Income and Substitution Effect

income-vs-substitution-1

If the price of a good increases, then there will be two different effects – known as the income and substitution effect.

If a good increases in price.

  1. The good is relatively more expensive than alternative goods and people can switch to other goods. (substitution effect)
  2. The increase in price reduces disposable income and this lower income may reduce demand. (income effect)

The substitution effect states that an increase in the price of a good will encourage consumers to buy alternative goods. The substitution effect measures how much the higher price encourages consumers to use other goods, assuming the same level of income.

The income effect looks at how the price change affects consumer income. If price rises, it effectively cuts disposable income and there will be lower demand. This can occur from income increases, price changes, or even currency fluctuations.

For example:

  • If the price of attending private schools increases, then the higher price may encourage consumers to switch to alternative schools such as a public school.
  • However, with the higher price of private schools, it means that after paying to attend these schools, they will have lower spare income. Therefore, consumers will chose to go to private schools because of this income effect.

Video – Difference between income and substitution effect

Video – Income and substitution effect with numbers (detailed video – 12 mins)

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