Useful Notes on Income and Substitutions Effects

Whenever price of a commodity falls (price of other commodity and money income remaining unchanged) or when relative price of a commodity falls, it has two effects. First, the consumer (given a constant money income) substitutes this commodity for the other one so as to maintain the original standard of living after compensating the consumer for the change in real income. This is referred to as substitution effect.

Thus, the substitution effect may be defined as the change in the consumption of the two commodities (or the substitution of one commodity by the other) as a result of a change in their relative prices-(given constant money income), so that the consumer is able to maintain the real income.

Second, it causes a rise in real income leading to income effect on quantity demanded raising the satisfaction level of the consumer. Rise in real income may be due to increase in money income (commodity prices remaining constant) or decline in prices, money income remaining constant.

Substitution effect implies a change in the quantity bought, when the price of the commodity changes, after ‘adjusting’ the income, so that the real income of the consumer remains the same as before. This adjustment of income was explained differently by Hicks and by Slutsky.

While Hicks assumes constancy of real purchasing power of the consumer by keeping the consumer on the same satisfaction level, Slutsky keeps real purchasing power constant in the sense that the consumer could purchase the original combination of the commodities. It will be noticed that Slutsky’s substitution effect pushes the consumer to a higher indifference curve. It implies that Slutsky’s substitution effect exceeds Hicksian’s substitution effect.

Hicksian and Slutsky approaches have their own merits and demerits. Hicksian approach is useful for the analysis of consumer surplus and welfare economics. But, it is not so easy to know the compensating variation under this approach, as it requires the knowledge of indifference curve revealing tastes and preferences of the consumer between various combinations of commodities. On the other hand, Slutsky approach can be easily used to establish the law of demand.

Under this approach, it is easier to find out the amount of income by which income of the consumer is to be adjusted to isolate the substitution effect. It has the merit of being dependent on observable market data. However, the substitution effect isolated by this approach involves some gain in the real income, graphically shown as a movement to a higher indifference curve:

Whenever the price of a commodity changes (while the price of other commodity and money income of the consumer remaining constant), the real income of the consumer changes. As a result, the consumer is able to rearrange his purchases. This implies that income effect exists as an element of price effect. Further, the consumer also intends to substitute relatively expensive commodity (whose price has remained constant) with the cheaper one (whose price has fallen).

This shows that the substitution effect is also present in the price. The total effect of a price change on the change in the quantity demanded is known as price effect. Hicksian and Slutsky approaches for separating the price effect into substitution effect and income effect.