Decomposition of Price Effect Into Income and Substitution Effect

Meaning

Price effect is the term used to describe the shift in demand for a commodity, let's say X, brought on by a change in the price of the same product. The term "price effect" refers to the phenomena that occurs when a commodity's price varies (let's say, the price of good X), while the consumer's likes and preferences, his income, and the price of item Y remain same. It displays the overall impact of a change in a commodity's price on consumer demand, all other factors being equal. The two direct effects of price change on consumer choice that make up the overall price effect are the I income effect and (ii) substitution effect.

The substitution effect develops as a result of a change in a commodity's relative price. It occurs as a result of the same commodity's price changing in absolute terms. When one commodity's price rises (or falls), it becomes comparably more expensive (or less expensive) than the other. Customers naturally prefer to buy less expensive things than ones that are more expensive. It's known as the substitution effect. A rational customer will swap a relatively cheaper good for a more expensive one when the relative prices of different goods vary. The substitution effect is the name given to this outcome of shifting relative prices of products. According to this effect, the consumer will typically purchase more of a good whose price has decreased and less of a good whose price has kept the same or grown because he will reallocate his spending in favor of the relatively cheaper good and replace the more expensive one.

Given the prices of two items X and Y, it was assumed that the consumer's income level remained constant or unaltered in the consumer's equilibrium analysis. Given the pricing of the two goods, as well as the consumer's interests and preferences, the purchase decision will be affected if the consumer's income level changes (i.e., either increases or drops). The term "income effect" refers to this influence on demand or purchasing behavior. When all other factors are equal, the income effect depicts the overall impact on demand for goods caused by a change in consumer income.

Thus, income and substitution effects make up the overall price effect. There are two ways to separate out the income and substitution effects from the total price effect. They include:

• Hicksian approach
• Slutchky approach

Decomposition of Price Effect into Income and Substitution Effects with a Fall in Price of Normal Goods Under Hicksian Approach

Superiority of ordinal approach over cardinal approach

• The ordinal approach explains the effects of changes in consumer demand due to changes in commodity prices, consumer income, and the relative prices of two goods, i.e., the price effect, income effect, and substitution effect, respectively.
• The Giffen paradox and impacts on consumer demand for inferior goods caused by changes in income are not explained by the cardinal method, however the phenomenon is explained by the ordinal approach using the negative income effect.
• By making the implausible assumption of a cardinal measurement of utility, the cardinal approach explains the concept of consumer surplus, whereas the implausible assumption of an ordinal measurement of utility, used in the ordinal approach, explains this principle.

Reference

Koutosoyianis, A (1979), Modern Microeconomics, London Macmillan