Substitution Method

Consider a two-commodity model for simplicity. When the price of one commodity falls, the consumer substitutes the cheaper commodity for the costlier commodity. This is known as substitution effect.

Income method

Suppose the consumer’s money income is constant. Again, let us consider a two-commodity model for simplicity. Assume that the price of one commodity falls. This results in an increase in the consumer’s real income, which raises his purchasing power. Due to an increase in the real income, the consumer is now able to purchase more quantity of commodities. This is known as income effect.

Hence, according to our example, the decline in the price level leads to an increasing consumption. This occurs because of the price effect, which comprises income effect and substitution effect.

To keep the real income constant, there are mainly two methods suggested in economic literature:

1) The Hicksian Method

2) The Slutskian method

According to Hicksian method of eliminating income effect, we just reduce consumer’s money income (by way of taxation), so that the consumer remains on his original indifference curve.

Slutsky attributes that the consumer’s money income should be reduced in such a way that he returns to his original equilibrium point E₁ even after the price change. What we are doing here is that we make the consumer to purchase his original consumption bundle at the new price level.