Substitution and Income Effects
We earlier learned about the impact of changes in income and prices individually on the budget constraint ad demand of products. We will now study this in more detail. The change in quantity demanded due to price change can be decomposed into substitution effect and income effect.
When the price of a commodity decreases, two things happen:
- Substitution effect: When a commodity becomes relatively cheaper, consumers will use more of this commodity instead of other commodities, which are relatively more expensive.
- Income effect: When a commodity becomes cheaper, the consumer can purchase more from his income than before, as if the consumer’s income rose.
Pure Substitution Effect
The following diagram shows the pure substitution effect. The red line shows the original budget constraint where the red dot represents the original choice. Now the price of good 1 reduces. Lower p1 makes good 1 relatively cheaper and causes a substitution from good 2 to good 1.
(x1’,x2’) to (x1’’,x2’’) is the pure substitution effect.
Changes to quantities demanded due to the change in relative prices, keeping income just enough to buy the original bundle, are the (pure) substitution effect of the price change.
Income Effect
At the new prices:
- If less income is needed to buy the original bundle then “real income” is increased
- If more income is needed to buy the original bundle then “real income” is decreased
Changes to quantities demanded due to the change in ‘real income’ are the income effect of the price change.
The following diagram also shows the income effect. The income effect is (x1’’,x2’’) to (x1’’’,x2’’’).
The grey arrow shows the substitution effect and the green arrow shows the income effect.
Overall Change
The change to demand due to lower p1 is the sum of the income and substitution effects, (x1’,x2’) to (x1’’’,x2’’’) – shown with black arrows.
When the price of a good decreases, there are the following possible outcomes.
- If both substitution effect and income effect are positive, the consumption of good 1 increases.
- The substitution effect is positive and the income effective is negative. If the negative income effect is smaller than the substitution effect, then the consumption of good 1 increase, otherwise it will decrease.