Substitution and Income Effects

Substitution Effect

A substitute is a good that satisfies the same need as another good, e.g.,  broccoli and cauliflower. The substitution effect states that a good becomes more of a bargain relative to other goods as its price declines; therefore, the good is substituted for other goods. For example, if the price of broccoli rises from $3 to $5 while the price of cauliflower remains constant at $3, households will be more inclined to consume more cauliflower and stay away from broccoli.

Income Effect

The term income effect, in economics, refers to a change in the consumption of a good or service due to a change in income. It is important to note that the income effect mainly expresses how increased purchasing power affects consumption. For example, if a CFA candidate’s income rises from $50,000 to $65,000 after passing the CFA level 1 exam, he will have more money to spend on rent, clothes, etc.

Examples of Both Effects

A good example for understanding the substitution effect is that of public and private colleges. Many students avoid private universities because they are too expensive for them to afford.  However, a slight decrease in the tuition fees in private universities will motivate more students to attend private universities.

On the other hand, the income effect could also affect the demand for private education. If the economy is booming, the students (or their parents) will have disposable income, which they might use to pay for their tuition in private colleges. In this instance, the demand for private universities will increase.

Real Income

While calculating the income effect separately from price effects, real income (income adjusted for inflation) is kept constant. As a result, there are different ways in which these two effects impact consumer behavior and businesses.

Wages, Interest Rates, and Savings

It is important to understand how income and substitution effects impact wages, interest rates, and savings. When wages increase, work becomes more profitable due to the substitution effect. An increase in wages also enables workers to maintain a decent standard of living by working less, which relates to the income effect. Similarly, higher interest rates cause an increase in income from savings which is another income effect. When savings become more attractive as compared to spending, consumer spending reduces.