Understanding how changes in prices influence consumer behavior is central to the study of microeconomics. Two fundamental concepts—the income effect and the substitution effect—help explain why consumers adjust their purchasing decisions when prices change, and why the demand curve generally slopes downward.
The Income Effect
The income effect refers to how a change in the price of a good affects a consumer’s real income, which is their purchasing power—what they can afford to buy with their existing monetary income. Even if a person’s actual income stays constant, changes in the prices of goods can make them feel either wealthier or poorer in terms of what they can buy.
Definition of The Income Effect
The income effect is the change in consumption resulting from a change in a consumer's real income caused by a change in the price of a good or service. It arises because a price decrease increases a consumer’s effective budget, while a price increase reduces it.
When the price of a good decreases, the consumer is able to buy more goods with the same amount of money. This increase in effective purchasing power may lead the consumer to buy more of the now cheaper good, as well as other goods.
Conversely, when the price of a good increases, the consumer’s purchasing power falls. They may reduce consumption of that good and other items as they feel poorer.
Even though their actual income in dollars has not changed, the consumer’s ability to purchase goods and services has changed. This perceived change in wealth leads to an adjustment in consumption.
Example of The Income Effect
Imagine a student who has a weekly food budget of 2 each. They buy 10 smoothies per week. Now imagine the price of a smoothie drops to 20, instead of 10.
Or they may stick with 10 smoothies and have $5 leftover to spend on something else.
In either case, the student feels like they have more real income because their dollars go further. This extra purchasing power may increase the student’s overall consumption and demand for smoothies and/or other goods.
Normal Goods and Inferior Goods
The direction of the income effect depends on the type of good in question.
For normal goods, the income effect is positive. When real income rises (due to a price fall), consumers tend to buy more of the good.
For inferior goods, the income effect can be negative. As real income rises, consumers may buy less of the good, switching to more desirable alternatives.
Real-World Illustration
Consider an individual who regularly buys instant noodles. If the price of noodles drops, the consumer might buy more because they feel wealthier. However, if their real income rises significantly, they might start buying fresh groceries instead of instant noodles. In this case, instant noodles are behaving as an inferior good.
The Substitution Effect
The substitution effect explains how consumers react to relative price changes between goods by choosing cheaper alternatives when prices change. It plays a crucial role in consumer choice, especially when there are several similar products in the market.
Definition of the Substitution Effect
The substitution effect occurs when a price change makes a good more or less attractive relative to its substitutes. If the price of a good falls, it becomes cheaper compared to alternatives, and consumers will tend to buy more of it and less of competing products. If the price of a good rises, it becomes relatively more expensive, and consumers may switch to cheaper alternatives.
This effect assumes that the consumer's level of satisfaction (utility) remains constant. It isolates the impact of a price change on consumer choice, ignoring the effect on purchasing power (which is captured by the income effect).
Example of the substitution effect
Suppose a consumer usually buys beef and chicken. If the price of chicken drops while the price of beef stays the same, the consumer may buy more chicken and less beef. Chicken now offers better value for money. The consumer substitutes away from the relatively more expensive beef in favor of chicken.
Everyday Examples of Substitution
If the price of Coca-Cola increases while Pepsi remains the same, some consumers may switch to Pepsi.
If name-brand painkillers become more expensive, consumers might buy generic versions.
When gas prices rise, some commuters may switch from driving to taking public transportation or biking, if possible.
Factors That Influence The Strength of The Substitution Effect
The substitution effect is stronger when:
Close substitutes are readily available.
The goods involved are similar in quality or use.
The good represents a large portion of the consumer’s budget, so price changes are more noticeable.
Consumers are more price-sensitive (also known as having elastic demand).
For example, luxury coffee from a local shop may be easily substituted with home-brewed coffee when prices rise, especially for budget-conscious consumers.
How Income and Substitution Effects Work Together
When the price of a good changes, both the income and substitution effects occur simultaneously. In most cases, these two effects move in the same direction, reinforcing each other.
When Price Falls
The substitution effect leads consumers to buy more of the now cheaper good, as it is more attractive relative to its alternatives.
The income effect increases consumers' purchasing power, allowing them to buy more of the good (if it's normal) or possibly other goods.
Together, these effects usually cause an increase in quantity demanded, helping explain why the demand curve slopes downward.
When Price Rises
The substitution effect leads consumers to buy less of the now more expensive good and switch to substitutes.
The income effect reduces purchasing power, making the good less affordable and possibly decreasing demand
Again, both effects typically result in a decrease in quantity demanded when the price increases.
Exception: Giffen Goods
In rare situations, known as the Giffen paradox, the income and substitution effects can work in opposite directions, leading to unusual demand behavior. A Giffen good is an inferior good for which the negative income effect outweighs the substitution effect.
As the price of the good rises, consumers end up buying more, not less.
This violates the law of demand.
For example, a poor household dependent on a cheap staple like bread may buy more bread when the price rises because they cannot afford more expensive food and must cut back on other items. This theoretical case is extremely rare and mainly used for academic discussion.
The role of Income and Substitution Effects in Shaping the Demand Curve
The downward-sloping demand curve, a fundamental concept in microeconomics, can be largely attributed to the combined impact of the income and substitution effects. When a good's price changes, these two effects drive the inverse relationship between price and quantity demanded.
How the income effect shapes the demand curve
A price decrease makes consumers feel wealthier by increasing their real income.
This leads to an increase in quantity demanded for most goods (especially normal goods).
Therefore, the demand curve slopes downward as price decreases and quantity demanded increases.
How the substitution effect shapes the demand curve
A lower price makes the good more attractive relative to other similar goods.
Consumers switch to the cheaper good, increasing its quantity demanded.
This contributes to the downward slope of the demand curve.
Visual Representation
While a full graphical analysis using indifference curves and budget constraints is beyond the scope of AP Microeconomics, it is useful to conceptually understand how price changes cause movement along the demand curve:
A movement down the curve (to the right) occurs when price decreases and quantity demanded rises due to both effects.
A movement up the curve (to the left) occurs when price increases and quantity demanded falls.
The income and substitution effects combine to form the typical downward-sloping shape of the demand curve seen in demand graphs.
Influence on Elasticity
The responsiveness of consumers to price changes—measured as price elasticity of demand—is influenced by the strength of the income and substitution effects.
If the substitution effect is strong, demand tends to be more elastic, meaning consumers are more responsive to price changes.
If the income effect is weak or negative, especially in the case of inferior goods, demand may be less elastic.
This helps explain why some goods (like luxury items or non-essentials) have more elastic demand, while others (like basic necessities) have inelastic demand.
Summary of Behavior
When price decreases:
Substitution effect: buy more of the cheaper good.
Income effect: buy more due to increased purchasing power (if normal good).
When price increases:
Substitution effect: buy less, switch to alternatives.
Income effect: buy less due to reduced purchasing power (if normal good).
The consistency of these responses across most goods and services in an economy is the basis for the law of demand, which states that as the price of a good rises, the quantity demanded falls, and vice versa, ceteris paribus (all else equal).
FAQ
The substitution effect, by definition, always works in the direction of increasing quantity demanded when a good’s price falls. It reflects how consumers respond to relative price changes by substituting toward the good that has become cheaper compared to alternatives. So, if the price of a good falls, the substitution effect will always lead to an increase in quantity demanded of that good, assuming utility remains constant. However, total demand may still fall in extremely rare cases if the income effect is so strongly negative that it outweighs the substitution effect—such as with certain Giffen goods. Still, it’s important to clarify that in such cases, it’s not the substitution effect causing demand to fall but rather the overpowering income effect. The substitution effect itself will never cause a consumer to demand less of a good simply because its price has decreased; instead, it’s always associated with switching toward the relatively cheaper good.
The strength of the substitution effect depends heavily on the availability of alternatives and the consumer’s preferences. For luxury goods, the substitution effect can be quite strong because many luxury items have close non-luxury substitutes. For example, if the price of designer shoes increases, consumers may opt for premium or standard brands instead, leading to a significant decrease in quantity demanded. In contrast, for necessities such as basic food items, the substitution effect tends to be weaker. Even if the price of bread rises, for instance, consumers might have fewer acceptable alternatives and continue buying similar quantities. This difference reflects the fact that luxuries are more elastic, meaning consumers are more sensitive to price changes, while necessities are inelastic, and demand changes less in response to price shifts. In summary, the substitution effect is more pronounced for luxury goods and more limited for essential goods, due to differences in available alternatives and consumer dependency.
In real-world consumer behavior, sales and promotions often trigger both income and substitution effects. For example, if a store offers a 30% discount on a popular item, the substitution effect causes consumers to buy more of the discounted item because it is now cheaper than competing products. Even customers who typically buy other brands may switch to the discounted item. At the same time, the income effect comes into play because the money saved can be used to buy more of that product or other items. This perceived increase in purchasing power leads to additional spending, either on the discounted good itself or on unrelated goods. In this way, retailers use pricing strategies to take advantage of both effects, increasing overall sales volume. Consumers, often unknowingly, adjust their buying patterns not just because the good is cheaper, but because they feel richer and are motivated to make the most of the temporary price advantage.
Consumer preferences, represented by indifference curves in advanced microeconomic theory, play a significant role in determining the size and direction of income and substitution effects. The substitution effect reflects a movement along an indifference curve, keeping utility constant, as the consumer chooses more of the cheaper good and less of the relatively more expensive one. The income effect, however, involves a shift to a higher or lower indifference curve, indicating a change in overall satisfaction due to increased or decreased purchasing power. If a consumer has a strong preference for a particular good, even a significant price drop in a substitute may result in only a small substitution effect. Conversely, if the consumer is indifferent between alternatives, even a small change in price can cause a major shift in consumption. The curvature of the indifference curves and the marginal rate of substitution between goods help determine how sensitive a consumer is to these effects.
Yes, but only under very rare and specific circumstances. This occurs in the case of Giffen goods, a unique category of inferior goods where the income effect is negative and stronger than the substitution effect. When the price of a Giffen good rises, the consumer feels poorer and paradoxically buys more of the good because they can no longer afford better alternatives. In such cases, the income effect leads to higher demand, even though the price increased. However, this behavior contradicts the typical law of demand, which states that quantity demanded falls as price rises. Giffen goods are often used as theoretical examples in economics and are not commonly found in modern markets. Most goods, including inferior ones, do not exhibit this behavior because their substitution effect still dominates. So, while the income effect can technically lead to an increase in demand during a price rise, it only does so under highly unusual conditions where consumer options are severely limited.
Practice Questions
Explain how the income and substitution effects help to explain the downward-sloping demand curve for a normal good.
The income and substitution effects both contribute to the downward-sloping demand curve for a normal good. When the price of a normal good falls, the substitution effect causes consumers to switch from relatively more expensive alternatives to the now cheaper good, increasing quantity demanded. Simultaneously, the income effect increases consumers' purchasing power, making them feel wealthier, which also leads them to buy more of the good. Since both effects work in the same direction—toward an increase in quantity demanded when price falls—they explain why the demand curve slopes downward for most normal goods.
A consumer faces a price increase for a good that is considered inferior. Using the concepts of income and substitution effects, explain how their consumption might change.
When the price of an inferior good increases, the substitution effect leads the consumer to buy less of it and more of relatively cheaper alternatives. However, because the good is inferior, the income effect works in the opposite direction: the consumer feels poorer and may end up buying more of the inferior good because they can no longer afford better substitutes. If the negative income effect is strong enough to outweigh the substitution effect, the consumer could paradoxically buy more of the good despite the price increase. This rare situation can result in upward-sloping demand, as with Giffen goods.
