Explaining the Income and Substitution Effects

The income effect and substitution effect are two concepts used to explain how and why consumers change their consumption patterns in response to changes in the price of a good or service. These effects are key to understanding the behavior of the demand curve in economics. Here’s the difference between them:

1. Income Effect:

• Definition: The income effect refers to the change in the quantity demanded of a good or service resulting from a change in the consumer’s real income (or purchasing power) due to a change in the price of the good. When the price of a good falls, the consumer’s real income increases because they can now afford more of the good or other goods with the same income. Conversely, when prices rise, real income effectively decreases.
• Impact on Demand: If the price of a good falls, consumers may feel richer and increase their consumption of that good or other goods. If the price rises, they may reduce their consumption due to the feeling of reduced purchasing power.
• Example: If the price of bread decreases, consumers may buy more bread because they can afford to buy more with the same budget, or they may use their increased purchasing power to buy other goods like milk or fruits.

2. Substitution Effect:

• Definition: The substitution effect refers to the change in the quantity demanded of a good when its price changes, making it more or less expensive relative to other goods. Consumers will substitute away from more expensive goods in favor of cheaper alternatives. When the price of a good falls, it becomes relatively cheaper compared to substitutes, leading consumers to buy more of it.
• Impact on Demand: If the price of a good falls, consumers may substitute this cheaper good for other, relatively more expensive goods. If the price rises, they may substitute away from it in favor of cheaper alternatives.
• Example: If the price of coffee decreases, some consumers who previously bought tea (as a substitute) might switch to coffee because it is now cheaper in comparison.

Key Differences:

• Income Effect is about changes in purchasing power: When the price of a good falls, you can afford more with the same income, and when it rises, your purchasing power decreases.
• Substitution Effect is about relative price changes: When the price of a good changes relative to substitutes, consumers switch to or away from that good based on its relative affordability.

How They Work Together:

Both the income effect and substitution effect work together to explain why the quantity demanded of a good changes when its price changes. For normal goods, both effects generally lead to an increase in quantity demanded when prices fall and a decrease when prices rise. For inferior goods, the income and substitution effects can sometimes work in opposite directions.

Topical examples of the income and substitution effects

1. Income Effect Example: Rising Petrol Prices and Consumer Behavior

• Context: Suppose the price of petrol rises significantly due to geopolitical tensions or supply chain disruptions, as seen during global oil price spikes in recent years.
• Income Effect: As petrol prices increase, consumers feel that their real income has decreased because they have to spend more on fuel, leaving less money for other goods and services. This reduced purchasing power may cause them to cut back on discretionary spending, such as dining out or purchasing non-essential items. In extreme cases, consumers might even reduce their driving or travel habits because the cost of maintaining those activities has become too high relative to their incomes.
• Outcome: This results in a decrease in demand for petrol and other related goods, not just because of the price change itself, but due to the overall effect on consumers’ available income.

2. Substitution Effect Example: Electric Vehicles (EVs) vs. Petrol and Diesel Cars

• Context: With the rising cost of petrol and diesel and increased concerns about climate change, electric vehicles (EVs) have become more affordable and popular as technology improves and governments provide incentives.
• Substitution Effect: When petrol and diesel prices rise, consumers may start substituting petrol or diesel-powered cars with electric vehicles, which are cheaper to operate due to lower fuel and maintenance costs. EVs become more attractive in comparison to traditional cars because they provide similar utility at a lower operating cost.
• Outcome: The demand for electric cars increases, while demand for petrol and diesel-powered cars may decline as consumers substitute toward the now relatively cheaper (in terms of operating cost) option of EVs.

3. Income Effect Example: Housing Market and Mortgage Rates

• Context: In a situation where mortgage interest rates rise, like during the recent inflationary pressures that caused central banks to raise interest rates, the cost of borrowing increases.
• Income Effect: As mortgage rates increase, homebuyers’ real purchasing power declines because higher mortgage payments leave them with less disposable income. For example, if someone was initially able to afford a £500,000 home with a low mortgage rate, they may only be able to afford a £400,000 home after mortgage rates rise, effectively reducing their real income in the housing market.
• Outcome: This leads to a decrease in demand for expensive homes as consumers feel "poorer" in terms of what they can afford with the same income, shifting their preferences toward smaller or less expensive properties.

4. Substitution Effect Example: Plant-Based Meat Alternatives vs. Traditional Meat

• Context: With the rising prices of meat products due to supply chain disruptions or environmental factors (e.g., droughts affecting cattle farming), plant-based meat alternatives like Beyond Meat and Impossible Foods have become more popular.
• Substitution Effect: As the price of traditional meat rises, consumers may switch to plant-based alternatives, which have become relatively cheaper and more accessible. The increasing availability of meat substitutes in supermarkets and restaurants, combined with rising meat prices, encourages consumers to substitute plant-based products for meat.
• Outcome: The demand for plant-based meat alternatives increases as they become more competitive in price relative to traditional meat products.

5. Income Effect Example: Inflation and Consumer Goods

• Context: During periods of high inflation, such as what many economies experienced recently, the general price level of goods and services rises, decreasing consumers’ real income.
• Income Effect: As prices for everyday goods like groceries, rent, and utilities rise, consumers feel that their purchasing power has declined, even if their nominal income hasn’t changed. They may cut back on non-essential items, like entertainment or luxury goods, as they prioritize basic necessities. This reduction in real income due to inflation can lead to lower demand for luxury items, vacations, or dining out, as consumers adjust their budgets.
• Outcome: A widespread decrease in demand for non-essential goods and services is seen due to the reduced purchasing power of consumers.