Decomposition of Price Effect
Decomposition of Price Effect into Income Effect and Substitution Effect
Price effect is the total effect on demand for a commodity due to a change in the price of the same commodity, other things remaining constant.
The income effect is the effect on demand for a commodity due to the change in the income of the consumer.
The substitution effect is the effect on the demand of a commodity due to a change in the relative price of the commodity, the real income of the consumer remaining constant.
Price Effect= Income Effect + Substitution Effect
Decomposition of price effect into income effect and substitution effect can be illustrated by the following figure:
In the above figure, initially, the consumer is equilibrium at point E1. The initial budget line AB is tangent to the indifference curve E1 where the consumer consumes OX1 units of X and OY1 units of Y. When the price of X decreases remaining other things constant, the initial budget line rotates towards rightward at AB1. The budget line is tangent to the indifference curve IC2 where the consumer consumes OX2 units of X and OY2 units of Y where the consumer achieves a higher level of satisfaction. The shift in consumer’s optimum from initial equilibrium point E1 to new equilibrium E2 is called the price effect.
The substitution effect can be analyzed by adjusting the increased real income of the consumer. As per the Hicksian approach, we need to reduce consumer’s money income to bring consumers to the initial real income level. This adjustment in money income shifts the budget constraint backward from AB’ to AB” and it is a parallel shift as shown by the price line AB”. The price line AB” is tangent at IC1 where the consumer consumes OX3 units of X and OY3 units of Y. The movement of equilibrium from E2 to E3 (X2 to X3 and Y2 and Y3) is called the substitution effect.
From the above graph,
Income Effect= From E1 to E2 and X1 to X2
Substitution Effect= From E2 to E3 and X2 to X3
