Price Effect

In microeconomics, the price effect refers to how a change in the price of a good influences the quantity demanded. This effect is driven by two distinct forces: the substitution effect and the income effect.

• Substitution Effect. The substitution effect describes the shift in quantity demanded of goods as a response to a change in their relative prices. For example, if the price of good X₁ rises, the price ratio between X₁ and good X₂ changes, leading to decreased demand for X₁ in favor of X₂. The substitution effect is consistently negative.
• Income Effect. The income effect captures the change in quantity demanded due to the impact on consumer purchasing power resulting from a price change. For instance, when the price of good X₁ increases, it not only affects relative prices but also indirectly reduces the consumer’s real income, limiting the amount they can buy at the same nominal income. The income effect can be either negative or positive, depending on the context.

For a more in-depth look at the substitution effect and the income effect, please refer to the individual pages. These two aspects of the price effect can be analyzed and visually represented using two main approaches:

• Hicks Method. The Hicks method models and quantifies income and substitution effects by identifying a theoretical third consumption bundle with the same level of utility (welfare).
• Slutsky Method. The Slutsky method models and quantifies income and substitution effects by finding a theoretical comparison bundle that maintains the same level of real income (purchasing power).