A:

The economic concepts of income effect and substitution effect express changes in the market and how these changes impact consumption patterns for consumer goods and services. 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. 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, in contrast with inferior goods.

Substitution Effect

Substitution may occur in the form of a consumer replacing 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 gain may prompt a consumer to replace an 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 generally has a negative consequence on retailers. It also means fewer options for the consumer. There are, however, some retailers that may benefit from such an effect, such as those in the market for cheaper items.

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. If private college tuition is more expensive than public college tuition, and money is a concern, consumers are attracted to public colleges. However, a small decrease in private tuition costs may be enough to motivate more students to begin attending private schools.

Income Effect

The income effect results in consumers spending more or less in general and does not necessarily indicate buying items of higher or lower value. A consumer may opt to purchase more expensive goods in lesser quantities or cheaper goods in higher quantities. A concept called marginal propensity to consume explains how consumers spend based on income. It is based on the balance between the spending versus saving habits of the consumer. 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. (For related reading, see: What effect does the income effect have on my business?)

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