Decomposition of Price effect

-RISHAV

CHART.1 DECOMPOSITION OF PRICE EFFECT

The substitution and income effects work in the same direction when good X is a normal good. The final price effect
is then positive. The consumer tends to increase consumption of Good X with fall in its price.

When good X is an inferior good, then the substitution and income effects work in opposite directions. When price
of good X (Px)falls, the consumer tends to increase consumption of good X as a result of substitution effect.
However, income effect here is negative. The price effect then depends on relative magnitude of the two effects. The
final price effect is positive for inferior goods, as change in the consumption of good X as a result of the substitution
effect is greater than the income effect.

When good X is a Giffen good then also substitution and income effects work in opposite directions. When price of
good X (Px)falls, the consumer tends to increase consumption of good X as a result of substitution effect. However,
income effect here is negative. Further, the magnitude of change in units of good X on account of the substitution
effect is less than the income effect. The price effect, the final outcome, is therefore negative.
 Decomposition of Price effect
-RISHAV

1. Decomposition of Price Effect: Normal Goods

We use the method of compensatory variation in money income in order to decompose the price effect into the
income and substitution effects. This is shown in Figure.1. It starts with the initial optimal consumption combination
attained at point e

Figure.1 Decomposition of Price Effect: Normal Goods

 Decomposition of Price effect
-RISHAV

When the price of good X falls, the consumer buys OX1 units of good X at the optimal consumption combination e 1
on the budget constraint PL1 and a higher indifference curve U1. The price consumption curve (PCC) obtained by
joining points e and e1 rises upwards.

This price effect can be decomposed into the substitution and income effects. This is done by using the method of
compensatory variation in consumer's money income. Suppose, we reduce consumer's money income at optimal
consumption combination e1 by the amount that is just sufficient to bring her/him back on the initial indifference
curve U. This will lead to a downward shift in the budget constraint as shown by budget constraint AB which is
parallel to budget constraint PL1. Commodity X is relatively cheaper on budget constraint AB than on PL. e 2 is the
optimal consumption combination at which the consumer is buying OX 2 units of good X. It shows consumer's
preference for cheaper good X even after reduction in her/his money income.

Suppose the consumer is given back the money income that was reduced under compensatory variation in her/his
money income. The consumer then shifts to optimal consumption combination e 1. Thus movement from e2 to e1
represents income effect. Income effect here is positive as good X is a normal good.

Thus, price effect is the net total of substitution effect and income effect. Consumer's movement from optimal
consumption combination e to e1, as a result of price effect, can be decomposed into two effects. First the
substitution effect, i.e., consumer's movement from e to e2 and then the income effect, i.e., consumer's movement
from optimal consumption combination e2 to e1. Thus,

Price Effect = Substitution Effect + Income Effect

In terms of optimal consumption combination:

e to e1 = e to e2 + e2 e1

In terms of units of good X purchased:

XX1 = XX2 + X2 X1

Here, as shown in chart.1, the substitution and income effects are working in same direction. Good X becomes
relatively cheaper with fall in its price and the consumer tends to increase its consumption. The income effect is also
positive. The consumer tends to increase consumption of good as it is a normal good. This is shown by the Income
Consumption Curve (ICC) which is rising upwards The final price effect is, therefore, positive. The consumer
finally tends to increase consumption of good X from OX to OX 1 with a fall in its price (Px).
 Decomposition of Price effect
-RISHAV

2. Decomposition of Price Effect: Inferior Goods

Decomposition of the price effect into substitution and income effects in the case of an inferior good is shown in
Figure.2 in which good X is an inferior good. It starts with the initial optimal consumption combination attained at
point e

Figure.2 Decomposition of Price Effect: Inferior Goods

 Decomposition of Price effect
-RISHAV

When the price of good X falls, the consumer buys OX1 units of good X at the optimal consumption combination e 1
on the budget constraint PL1 and a higher indifference curve U1. The price consumption curve (PCC) obtained by
joining points e and e1 rises upwards. It shows positive price effect. When price of good X falls the consumer
increases consumption of good X from OX to OX1.

Same as section 2, this price effect can be decomposed into the substitution and income effects by using the method
of compensatory variation in consumer's money income. Suppose, we reduce consumer's money income at optimal
consumption combination point e1 by the amount that is just sufficient to bring her/him back on the initial
indifference curve U. This will lead to a downward shift in the budget constraint as shown by budget constraint AB
which is parallel to budget constraint PL1. Commodity X is relatively cheaper on budget constraint AB than on PL.
e2 is the optimal consumption combination at which the consumer is buying OX2 units of good X. It shows
consumer's preference for cheaper good X even after reduction in her/his money income.

Suppose the consumer is given back the money income that was reduced under compensatory variation in her/his
money income. The consumer then shifts to optimal consumption combination e 1. Thus movement from e2 to e1
represents income effect. Income effect here is negative as good X is an inferior good.

Thus, price effect is the net total of substitution effect and income effect. Consumer's movement from optimal
consumption combination e to e1, as a result of price effect, can be decomposed into two effects. First the
substitution effect, i.e., consumer's movement from e to e2 and then the income effect, i.e., consumer's movement
from optimal consumption combination e2 to e1. Thus,

Price Effect = Substitution Effect + Income Effect

In terms of optimal consumption combination:

e to e1 = e to e2 + e2 e1

In terms of units of good X purchased:

XX1 = XX2 + X2 X1

Here, as shown in chart.1, the substitution and income effects are working in opposite direction. Good X becomes
relatively cheaper with fall in its price and the consumer tends to increase its consumption. However the income
effect is negative. The consumer tends to reduce consumption of good X as it is an inferior good. This is shown by
the Income Consumption Curve (ICC) which is rising upwards but bending backwards. The final price effect is,
however, positive as the magnitude of substitution effect is greater than the income effect. The consumer finally
tends to increase consumption of good X from OX to OX 1 with a fall in its price (Px).
 Decomposition of Price effect
-RISHAV

3. Decomposition of Price Effect: Giffen Goods

Decomposition of the price effect into substitution and income effects in the case of a Giffen good is shown in
Figure.3 in which good X is a Giffen good. It starts with the initial optimal consumption combination attained at
point e

Figure.3 Decomposition of Price Effect: Giffen Goods

 Decomposition of Price effect
-RISHAV

When the price of good X falls, the consumer buys OX1 units of good X at the optimal consumption combination e 1
on the budget constraint PL1 and a higher indifference curve U1. The price consumption curve (PCC) obtained by
joining points e and e1 rises upwards but bending backwards towards Y-axis. It shows negative price effect. When
price of good X falls the consumer also reduces consumption of good X from OX to OX 1.

Same as above, this price effect can be decomposed into the substitution and income effects by using the method of
compensatory variation in consumer's money income. Suppose, we reduce consumer's money income at optimal
consumption combination point e1 by the amount that is just sufficient to bring her/him back on the initial
indifference curve U. This will lead to a downward shift in the budget constraint as shown by budget constraint AB
which is parallel to budget constraint PL1. Commodity X is relatively cheaper on budget constraint AB than on PL.
e2 is the optimal consumption combination at which the consumer is buying OX 2 units of good X. It shows
consumer's preference for cheaper good X even after reduction in her/his money income.

Suppose the consumer is given back the money income that was reduced under compensatory variation in her/his
money income. The consumer then shifts to optimal consumption combination e 1. Thus movement from e2 to e1
represents income effect. Income effect here is negative as good X is a Giffen good.

Thus, price effect is the net total of substitution effect and income effect. Consumer's movement from optimal
consumption combination e to e1, as a result of price effect, can be decomposed into two effects. First the
substitution effect, i.e., consumer's movement from e to e2 and then the income effect, i.e., consumer's movement
from optimal consumption combination e2 to e1. Thus,

Price Effect = Substitution Effect + Income Effect

In terms of optimal consumption combination:

e to e1 = e to e2 + e2 e1

In terms of units of good X purchased:

XX1 = XX2 + X2 X1

Here, as shown in chart.1, the substitution and income effects are working in opposite direction. Good X becomes
relatively cheaper with fall in its price and the consumer tends to increase its consumption. However the income
effect is negative. The consumer tends to reduce consumption of good X as it is an inferior good. This is shown by
the Income Consumption Curve (ICC) which is rising upwards but bending backwards. The final price effect is also
negative as the magnitude of substitution effect is less than the income effect. The consumer finally tends to reduce
consumption of good X from OX to OX1 with a fall in its price (Px).