What does matter is the price relative to the prices

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does not matter. What does matter is the price relative to the prices of other goods, and what that price allows you to buy with your income. We decompose the effect of a change in the price of one good accordingly, into a substitution effect and an income effect . 1. Substitution effect: given fixed utility, how does quantity respond to price changes? A rise or fall in the price of a good changes its relative price with respect to the prices of other goods. This is easy to see in the two goods setting, where the relative price is given by P x /P y . But it applies to any number of goods. An increase in P x will make its relative price with respect to P y higher, and a decrease in P x will have the opposite effect. 2. Income effect: given fixed prices, how does quantity respond to income change? A rise or fall in the price of a good changes the consumer’s purchasing power, and hence his real income. The consumer then changes his optimal bundle choice according to whether a good is normal or inferior.
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