Understanding Income Effect vs. Substitution Effect
Income Effect vs. Substitution Effect: An Overview
The income effect expresses the impact of increased purchasing power on consumption, while the substitution effect describes how consumption is impacted by changing relative income and prices.
These economic concepts concern changes in the market and how they impact consumption patterns for consumer goods and services.
Different goods and services are affected by these changes in the market in different ways. Some products, called inferior goods, generally are purchased less whenever incomes increase. Consumer spending on normal goods typically increases with higher purchasing power, which is in contrast with inferior goods.
- The income effect is the change in the consumption of goods by consumers based on their income (purchasing power).
- The substitution effect happens when consumers replace cheaper items with more expensive ones due to price changes or when their financial conditions improve, and vice-versa.
- The income effect can be both direct (when it is directly related to a change in income) or indirect (when consumers must make buying decisions not directly related to their incomes).
- A small reduction in price may make an expensive product more attractive to consumers, which can also lead to the substitution effect.
- Companies experience the substitution effect, too, e.g., when they outsource production to take advantage of cheaper labor costs.
The income effect is the change in the consumption of goods based on income. This means consumers will generally spend more if they experience an increase in income. They may spend less if their income drops.
The effect doesn’t dictate the kinds of goods consumers will buy. They may opt to purchase more expensive goods in lesser quantities or cheaper goods in higher quantities, depending on their circumstances and preferences.
The income effect can be both direct or indirect. When a consumer chooses to make changes to the way they spend because of a change in income, the income effect is said to be direct. For example, a consumer may choose to spend less on clothing because their income has dropped.
An income effect becomes indirect when a consumer is faced with making buying choices because of factors not related to their income. For instance, food prices may go up, leaving the consumer with less income to spend on other items. This may force them to cut back on dining out, resulting in an indirect income effect.
The marginal propensity to consume explains how consumers spend based on income. It is a concept based on the balance between the spending and saving habits of consumers.
The marginal propensity to consume is included in a larger theory of macroeconomics known as Keynesian economics. The theory draws comparisons between production, individual income, and the tendency to spend more of it.
The substitution effect may occur when, due to a change in relative prices and finances, a consumer replaces one product with another. That might mean switching out cheaper or moderately priced items for ones that are more expensive.
For example, a good return on an investment or other monetary gains may prompt a consumer to replace the older model of an expensive item for a newer one.
The inverse is true when incomes decrease. Substitution in the direction of buying lower-priced items has a generally negative consequence on retailers because it means lower profits. It also may mean that there are fewer options for the consumer.
Retailers who generally sell cheaper items typically benefit from the substitution effect.
While the substitution effect changes consumption patterns in favor of the more affordable alternative, even a modest reduction in price may make a more expensive product more attractive to consumers.
For instance, if private college tuition is more expensive than public college tuition—and money is a concern—consumers will naturally be attracted to public colleges. But a small decrease in private tuition costs may be enough to motivate more students to begin attending private schools.
The substitution effect is not limited to consumers. When companies outsource part of their operations, they are demonstrating the substitution effect. Using cheaper labor in a different country or by hiring a third party results in a drop in costs. This nets a positive result for the corporation, but a negative effect for the employees who may be replaced.
- The income effect concerns change in demand for a product due to change in income relative to market prices (purchasing power).
- The substitution effect concerns change in demand for a product due to a relative change in prices and the availability of substitutable products.
- In circumstances where prices rise in a market with few products (substitutions), the income effect may have the larger impact. Consumers may decide to stop buying a product altogether.
- On the other hand, in circumstances where prices rise for products and a market has multiple substitution options available, the substitution effect may have the larger impact. Consumers can choose to buy a similar product that’s more affordable.
What Is the Substitution Effect?
The substitution effect is an economic concept that involves the substitution of one product for another when there’s a change in their relative pricing.
What Occurs Simultaneously With An Income Effect?
The income effect involves a change in purchasing power and a change in demand or consumption. So, for instance, if purchasing power decreases, demand for a product usually decreases.
What Is the Substitution Effect of a Price Change?
When the price of a product rises relative to alternative products in the same market, consumers will substitute one of the lower priced alternatives for the now higher priced product.