change in the relative prices of goods,
leading consumers to substitute one good for another.
Income Effect: The change in consumption resulting from a change in purchasing power due to a change
in the price of a good.
Price effect = = substitution effect + income effect
Derivation of Price Consumption Curve (PCC)

 Definition: A curve that shows the combinations of two goods that a consumer can purchase with
a given income, varying the price of one good while holding the other constant.
 Initial Equilibrium
 When the price of a commodity (X) is (P_1), the consumer's equilibrium is at point (E_1) on
indifference curve (IC_1) where the quantity demanded is (OX_1) 2.
 Price Decreases:
 As the price of X falls to (P_2), the consumer's real income increases, leading to a new
equilibrium at point (E_2) on a higher indifference curve (IC_2) where the quantity demanded is
(OX_2) 2.
 A further decrease in the price to (P_3) shifts the equilibrium to (E_3) on (IC_3) with quantity
demanded (OX_3) 2.
 Plotting PCC:
 By joining points (E_1), (E_2), and (E_3), we derive the Price Consumption Curve (PCC), which
is downward sloping. This curve shows how the quantity demanded of the commodity changes
with its price 2.
 When, the price of good charges, the consumer would be either better off or worse off than
before, depending upon whether the price falls or rises. In other words, as a result of change
in price of a good, his equilibrium position would lie at a higher indifference curve in case of
the fall in price and at a lower indifference curve in case of the rise in price.
Price effect is shown in Fig. 8.31. With given prices of goods X and Y, and a given money income as
represented by the budget line PL1, the consumer is in equilibrium at Q on indifference curve C 1. In this
equilibrium position at Q, he is buying OM 1 of X and ON1 of Y. Let price of good X fall, price of Y and
his money income remaining unchanged.
 As a result of this price change, budget line shifts to the position PL 2. The consumer is now in
equilibrium at R on a higher indifference curve IC 2 and is buying OM2 of X and ON2 of Y. He
has thus become better off, that is, his level of satisfaction has increased as a consequence of the
fall in the price of good X. Suppose that price of X further falls so that PL 3 is now the relevant
price line.
 With budget line PL3 the consumer is in equilibrium at S on indifference curve IC 3 where he has
OM3 of X and ON3 of Y. If the price of good X falls still further so that budget line now takes the
position of PL4, the consumer now attains equilibrium at T on indifference curve IC 4 and has
OM4 of X and ON4 of Y.
 When all the equilibrium points such as Q, R, S, and T are joined together, we get what is called
Price Consumption Curve (PCC). Price consumption curve traces out the price effect. It shows
how the changes in price of good X will affect the consumer’s purchases of X, price of Y, his
tastes and money income remaining unaltered.
 In Fig. 8.31 price consumption curve (PCC) is sloping downward. Downward sloping price
consumption curve for good X means that as the price of good X falls, the consumer purchases a
larger quantity of good X and a smaller quantity of good Y. This is quite evident from Fig. 8.31
In Fig. 8.32 upward-sloping price consumption curve is shown. Upward-sloping price consumption
curve for X means that when the price of good X falls, the quantity demanded of both goods X and Y
rises. We obtain the upward-sloping price consumption curve for good X when the demand for good
is inelastic, (i.e., price elasticity is less than one).
Price consumption curve can also have a backward-sloping shape, which is depicted in Fig. 8.33.
Backward-sloping price consumption curve for good X indicates that when price of X falls, after a
point smaller quantity of it is demanded or purchased. This is true in case of exceptional type of
goods called Giffen Goods.
 Price consumption curve for a good can take horizontal shape too. It means that when the price of the
good X declines, its quantity purchased rises proportionately but quantity purchased of Y remains the
same. Horizontal price consumption curve is shown in Fig. 8.34. We obtain horizontal price
consumption curve of good X when the price elasticity of demand for good X is equal to unity

But it is rarely found that price consumption curve slopes downward throughout or slopes upward
throughout or slopes backward throughout. More generally, price consump­tion curve has different slopes
at different price ranges. At higher price levels it generally slopes downward, and it may then have a
horizontal shape for some price ranges but ultimately it will be sloping upward. For some price ranges it
can be backward sloping as in case of Giffen goods. A price consumption curve which has different
shapes or slopes at different price ranges is drawn in Fig. 8.35.
Decomposition Of Price Effect Into Income And Substitution Effects

 Price effect is a combination of income and substitution effects taking place simultaneously.
But, only the price effect is observed as a change in quantity demanded with a change in
price.
 Income and substitution effects cannot be observed directly because only the overall price
effect is observable in the end. Price effect needs to be decomposed into income and
substitution effects to study their magnitude and direction.
 As the price of a commodity falls, it becomes cheaper in comparison to other commodities
leading to a substitution effect.
 The real income of consumers also increases leading to the income effect. Both of these
effects make up the price effect.
 To separate the substitution effect from the income effect, the real income of the consumer
has to be made constant.
 In other words, the income effect can be negated by returning the real income of consumers
back to the level before the price change.
 In this way, the change in quantity demanded will re½ect only the substitution effect
because the income effect will be eliminated.
 After obtaining the substitution effect in this way, the difference between the price effect
and the substitution effect shows the magnitude of the income effect.
 Hence, the change in quantity demanded is decomposed into two parts- change in quantity
demanded due to substitution effect and change in quantity demanded due to income effect.
Hicks’ Method for Income and Substitution effects

 According to Hicks, income level must be reduced in such a manner that the consumer returns to
the original level of utility.
 The budget line needs to be shifted leftwards in order to return the consumer to the original
indifference curve.
 The new budget line must be tangent to the original indifference curve.
 Hence, the income effect is eliminated by reducing the income level through a leftward shift in
the budget line. As a result, the visible change in quantity demanded is due to the substitution
effect only.
Hicks’ Method
In the case of normal goods, both the income and substitution effects are positive. Therefore, the
resultant price effect is also positive
 In the diagram, the consumer is at equilibrium at point E 1 initially.
 We consider the quantity demanded of our normal good on the x-axis (muffins) and the quantity
demanded of another normal good on the y-axis. As the price of normal good (muffins, in our
example) decreases, the budget line rotates from ‘XY’ to ‘XZ’.
 The new equilibrium point is at E 2, where the new budget line ‘XZ’ is tangent to the indifference
curve I2.
 The change in quantity demanded due to a fall in the price of muffins ns is the difference between
B1 and B2. This represents the price effect.
 To decompose this price effect, the increase in real income due to a fall in the price of muffins must
be offset by eliminating the income effect.
 To reduce the income level, the budget line is shifted parallelly from ‘XZ’ to ‘PQ’. The magnitude
of this shift, or the amount of income to be reduced, is such that the consumer is back on the
original indifference curve I1.
 The budget line ‘PQ’ is tangent to I 1. Therefore, the consumer is at equilibrium at a new point E 3
which is on the original indifference curve, but is associated with a new budget line ‘PQ’. The
quantity demanded at this point is B 3.
 The difference between B1 and B3 is the substitution effect because the income effect has been
offset.
 The change in quantity demanded occurs only due to the substitution effect.
 The income effect can be obtained by subtracting the substitution effect from the price effect,
which will be equal to the difference between B 2 and B3.
Criticisms Regarding Indifference Curve

 Indifference curve is said to make unrealistic assumptions about human

behaviour.
 It is unable to explain risky choices undertaken by the consumer.
 It has been criticized for being an ‘old wine in a new bottle’ for it has
merely rehashed the concept of diminishing marginal utility of a product
in new terms.
 It is based on unrealistic expectations of rationality, perfect competition,
divisibility of goods and perfect knowledge of scale or preference,
completely negating the imperfections in the decision making process of
the consumer.
 It has been argued by some economists that a consumer is indifferent to
close alternative combinations as he or she is not able to recognize and
appreciate the difference between the two.
 But as the difference between the goods in the combination increase, the
difference becomes more apparent and the same indifference curve will
not yield satisfaction to the consumer.