Introduction
The Law of Demand tells us that, other things remaining the same, quantity demanded of a commodity varies inversely with its price. Modern microeconomics, particularly the indifference curve analysis developed by Hicks and Allen and presented in your prescribed text “Microeconomics” by T.R. Jain & V.K. Ohri, goes deeper and explains why this happens. It shows that when the price of a good changes, the total change in quantity demanded, called the price effect, can be decomposed into two distinct parts:
- Substitution Effect (SE)
- Income Effect (IE)
The statement that “price effect is the combination of substitution and income effect” means that the overall response of demand to a price change is the sum of these two effects. This question requires a clear conceptual explanation, supported by an indifference curve diagram, in the style used in Panjab University B.Com (Sem I) examinations.
1. Meaning of Price Effect
Suppose a consumer consumes two goods X and Y. If the price of X changes while money income and the price of Y remain constant, the consumer’s equilibrium will shift, leading to a change in the quantity demanded of X.
The price effect is the total change in quantity demanded of a commodity resulting from a change in its own price, other things remaining the same.
If the initial quantity demanded of X is Q0 at price P0, and after a fall in price to P1 the equilibrium quantity becomes Q1, then:
Price Effect (PE) = Q1 − Q0
For a normal case where price falls and quantity demanded rises, the price effect is positive for quantity (and negative with respect to price).
2. Meaning of Substitution Effect
When the price of X falls and the price of Y remains unchanged, X becomes relatively cheaper as compared to Y. Even if the consumer’s real income (or utility) were somehow kept constant, he would tend to substitute X for Y, because each rupee spent on X now yields more satisfaction than a rupee spent on Y.
The substitution effectconsumer’s real income or utility is kept constant, so that he remains on the same indifference curve and merely substitutes the relatively cheaper good for the relatively dearer one.
Key features of substitution effect
- It arises due to change in relative prices, not due to change in real income.
- The consumer is kept on the same indifference curve (same level of satisfaction).
- For a fall in price of X, substitution effect for X is always positive (quantity of X demanded increases).
- For a rise in price of X, substitution effect for X is always negative.
3. Meaning of Income Effect
When the price of X falls, the consumer can buy the same quantities of X and Y as before and still save some money. In other words, his purchasing power or real income increases, even though his money income is unchanged. This change in real income itself affects the quantity demanded of X.
The income effectreal income of the consumer caused by the price change, when relative prices are kept constant.
The sign of the income effect depends on the nature of the good:
- Normal good: Real income ↑ ⇒ quantity demanded ↑ (positive income effect).
- Inferior good: Real income ↑ ⇒ quantity demanded ↓ (negative income effect).
- Giffen good (extreme inferior): Negative income effect is so strong that it may outweigh substitution effect.
4. Price Effect as the Sum of Substitution Effect and Income Effect
Consider again a fall in price of X. The total change in quantity demanded of X (price effect) can be logically decomposed into two parts:
- First, because X becomes cheaper relative to Y, the consumer substitutes X for Y while staying on the same indifference curve. This is the substitution effect.
- Secondly, because the real purchasing power of the consumer has increased, he moves to a higher or lower indifference curve (depending on whether X is normal or inferior) and further adjusts his quantities. This is the income effect.
Thus, the total change in quantity demanded of X due to a change in its price is equal to the sum of the substitution effect and the income effect:
Price Effect (PE) = Substitution Effect (SE) + Income Effect (IE)
5. Diagrammatic Explanation: Decomposition of Price Effect into SE and IE
The relationship PE = SE + IE can be shown clearly with the help of an indifference curve–budget line diagram, using the Hicksian compensated variation technique.
In the diagram:
- The consumer initially faces budget line BL₁ and is in equilibrium at E₁ on indifference curve IC₁, consuming Q₀ units of X.
- When the price of X falls, the budget line rotates outward to BL₂. If there is no income compensation, the consumer moves to a higher indifference curve IC₂, reaching equilibrium at E₂, consuming Q₁ units of X. The movement E₁ → E₂ (Q₀ → Q₁) is the total price effect.
- To isolate the substitution effect, a compensated budget line BL* is drawn parallel to BL₂ (same relative prices) but tangent to the original indifference curve IC₁ at point E*. Movement from E₁ to E* along IC₁ (Q₀ → Q′) is the substitution effect.
- Finally, movement from E* on IC₁ to E₂ on higher IC₂ (Q′ → Q₁), along BL₂, represents the income effect of the price change.
Hence, geometrically and conceptually:
(E₁ → E₂) Price Effect = (E₁ → E*) Substitution Effect + (E* → E₂) Income Effect
6. Behaviour of Price Effect for Different Types of Goods
Since substitution effect is always negative with respect to price (a fall in price of X always increases demand for X through SE), the overall price effect depends crucially on the sign and magnitude of income effect.
| Type of Good | Substitution Effect (SE) | Income Effect (IE) | Resulting Price Effect (PE) | Nature of Demand Curve |
|---|---|---|---|---|
| Normal good | For price ↓, SE is positive (Q of X rises) | Positive (real income ↑ ⇒ demand ↑) | SE and IE reinforce each other; PE strongly negative w.r.t price | Downward sloping; law of demand firmly holds |
| Inferior good (non-Giffen) | For price ↓, SE is positive | Negative but smaller than SE | SE > |IE| ⇒ net PE still negative w.r.t price | Downward sloping demand curve (law of demand holds) |
| Giffen good (extreme inferior) | For price ↓, SE is positive | Strongly negative; dominates SE | |IE| > SE ⇒ PE becomes positive: price ↓ ⇒ demand ↓ | Upward sloping demand curve; apparent violation of law of demand |
This table shows that the direction and strength of the price effect cannot be understood by looking at substitution effect alone. It is the combination of SE and IE that finally determines how quantity demanded responds to a change in price.
7. Importance of Viewing Price Effect as SE + IE
The decomposition of price effect into substitution and income effects has several important implications in microeconomic theory:
The traditional law of demand simply states an inverse relationship between price and quantity demanded. The indifference curve approach explains this law by showing that even if income effect were zero, the substitution effect alone would make the individual demand curve slope downwards. Income effect only modifies the strength of that relationship.
The classification of goods into normal, inferior and Giffen is based on the sign and magnitude of the income effect. Since price effect is the sum of SE and IE, understanding IE is essential to explain why some inferior goods may still follow the law of demand and why exceptional Giffen behaviour may occur.
In advanced microeconomics and welfare economics, we distinguish between Marshallian (uncompensated) demand and Hicksian (compensated) demand. The compensated demand curve isolates the substitution effect (holding utility constant). The idea that PE = SE + IE is at the heart of this distinction.
When governments impose indirect taxes or give subsidies, both relative prices and real incomes change. By separating substitution and income effects, economists can analyse how much of the change in consumption is due to distortion of relative prices and how much is due to redistribution of real income.
Presenting price effect as a combination of SE and IE provides a logically rigorous and examiner-friendly framework which is exactly what is expected in B.Com (Sem I) answers based on T.R. Jain & V.K. Ohri.
Conclusion
In conclusion, the statement that “price effect is the combination of substitution and income effect” is fully justified in the modern indifference curve analysis of demand. When the price of a good changes, the consumer’s equilibrium quantity changes for two reasons: first, because the good has become relatively cheaper or dearer compared with other goods (substitution effect), and second, because the consumer’s real income or purchasing power has changed (income effect). The total price effect is therefore the sum of these two forces. This combined view not only explains the ordinary downward-sloping demand curve for normal goods, but also throws light on the behaviour of inferior and Giffen goods and provides a rigorous foundation for modern demand theory as presented in the Panjab University B.Com (Sem I) syllabus.