Income and Substitution Effects

The income and substitution effects. Changes in price influence consumer demand for goods. According to the law of demand, the effects of a price change can be broken down into:

• Substitution Effect. The substitution effect refers to changes in the quantity of goods demanded due to shifts in their relative prices. When the price of a single good changes, it alters the relative prices of all other goods, indirectly affecting consumer choices. Typically, consumers reduce their demand for a good that has become more expensive in favor of alternatives, while increasing their demand for a good that has become cheaper, often at the expense of other goods.
• Income Effect. The income effect describes how a change in purchasing power, resulting from a price variation, impacts the quantity of goods demanded. For example, a price reduction for a good increases the consumer’s real income (purchasing power), even if their nominal income remains unchanged. This boost in purchasing power generally leads to increased demand for all goods. Conversely, when a good's price rises, the consumer's real income decreases, leading to a reduction in overall demand.

The income and substitution effects combine to create an overall effect that establishes a new equilibrium in consumer choices. These effects can be visualized graphically as follows:

Starting from the initial equilibrium at point A, consider two goods, X₁ and X₂. A decrease in the price of good P_X1 changes the relative prices, altering the slope of the budget constraint line (arrow 1). With the new budget constraint, the consumer’s choice shifts from point A to point B, which represents the substitution effect. However, point B is not the final equilibrium. The price reduction also increases the consumer’s real income, giving them greater purchasing power to spend on goods X₁ and X₂. This translates into a potential increase in consumption of both goods and, graphically, a rightward shift of the budget constraint (arrow 2). Based on the indifference curves (representing consumer preferences), the consumer’s choice moves from point B to point C. This final adjustment is