The substitution and income effects of price changes

Price changes influence consumer behaviour through two main mechanisms: the substitution effect and the income effect. These can be illustrated using indifference curves and budget lines.

When the price of a good rises, the budget line pivots inwards towards the origin, reducing the affordable quantities.

The substitution effect

• The substitution effect occurs when a price change alters the relative cost of goods, leading consumers to switch towards the cheaper option while maintaining the same level of utility.
• For a price increase in one good, consumers buy less of it because it becomes relatively more expensive compared to alternatives.
• For a price decrease, consumers buy more of it as it becomes relatively cheaper.

The income effect

• The income effect reflects the change in consumption due to altered purchasing power from a price change, assuming relative prices stay constant.
• A price increase reduces real income, often leading to lower consumption of normal goods.
• A price decrease boosts real income, typically increasing consumption of normal goods.

Effects on normal goods

Normal goods are those for which demand rises as income increases. Price changes for these goods result in substitution and income effects that reinforce each other.

Price increase for a normal good

• Substitution effect - Consumers reduce consumption of the more expensive good.
• Income effect - The loss in real income further decreases consumption of both goods.
• Combined result - Total demand for the good falls, leading to a downward-sloping demand curve.

Price decrease for a normal good

• Substitution effect - Consumers increase consumption of the cheaper good.
• Income effect - The gain in real income allows for more consumption of the good, amplifying the increase.
• Combined result - Total demand for the good rises, consistent with a standard downward-sloping demand curve.

Effects on inferior goods

Inferior goods are those for which demand decreases as income rises, as consumers switch to higher-quality alternatives. For these goods, the income effect opposes the substitution effect, though the substitution effect usually dominates.

Price increase for an inferior good

• Substitution effect - Consumers buy less of the now more expensive inferior good, favouring alternatives.
• Income effect - The reduction in real income may increase demand for the inferior good, as consumers can afford fewer superior options.
• Combined result - Demand typically falls, but less sharply than for normal goods, since the negative income effect partially offsets the substitution effect.

Price decrease for an inferior good

• Substitution effect - Consumers buy more of the now cheaper inferior good.
• Income effect - The increase in real income reduces demand for the inferior good, as consumers upgrade to better alternatives.
• Combined result - Demand usually rises, but the positive substitution effect outweighs the negative income effect.

Giffen goods and their demand characteristics

Giffen goods are a rare subtype of inferior goods, typically staple necessities in low-income households, where the income effect dominates the substitution effect, resulting in unusual demand behaviour.

Key features of Giffen goods

• Demand increases when price rises and decreases when price falls, leading to an upward-sloping demand curve.
• The income effect is strongly negative and overrides the substitution effect.
• These goods often form a large part of a limited budget, such as basic food staples like bread or rice in impoverished settings.

Price increase for a Giffen good

• Substitution effect - Encourages less consumption as the good becomes relatively more expensive.
• Income effect - The sharp drop in real income forces consumers to buy more of the staple to meet basic needs, cutting back on other items.
• Combined result - Overall demand rises; for example, if the price of a cheap carbohydrate source increases, low-income families might purchase more of it while forgoing pricier proteins.

Price decrease for a Giffen good

• Substitution effect - Prompts more consumption as the good becomes relatively cheaper.
• Income effect - The rise in real income allows consumers to afford superior alternatives, reducing reliance on the staple.
• Combined result - Overall demand falls, as the good's budget share decreases and consumers diversify their spending.