Income and Substitution Effects
Income Effect: When there is a change in the price of a commodity, it can affect the decisions of the purchaser. This is the Income Effect. If there is an increase in prices without any change in your income, makes you feel poorer and therefore buy less. On the other hand, if there is a decrease in prices without any change in your income, makes you feel richer and you spend more on goods and services.
Substitution Effect: Substitution effect considers the relative price of two commodities. Let us assume that the price of 1 kg of apples has increased whereas the price of 1 kg of oranges stays the same. Then there is an inclination towards buying oranges. Likewise, if the price of apple decreases or the price of oranges increases, it influences our decision to either buy more or fewer apples. Hence, substitution effect is the tendency of the purchaser to change his purchase based on the change in relative price.
Income effect also has an impact on the buying decisions when there is a change in relative price. That is, when the price of apples goes up, the purchaser feels poorer and ends up buying fewer apples and oranges.
However, the total effect of the income effect and the substitution effect is not very clear.
|Total Effect||-||-/+ (?)|
Let us consider the total effect when there the price of apple increases. The consumption of both apples and oranges decrease when there is a change in price according to the income effect. Whereas, according to Substitution effect, the consumption of apples decreases while more oranges are consumed. Therefore, it is clear that in both cases the consumption of apples decreases.
Therefore, the total effect for apples is negative consumption. Contrary, it is not clear as to effect change in price has on oranges. This is because according to the income and substitution effects there is both increases and decrease respectively in the consumption of oranges.
However, generally speaking, substitution effect is stronger than income effect. For example, when the price of apple increases, there is a tendency to buy fewer apples and more oranges because the change in relative prices affects buying decisions (substitution effect) more than any superficial change in income (income effect).