Substitution Effect and Income Effect

Substitution Effect refers to the change in demand for a commodity as a result of a change in the relative price of that commodity compared to that of its substitute goods. As the price of an item increases, consumers switch to cheaper alternatives/substitutes.

Examples:

  1. If the price of lamb meat increases in the market, people will start eating more chicken and less lamb. It can, therefore, be said that if the price of lamb goes up, it is substituted by chicken.
  2. The rise in consumption of tea, when the price of coffee goes up is yet another example of the substitution effect.
  • When the price of an item rises, it becomes more expensive relative to other items in the market. As a result, consumers switch from the item to its substitutes.
  • The substitution effect is strongest for products that have close substitutes. For example, if the price of Pepsi increases, consumers will shift towards drinking coca-cola.
  • The substitution effect shows the change in the consumption pattern of a consumer.

Substitution Effect on Inferior Goods:

  • The substitution effect is not seen in inferior goods. If the price of Inferior goods increases, it witnesses a rise in demand. Inferior goods are purchased in greater quantities if their prices rise. People on extremely limited budgets are forced to buy even more inferior goods because their increasing price places other higher-quality goods out of their reach.

Example: 

  • Even if the price of millets increases, poor people will be forced to buy it. This is because substitutes of millets like rice/wheat are already expensive and can’t be afforded by poor people.

Graph of Substitution Effect:

Substitution Effect and Income Effect
Substitution Effect and Income Effect

Consider the above Demand Curves for Tea and Coffee:

  • If the price of tea increases from P2 to P1, the demand of Tea decreases from Q2 to Q1. Subsequently, the demand for coffee increases, and hence the demand curve shifts to the right.

Income Effect

  • Income Effect can be defined as the change in demand of an item/service caused by a change in consumer’s purchasing power, resulting from a change in his/her real income.

Example: 

  • The monthly income of Ram is Rs 3000. He spends all his income on buying pens. If the price of one pen is Rs 10, he is able to buy 300 pens. If the price of a pen decreases to Rs 5, Ram will be able to buy 600 pens from the same income. This is known as the Income Effect.
  • The disposable income available to a person is simply known as Nominal Income. This nominal income, when adjusted for inflation/deflation, is known as Real Income.
  • When the price of items increases, consumers can purchase fewer items from the same nominal income. This means that when the price of items rises, the purchasing power decreases. Therefore, it is said that real income decreases when the price of items rises.
  • On the other hand, if the price of items decreases, consumers can buy more quantities of items from the same nominal income. This means that when the price of items rises, the purchasing power increases. Therefore, it is said that real income increases when the price of items falls.

Example: 

  • The monthly income of Raghu is Rs 20,000. He is willing to buy chairs whose price is Rs 5000/chair. If the price of each chair increases to Rs 10,000, determine what happens to nominal and real income. How does purchasing power change?
  • Nominal Income remains the same as the monthly salary of Raghu does not change.
  • When the price is Rs 5000/chair, he will be able to buy 4 chairs. But when the price of the chair increases to Rs 10000, he will be able to buy 2 chairs only.
  • Since he is able to purchase less from the same income, purchasing power is said to have decreased. Hence the real income also decreases.
  • Real income can change in the following ways:
    1. By an increase/decrease in the price of goods/services
    2. By rising/fall in nominal income
    3. By currency fluctuations
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