Substitution and Income Effect | By The Digital Insider

The impact of a change in the price of a commodity can be divided into two effects; viz., Substitution Effect and Income Effect.

What is Substitution Effect?

The term substitution effect refers to the practice of substituting one commodity with another when it becomes comparably less expensive. When a particular commodity’s price decreases, it becomes comparatively less expensive than its substitute (assuming no change in the price of the substitute). In turn, this increases demand for the given commodity. For instance, if the cost of a particular good, like Sprite, decreases while the cost of its substitute, like Mountain Dew, remains constant, Sprite will become comparably less expensive and replace Mountain Dew, which ultimately results in increasing demand for Sprite.

What is Income Effect?

The term income effect refers to the effect on demand that occurs when a consumer’s real income changes as a result of a change in the price of a given commodity. The consumer’s purchasing power (real income) increases when the price of the given commodity decreases. As a result, consumers can spend the same amount of money on more of the given commodity. For instance, a decrease in the price of a certain good (let’s say Coke) will increase the consumer’s purchasing power and allow him to purchase more Coke with the same amount of money.

Direction of Substitution and Income Effect

1. Substitution Effect:

The substitution effect is always positive. It means that when a commodity’s price decreases, more of it will be consumed and used in place of goods whose prices have not decreased. The consumer always tries to replace a comparatively expensive good with a relatively cheaper one. As a result, the Substitution Effect is always positive because a decrease in the price of a good encourages higher consumption.

2. Income Effect: 

The direction of the income effect is not obvious and definite. It could be positive or negative.

• If more of a commodity is purchased when the decrease in the price of the commodity leads to an increase in the purchasing power, the income effect will be positive.
• If less of the commodity is purchased when the decrease in the price leads to an increase in the purchasing power, the income effect will be negative.

The nature of a commodity depends on the relative strength of the Substitution and Income Effect

A commodity may fall under the category of Normal Good, Inferior Good, or Giffen Good, based on the relative degree and direction of the income and substitution effects. These are three different cases: 

Case 1:  Normal Goods

Both the substitution and income effects are positive in the case of normal goods.

• Substitution Effect: When the price of Normal Goods decreases, consumers are more likely to purchase them since they are now comparably less expensive than their substitutes, whose prices have not decreased.
• Income Effect: A decrease in the price of Normal Goods increases real income and the quantity purchased. 

It implies that the substitution effect and the income effect for Normal Goods act in the same direction. Hence, the Price Effect will also be positive, indicating that when the price of a good is decreased, consumers will purchase more of it. For Normal Goods, the demand curve slopes downward, which means that the quantity demanded always varies inversely with price. 

Case 2: Inferior Goods

When it comes to Inferior Goods, the substitution effect is positive, whereas the income effect is negative.

• Substitution Effect: A decrease in the price of Inferior Goods increases their demand because they are now comparatively less expensive than their substitutes, whose prices have not decreased. Hence, a positive substitution effect results in an increase in consumption. 
• Income Effect: A decrease in the price of Inferior Goods raises real income, which lowers the demand for Inferior Goods as consumers switch to superior goods. Thus, the income effect is negative as it reduces consumption with a decrease in the price.

The total impact of price reduction is an increase in demand. It occurs because the positive substitution effect is stronger than the negative income effect. In simple terms, the increase in demand because of the positive substitution effect is more than the reduced demand because of the negative income effect. Therefore, the demand curve for inferior commodities slopes downward; i.e., the quantity demanded always changes inversely with price.

Case 3: Giffen Goods

Giffen Goods are a special type of Inferior Goods in which the negative income effect is stronger than the positive substitution effect.

• Substitution Effect: In the case of Giffen Goods also, the substitution effect is positive because the demand for them rises as a result of the decrease in their price relative to their substitutes’ unchanged prices.
• Income Effect: As actual income rises because of a decrease in the price of Giffen Goods, consumer’s demand for Giffen Goods declines as they switch to more superior goods.

The total impact of price reduction is a fall in demand. It occurs because the negative income effect is stronger than the positive substitution effect. In simple terms, the increase in demand because of the positive substitution effect is less than the reduced demand because of the negative income effect. Hence, demand for Giffen Goods changes directly with a price; i.e. demand decreases with a price decrease and increases with a price increase. Also, as Giffen Goods break the Law of Demand, their demand curve slope upwards.

A good is said to be a Giffen Good if it satisfies the following three conditions:

1. An inferior good with a large negative income effect.
2. The substitution effect of a change in price must be small.
3. A good should absorb a major portion of the income of a consumer.

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Published on The Digital Insider at https://bit.ly/3znnMNI.