Indifference Curve Analysis: Income Effect, Substitution Effect and Price Effect

(Complete Consumer Theory Notes for Competitive Exams – JKSSB, SSC, Accounts | Home Academy)

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1. Introduction

The Indifference Curve Analysis explains how a consumer reacts to changes in income and prices of goods.

This modern approach to consumer behavior was developed by John Hicks and Roy G. D. Allen.

It shows how consumer equilibrium changes when:

• Income changes

• Price of a commodity changes

The analysis separates the price effect into two components:

Price Effect = Income Effect + Substitution Effect

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2. Effect of Change in Income (Income Effect)

Meaning

The Income Effect refers to the change in quantity demanded of a good due to a change in real income, while prices remain constant.

When income changes, the budget line shifts parallel to itself.

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Diagram Explanation

Good Y
  |
  |        IC3
  |      *
  |    *
  |  *   IC2
  | *
  |* IC1
  |____________________
        Good X

• IC1 → Initial satisfaction

• IC2, IC3 → Higher satisfaction levels

If income increases, the consumer moves to higher indifference curves.

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Types of Income Effect

Type of Good	Effect of Income Increase
Normal Goods	Demand increases
Inferior Goods	Demand decreases
Giffen Goods	Special case of inferior goods

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3. Effect of Change in Price of a Good

When the price of a commodity changes, the budget line rotates.

Example

If the price of Good X decreases

Consumer can buy more of Good X

Budget line rotates outward

Good Y
  |
  |        IC2
  |       *
  |     *
  |   *
  | *
  |________________________
       BL1   BL2
         Good X

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4. Price Effect

Meaning

The Price Effect refers to the total change in quantity demanded due to a change in price of a commodity.

Formula

Price Effect = Income Effect + Substitution Effect

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5. Substitution Effect

Meaning

The Substitution Effect refers to the change in consumption caused by the change in relative prices, assuming real income remains constant.

Consumers substitute:

• Cheaper goods for expensive goods

Example
If tea becomes cheaper than coffee, consumers buy more tea instead of coffee.

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6. Methods to Measure Substitution Effect

Two main economists explained the measurement of substitution effect.

Method	Economist
Hicksian Method	John Hicks
Slutsky Method	Eugen Slutsky

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Hicks Method

Maintains constant satisfaction level while measuring substitution effect.

Slutsky Method

Maintains constant purchasing power.

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7. Decomposition of Price Effect

Price Effect is divided into:

1️⃣ Substitution Effect
2️⃣ Income Effect

Diagram Explanation

Good Y
  |
  |        IC2
  |      *
  |    *
  |  *
  | *
  |________________________
       A    B    C
          Good X

• A → Initial equilibrium

• B → Substitution effect

• C → Final equilibrium

Movement A → B = Substitution Effect
Movement B → C = Income Effect

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8. Decomposition of Price Effect for Different Goods

Case 1: Normal Goods

Effect	Direction
Substitution Effect	Positive
Income Effect	Positive
Total Price Effect	Strongly Positive

Demand increases when price falls.

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Case 2: Inferior Goods (Not Giffen)

Effect	Direction
Substitution Effect	Positive
Income Effect	Negative
Price Effect	Still Positive

Demand still increases when price falls, but less strongly.

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Case 3: Giffen Goods

Effect	Direction
Substitution Effect	Positive
Income Effect	Strongly Negative
Price Effect	Negative

Demand increases when price increases.

This violates the law of demand.

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9. Comparison Table (Very Important for Exams)

Type of Good	Substitution Effect	Income Effect	Price Effect
Normal Goods	Positive	Positive	Positive
Inferior Goods	Positive	Negative	Positive
Giffen Goods	Positive	Strong Negative	Negative

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10. Example to Understand

Suppose price of rice falls.

For Normal Goods

Consumer buys more rice.

For Inferior Goods

Consumer buys less rice and more superior goods.

For Giffen Goods

Consumer buys less rice when price falls.

Example historically associated with Robert Giffen.

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Important Points for Competitive Exams

Most questions in JKSSB, SSC, and Accounts exams come from:

Price Effect = Income Effect + Substitution Effect

Giffen goods violate the law of demand
Substitution effect always positive
Income effect depends on type of good
Hicks and Slutsky decomposition methods

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MCQ Questions

1 Price Effect is equal to

A Income Effect – Substitution Effect
B Income Effect + Substitution Effect
C Income Effect × Substitution Effect
D None

✅ Answer: B Income Effect + Substitution Effect

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2 Substitution effect occurs due to

A Income change
B Relative price change
C Population change
D Technology change

✅ Answer: B Relative price change

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3 The substitution effect was explained by

A John Hicks
B Adam Smith
C Keynes
D Ricardo

✅ Answer: A John Hicks

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4 Giffen goods are

A Normal goods
B Luxury goods
C Inferior goods with strong income effect
D Public goods

✅ Answer: C Inferior goods with strong income effect

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5 Which economist explained the Slutsky method?

A Marshall
B Eugen Slutsky
C Keynes
D Pigou

✅ Answer: B Eugen Slutsky

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6 In normal goods the income effect is

A Positive
B Negative
C Zero
D Infinite

✅ Answer: A Positive

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7 Giffen goods violate

A Law of supply
B Law of demand
C Law of production
D Law of returns

✅ Answer: B Law of demand

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8 Substitution effect is always

A Positive
B Negative
C Zero
D Constant

✅ Answer: A Positive

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