According to the Slutsky method of decomposition, the price effect is separated into the substitution effect and the income effect; we have to keep the real income constant. Real income is said to be constant if the consumer can maintain the initial equilibrium bundle of goods and services despite a change in prices.
It means, if the price of the commodity changes, it changes the real income of the consumer, and following the Slutsky method of price effect decomposition, we impose a tax or subsidy in such a way that the budget line passes through the initial equilibrium and is parallel to the new budget line.
Let’s assume the following condition.
Here, the Initial Equilibrium of the consumer is at E1 with OX1 quantity of X. When the price declines so the budget line swings outward from AB to AC, and the consumer attains a new equilibrium at E2 with OX2 quantity of X. The movement from E1 to E2 is a price effect.
Now, following the Slutsky method, we impose a tax to keep real income at the same level. After the tax, the budget line after tax is A’C’, which passes through E1 and is parallel to AC.
Now, when IE =0, i.e. real income constant, the consumer attains a new equilibrium at E3 with OX3 quantity of X. This movement from E1 to E3 is the Substitution Effect. i.e.
Now, if we refund the tax amount from the consumer, s/he moves from E3 to E2, which is called the income effect. i.e.
Case – Price increase for Inferior Good
Case – Price increase for Normal Good
