Substitution Effect and Income Effect with Graph and Examples
Understanding the difference between substitution effect and income effect is essential for students studying consumer behavior in economics. These two concepts explain how and why buyers change their demand when prices or incomes change. This knowledge is crucial for exams, business decision-making, and real-world financial choices.
| Basis | Substitution Effect | Income Effect |
|---|---|---|
| Definition | Change in quantity demanded due to change in price of the good relative to other goods (keeping real income constant). | Change in quantity demanded due to change in consumer's real income or purchasing power (after price change). |
| Cause | Relative price change between goods. | Change in real income or purchasing power. |
| Direction | Always moves demand in opposite direction to price change. | Direction depends on type of good (normal/inferior). |
| Graph Representation | Movement along the same indifference curve. | Shift to a new indifference curve. |
| Example | If tea becomes cheaper than coffee, more tea is demanded replacing coffee. | If income rises, more of all normal goods are bought; for inferior goods, demand may decrease. |
| Applicability | All price changes. | Depends on type of good and size of price/income change. |
Difference Between Substitution Effect and Income Effect
The substitution effect is the change in demand for a good when its price changes relative to other goods, causing consumers to substitute it. The income effect is the change in demand resulting from a change in consumers' real income after a price change.
Meaning and Explanation: Substitution Effect
The substitution effect explains how consumers shift from a costlier good to a cheaper substitute when prices change, keeping real income constant. It is always present, regardless of whether a good is normal or inferior.
- If the price of rice falls, it becomes cheaper compared to wheat. Consumers buy more rice and less wheat.
- This effect works to increase demand when price falls, and decrease demand when price rises.
Meaning and Explanation: Income Effect
The income effect is how a price change alters the consumer’s real income or purchasing power, affecting how much they can buy. For normal goods, increased real income leads to more demand; for inferior goods, demand might fall as real income rises.
- If the price of milk drops, consumers' money buys more milk or other goods (real income rises), so they may buy more milk.
- For some inferior goods, a fall in price and rise in real income leads to less demand (e.g., coarse grains).
Graphical Presentation of Substitution and Income Effects
Both effects can be shown using an indifference curve diagram. When the price of a good falls, the budget line pivots, and the consumer moves to a new equilibrium. The total effect splits into:
- Substitution effect: movement along the same indifference curve due to relative price.
- Income effect: shift to a higher or lower indifference curve reflecting changed real income.
For diagrams, refer to Indifference Curve and Consumer Equilibrium in Case of Two Commodity on Vedantu for visual step-by-step explanations.
Special Cases: Normal Goods, Inferior Goods, Giffen Goods
The strength and direction of income and substitution effects depend on the type of good:
- Normal good: Both effects support more demand when price falls.
- Inferior good: Substitution effect is positive; income effect is negative but usually weaker.
- Giffen good: Negative income effect is so strong it outweighs substitution, causing demand to fall when price falls.
For more, read about Law of Demand and Determinants of Demand.
Real-Life Examples
- If chicken becomes cheaper than fish, many consumers will buy more chicken instead—substitution effect.
- For staple foods in poor families, if the price drops, sometimes real income rises enough that they switch to superior foods—income effect dominating substitution.
Knowledge of these effects is tested in school-board exams, competitive tests, and helps in daily price and purchase decisions.
Further Reading and Related Topics
To deepen your understanding, visit these Vedantu resources: Income Elasticity of Demand, Price Elasticity of Demand, and Elasticity of Demand.
Practice board-level questions using Sandeep Garg Microeconomics Class 12 Solutions Chapter 6.
Summary
The difference between substitution effect and income effect helps us understand consumer choices as prices and incomes change. Substitution effect relates to choices between goods; income effect relates to changes in purchasing power. These concepts, illustrated via indifference curves, are key for exams and real-world applications. Explore more on Vedantu for concept clarity and practice.
FAQs on Difference Between Substitution Effect and Income Effect Explained
1. What is the primary difference between the substitution effect and the income effect?
The primary difference lies in what causes the change in a consumer's buying habits. The substitution effect occurs when a consumer switches between goods due to a change in their relative prices, choosing the cheaper option. In contrast, the income effect results from a change in the consumer's real income or purchasing power caused by the price change.
2. Can you explain the substitution effect with a simple, real-world example?
Certainly. Imagine the price of coffee significantly increases while the price of tea stays the same. The substitution effect is observed when a consumer decides to buy less coffee and more tea because tea has become relatively cheaper. The consumer is substituting one good for another to maintain their level of satisfaction without increasing expenditure.
3. What is the income effect and how does it work in practice?
The income effect describes how a price change alters a consumer's purchasing power. For example, if the price of petrol falls, a person who drives daily now has more money left over after filling their tank. This increase in real income might lead them to buy more of other goods, or even more petrol. The effect depends on whether the good is a normal or an inferior good.
4. How do the substitution and income effects combine to explain the law of demand for a normal good?
For a normal good (e.g., clothes, electronics), both effects work in the same direction to uphold the law of demand. When the price of a normal good falls:
- Substitution Effect: The good is now relatively cheaper, so consumers buy more of it.
- Income Effect: The consumer's real income increases, and for a normal good, this leads them to buy more.
5. What is the relationship between the price effect, substitution effect, and income effect?
The price effect represents the total change in the quantity demanded of a good when its price changes. It is the sum of the other two effects. The relationship can be expressed with the equation: Price Effect = Substitution Effect + Income Effect. This equation helps economists break down a consumer's reaction to a price change into a component related to relative prices and a component related to purchasing power.
6. How are the income and substitution effects represented on an indifference curve graph?
On an indifference curve graph, the total price effect is shown by a consumer moving from one equilibrium point to another after a change in the budget line. This movement is decomposed into two parts:
- The substitution effect is represented by a movement along the original indifference curve to a point where the slope matches the new relative prices.
- The income effect is shown by a parallel shift from this point to a new, higher or lower indifference curve, reflecting the change in real income.
7. How do the substitution and income effects operate differently for inferior goods?
For an inferior good, the two effects work in opposite directions. When the price of an inferior good (e.g., coarse grains) falls:
- The substitution effect is positive, encouraging the consumer to buy more because it is now relatively cheaper.
- The income effect is negative. The increase in real income makes the consumer feel richer, so they reduce their consumption of the inferior good in favour of better-quality substitutes.
8. Why do the income and substitution effects cause Giffen goods to defy the law of demand?
Giffen goods are a rare type of inferior good where the negative income effect is stronger than the positive substitution effect. When the price of a Giffen good (like a basic staple in a very poor household) falls, the increase in real income is so significant that the consumer drastically cuts back on the Giffen good to afford more desirable foods. This powerful negative income effect outweighs the substitution effect, leading to the paradoxical result that a fall in price causes a decrease in quantity demanded.
9. Why is the substitution effect always considered negative (price and quantity demanded move in opposite directions)?
The substitution effect is always negative because it is based on the principle of rational consumer choice. When a good becomes relatively cheaper, a consumer will always substitute it for other, now relatively more expensive, goods to maximise their utility, assuming their real income remains constant. This is a fundamental aspect of the shape of indifference curves; consumers will always prefer a cheaper bundle of goods that provides the same level of satisfaction.
10. How do the income and substitution effects apply to a change in a worker's wage rate?
A change in the wage rate creates income and substitution effects on a worker's choice between labour and leisure. If the wage rate increases:
- Substitution Effect: The opportunity cost of leisure becomes higher (you give up more money for every hour you don't work). This encourages the worker to substitute leisure for work, i.e., work more hours.
- Income Effect: A higher wage increases overall income. Since leisure is a normal good, the worker can now afford to 'buy' more leisure. This encourages the worker to work fewer hours.
