6.2 Income and Substitution Effects of
Price Changes LO 3
A change in the price of a product generates both an income effect
and a substitution effect. The substitution effect is the reaction of the
consumer to the change in relative prices, with purchasing power
(real income) held constant. The substitution effect leads the
consumer to increase purchases of the product whose relative price
has fallen.
The income effect is the reaction of the consumer to the change in
purchasing power (real income) that is caused by the price change,
holding relative prices constant at their new level. A fall in one price
will lead to an increase in the consumer’s real income and thus to an
increase in purchases of all normal goods.
The combined income and substitution effects ensure that the
quantity demanded of any normal good will increase when its price
falls, other things being equal. Normal goods, therefore, have
negatively sloped demand curves.
Most inferior goods have negatively sloped demand curves. The
income and substitution effects work in opposite directions, but the
income effect is too small to offset the substitution effect.
Giffen goods are rare. They are inferior goods with an income effect
strong enough to dominate the substitution effect. The demand curve
for a Giffen good is positively sloped.