Income and Substitution Effects
Income and Substitution Effects describe how changes in the price of a good
influence consumer behavior. These effects help explain why the demand curve
slopes downward for most goods.
Substitution Effect:
- The substitution effect occurs when a change in the price of a good makes it more
or less expensive relative to other goods. As the price of a good decreases, it
becomes relatively cheaper compared to substitutes, leading consumers to
purchase more of it. Conversely, if the price increases, the good becomes relatively
more expensive, and consumers will buy less of it and more of other goods. The
substitution effect always moves in the opposite direction of the price change: a
price decrease leads to an increase in quantity demanded, and a price increase
leads to a decrease in quantity demanded.
Income Effect:
- The income effect occurs because a change in the price of a good affects the
consumer's real income (purchasing power). When the price of a good decreases,
the consumer's real income effectively increases because they can buy the same
amount of the good for less money, allowing them to purchase more of other goods
as well. Conversely, a price increase effectively reduces the consumer's real
income. For normal goods, the income effect reinforces the substitution effect (a
price decrease leads to an increase in quantity demanded), but for inferior goods,
the income effect can counteract the substitution effect (a price decrease might
lead to a decrease in quantity demanded).
Normal and Inferior Goods:
- Normal Goods: For normal goods, both the income and substitution effects work in
the same direction. A decrease in price leads to an increase in quantity demanded
due to both the substitution effect (the good is cheaper relative to substitutes) and
the income effect (the consumer feels richer and buys more).
-Inferior Goods: For inferior goods, the income and substitution effects work in
opposite directions. A decrease in price still leads to an increase in quantity
demanded due to the substitution effect, but the income effect might reduce the
quantity demanded because the consumer feels richer and buys less of the inferior
good.
Income and Substitution Effects describe how changes in the price of a good
influence consumer behavior. These effects help explain why the demand curve
slopes downward for most goods.
Substitution Effect:
- The substitution effect occurs when a change in the price of a good makes it more
or less expensive relative to other goods. As the price of a good decreases, it
becomes relatively cheaper compared to substitutes, leading consumers to
purchase more of it. Conversely, if the price increases, the good becomes relatively
more expensive, and consumers will buy less of it and more of other goods. The
substitution effect always moves in the opposite direction of the price change: a
price decrease leads to an increase in quantity demanded, and a price increase
leads to a decrease in quantity demanded.
Income Effect:
- The income effect occurs because a change in the price of a good affects the
consumer's real income (purchasing power). When the price of a good decreases,
the consumer's real income effectively increases because they can buy the same
amount of the good for less money, allowing them to purchase more of other goods
as well. Conversely, a price increase effectively reduces the consumer's real
income. For normal goods, the income effect reinforces the substitution effect (a
price decrease leads to an increase in quantity demanded), but for inferior goods,
the income effect can counteract the substitution effect (a price decrease might
lead to a decrease in quantity demanded).
Normal and Inferior Goods:
- Normal Goods: For normal goods, both the income and substitution effects work in
the same direction. A decrease in price leads to an increase in quantity demanded
due to both the substitution effect (the good is cheaper relative to substitutes) and
the income effect (the consumer feels richer and buys more).
-Inferior Goods: For inferior goods, the income and substitution effects work in
opposite directions. A decrease in price still leads to an increase in quantity
demanded due to the substitution effect, but the income effect might reduce the
quantity demanded because the consumer feels richer and buys less of the inferior
good.
