Income Effect vs. Substitution Effect — What's the Difference?
By Tayyaba Rehman — Published on November 5, 2023
Income Effect relates to how purchasing power changes impact consumption, while Substitution Effect pertains to changes in consumption due to relative price alterations.
Difference Between Income Effect and Substitution Effect
Table of Contents
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Key Differences
Income Effect and Substitution Effect are two economic concepts that explain how consumers react to price changes. The Income Effect deals with how alterations in a consumer's purchasing power, resulting from a change in real income, impact the quantity of goods they buy. In contrast, the Substitution Effect focuses on how consumers swap between goods when the relative prices of those goods change.
When the price of a product drops, the Substitution Effect may lead a consumer to buy more of that product instead of other, now relatively more expensive, products. The Income Effect, on the other hand, considers that with the price drop, a consumer effectively has more income to spend, potentially increasing their overall purchasing.
Both the Income Effect and Substitution Effect can work together or in opposing directions. For instance, with inferior goods (goods people buy less of as their income rises), a price reduction may lead to buying less of that good (negative Income Effect) but more of other goods due to relative price changes (Substitution Effect).
Understanding both the Income Effect and Substitution Effect is crucial for businesses and policymakers. While the Income Effect emphasizes changes in real income and purchasing power, the Substitution Effect underscores the importance of relative prices in consumption choices.
Comparison Chart
Definition
Change in consumption due to changes in real income.
Change in consumption due to changes in relative prices of goods.
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Trigger
Change in purchasing power.
Change in the price of a product relative to others.
Goods Type Influence
More pronounced with normal goods.
Relevant for all types of goods.
Direction
Can be positive (normal goods) or negative (inferior goods).
Typically moves in the direction of the price change.
Key Concern
Purchasing power and real income.
Price of one good in comparison to another.
Compare with Definitions
Income Effect
Income Effect varies for different goods.
For luxury cars, a strong positive Income Effect was observed when the economy boomed.
Substitution Effect
Substitution Effect can augment or counteract the Income Effect.
For luxury items, the Substitution Effect was negligible despite a strong Income Effect.
Income Effect
Income Effect is a real income change consequence.
A pay raise led to an increase in luxury goods consumption due to the Income Effect.
Substitution Effect
Substitution Effect emphasizes relative product pricing.
A significant Substitution Effect was noticed when soda became cheaper than juice.
Income Effect
Income Effect can increase or decrease consumption.
Higher real income from a tax cut, showcasing a positive Income Effect, boosted vacation spending.
Substitution Effect
Substitution Effect arises from relative price changes.
A drop in chicken prices, causing a Substitution Effect, led to less beef consumption.
Income Effect
Income Effect describes purchasing power shifts.
The Income Effect from a bonus enabled buying a new laptop.
Substitution Effect
Substitution Effect occurs when consumers swap goods.
The increasing cost of gas resulted in a Substitution Effect towards electric cars.
Income Effect
Income Effect can be inverse for inferior goods.
Due to the Income Effect, people bought less canned food when their income increased.
Substitution Effect
Substitution Effect influences consumption choices.
Due to the Substitution Effect, many shifted from branded to generic products when prices soared.
Common Curiosities
What triggers the Income Effect?
Changes in real income or purchasing power lead to the Income Effect.
Can the Income Effect and Substitution Effect act in opposite directions?
Yes, especially with inferior goods where a price drop can decrease consumption (Income Effect) but increase other goods' consumption (Substitution Effect).
Which effect focuses on relative product pricing?
The Substitution Effect.
Is the Substitution Effect only relevant when prices drop?
No, it's relevant whenever there's a change in the relative prices of goods, whether they rise or fall.
Can the Substitution Effect ever be zero?
Yes, if goods are perfect complements with fixed consumption ratios, the Substitution Effect is zero.
What might cause a negative Income Effect?
Inferior goods, where increased income results in decreased consumption of that good.
How do the Income Effect and Substitution Effect impact demand curves?
Both effects can cause shifts along or shifts of the demand curve based on price and income changes.
How does the Income Effect respond to a salary increase?
It typically results in increased consumption due to greater purchasing power.
How is the Substitution Effect initiated?
The Substitution Effect arises when there's a change in the relative price of goods.
Which effect is more concerned with changes in wealth or income?
The Income Effect.
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Written by
Tayyaba RehmanTayyaba Rehman is a distinguished writer, currently serving as a primary contributor to askdifference.com. As a researcher in semantics and etymology, Tayyaba's passion for the complexity of languages and their distinctions has found a perfect home on the platform. Tayyaba delves into the intricacies of language, distinguishing between commonly confused words and phrases, thereby providing clarity for readers worldwide.
