Income and substitution effects, plus the Hicks and Slutsky decompositions, are covered with full diagrams in the Economics Made Simple Complete Bundle — textbook, practice questions with mark schemes, flashcards and 100 case studies.
Income and Substitution Effects
Let us assume there is a decrease in the price of a product. This will have two effects:
- Consumer will prefer buying more of that good because it has become cheaper and he/she will decrease the demand for those goods which are now comparatively more expensive. This effect is also called the Substitution Effect
- Since the price of that particular product has decreased, if the consumer buys the same quantity of that good, he/she has more money income than before the decrease in price. In other words, his/her purchasing power has increased. This in turn is called the Income Effect
We have presented in a previous post (Price Consumption Curve) that a decrease in the price of a good has an effect not only on consumer’s consumption level, but also on his/her income. The price consumption curve shows various combinations of solutions for the utility maximization problem. There points indicate the satisfaction or the utility of the consumer after a decrease in the price of one good.
Conversely, the Income Consumption Curve shows various combinations of utility maximization points (having each correspondent budget line tangent to the indifference curve) which indicates consumer’s satisfaction after an increase in income.
Therefore, the Price Consumption Curve underpins a shift of the Demand Curve that is downward sloping due to the fact that a decrease of the price of a good leads to an increase in the level of consumption for that good. The Income Consumption Curve is also based on a shift of the Demand Curve, but unlike prices income is an external factor that shifts the demand curve and increases the consumption level of consumers.
This whole scenario of a decrease in the price of one good is a very simplified model that helps understanding two important concepts which are the substitution effect and the income effect.
Substitution Effect
Substitution Effect refers to the change in the level of consumption of a good following a change in its price, holding utility level constant.
The substitution effect works in such way that consumers will replace the consumption of an expensive good with the consumption of a less expensive good, as long as the utility or satisfaction from doing so remains constant.
Income Effect
Income Effect refers to the change in the level of consumption of a good resulting from a change in consumer’s income due to a change in price, holding utility level constant.
This definition provides an insight into consumers’ purchasing power and how this changes when their income changes.
(Please Leave a comment if you need additional explanations on this topic or graphs)