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Income Effect, Price Effect and Substitution Effect – A comparison

What is the Income effect?

The change in demand in regards to a service or good that is caused by a change in a consumer’s purchasing power, resulting from a change in real income is the income effect in microeconomics. Some reasons for this change in result can be a wage increase, etc. Adding to this, another reason might be the freeing up of existing income due to an increase, or where the money is spent there is an increase in the good’s price. For instance;

  • In the case of higher meat prices, the consumers may be encouraged to switch to alternative food sources, like buying vegetables.
  • Despite this, after buying the meat even after the high prices they will have reduced income which is spare. Hence, because of this income effect, the consumers will buy less meat.

When good like diamond is taken in consideration, then there are fewer chances of substitution effect as there is no alternative. But the demand will be decreased because of the higher prices and the income effect.

Consider that there is a consumer who buys a grilled cheese sandwich which is cheap to eat for lunch at work, on an average day, however, splurges on a hot dog that is luxurious occasionally. Now if the grilled cheese sandwich’s price increases.

In general, when the income rises then it is expected of the consumers to spend more and spend less when their income falls. Correlation between spending and income also trends with economic cycles. The consumer discretionary and consumer staples sectors are heavily affected by this. Due to the consumers spending more, the higher income levels can result in higher prices and businesses are allowed to charge more because of the rise in demand.

Understanding Income effect 

In the case of normal economic goods, when there is a rise in real consumer income so there will be a demand for a greater quantity of goods for purchase by the consumers. A part of consumer choice theory is the income effect. It is what relates preferences to consumption expenditures and consumer demand curves, for the consumer goods and services it expresses the impact of relative market prices and incomes on consumption patterns.

In consumer economic choice theory the income effect and substitution effect are related economic concepts. The impact on consumption by the changes in purchasing power is expressed by the income effect, whereas the change in the pattern of consumption caused by the change in relative prices of related goods which can be substituted for one another is described by the substitution effect.

The Income Effect and Changes in Demand

Due to currency fluctuations, nominal income changes or price changes can be a cause of changes in real income. If without any price changes the nominal income increases so due to this at the same price the consumers can purchase more goods and there will more demand for most goods by the consumers.

Deflation, means when the prices fall, and the nominal income is the same so then more goods can be purchased by the consumer’s nominal income. Both of these cases are relatively straightforward. Adding to this, when there are changes in the relative prices of different goods, then regarding each good the purchasing power of consumer’s income relative change and the income effect comes into play. The results of the income effect, the rise of fall in demand for the good, are impacted by the characteristics of the good.

Normal goods are described as goods that have an increased demand due to the incomes of people and the rise in purchasing power. They are defined as those having an income elasticity of demand coefficient that is positive, however, less than one. For the normal goods, the income effect and the substitution effect both work in the same direction. There will be an increase in the quantity that is demanded due to the result of relative price downfall, because the goods are now cheaper than the goods that are substituted. Also, a greater total purchasing power will be there for the consumers because of the lower price and the overall consumption can also be increased.

Inferior goods are known to be the goods regarding which when the consumers’ real income rises or the rise happened as the income fall, as a result of a decline in the demand. This happens when the substitutes of the goods are more costly which see an increase in demand as the economy of the society improves. The income elasticity of demand is negative for inferior goods. The income effect and substitution effect work in opposite directions.

When there is an increase in the price of the inferior goods so it means the consumers are more willing to purchase the other substitute goods, however, because of their lower real income the consumers will be encouraged to consume lower amount of any other substitute normal goods.

Inferior goods are the goods that are viewed as goods of lower quality, but despite this, on a tight budget, they can get the job done. Such as the coarse and scratchy toilet paper.  To pay the premium price, as they prefer higher quality goods, they will be required to have a greater income.

Calculating Income Effect

One of the several ways to mathematically analyze the income effect includes looking at the marginal propensity to income (MPC). On income and expenditures, the date is provided in the monthly report of Personal Income and Outlays. To understand that with the changes in income how much the consumers are spending, this data can be used by the MPC. By dividing the change in consumption by the change in income the MPC is calculated.

To understand the income effect a demand curve may be used. On the y-axis, income is represented, and on the x-axis demand is. The income-demand curve is typically sloping upwards and the marginal change in quantity demand per income increase is defined by the income elasticity of demand.

What is the Substitution effect?

The substitution effect is hen an increase in the price of goods encourages the consumers to buy alternative goods. When income of same level is assumed so how much the higher prices encourages the consumers to buy different goods is measured by the substitution effect.

Income and Substitution Effect for Wages

In case for a worker he has a choice between work and leisure.

  • Instead of leisure work becomes more relatively profitable if the wages increases, known as the substitution effect.
  • On the other hand, with higher wages, through less work, a decent standard of living can be maintained, known as the income effect.

For higher reward, leisure must be given up for more hours of work, because of the substitution effect of higher wages.

Whereas, with the income effect of higher wages, the hours the worker work will be reduced as through fewer hours they can maintain a target level of income.

People will have to work more (up to W1, Q1) if the income effect is less than the substitution effect. Yet, a certain hourly wage will be achieved where fewer hours can be consumed for work.

This is dependent on the worker. If leisure is preferred by you and you are lazy so with higher wages you will be aided to work less. It will be soon dominated by the income effect. The income effect will take  a long time to occur when there is a load of debts and spending commitments.

A relationship of Income effect and substitution effect with interest rates and saving

  • Income effect: When the interest rates are higher so the income from the savings increase.
  • Substitution effect: When the interest rates are higher so the because of it the saving becomes more attractive than spending, resulting in reduced consumer spending.

What is the Price Effect?

The change which is experienced in the demand of certain good or service after a modification takes place in its price so is called the price effect. The consequence that a certain event has on the price of a financial instrument is what the price effect is also referred to.

 There’s an effect in the items number which is supplied or demanded whenever the given good or services’ price is modified. Within the law of supply and demand, the economic principle behind a price effect lies. For normal goods, price is the key driver of the quantities which are purchased or offered. In case if the price is lifted then the demand decreases and the supply increase, and vice versa.

While if we look at the other side so the concept described above can also be applied to the financial securities which are exposed to the internal and external realities. Such as, in a country, a company that experiences political turmoil will face stocks’ price affected adversely. If the business is exposed to that particular location so it is affected by this scenario.

Therefore, the change in interest rates can result in the price effect, for the bond market this is the case. The price of most bonds will be reduced if the interest rate rises.

For example, George bought a bond from a financial corporation. $3000 is spent by him to buy a recent issue as he trusted a rumour he had heard regarding interest rate reduction. If the federal interest rate is reduced so there will be an automatic change upwards as stated by the price effect.

Although, the result was the opposite. As there was a rise in the federal interest rate so the price of George’s bond fell from $3000 to $2280 which caused him a loss of $720. The consequences of a price change in a financial scenario are explained by this. Now George has two options, either to recover the capital that he invested he has to wait for the bond to mature or to get rid of the bond he has to take the loss.

Calculating Price Effect

On the y-axis, the price is plotted and on the x-axis, the demand quantity is plotted in a demand curve. It is typically a downward sloping shape. In demand per price change, the change which is expected is described by the price elasticity of demand. To understand the potential effects of increase or decrease in the offerings by the businesses, the demand curve can prove to be important.

An Overview of Income effect vs. Price Effect

To understand the economic trends both the concepts of income effect and price effect benefits the analysts, economists and business professionals. For the companies to establish and monitors price levels for the goods centered on theories and trends, the usage of income effect and price effect can be done. Two different isolated variables are used by the income effect and price effect to comprehend the demand changes.

An Overview of Income effect vs. Substitution effect

The increased purchasing power has an impact on consumption which is explained by the income effect. On the other hand, the impact of changing relative income and prices on consumption is explained by the substitution effect. Both of these concepts of economics explain the market changes and their impact on consumption patterns for goods and services for the consumer.

These changes are experienced by various goods and services in different ways. Inferior goods, in general, whenever the income increases there are a decrease in consumption. In contrast with inferior goods, consumer spending and normal goods consumption increase typically with high purchasing power.

Summary

  • Based on the consumer’s income the change in goods consumption is the income effect.
  • When a cheap item is replaced with a more expensive one by the consumers based on their financial conditions changes is when the substitution effect happens.
  • The income effect can be both direct and indirect. Direct is when there is a direct relation to a change in income while indirect is when buying decisions must be made by the consumers which are not directly related to their incomes.
  • An expensive product might be made more attractive to the consumers, leading to a substitution effect, by a small reduction in the price.
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