How do you react when the price of your favorite product increases? Do you still purchase it or switch to a cheaper alternative? These are the two possible outcomes of economic theory Income Effect and Substitution Effect.
The income effect refers to the change in consumption patterns resulting from a change in purchasing power due to a change in income. While substitution effect refers to the change in consumption patterns resulting from a change in relative prices, leading consumers to substitute one good for another.
Income vs. Substitution Effect
| Income Effect | Substitution Effect |
|---|---|
| The income effect refers to the change in consumption patterns resulting from changes in purchasing power due to a change in income. | The substitution effect refers to the change in consumption patterns resulting from changes in relative prices between goods or services. |
| It arises when an individual’s income changes, either increasing or decreasing. | It occurs when the price of one good or service changes relative to the price of another. |
| The income effect can lead to an increase or decrease in the quantity demanded of a good depending on whether it is a normal or inferior good. | The substitution effect leads to a change in the quantity demanded of a good in response to the change in relative prices, typically resulting in a decrease in the quantity demanded of the relatively more expensive good. |
| It is independent of changes in the price of the good itself. | It is directly influenced by changes in the relative prices of goods or services. |
| The income effect can work in the same direction as the substitution effect, reinforcing its impact, or in the opposite direction, counteracting it. | The substitution effect operates independently and can exist even without the presence of the income effect. |
| It is related to changes in real income and reflects the impact on purchasing power. | Its effect is rooted in the concept of price elasticity of demand and the substitution behavior of consumers. |
What is the income effect?
The income effect is a concept in economics that describes the change in consumption patterns or demand for goods and services as a result of a change in an individual’s income. When a person’s income increases, the income effect suggests that they are likely to increase their overall spending and consumption.
Conversely, when income decreases, individuals may reduce their spending and consumption. The income effect is a significant factor in understanding consumer behavior and analyzing the impact of income changes on the economy.
For example, if a consumer’s real income increases, they may choose to consume more steak and chicken. The income effect can move consumption in either direction depending on whether real income increases or decreases.
What is the substitution effect?
The substitution effect is the change in consumption that results from a change in the price of a good. The substitution effect occurs when a good becomes more expensive and consumers substitute away from that good.
For example, if the price of steak increases, consumers may substitute chicken for steak. The substitution effect always moves consumption in the direction of cheaper goods.
Conversely, when the price of a good or service increases, consumers may choose to substitute it with alternative, relatively cheaper options. The substitution effect plays a role in analyzing how changes in prices affect consumer demand and the overall allocation of resources in the economy.
The impact of changes in price and income on consumer behavior
When prices of goods and services rise, consumers purchase fewer items and this is known as the income effect. The substitution effect occurs when a consumer substitutes a good or service for another due to changes in price. For example, if the price of beef rises, the consumer may substitute chicken for beef.
The income effect suggests that as prices rise, people will buy less because their money does not go as far. This happens because people’s real incomes decrease when prices increase and they can’t afford as much. The substitution effect says that as prices rise, people will switch to cheaper alternatives. So, if the price of beef rises, people will buy more chicken instead.
Some economists believe that the substitution effect is stronger than the income effect because people are always looking for ways to save money and stretch their budgets. Others believe that the income effect is stronger because it directly impacts how much people can afford to spend on goods and services.
Comparative analysis of income effect and substitution effect
Income Effect:
- Results from a change in consumer income
- Reflects the impact on purchasing power
- Higher-income leads to increased demand for goods and services
- Lower-income leads to decreased demand for goods and services
Substitution Effect:
- Arises from a change in relative prices of goods
- Influences consumer’s choice between different goods
- The lower price of goods leads to increased demand for that good
- The higher price of goods leads to decreased demand for that good
Key differences between income and substitution effect
- Cause: The income effect is caused by a change in the consumer’s income, whereas the substitution effect is caused by a change in the relative prices of goods.
- Impact: The income effect reflects the change in purchasing power resulting from a change in income, whereas the substitution effect focuses on the change in consumers’ choice between goods due to a change in relative prices.
- Direction: The income effect can lead to an increase or decrease in demand depending on whether income rises or falls. In contrast, the substitution effect always leads to a change in demand in the opposite direction of the price change.
- Focus: The income effect emphasizes the impact of income changes on overall purchasing power, while the substitution effect highlights the shift in consumer preferences and substitution of goods based on price changes.
- Difference between Needs and Wants
- Difference between Scarcity and Shortage
- Difference between Collusive and Non-Collusive Oligopoly
Conclusion
The income effect and substitution effect are two important concepts in economics that help explain consumer behavior in response to changes in income and relative prices. While the income effect focuses on changes in purchasing power resulting from income changes, the substitution effect analyzes the shifts in consumer preferences and substitution between goods due to price changes.
