7.2.3—Income, substitution and price effects

When the price of a good changes, the consumer’s choice changes for two reasons. The substitution effect replaces relatively expensive goods with the now relatively cheaper good; the income effect changes real purchasing power.

For a normal good, a price fall usually raises demand through both effects. For an inferior good the income effect works in the opposite direction; for a Giffen case it could be so strong that demand falls when price falls, although this is unusual.

A cheaper bus ticket makes bus travel cheaper relative to taxis and also leaves the household with more real purchasing power. Both channels can raise bus journeys, but a normal-good assumption is doing work.

The income effect is not simply a cash-income change, and the substitution effect is not “switching because preferences changed”.