Income and Substitution Effects

How a price change affects choices in two ways - by changing relative prices and by changing how rich people feel - and why separating them helps.

When the price of a good changes, it affects what people buy in two distinct ways. Economists separate them into the substitution effect and the income effect.

The substitution effect

When a good becomes cheaper relative to other goods, people tend to buy more of it and less of the alternatives, because it now offers better value. This is the substitution effect. It always pushes demand in the opposite direction to the price change: lower price, more demand.

The income effect

A price change also changes people’s purchasing power. If a good you buy regularly becomes cheaper, you effectively have more money to spend, as if your income rose. This is the income effect.

How the income effect works depends on the type of good:

Normal goods: people buy more when they feel richer, such as better-quality clothes. The income effect reinforces the substitution effect.
Inferior goods: people buy less when they feel richer, switching to better alternatives. For example, as incomes rise, people may buy less of the cheapest grains and more vegetables, meat or packaged foods. For inferior goods, the income effect works against the substitution effect.

An example

Suppose the price of rice falls:

Substitution effect: rice is now cheaper relative to wheat, so the family buys more rice.
Income effect: the family spends less on its usual rice, freeing money. If rice is a normal good for them, they buy even more. If it is an inferior good, they may use the savings to buy more vegetables or eggs instead.

Why it matters

Separating the effects helps economists predict how taxes, subsidies and price changes affect behaviour and welfare. For example, it helps explain why a food subsidy may partly increase food purchases and partly free money for other things.

Cheaper petrol

Petrol prices fall. The substitution effect encourages people to drive more instead of taking buses. The income effect frees money that households may spend on other things, such as eating out. Both effects shape the overall response to the price change.

Thinking a price cut always leads to more buying through one simple channel

A price change works through both relative prices and purchasing power. For inferior goods, the two effects push in opposite directions, so the overall response can be smaller than expected.

Key takeaways

The substitution effect: a cheaper good is bought more because it is relatively better value.
The income effect: a price change alters purchasing power.
For normal goods, both effects work together; for inferior goods, they work against each other.
Separating the effects helps predict responses to taxes, subsidies and price changes.