The Income and Substitution Effects of a Change in Price:

The inverse relationship between the price and quantity demanded of a product has been attributed to the consequence of two factors - (1) the income effect and (2) the substitution effect.

(i) The Income effect: A fall in a commodity's own price causes the consumer's real income (i.e. the physical quantity of the commodity that can be purchased with the same money income) to increase. This is referred to as the income effect of a change in price.

(ii) The substitution effect: This refers to the fact that as the price of a commodity falls, it becomes more attractive and preferable to a similar commodity whose price remains constant, and hence we buy more of it.

This analysis of the effect of a change in price of a commodity was pioneered by British economists, Sir John Hicks (1904 - 1989) and Roy Allen (1906 - 1983). Our analysis is restricted to a normal good - a good whose demand increases as consumer's income increases.