Introduction
When describing consumer behavior, economists frequently use the words income effect and substitution effect. These ideas are crucial in understanding how customers react to price and income changes. However, for those unfamiliar with economics, the phrases might be perplexing. In this blog article, we will examine the distinction between the income effect and the substitution effect and present examples to assist illustrate these concepts.
Income Effect vs Substitution Effect
The income effect describes the impact of increasing purchasing power on consumption, whereas the substitution effect describes how changing relative income and prices affect consumption.
These economic topics are concerned with market developments and how they affect consumer products and services consumption patterns.
Different goods and services are affected in different ways by market developments. When incomes rise, some things, known as inferior goods, are purchased less frequently. In contrast to substandard goods, consumer expenditure on normal items often grows with greater purchasing power.
Difference Between Income Effect and Substitution Effect in Tabular Form
| BASIS OF COMPARISON | INCOME EFFECT | SUBSTITUTION EFFECT |
| MEANING | The substitution effect denotes an effect caused by adjusting the cost of a service or a product, causing customers to replace more expensive items with lower-valued ones. | The income impact refers to the modification of a product's or service's interest caused by a change in a customer's real income. |
| REFLECTED BY | The movement of the income-consumption curve. | A DECREASE IN THE PRICE OF PRODUCT |
| AN INCREASE IN THE PRICE OF PRODUCT | Will make it less costly than its substitutes, which will bring in more clients and result in higher demand items or services. | Increases a buyer's genuine spending power, allowing them to buy more with the same budget. |
| AN INCREASE IN THE PRICE OF THE PRODUCT | Customers will switch to different products as alternative merchandise becomes less expensive. | Reduces extra cash, which reduces the amount demanded. |
| MANIFESTATION | Change in the amount asked or quantity desired of a product due to its development in costs. | Effect of rising or decrease in purchasing power on utilization. |
| EXPRESSES | The effect of rising or falling purchasing power on consumption. | Price changes cause a change in the quantity demanded for a good. |
What Is the Income Effect?
The income impact is an economic theory that describes how changes in income or pricing of commodities affect demand for a product.
According to the income impact, as one's salary rises, he or she gains more discretionary income to spend on products. As a result, greater income should lead to increased demand for the majority of goods and services.
Similarly, if the price of a product that someone frequently purchases declines, that person not anymore has to spend as much money on the thing in question. As a result, he or she has a greater amount to spend on other things, increasing demand for goods.
Income declines or price increases have the opposite impact, diminishing demand. The income effect has notable exceptions. For example, when someone's income improves, demand for lower-quality goods often falls since that person no longer must settle for a lower-quality product. Someone who buys one-ply toilet paper out of need is unlikely to increase his or her consumption once they start earning more. Instead, people will most likely buy higher-quality toilet paper.
Example of Income Effect
Economists frequently employ the income effect to compare changes in demand for two distinct items or services as a result of a change in real income. They draw an income-demand curve to represent the degree of demand as a function of income.
Let's say Jane enjoys both online games and films. A theatre ticket costs $15, whereas a new video game costs $60. Each month, Jane gets $150 to spend on video games and films.
Jane has several options for budgeting her money. She could, for example, watch ten movies and buy zero games, or she could watch two movies and buy two games, or she could watch six movies and buy one game.
If Jane's income rises, she may be able to boost her monthly amusement expenditure to $300. This raises her income, allowing her to watch 20 films per month, buy five games per month, or any combination of the two.
If her salary falls, she may have to limit her entertainment expenditure to $60 per month, allowing her to view only four films or purchase one game.
Jane's spending habits are determined by her personal preferences. Jane, for example, may prefer video games to movies. She does, however, purchase movie tickets because her restricted cash only allows her to purchase one or two games every month. If her money rises, she may increase her game consumption while decreasing her movie viewing since she regards movies as a lesser good.
How Does the Income Effect Create Change in Demand?
The income effect influences demand by providing people with more money to spend. In theory, people try to maximize the practical use, or value, of their money. After paying for needs such as housing and food, any extra money can be spent on leisure items. Leisure goods give varying levels of utility depending on consumer preferences.
In general, consuming larger quantities of a thing results in greater utility. For example, if someone enjoys purchasing one book, that person will most likely enjoy purchasing two books, three books, five books, or even ten books. Finally, the concept of declining marginal utility contends that more consumption will not offer more utility.
People can, however, purchase a wide range of goods and services, which helps them resist the effect of falling marginal value. For example, someone looking for entertainment may buy books, movies, video games, comic books, DVDs, sports tickets, concert tickets, hotel stays, or any number of other enjoyable items. A foodie can spend money on restaurants, delivery meals, high-quality groceries, and so on. Someone can mitigate the effect of a product's diminishing marginal utility by acquiring numerous similar ones.
People will tend to rise their use of the items they appreciate when they've got more money to spend because they want to maximize the value they get.
What Is the Negative Income Effect?
Normal items often have a negative income effect. It means that rising consumer income has a negative impact on the commodities produced. In the case of ordinary goods, demand for the products decreases when consumer income falls, and vice versa. The income and substitution effects do not favour the commodities in this case. When a consumer's income falls, the product becomes out of reach, and they stop purchasing it. They may exchange the good for a better option that meets their needs. A positive income effect occurs when there is a positive influence on the product as a result of changes in the consumer's income when the individual's income rises, as well as the demand for these things. The income effect and the substitution effect both operate in the product's favour. As the price falls and their purchasing power rises, consumers consider it more affordable. Mobile phones, air conditioners, and other items are examples.
What Is the Substitution Effect?
When a purchaser's financial situation changes, he or she may substitute less expensive or lower-priced products for more expensive ones. For example, a product return from a venture or other financial benefits may prompt a customer to replace an older model of a costly item with a more recent one.
When earnings fall, the inverse is true. Substitution for lower-valued items has a generally negative impact on merchants because it implies lesser benefits. It also means that the customer has fewer options.
While the replacement impact alters utilization designs or consumption habits for the more reasonable alternative, even a minor cost reduction may make a more expensive item more desirable to the end user. For example, if private schooling is more expensive than public schooling and money is an issue, customers will typically go towards public colleges. In any event, a slight decrease in private educational cost prices may be sufficient to entice more students to enroll in private schools.
The substitution effect is not limited to purchasers. When firms reconsider a portion of their activities, they are employing the substitution effect, incorporating less expensive labor in another country or by hiring a third-party result in a cost decrease. This results in a favorable conclusion for the corporation, but a negative outcome for the reps who may be replaced.
How Does the Substitution Effect Relate to Change in Demand?
The substitution impact is the change in demand for a good caused by a price adjustment. When the price of a commodity rises in comparison to the price of alternative substitute goods, demand for that good fall. The substitution effect is one of two elements that contribute to the law of demand, which asserts that when a good's price rises, consumers buy less of it. The income effect, which captures the reality that shifting prices modify the world of feasible product combinations that a person can purchase, is the other aspect.
How to Calculate the Substitution Effect?
To calculate the substitution effect, you must first isolate the influence of a change in relative pricing. When the price of a good changes, the buyer is always forced to reconsider the combination of goods that will maximize their utility (the total net advantages that anything delivers).
Microeconomic theory believes that an individual is continually seeking to maximize their utility function within the constraints of a budget. As a result, the consumer will seek for the mix of commodities that gives the maximum amount of utility at the lowest possible cost. Changing prices affect the potential combinations of commodities, forcing buyers to seek out the new bundle that delivers the greatest utility within the new set of alternatives.
The consumer, on the other hand, selects a new package according to both the updated relative cost (substitution impact) and the change in the overall cost of a package at the changed price (income effect). That is, assessing the substitution effect necessitates removing the income effect from the equation. There are two methods to do this without getting into the calculus.
Assume you have $100 to spend on workplace breakfast. Doughnuts are $1 each, while bagels are $2 each. This pricing implies that you can purchase 100 doughnuts, 50 bagels, or a mix of the two. Let's say you find yourself bringing 50 doughnuts and 25 bagels to work. Assume that the cost of bagels falls to $1 per piece. Your possibilities change dramatically. For starters, instead of two doughnuts, you now just need one. Second, if you purchased the same package previously, you have an extra $25 to spend.
Calculating the substitution impact necessitates focusing solely on the first portion of the equation, ignoring the question regarding what you would do with the extra money. One method would be to take that extra $25 off the table. We could offer you $75 (the cost of the previous consumption bundle at the new prices) and observe what you buy to isolate the substitution effect. The Slutsky substitution effect is the name given to this procedure. If you go in with 40 doughnuts and 35 bagels, the new price results in 10 doughnuts being substituted for 10 bagels.
The Hicksian method is an alternate way of determining the substitution effect. We would force you to remain on the same curve of indifference (all the combinations of items that yield equal utility at varied total costs) under this technique. The Hicksian substitution effect effectively asks you to discover the cheapest combination of commodities at the new price while maintaining the same level of utility.
Main Differences Between the Income Effect and Substitution Effect
The following points are notable in terms of the distinction between the income effect and the substitution effect:
- The change in demand for a commodity induced by a change in consumer real income is referred to as the income effect. The substitution effect refers to the effect caused by a change in the price of a good or service, which causes the consumer to replace higher-cost items with lower priced ones.
- The income effect is illustrated by movement along a positive sloped income-consumption curve. In contrast to the substitution impact, which is represented by movement along the price-consumption curve, which has a negative slope,
- The income effect occurs as a result of income being freed up, whereas the substitution effect occurs as a result of price changes.
- The income effect depicts the influence of changes in buying power on consumption. On the other hand, the substitution effect reflects a shift in an item's consumption pattern as a result of price changes.
- The income effect of a price increase on a good is a loss in discretionary income, which leads to a decrease in the quantity desired. In contrast, the substitution effect of an increasing price of a good is that customers would purchase less expensive alternatives.
- The income effect of a decrease in the price of a good is that the buying power of the client increases, allowing them to buy more with the same budget.
Conclusion
To put it simply, the income effect deals with the effect of an adjustment or change in the end consumer's real income, whereas the substitution effect suggests the substitution of one item for another due to an adjustment or change in the total cost of a product or service. These are the two components of the impact of a product's cost adjustment or modification on consumption patterns. Hicksian's and Slutksy's approaches deconstruct the entire value or price effect into two effects: substitution and income.