Price Changes, Income Effects, and Substitution Effects

When a good's price changes, two things happen at once. Its price relative to other goods changes, and the consumer's purchasing power changes. Economists separate the total response into a substitution effect and an income effect.

Substitution effect

If mobile data becomes cheaper while other prices stay fixed, data is now relatively cheaper. Holding the consumer at the original utility level, the consumer normally substitutes toward data and away from other goods. This compensated comparison isolates the substitution effect.

For a price decrease, the substitution effect always raises demand for the now-cheaper good under standard well-behaved preferences. It is driven by the change in the budget line's slope.

Income effect

The price decrease also makes the original basket cheaper, increasing real purchasing power. Restoring the consumer from the compensated budget to actual income gives the income effect.

• For a normal good, higher real income raises consumption, so the income effect reinforces the substitution effect after a price fall.

• For an inferior good, higher real income lowers consumption, so the income effect opposes the substitution effect.

An inferior good is not necessarily low quality. It is simply a good a particular consumer buys less of as income rises, holding prices fixed. Instant noodles, slow transport, or second-hand items may be inferior in one context and normal in another.

Three baskets tell the story

Let the initial basket be $A$, a hypothetical compensated basket be $B$, and the final basket be $C$. For quantity X:

The compensated basket is an analytical construction. It asks what the consumer would choose at new relative prices if purchasing power were adjusted to keep original satisfaction reachable. It need not be a basket actually observed in the market.

In the rare theoretical case of a strongly inferior Giffen good, the negative income effect can outweigh substitution, so a price fall reduces quantity demanded. This does not overturn the substitution effect; it means the two components point in opposite directions and one is larger.

Movement versus shift

A change in X's own price moves the consumer along their demand curve for X. Income, preferences, prices of related goods, or expectations can shift that curve. Keeping this distinction clear prevents us from describing every increase in purchases as an increase in demand.

Reconstruct three baskets

Suppose a consumer initially chooses 5 data units and 10 units of other goods. After data becomes cheaper, imagine adjusting income so the old satisfaction level is just reachable. At the new relative prices, the consumer chooses 7 data units and 7 other units. The movement from $(5,10)$ to $(7,7)$ is the substitution effect.

Now restore actual income. The final basket becomes $(10,10)$. The movement from $(7,7)$ to $(10,10)$ is the income effect. For data:

For other goods, substitution is $-3$ and income is $+3$, so the observed total is zero. Seeing no final change does not mean nothing happened; two opposing mechanisms exactly offset each other.

Normal and inferior describe responses

A normal good is one whose demand rises with real income, holding prices fixed. An inferior good's demand falls. These labels describe a particular consumer in a particular range, not product quality or dignity. Bus travel can be inferior for one household and normal for another.

Keep movement and shift separate

Changing data's own price traces different quantity choices along data demand. A change in income, preference, or another good's price can shift data demand. When explaining observed purchases, first identify which variable changed; only then choose the correct curve language.