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The demand curve or schedule shows the amount of a product that consumers are willing to buy at alternative prices during a specific time period. The law of demand states that the amount of a product bought is inversely related to its price. We have seen how the law of demand can be derived from fundamental principles of consumer behavior. Now, we go further and distinguish two different phenomena underlying a consumer’s response to a price change. First, as the price of a product declines, the lower opportunity cost will induce consumers to buy more of it – even if they have to give up other products. This tendency to substitute a product that has become cheaper for goods that are now relatively more expensive is called the substitution effect of a price change.
Second, if a consumer’s money income is fixed a reduction in the price of a product will increase his or her income – the amount of goods and services he or she is able to buy with that fixed amount of money income. If your rent were to decline by $100 per month, for example, that would allow you to buy more of a number of other goods. This increase in your real income has the same effect as if the rent had remained the same but your income had risen by $100 per month. As a result, this second way in which a price change affects consumption is called the income effect. Typically, consumers will respond to the income effect by buying more of the cheaper product and other products as well because they can better afford to do so. Substitution and income effects generally work in the same direction – in other words, in the same way; they both cause consumers to purchase more of a good as its price falls and less of a good as its price rises.