The impact of a change in the price of a commodity can be divided into two effects; viz., Substitution Effect and Income Effect.

What is Substitution Effect?

The term substitution effect refers to the practice of substituting one commodity with another when it becomes comparably less expensive. When a particular commodity’s price decreases, it becomes comparatively less expensive than its substitute (assuming no change in the price of the substitute). In turn, this increases demand for the given commodity. For instance, if the cost of a particular good, like Sprite, decreases while the cost of its substitute, like Mountain Dew, remains constant, Sprite will become comparably less expensive and replace Mountain Dew, which ultimately results in increasing demand for Sprite.

What is Income Effect?

The term income effect refers to the effect on demand that occurs when a consumer’s real income changes as a result of a change in the price of a given commodity. The consumer’s purchasing power (real income) increases when the price of the given commodity decreases. As a result, consumers can spend the same amount of money on more of the given commodity. For instance, a decrease in the price of a certain good (let’s say Coke) will increase the consumer’s purchasing power and allow him to purchase more Coke with the same amount of money.