5.20 : Income and Substitution Effects

When the price of a product changes, it affects the consumption behavior of the consumer. This change in consumption is called the total effect, which is the sum of the substitution effect and income effect.

When the price of a good decreases, consumers tend to substitute it for other goods. For example, the student purchases more books when the price of books decreases from $20 per unit to $10 per unit, while the price of snacks remains at $5 per unit. The relative price of books to snacks changed. He buys more books than before because of changes in relative prices, which means more books can be consumed when sacrificing snacks. This response in the change in consumption of one good due to a change in the relative prices of goods, is called the substitution effect.

When the price of books decreases, even though the consumer's income hasn't changed, their purchasing power, or the amount of goods they can buy with their income, increases. Consumers benefit when they can purchase the same quantity of a product for a lower price, as they now have extra income that can be used to buy more total items. This consumption response to a change in the real income of consumers is called the income effect.