Income Effect vs. Substitution Effect: An Overview

The income effect expresses the impact of increased purchasing power on consumption, while the substitution effect describes how consumption is impacted by changing relative income and prices. These economics concepts express changes in the market and how they impact consumption patterns for consumer goods and services.

Different goods and services experience these changes in different ways. Some products, called inferior goods, generally decrease in consumption whenever incomes increase. Consumer spending and consumption of normal goods typically increases with higher purchasing power, which is in contrast with inferior goods.

Income Effect

The income effect is the change in consumption of goods based on income. This means consumers will generally spend more if they experience an increase in income, and they may spend less if their income drops. But the effect doesn't dictate what kind of goods consumers will buy. In fact, they may opt to purchase more expensive goods in lesser quantities or cheaper goods in higher quantities, depending on their circumstances and preferences.

The income effect can be both direct or indirect. When a consumer chooses to make changes to the way he or she spends because of a change in income, the income effect is said to be direct. For example, a consumer may choose to spend less on clothing because his income has dropped. An income effect becomes indirect when a consumer is faced with making buying choices because of factors not related to her income. For instance, food prices may go up leaving the consumer with less income to spend on other items. This may force her to cut back on dining out, resulting in an indirect income effect.

The marginal propensity to consume explains how consumers spend based on income. It is a concept based on the balance between the spending and saving habits of consumers. Marginal propensity to consume is included in a larger theory of macroeconomics known as Keynesian economics. The theory draws comparisons between production, individual income, and the tendency to spend more of it.

Substitution Effect

The substitution may occur when a consumer replaces cheaper or moderately priced items with ones that are more expensive when a change in finances occurs. For example, a good return on an investment or other monetary gains may prompt a consumer to replace the older model of an expensive item for a newer one.

The inverse is true when incomes decrease. Substitution in the direction of buying lower-priced items has a generally negative consequence on retailers because it means lower profits. It also means fewer options for the consumer.

Retailers who generally sell cheaper items typically benefit from the substitution effect.

While the substitution effect changes consumption patterns in favor of the more affordable alternative, even a modest reduction in price may make a more expensive product more attractive to consumers. For instance, if private college tuition is more expensive than public college tuition—and money is a concern—consumers will naturally be attracted to public colleges. But a small decrease in private tuition costs may be enough to motivate more students to begin attending private schools.

The substitution effect is not just limited to consumers. When companies outsource part of their operations, they are using the substitution effect. Using cheaper labor in a different country or by hiring a third-party entity results in a drop in costs. This nets a positive result for the corporation, but a negative effect for the employees who may be replaced.

Key Takeaways

  • The income effect is the change in consumption of goods by consumers based on their income.
  • The substitution effect happens when consumers replace cheaper items with more expensive ones when their financial conditions change.
  • The income effect can be both direct (when it is directly related to a change in income) or indirect (when consumers must make buying decisions not directly related to their incomes).
  • A small reduction in price may make an expensive product more attractive to consumers, which can also lead to the substitution effect.