Income effect and substitution effect - the key to understanding the change in demand

2024 Author: Howard Calhoun | [email protected]. Last modified: 2023-12-17 10:16

A change in the price of a good generally leads to a decrease in demand for it. This is explained by the fact that there is an income effect and a substitution effect, which determine this type of equilibrium graph in the market. The two phenomena are so intertwined that scientists are still developing methods to help quantify their effects.

The substitution effect is that the buyer seeks to purchase more goods, the cost of which has decreased, replacing them with more expensive goods. This is how the influence on demand of the price of substitute goods, on the desire of consumers to buy certain products, is manifested. If substitutes are more expensive, then it will grow, and if it is cheaper, then it will fall. However, the income effect and the substitution effect do not apply to luxury goods and so-called Giffen goods. This is due to the fact that in the case of them, one of the vectors acts stronger than the other, so the demand will change, all other things being equal.conditions in the same direction as the price of the goods.

In a word, the income effect is that when the cost decreases, a part of the consumer's budget is released, which makes him relatively richer. If the price of one of the goods necessary for the subject increases, then he becomes relatively poorer, which leads to the fact that he reduces the consumption of almost all the usual goods. This is where the substitution effect comes into play, which forces the buyer to look for substitutes for products that have risen in price in order to be able to satisfy all their needs to a fuller extent. Therefore, the combined income effect and the substitution effect have a significant impact on the price level and competition in the industry, and hence on the market environment.

As mentioned above, there is a problem in the economy related to the differentiation of the influence of two oppositely directed vectors on the magnitude of demand. The income effect and the substitution effect are usually considered on the basis of two approaches. Adherents of the first approach developed by E. E. Slutsky, insist that only the level of income that provides the same set of goods can be called unchanged. Slutsky's graphical model indicates that the consumer's optimal choice is determined by the tangency point of the indifference curve and the budget line. In order to consider the income effect and the substitution effect separately, Slutsky draws an additional budget line associated with a changethe relative income of the consumer caused by a decrease or increase in the price of a good. Then the scientist draws another budget line, but without taking into account the first factor, which allows us to calculate the substitution effect using this graphical model.

A similar approach is demonstrated by the foreign economist J. Hicks, who proceeds from the fact that the relative level of income depends on the usefulness of the goods that are acquired with it. Therefore, if different amounts in absolute terms provide the same satisfaction of needs, then in relative terms they are equal.