Business Economics · Consumer demand and behaviour

Income and Substitution Effects of a Price Change Explained

Updated 11 October 2026 · Fact-checked

When a price changes, the total change in quantity demanded splits into a substitution effect and an income effect. The substitution effect comes from the change in relative prices. The income effect comes from the change in real income. Their signs decide whether a good is normal, inferior or Giffen.

Understand Income and Substitution Effects

A price change does two things at once. It changes how expensive the good is compared with other goods. It also changes how much you can buy with your money, which is your real income. Consumer theory separates these two effects so you can see why demand moves.

The substitution effect is the response to the change in relative price alone. Real income is held fixed in some way. If the price of a good falls, you switch towards it and away from other goods. So the substitution effect always moves quantity in the opposite direction to the price. A fall in price raises quantity. A rise in price lowers quantity.

The income effect is the response to the change in real income. A fall in a good's price makes you better off, as if you had more money. For a normal good, you buy more when income rises. So the income effect works in the same direction as the substitution effect, and demand slopes down. For an inferior good, you buy less when income rises. So the income effect works against the substitution effect.

For most inferior goods, the substitution effect is bigger, so the demand curve still slopes down. A Giffen good is a rare case. It is inferior, and the negative income effect is strong enough to outweigh the substitution effect. After a price rise, quantity demanded rises. The demand curve slopes upward. Every Giffen good is inferior, but most inferior goods are not Giffen.

There are two ways to hold real income fixed. Hicks keeps the consumer on the original indifference curve, so utility is unchanged. Slutsky gives just enough income to buy the original bundle at the new prices. Both give a substitution effect with the sign described above. In diagrams, you draw a line parallel to the new budget line and tangent to the old curve (Hicks) or passing through the old bundle (Slutsky). The price consumption curve traces the best bundle at each price. Reading the quantity of the good against its price gives the demand curve.

Key rules to remember

Decomposition: Total effect = Substitution effect + Income effect; Each effect is the change in quantity demanded of the good. Keep the signs when you add them.
Slutsky compensated income: m' = m + (p1' − p1) × x0; x0 is the original quantity of the good, p1 is the old price and p1' is the new price. After a price fall, p1' − p1 is negative, so income is reduced. After a price rise, income is increased.
Slutsky substitution effect: SE = x(p1', m') − x(p1, m); Demand at the new price with compensated income m', minus original demand.
Income effect: IE = x(p1', m) − x(p1', m'); Moves from the compensated income back to the actual income, at the new price.
Hicks substitution effect: Utility held at the original level: SE = x(p1', u0) − x(p1, u0); Uses compensated demand on the original indifference curve.
Sign rules: SE always opposite to price change. Normal good: IE opposite to price change. Inferior good: IE same direction as price change. Giffen: |IE| > |SE| and good is inferior.; Use these to classify any good from the signs.

How to solve Income and Substitution Effects questions

Use this method for diagram, numerical or classification questions on this topic.

1Write down the original price, new price, income and the original bundle. Note whether the price rises or falls.
2Work out the total effect: new quantity minus original quantity, at actual income.
3Choose the compensation method. Use Slutsky if the question gives prices and income. Use Hicks if it gives a utility function or an indifference curve.
4Find the compensated income (Slutsky) or the compensated bundle on the original indifference curve (Hicks). Evaluate demand at the new price there.
5Substitution effect = compensated demand minus original demand. Income effect = actual new demand minus compensated demand.
6Check that the effects add up to the total effect, and that the substitution effect is opposite to the price change.
7Classify the good from the signs of the income effect and the total effect. Normal: IE helps SE. Inferior: IE opposes SE. Giffen: inferior and IE outweighs SE.
8In a written answer, state the result in words and name the assumption (for example, Slutsky holds the original bundle affordable).

Quickest way: Three-number shortcut

When to use it: Use when a question gives quantities before, at the compensated point and after, or gives any two of the three effects.

Total effect = SE + IE. If you know any two, subtract to get the third.
Set the sign of the SE first: opposite to the price change.
Compare the sign of IE with SE to classify the good. If the total effect has the same direction as the price change, the good is Giffen.
For Slutsky numbers, compute m' = m + (new price − old price) × original quantity, then evaluate demand once at m'.

Common mistakes in Income and Substitution Effects

Saying the substitution effect can be positive for a price fall.
Students mix up the substitution effect with the total effect.
Fix: The substitution effect always moves quantity against the price change. Only the income effect can work in the opposite way for an inferior good.
Calling every inferior good a Giffen good.
Both have a negative income effect.
Fix: A good is Giffen only if the income effect is larger than the substitution effect, so the total effect has the wrong sign.
Getting the sign of the Slutsky compensation wrong.
Students forget that a price fall raises real income, so income must be taken away to hold the original bundle affordable.
Fix: Use m' = m + (p' − p) × x0 and check the sign. A price fall gives m' below m.
Computing the income effect as new demand minus original demand.
This is the total effect, not the income effect.
Fix: The income effect is the move from the compensated point to the final point at the new price.
Mixing up Hicks and Slutsky.
Both use a hypothetical income change.
Fix: Hicks holds utility constant. Slutsky holds the original bundle just affordable. Say which one you use.
Deriving the demand curve by plotting income against quantity.
Students confuse the price consumption curve with the income consumption curve.
Fix: For each price, read the quantity at the tangency point. Plot price on the vertical axis and that quantity on the horizontal axis.

Worked examples

Example 1

A consumer has income ₹1,200 and buys goods X and Y with utility such that demand for X is x = m ÷ (2 × px) and demand for Y is y = m ÷ (2 × py). The price of Y is ₹10. The price of X falls from ₹10 to ₹5. Using the Slutsky method, find the substitution effect and the income effect on X.

Show the solution

Original demand: x0 = 1,200 ÷ (2 × 10) = 60. Also y0 = 1,200 ÷ 20 = 60.
New demand at actual income: x1 = 1,200 ÷ (2 × 5) = 120. Total effect = 120 − 60 = +60.
Slutsky compensated income: the cost of the original bundle at new prices = 5 × 60 + 10 × 60 = 300 + 600 = ₹900.
Demand for X at price ₹5 and income ₹900: x' = 900 ÷ 10 = 90.
Substitution effect = 90 − 60 = +30.
Income effect = 120 − 90 = +30.
Check: 30 + 30 = 60, which matches the total effect. X is a normal good, as both effects are positive.

Answer: Substitution effect = +30 units, income effect = +30 units, total effect = +60 units. X is a normal good.

Example 2

The price of a staple food rises. Quantity demanded rises by 5 units. The substitution effect is a fall of 8 units. Find the income effect and classify the good.

Show the solution

Total effect = +5 units. Substitution effect = −8 units.
Income effect = total effect − substitution effect = 5 − (−8) = +13 units.
Check: −8 + 13 = +5.
The price rose, so real income fell. Quantity demanded rose because of the fall in real income. So the good is inferior.
The income effect (+13) is larger in size than the substitution effect (−8). The total effect has the opposite sign to the substitution effect. The demand curve slopes upward.

Answer: Income effect = +13 units. The good is an inferior good and, because the income effect outweighs the substitution effect, a Giffen good.

Exam tips

In MCQs, work out the sign of the substitution effect first. Then you only need to classify the income effect.
For written answers, draw the budget lines and the compensating line, label the three points, and mark SE and IE on the quantity axis.
Say which method you use (Hicks or Slutsky) and why the compensated line is placed where it is.
A numerical question usually gives a demand function. Evaluate it at three points only: original, compensated and final.
If asked about deriving the demand curve, link the price consumption curve to the demand curve and say that price is on the vertical axis.

Practice questions from Consumer demand and behaviour

Income and Substitution Effects: frequently asked questions

What is the difference between the Hicks and Slutsky substitution effect?

Hicks keeps the consumer on the original indifference curve, so real income is measured as utility. Slutsky gives enough income to buy the original bundle at the new prices. Both give a substitution effect opposite to the price change, but the numbers can differ.

How do you derive a demand curve from the price consumption curve?

Change the price of the good and find the tangency point on the budget line at each price. The set of those points is the price consumption curve. Plot each price against the quantity at its tangency point to get the demand curve.

Is a Giffen good the same as an inferior good?

No. A Giffen good is a special inferior good. Its income effect is strong enough to outweigh the substitution effect, so a price rise leads to higher quantity demanded. Most inferior goods still have downward-sloping demand.

Why is the substitution effect always negative?

Because it measures the response to a change in relative price with real income held fixed in the Hicks or Slutsky sense. The consumer shifts towards the cheaper good. For a price fall, quantity rises. For a price rise, quantity falls.