Income Effect vs. Substitution Effect: An Overview

What Affects Consumption?

Goods and services are affected by income and substitution in different ways. The income effect is the change in consumption due to changes in consumer income. The substitution effect describes how consumption is impacted by price changes or increases in a consumer's relative income. As income increases, Inferior goods are purchased less as consumers with higher purchasing power spend more on normal goods.

Income Effect

The income effect is the change in consumption based on changes in income. Consumers spend more if their income increases and spend less if their income drops. The income effect doesn't dictate the kinds of goods consumers will buy. They may purchase more expensive goods in lesser quantities or cheaper goods in higher quantities based on circumstances and preferences.

The income effect can be direct or indirect. A consumer whose income has decreased may purchase less clothing, a direct income effect. The income effect is indirect when a consumer is forced to rearrange their basket of goods when factors are unrelated to their income. If food prices increase, they will have less income to spend on other items, such as dining out.

Substitution Effect

The substitution effect occurs when a consumer replaces one product with another due to a change in relative prices and personal finances. This includes replacing cheaper items with those more expensive, or vice versa. A good return on an investment or other windfall may prompt a consumer to replace the older model item, such as a car, with a newer one.

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. If private college tuition is more expensive than public college tuition, consumers may choose the less expensive option. However, a small decrease in private tuition costs may be enough to motivate more students to attend.

The substitution effect is not limited to consumers. When companies outsource part of their operations, they demonstrate the substitution effect. Cheaper labor in a different country or hiring a third party results in a drop in costs. This yields a positive result for the corporation but a negative effect for the employees who may be replaced.

Income Effect vs. Substitution Effect

• The income effect means a change in demand for a product due to a change in income.
• The substitution effect shows the demand for a product due to a relative change in price and the availability of substitutable products.
• When prices rise in a market with few choices or substitutes, the income effect may have a larger impact. Consumers may decide to stop buying a product altogether.
• When prices rise for products where many multiple substitution options exist, the substitution effect may have a greater impact. Consumers can choose to buy a similar product that's more affordable.

The Bottom Line

The consumption of goods and services can be affected by changes in a consumer's income, price levels, and the availability of market substitutes. The income effect is the resulting change in demand for a good or service caused by an increase or decrease in a consumer's purchasing power or real income. The substitution effect occurs when consumers replace one product with another due to price changes and personal finances.