Question

Discuss the decomposition of price effect into income and substitution effect

Answer 1

The price effect is the income effect plus the substitution effect, i.e. the price effect is divided into two parts: the income effect and the substitution effect. According to the Hicks substitution effect it is negative, the consumer increases the demand for goods X whose price falls and decreases the quantitative demand for goods Y, because the price of X is less than the price of Y. The income effect is positive accordingly, because in this case the consumer spends less money to buy goods.

Graphical representation of the decomposition