Understanding the income effect versus the 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 affected by changes in relative income and prices. These economic concepts express market changes and their impact on consumption patterns of consumer goods and services.

Different goods and services undergo these changes in different ways. Certain products, called inferior goods, generally decrease in consumption each time income increases. Consumer spending and the consumption of normal goods generally increase with higher purchasing power, which is in contrast to lower quality goods.

Key points to remember

  • The income effect is the variation in consumption of goods by consumers as a function of their income.
  • The substitution effect occurs when consumers replace cheaper items with more expensive items when their financial conditions change.
  • The income effect can be both direct (when it is directly linked to a change in income) or indirect (when consumers have to make purchasing decisions not directly linked to their income).
  • A small price drop can make an expensive product more attractive to consumers, which can also lead to the substitution effect.

Income effect

The income effect is the change in consumption of goods as a function of income. This means that consumers will generally spend more if they experience an increase in their income, and they can spend less if their income decreases. But the effect does not dictate the type of goods consumers will buy. They can choose to buy more expensive products in smaller quantities or cheaper products in larger quantities, depending on their circumstances and preferences.

The income effect can be both direct or indirect. When a consumer chooses to change 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 declined.

An income effect becomes indirect when a consumer is faced with purchasing choices due to factors unrelated to their income. For example, food prices can rise, leaving the consumer with less income to spend on other items. This may force them to reduce their outings to restaurants, leading to an indirect effect on income.

The marginal propensity to consume explains how consumers spend based on income. It is a concept based on the balance between the consumption and savings habits of consumers. The marginal propensity to consume is included in a larger macroeconomic theory known as Keynesian economics. The theory draws comparisons between production, individual income and the tendency to spend more.

Substitution effect

Substitution can occur when a consumer replaces cheaper or moderately priced items with more expensive items when a financial change occurs. For example, a good return on investment or other monetary gains may cause a consumer to replace the old model of an expensive item with a new one.

The reverse is true when incomes decline. Substitution in the direction of buying items at low prices generally has a negative consequence on retailers, as it means lower profits. It also means fewer options for the consumer.

Retailers who generally sell cheaper items generally benefit from the substitution effect.

While the substitution effect shifts consumption patterns in favor of the more affordable alternative, even a modest price reduction can make a more expensive product more attractive to consumers. For example, if private college tuition is more expensive than public college tuition – and money is a concern – consumers will naturally be drawn to public colleges. But a slight decrease in private tuition fees may be enough to motivate more students to start attending private schools.

The substitution effect is not limited to consumers. When companies outsource part of their operations, they use the substitution effect. Using cheaper labor in another country or hiring a third party results in lower costs. This represents a positive result for the company, but a negative effect for the employees who could be replaced.

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