Income Effect is a result of the change in the real income due to the change in the price of a commodity, As against, substitution effect arises due to change in the consumption pattern of a substitute good, resulting from a change in the relative prices of goods.
In economics, the total change in the consumption basket due to the change in price is called price effect. When there is a change in the price of the product or service, the budget line slope changes resulting in the change in the conditions for consumer equilibrium.
In this way, to adjust under new price conditions, a customer adjusts the consumption basket, so as to gain maximum satisfaction. Price effect can be income effect and substitution effect. This article presents you important differences between income effect and substitution effect. Have a look.
Content: Income Effect Vs Substitution Effect
|Basis for Comparison||Income Effect||Substitution Effect|
|Meaning||Income effect refers to the change in the demand of a commodity caused by the change in consumer's real income.||Substitution effect means an effect due to the change in price of a good or service, leading consumer to replace higher priced items with lower prices ones.|
|Reflected by||Movement along income-consumption curve||Movement along price-consumption curve|
|Effect of||Income being freed up.||Relative price changes.|
|Expresses||Impact of rise or fall in purchasing power on consumption.||Change in quantity demanded of a good due to change in prices.|
|Rise in price of a good||Reduces disposable income, which in turn decrease quantity demanded.||As alternative goods are comparatively cheaper and so customers will switch to other goods.|
|Fall in price of a good||Increases real spending power of a consumer, that allows customers to buy more, with the given budget.||Will make it cheaper than its substitutes, which will attract more customers and result in higher demand.|
Definition of Income Effect
When there is a decrease in the price of a good or service, the consumer will be able to buy the more quantity with the same amount or same quantity with less amount of money. In this way, the overall purchasing power of the consumer increases, which induces him to buy more of that commodity whose price has decreased, increases. The inverse is also true, i.e. any increase in the price of a good or service will result in the fall in consumption, due to income effect.
Suppose Mr. Alex spends half of his income on purchasing grocery and a decline of 10% in the price of grocery will increase his free money available to him which he can spend on buying additional grocery or something else of his choice.
Definition of Substitution Effect
When the price of a commodity falls, it becomes comparatively cheaper than another commodity, which instigates customers to replace commodity whose price has been decreased for other commodities that are relatively expensive now. As a result of this, the aggregate demand of the commodity whose price has been reduced, increases and vice versa. This is known as substitution effect, which arises due to the inherent tendency of consumer’s to substitute cheaper goods for relatively expensive ones, after eliminating real income effect of price change.
Key Differences Between Income Effect and Substitution Effect
The following points are noteworthy so far as the difference between income effect and substitution effect is concerned:
- The change in the demand for a commodity caused by the change in consumer’s real income is called income effect. An effect due to the change in the price of a good or service, leading the consumer to replace higher priced items with lower prices ones, is called substitution effect.
- The income effect is represented by the movement along income-consumption curve, which have a positive slope. Unlike, substitution effect which is depicted by movement along price-consumption curve, which have a negative slope
- The income effect is a result of income being freed up whereas substitution effect arises due to relative changes in prices.
- Income effect shows the impact of rise or fall in purchasing power on consumption. On the contrary, substitution effect reflects the change in the consumption pattern of an item due to change in prices.
- Income effect of a rise in the price of a good is the decrease in discretionary income leading to decrease in the quantity demanded. As against this, the substitution effect of the increased price of a good is that consumers customers will buy less costly alternatives.
- Income effect of a fall in prices of a good is that the purchasing power of customer will increase, allowing customers to buy more with the same budget. Conversely, substitution effect of a fall in prices of a good is that the good will become cheaper than its substitutes, which will attract more customers, leading to higher demand.
To put simply, income effect refers to the effect of the change in real income of consumer while substitution effect means substitution of one product for another, as a result of the change in the relative price of a good. These are the two components of the effect of the change in the price of a good on the consumption pattern. Hicksian approach and Slutksy’s approach, decompose the total price effect into the two effects i.e. income and substitution effects.