Income and substitution effects

Changes in the price of a good will always lead to a changes in quantity demanded. For instance, a fall in price will cause
quantity demanded to increase. This increase in quantity demanded can be explained in terms of the income and
substitution effects.

The substitution effect refers to the effect of a change in the price of a product arising from the consumer switching to
or from alternative (substitute) products. In other words, it is the substitution of one product for another resulting from
a change in their relative prices. For example, assume that the price of good X falls and the prices of other goods and
services remain constant. This fall in the price of good X will make good X more attractive since it will appear cheaper
relative to others. Hence consumers will substitute good X in place of other goods. It can be inferred that the substitution
effect for a good is always negative since the fall in the price of a good cause its demand to increase while for other
goods demand fall. Usually the substitution effect will cause a consumer to move along the same IC curve.

The income effect refers to the effect of a change in price of a good on its quantity demanded resulting from the
consumer becoming better off or worse off due to the price change. In other words, it refers to the change in consumers’
real income as the price of a good change. Supposing that the price level falls, which cause real income to rise, whether
of not the consumer will buy more of the good depends on the good being normal or inferior. Usually for a normal good
as real income increases the consumer will buy more of it meaning that the income effect is positive. For some goods
such as necessities the income effect is zero. This means that as real income changes quantity demanded remains the
same. On the other hand in the case of an inferior good, as real income rises the consumers will buy less yielding a
negative income effect.

The net effect of a price change depends on the relative strengths of the income and substitution effects. Consider the
table below.

Situation Type of good Effect on quantity of a fall in price

Substitution Income Total effect

effect effect

1 Normal (luxury) -ve (rise) + ve (rise) Rise

2 Normal(necessity) -ve (rise) 0 (no effect) Rise

3 Inferior -ve (rise) -ve (fall) Rise (since substitution effect > income
effect)

In situation 1 the negative substitution effect reinforces the positive income effect. Thus, as real income increases the
consumer will purchase more of the good. Quantity demanded will also increase in the second situation since the
negative substitution effect will cause quantity demanded to increase which will be unaffected by the income effect as
it is zero. In this case the income effect is zero since the goods in question is a necessity. In the case of inferior goods
(situation 3) a price fall will still cause quantity demanded to rise. The negative substitution effect will mean that
consumers will buy more. However, its income effect will be negative meaning that as real income rise people will reduce
their consumption of the good concerned. Concerning inferior goods the negative substitution effect is greater than the
negative income effect, causing the total effect on quantity demanded to be positive. In other words, as price of the
good falls quantity demanded will increase.

1
The diagram given below shows the effects of a fall in the price of good X.

The consumer is in equilibrium at point e where the budget line AB is tangent to indifference curve IC. A fall in the price
of good X will cause the budget line AB to shift to the right to AC. The consumer will now be in equilibrium at point e1
where the budget line AC is tangent with IC1. The fall in the price of good X has caused quantity demand to increase
from OQ to OQ1. This price effect can be separated into the substitution and income effects.