Economics, 3rd Edition

Income and Substitution Effects

In Chapter 3 we took a brief look at the 

income effect

 and the 

substitution effect

 as reasons why a fall 

in price leads to a rise in quantity demanded.

income effect 

the change in consumption that results when a price change moves the consumer to a higher or lower 

indifference curve

substitution effect 

the change in consumption that results when a price change moves the consumer along a given 

indifference curve to a point with a new marginal rate of substitution

Consider this thought experiment: If the price of cola falls you are now able to purchase more cola with 

your income – you are in effect richer. Because you are richer, you can buy both more cola and more pizza. 

For example, assume your income is 

€1,000 and the initial price of cola is €2 and pizza is €10. You currently 

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CHAPTER 5  BACKGROUND TO DEMAND: THE THEORY OF CONSUMER CHOICE  119

buy 250 litres of cola and 50 pizzas. If the price of cola falls to 

€1 per litre you can adjust your spending 

and now buy 300 litres of cola (spending 

€300) and use the remaining €700 to buy more pizza (70 pizzas). 

This is the income effect.

Second, note that now that the price of cola has fallen, you get more litres of cola for every pizza that 

you give up. Because pizza is now relatively more expensive, you might decide to buy less pizza and more 

cola. This is the substitution effect.

Both of these effects occur when prices change. The decrease in the price of cola makes the con-

sumer better off. If cola and pizza are both normal goods, the consumer will want to spread this improve-

ment in his purchasing power over both goods. This income effect tends to make the consumer buy 

more pizza and more cola. Yet, at the same time, consumption of cola has become less expensive 

relative to consumption of pizza. This substitution effect tends to make the consumer choose more cola 

and less pizza.

The end result of these two effects is that the consumer certainly buys more cola, because the income 

and substitution effects both act to raise purchases of cola. But it is ambiguous whether the consumer 

buys more pizza, because the income and substitution effects work in opposite directions. This conclusion 

is summarized in Table 5.1.