Consumer Response to Price Changes (Cambridge (CIE) A Level Economics): Revision Note

Income and substitution effects

• When the price of a product changes, two effects happen at the same time:

  • Substitution effect

    • The product becomes cheaper or more expensive relative to other goods, so the consumer may switch towards or away from it

  • Income effect

    • The price change makes the consumer feel effectively richer or poorer because their real purchasing power changes

• This can be shown with indifference curves and budget lines and can be understood clearly with everyday examples

1. Price increase for a normal good

• Consider a consumer choosing between:

  • Good X: cinema tickets

  • Good Y: takeaway pizza

• Both are normal goods (demand increases when income rises)

Substitution effect (moving along the same indifference curve)

• If the price of cinema tickets rises:

  • Cinema becomes more expensive relative to pizza

  • Even if income has not changed, the cinema now gives less “value per pound” than before

  • This pivots the budget line from BL1 to BL2

  • The substitution effect means the consumer will cut back on cinema tickets and buy more pizza instead, holding their real level of satisfaction constant

• This moves one combination of cinema-and-pizza on an indifference curve from Point A to another combination on the same curve at Point B, where they are still equally satisfied but have adjusted the mix

Income effect (moving to a lower indifference curve)

• Now add the income effect:

  • As the cinema is more expensive, the consumer’s income doesn’t stretch as far

  • They feel poorer in real terms, even though their income is unchanged

  • For a normal good like the cinema, feeling poorer means they will usually want less of it, not more

  • The income effect also pushes them towards fewer cinema tickets and less pizza too at Point C

Summary

• For a normal good, after a price increase:

  • Substitution effect: reduces quantity demanded of X

  • Income effect: also reduces quantity demanded of X

• Together, these explain why the demand curve for normal goods slopes downward

2. Price decrease for a normal good

• Now consider the price of cinema tickets. falling

Substitution effect (moving along the same indifference curve)

• Cinema tickets are now cheaper compared to pizza

• The consumer will tend to swap some pizza for more cinema because the cinema now gives more satisfaction per pound.

• This is the substitution effect. There will be a movement along the same indifference curve to a point with more cinema and less pizza, keeping overall satisfaction constant

Income effect (moving to a higher indifference curve)

• Because the cinema is cheaper, the consumer's real income has increased, so each £ now goes further

• For a normal good, higher real income means they want more cinema, not less

• They may also increase pizza consumption, because feeling richer often boosts demand for many normal goods

Summary

• For a normal good after a price fall:

  • Substitution effect: increases quantity demanded of X

  • Income effect: also increases quantity demanded of X

• Both work in the same direction, so demand clearly increases when the price falls

3. Price change for an inferior good

• If we now consider:

  • Good X: supermarket-value noodles (cheap, basic meal)

  • Good Y: fresh pasta dishes (more expensive, higher quality)

• Assume value noodles are an inferior good: when real income rises, the consumer prefers to buy fewer noodles and more of the nicer pasta meals

Price decrease for an inferior good

• If the price of value noodles (X) falls:

  • Substitution effect:

    • Noodles are cheaper relative to fresh pasta

    • The consumer is likely to buy more noodles and fewer pasta dishes, because noodles now look like better value

    • This effect always increases demand for the cheaper good, whether it is normal or inferior

  • Income effect:

    • The lower price means their real income rises

    • As noodles are inferior, feeling richer may make them want fewer noodles and more pasta

    • So the income effect for an inferior good goes in the opposite direction to the substitution effect

• In most real‑world cases, the substitution effect is stronger. The total demand for noodles still rises when the price falls, but not as much as it would if noodles were a normal good

4. The special case of a giffen good

• A giffen good is a very unusual type of inferior good where:

  • The negative income effect is so strong that it more than cancels out the substitution effect

  • As a result, when the price rises, demand also rises, and when price falls, demand falls

Example

• Plain bread or basic rice

  • People are so poor that they spend most of their income on this cheaper staple item

  • When the price of the staple rises, they feel much poorer and cannot afford better quality foods

  • They may be forced to cut back on meat, fruit, or vegetables

  • They buy more of the cheaper staple item, even at a higher price, simply to avoid going hungry

Summary

• Substitution effect: The higher price of bread should reduce quantity demanded

• Income effect: The higher bread price makes them much poorer, so they cut back on higher‑quality foods and buy more bread

• If the income effect is bigger than the substitution effect, the result is a giffen good, where the demand curve slopes upward