Distinguish between substitution effect and Income effect. Make a comparison with illustration between Slusky’s approach and Hicksian approach to decompose the price effect into substitution effect and income effect.

 The substitution effect and income effect are two separate concepts used in microeconomics to explain how changes in price affect consumer behavior.

The substitution effect refers to the change in the quantity demanded of a good due to a change in its relative price, holding the consumer's utility constant. In other words, when the price of a good changes, consumers will substitute towards either a cheaper or more expensive alternative. For example, if the price of Pepsi increases, consumers may switch to a cheaper alternative, such as Coke.

On the other hand, the income effect refers to the change in the quantity demanded of a good due to a change in the consumer's purchasing power or income, holding the relative prices constant. In other words, when a consumer's income changes, their ability to buy goods changes as well, and they may adjust their consumption habits accordingly. For example, if a person's income increases, they may choose to purchase more luxury goods.

Now, let's compare the Slusky approach and Hicksian approach to decompose the price effect into substitution and income effects. Both approaches aim to separate the effects of a price change into substitution and income effects, but they differ in their methods of doing so.

The Slusky approach decomposes the price effect by holding utility constant at the pre-price change level. In other words, it assumes that the consumer's preferences or tastes remain the same after the price change. Under this approach, the substitution effect is the change in the quantity demanded due to the price change, while the income effect is the change in the quantity demanded due to the increase in real income resulting from the lower price.

The Hicksian approach, on the other hand, decomposes the price effect by holding real income constant. In other words, it assumes that the consumer's purchasing power remains constant after the price change. Under this approach, the substitution effect is the change in the quantity demanded due to the price change, while the income effect is the change in the quantity demanded due to the decrease in real income resulting from the higher price.

To illustrate the difference between the two approaches, consider a consumer who purchases both Pepsi and Coke. If the price of Pepsi increases, the consumer will substitute towards Coke due to the higher relative price of Pepsi. The Slusky approach would hold the consumer's utility constant and attribute this change to the substitution effect, while the Hicksian approach would hold real income constant and attribute this change to the substitution effect as well.

However, if the price of Pepsi decreases, the consumer will be able to purchase more Pepsi and Coke with the same amount of money, resulting in an increase in real income. The Slusky approach would attribute this increase in consumption to the income effect, while the Hicksian approach would attribute it to the substitution effect, since the consumer is substituting towards more Pepsi and Coke due to the lower price.

In summary, both the substitution effect and income effect are important concepts used in microeconomics to explain consumer behavior in response to changes in price and income. The Slusky and Hicksian approaches provide different methods of decomposing the price effect into these two effects.

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