Case 4.

4
Income and Substitution Effects:
an Alternative Approach
Slutskys approach to defining real income
The analysis of income and substitution effects that is examined in section 4.3 of Economics (6
th
edition) is that developed by Sir John Hics (see !erson !rofile). Hics defined the substitution
effect as that "hich arises purely from a chan#e in relative prices. $n other "ords it is the effect of
a price chan#e "hen real income is held constant.
Hics defined a consumer%s real income to be constant if the level of satisfaction could be
maintained constant& in other "ords if the consumer can remain on the same indifference curve.
'ith this definition of constant real income( the substitution effect is illustrated by slidin# the
bud#et line round the ori#inal indifference curve. $n )i#ure *( this results in a move from point f to
point g on the ori#inal indifference curve I
*
.
Hics% definition( then( of constant real income relies on the subjective tastes of the consumer.
$t "ill differ from consumer to consumer dependin# on the shape of each one%s indifference curves
+n alternative analysis "as the earlier one developed by the ,ussian economist and
mathematician -v#eny Slutsy (*../ 0 *14.). Slutsy defined constant real income as that "hich
"ould allo" the consumer to buy exactly the same 2uantity of #oods after a price chan#e as
before. This definition does not involve reference to an indifference curve and hence to the
sub3ective tastes of individual consumers.
f
g
Units of Good X
U
n
i
t
s

o
f

g
o
o
d

Y
I
1
I
2
Substitution
effect
Income
effect
Q
X
1
h
B
2
B
1
Q
X
2
Q
X
3
B
1a
Figure 1 Income and substitution effects: Hicks' analysis
The Slutsy analysis is sho"n in the )i#ure 4( "hich( lie )i#ure *( analyses the effect of a rise
in the price of #ood 5.
Just as in )i#ure *( the full effect (i.e. income plus substitution effects) of the price rise is for
the 2uantity of 5 consumed to fall from Qx
*
to Qx
3
(a movement from point f to point h). 6ut this
time the income and substitution effects are analysed differently.
To eep real income constant and thus to isolate the pure substitution effect( the Slutsy
approach is to dra" a ne" hypothetical bud#et line (B
*a
) throu#h point f. 6y passin# throu#h point
f it sho"s that the consumer could (if that "as "hat "as "anted) continue to purchase the same
amount of the t"o #oods as before. 6ut to illustrate the chan#e in relative prices( B
*a
is dra"n
parallel to the real ne" bud#et line( 6
4
. 'ith this hypothetical bud#et line( B
*a
( the consumer "ill
consume at point g' on indifference curve I
*
'. The move from f to g' (i.e. from Qx
*
to Qx
4
') thus
represents the substitution effect.
Slutsy%s income effect then becomes the move from g' to h (i.e. from Qx
4
' to Qx
3
).
Question
Sho" on one dia#ram both the Hics and the Slutsy analysis of the income and substitution
effects of a fall in the price of #ood 5.
Units of Good X
U
n
i
t
s

o
f

g
o
o
d

Y
I
*
I
4
h
B
2
B
1
Q
X
1
f
Q
X
3
Figure 2 Income and substitution effects: Slutskys analysis
I
*
'
g'
Q
X
2
'
Substitution effect
Income effect
B
1
a