Editing Utility maximization problem (section)

== Reaction to changes in prices ==
For a given level of real wealth, only relative prices matter to consumers, not absolute prices.  If consumers reacted to changes in nominal prices and nominal wealth even if relative prices and real wealth remained unchanged, this would be an effect called [[money illusion]]. The mathematical first order conditions for a maximum of the consumer problem guarantee that the demand for each good is homogeneous of degree zero jointly in nominal prices and nominal wealth, so there is no money illusion.

When the prices of goods change, the optimal consumption of these goods will depend on the substitution and income effects. The [[substitution effect]] says that if the demand for both goods is homogeneous, when the price of one good decreases (holding the price of the other good constant) the consumer will consume more of this good and less of the other as it becomes relatively cheeper. The same goes if the price of one good increases, consumers will buy less of that good and more of the other.<ref name=":1">{{Cite book|title=Utility Maximization and Demand|publisher=University of Minnesota library|year=2011|pages=chapter 7.2}}</ref>

The income effect occurs when the change in prices of goods cause a change in income. If the price of one good rises, then income is decreased (more costly than before to consume the same bundle), the same goes if the price of a good falls, income is increased (cheeper to consume the same bundle, they can therefore consume more of their desired combination of goods).<ref name=":1" />