CONSUMER’S EQUILIBRIUM AND THE SUBSTITUTION EFFECT OF PRICE CHANGE.
The consumer’s choice of how much to consume of various goods depends on the prices of those goods. If prices change, the consumer’s equilibrium choice will also change.
In the economic literature, there are two slightly different methods for explaining the impact of a price change on the quantity demanded of the two goods by the consumer.
The ‘first method is attributed to Hicks and Allen and is named as Hicks-Allen Substitution Effect. The second method put forward by S. Slutsky, a Russian economist, is known as Slutsky Substitution Effect. The two concepts differ in the way in which real income of the consumer is to be maintained constant when the substitution effect is to be observed. We explain the Hicks-Allen Mettfod of tracing the substitution effect. The Hicks-Allen Substitution Effect.
In the Hicksian method, price change is accompanied by so much change in money income that the consumer is neither better off nor worse off than before. The money income is changed by an amount which keeps the consumer on the same indifference curve. For instance,, the price of good say X falls, and that of good Y remains unchanged. With this fall in the price of good X., the real, income of the consumer would increase. This increase in the real income of the consumer is so withdrawn that he is neither better off nor worse off than before. The amount by which the money income is ‘reduced is called compensating variation in income. Substitution effect thus means the cbange in the amount demanded of a commodity resulting from a change in its -relative price alone, real income of the consumer remaining constant. The Hicksian substitution effect in now explained with the help of diagram below.
In this diagram (3.17) the consumer with given money income and given prices of the two goods represented by price line PL is in equilibrium at point Q on the indifference curve IC. He buys ON quantity of good Y and OM of good .X.
Related Economics Topics
- Marginal Rate of Substitution (MRS)
- Consumer’s Equilibrium Under Various Situations
- Changes In Consumer’s Equilibrium: Price Effect
- Consumer’s Equilibrium Through Indifference Curves Analysis
- Price effect when commodity X is a Giffen good