This is the term that is used when there is the exchange of goods between the countries and when there is a need to find out if there are issues that are being faced by the purchasing party. This would be with regard to the purchasing power of the individual or the firm. There are two things that need to be studied in order to understand it better. They are very much essential in the economic scenario. Let us see simple examples and then correlate them with the international level.


Let us take an example to talk about it in detail and for more understanding. If you get a ten percent hike in the hourly income that you receive, then what would you do? You can choose to adjust your working hours accordingly. You can choose to increase it, decrease it or maintain the same. All three would be the options from which you can choose from. This is the substitution effect.


The substitution effect:

Let us assume the case of the private institutions and the public one. If there is an increase of rates by about 10 percent in the case of the private universities and an increase in rates by only 3 percent in the public universities, the tendency would be to move from the private to public universities. This is true in all the other things that are happening around us too. It can be in the goods, the brands, and much more. Few examples would be the relative price of one beverage Vs the beverage of another brand, and so on.

The change of relative prices is the substitution effect (steep line to dotted line) and the change of purchasing power is the income effect (dotted line to parallel solid line)


The income effect:

It can happen due to various reasons. They can be the change in income, the change in prices of the goods, the change in currency value and so on. Since it is known us that income can not be considered as a good, it has to be exchanged with some good in return. Thus the purchasing power of a person increases when there is a decrease in the price of the goods that he wants to purchase.