Question

Hicks-Allen substitution effect is based on the principle of __________.

• A. compensating variation in income
• B. increase in real income
• C. law of diminishing marginal utility
• D. law of equi-marginal utility

Answer 1

The correct option is A compensating variation in income

In the Hicks-Allen method of substitution we remove the income effect by introducing taxation. We do this so that we can keep the consumer on his/her original indifference curve. This method of the substitution effect allows us to separate the income effect and substitution effect. They also use this method for a better measurement of the consumer surplus.