How do you calculate the income effect distinctly from the price effect?

Economists calculate the income effect separately from the price effect by keeping real income constant in the calculation. Normally, one formula is used to calculate the price effect using the income and substitution effects. There are two methods of separating the income and substitution effects.

Changes in price often have a dramatic impact on consumption. Consumer spending and demand rise or fall based on what goods consumers are able to purchase at what prices. Increases in consumer income and reductions in price allow higher levels of consumption of goods and services. How much demand and consumption of a consumer good or service increase may be estimated using complex mathematical calculations. The price effect is comprised of both the income and substitution effect.

The Hicksian Method

The Hicksian method, developed by British economist John R. Hicks, reduces hypothetical consumer income in the calculation to determine the impact of the substitution and income effects. In the economy, taxation could be an arbitrary means of reducing consumer income. The impact of the reduction in income alone could be readily seen using this modification.

The Slutskian Method

Also, the substitution effect could be singled out using the Slutskian method. This method reduces the price of the commodity in the calculation, resulting in the price effect. Consumers' incomes allow for the purchase of additional goods after a decrease in price. Then, consumer income is decreased until the purchase of goods falls back to where it was before the price decrease. Now, only the substitution effect remains.

Using one of these methods, economists calculate a better estimate of the impact of the income and substitution effects. (For related reading, see "What's the Difference Between the Income Effect and the Price Effect?")

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