2 Most Important Components in which Price effect can be split

Let us start with a case where a person consumes two goods – rice and vegetables. It is also assumed that both the goods are normal goods. Income of the consumer is represented by his budget line AB (figure 7.14).

Indifference curve IC₁ of the consumer is tangent to his budget line at point ‘S’ implying that the optimum combination of goods that maximizes his utility within his budget constrain includes Ox₁ quantity of rice and Sx₁ quantity of vegetables.

If, for any reason, the price of rice decreases, budget line of the consumer rotates outward, indicating an increase in his purchasing capacity. The new budget line of the consumer, represented by AB’, can now afford more of rice in the bundle than the old bundle. New budget line AB’ is tangent to a higher indifference curve IC₂.

The new equilibrium point, T, shows the optimal combination of goods, i.e., Ox₂ quantity of rice and Tx₂ quantity of vegetables. Change in quantity of consumption of a product, as a result of change in its unit price, is called the Price Effect. In this particular example, price effect is equal to x₁x₂.

Price effect can be split into two components: (a) Substitution effect and (b) Income effect.

1. Substitution Effect:

Substitution effect is defined by change in consumption of a product as a result of change in its price only, income of the consumer remaining the same. Since we need to observe the change in consumption due to change in product price, new price ratio is to be considered. Any budget line parallel to AB’ represents new price ratio.

But as income or purchasing power of the consumer is to be kept equal to the initial budget, it is required to eliminate extra purchasing power of the consumer generated due to change in price of one of the products. For this reason, we must consider the old indifference curve (IC₁).

It is interesting to note that in this analysis, as presented by Hicks, indifference curve is regarded as the representation of purchasing power of an individual. So, following Hicksian analysis the old level of satisfaction (represented by IC₁) is to be maintained.

If an imaginary budget line can be drawn which is parallel to AB’ and tanget to IC₁, both the conditions are satisfied. Point of tangency between budget line CD and indifference curve IC₁ is L which determines optimal quantity of rice (i.e. Ox₃) to be purchased at reduced price for enjoying the initial utility level (represented by IC₁). Initial consumption of rice being at Ox₁ substitution effect equals to x₁x₃ (i.e., Ox₃ – Ox₁).

2. Income Effect:

The Income Effect is referred to as a change in quantity of consumption of a good caused by an increase in income without any change in price of goods. In the above example, the movement from point L to point T is considered as income effect (see figure 7.15). This movement shows only the impact of change in income (purchasing power) of the consumer (caused by fall in price of the goods).

The change is a result in increase in consumer’s income only (as this can be treated as an outward parallel shift of budget line CD) and not due to any change in price of goods (since, slope of budget line CD and AB’ are same at points L and T respectively). Thus, for this particular case, the income effect is equal to x₃x₂.