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This is known sluhs price effect. However, this price effect comprises of two effects, namely substitution effect and income effect. Substitution Effect Let us consider a two-commodity model for simplicity.

Dluts the price of one commodity falls, the consumer substitutes the cheaper commodity for the costlier commodity. This is known as substitution effect. Again, let us consider a two-commodity model for simplicity. Assume that the price of one commodity falls. 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.

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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. Now, can you tell how much increase in consumption is due to income effect and X sluts much increase in consumption is due to substitution effect? To answer this question, we need to separate the income effect and substitution effect. How to separate the income effect and substitution effect? Let us look at figure 1. Figure 1 shows that price effect change in Pxwhich comprises substitution effect and income effect, leads to Escort lx change in quantity demanded change in Qx.

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