THEORY OF

CONSUMER
BEHAVIOUR
UNIT 2
PRICE, INCOME & SUBSTITUTION EFFECT
IMPACT OF PRICE CHANGE
• Economists often separate the impact of a price change into two impact of a price change
into two components:
 the substitution effect;
 the income effect.

• The substitution effect involves the substitution of good x1 for good x2 or vice versa due
to a change in relative prices of the two goods.

• The income effect results from an increase or decrease in the consumer’s real income or
purchasing power purchasing power as a result of the as a result of the price change.

• The sum of these two effects is called the sum of these two effects is called the price
effect.
SUBSTITUTION EFFECT
• When the price of a good or service decreases, then consumers tend to prefer that good
or service over other, more expensive substitutes. This is known as the substitution
effect.

• The substitution effect states that when the price of a product decreases, then (all other
things being equal) its demand will increase because consumers will prefer to buy the
lower-priced product over its higher-priced substitutes.

• In short, the substitution effect measures the change in the quantity demanded of a

product or service, as a result of a change in its relative price in comparison to other,
similar products or services. Other examples include closely related goods like gel pens
and ballpoint pens, butter and margarine, etc.
INCOME EFFECT
• When the price of a good or service decreases, then that causes an increase in the
consumer’s purchasing power. The consumer can now buy more of that good with the
same amount of money. This is known as the income effect.

• The income effect measures the change in the demand for a product or service as a result
of a change in the real income of the consumer. The change in income can either be direct
or indirect. A direct change in income occurs when the consumer starts earning more
money, for instance, due to a rise in salary or wages.

• An indirect change in income occurs when the consumer can buy more of a particular
commodity for the same amount of money, due to a fall in the price of that commodity.