AP® Microeconomics · Unit 2 · Topic 2.1
The Income and Substitution Effects
When a good's price falls, people buy more of it for two separate reasons: it's now cheaper relative to other goods (substitution effect), and their money now stretches further, like a raise (income effect).
A price drop does two jobs at once. First, it changes relative prices: if coffee gets cheaper but tea doesn't, coffee is now a better deal compared to tea, so you swap toward it. That's the substitution effect. Second, the price drop quietly makes you richer, even though your paycheck is unchanged. If you used to spend $20 a month on coffee and now the same cup costs less, you can buy your usual amount and still have money left over. That leftover cash is real purchasing power you didn't have before, and you tend to spend some of it on more of lots of things, including the good that got cheaper. That's the income effect.
Both effects usually push in the same direction for a normal good: lower price, more quantity demanded, which is exactly why demand curves slope downward. The two effects are separable: the substitution effect is about relative prices changing while purchasing power is held fixed; the income effect is about purchasing power changing while relative prices are held fixed. To isolate them for a price drop, imagine first letting the person re-optimize while giving back exactly enough income to keep her just as well off as before (pure substitution), then handing her the real income gain and letting her spend it (pure income effect).
This matters because it explains the shape and slope of demand, which is the foundation Unit 2 builds everything else on: elasticity, shifts versus movements along the curve, and later, who bears a tax or how a price ceiling distorts the market. Separating the two effects is also what lets economists predict the one case where demand can slope upward: a strongly inferior good whose income effect overwhelms its substitution effect.
Key terms
- Substitution effect
- The change in quantity demanded from a good becoming cheaper or pricier relative to other goods, holding purchasing power fixed.
- Income effect
- The change in quantity demanded because a price change alters real purchasing power, holding relative prices fixed.
- Real income
- The purchasing power of a person's money, which rises when prices fall even if actual earnings stay the same.
- Normal good
- A good people buy more of as real income rises, so its income effect reinforces the substitution effect.
- Inferior good
- A good people buy less of as real income rises, so its income effect works against the substitution effect.
Watch it explained
- How it worksHow do the substitution effect and the income effect add up to the law of demand?
- How it worksWalk me through separating the two effects when the price of coffee falls by half.
- Going furtherWhat happens to the income effect when the good is inferior instead of normal?
- Common mistakeWhy isn't the income effect a change in the money you actually earn?
Check yourself
End of topic.