What is income and substitution effect?

When the price ratio between items changes it can induce a change in consumption. There are two reasons for this. First, reducing the relative price of an item makes consumers more likely to purchase it when compared to other options (as long as they are normal goods, not inferior goods, which we assume in this article). Second, a consumer can now buy more of the item with the same amount of money. The first part, attributable to the change in the price ratio, is known as the substitution effect. The second part, the change in consumption that is brought about by the change in purchasing power, is known as the income effect.

Consider the graph below depicting two items, A and B, which are substitutes in consumption, i.e. an individual derives utility from both items and makes choices about how much to consume of each item depending on their relative prices. Initially, the consumer can afford up to QA of A or up to QB of B.

Depending on the individual’s preferences over items A and B, a series of indifference curves can be plotted. Along each indifference curve, the individual achieves the same degree of utility for the various combinations of items A and B. It is assumed that the individual seeks to maximize utility and that utility increases with consumption. Thus the individual will choose to consume the combination of items A and B at the point where the budget line QBQA is tangential to the indifference curve IC. Here, the individual initially chooses to consume qA of A and qB of B.

Now suppose that the price of item A falls such that if the individual were to devote all income to item A, QA’ of A would be consumed. The new budget line for the individual is QBQA’, a higher level of utility is attainable (indifference curve IC’) and the individual now chooses to consume qA’ of A and qB’ of B, which is the point where QBQA’ is tangential to IC’. Note how the individual’s consumption of item A has increased from qA to qA’, while consumption of item B has decreased from qB to qB’.

Because item A has become cheaper, the individual’s overall purchasing power has increased. Were the individual to continue to consume qA of A and qB of B in this new situation, they would have surplus income. Instead, in the grand quest to maximize utility, the individual moves from indifference curve IC to indifference curve IC’ for higher utility. The question remains, how much of the change in consumption from (qA,qB) to (qA’,qB’) is due to the change in the price ratio, and how much of it is due to the change in purchasing power?

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To answer this, consider how much of each item the individual would have consumed at the new price ratio but at the original level of utility (i.e. remaining on the original indifference curve IC). This can be worked out by drawing an imaginary budget line parallel to QBQA’ that is tangent to the original indifference curve IC. In the graph, this imaginary budget line is the gray, dotted line. We now see a greater decrease in the consumption of item B, from qB to q–, and a lesser increase in the consumption of item A, from qA to q+. This change in consumption from (qA,qB) to (q+,q–) is attributable purely to the change in the price ratio; it is the substitution effect (also known as the Hicksian substitution effect after the economist John Hicks).

Of course, the individual instead moves to the “better” indifference curve IC’ where (qA’,qB’) is consumed. A move from (q+,q–) to (qA’,qB’) is not due to a change in the price ratio. Rather, it is due to the change in the individual’s purchasing power brought about by one the items becoming cheaper to consume. This is the income effect. Note how the income effect moves in the same direction as the substitution effect for the individual’s consumption of item A, while it does the opposite for the consumption of item B. The individual consumes more of item A both due to it replacing some consumption of item B and having greater purchasing power. However, the individual can also afford more of item B thanks to greater purchasing power, and thus the overall reduction in consumption of item B is dampened.

It is conceivable that the income effect dominate the substitution effect and vice versa for different types of items and different individual preferences and indifference curves. Indeed, the shape of the indifference curve is closely related to the cross (or cross-price) elasticity of demand, which describes whether and to what extent items are substitutes or complements in consumption.

Further reading

For an introductory analysis of substitution and income effects with intuitive explanations, see chapter 8 of Hal Varian’s textbook, “Intermediate Microeconomics: A Modern Approach”.

Good to know

Understanding substitution and income effects is also useful in the theory of production when the price ratio between inputs changes. Indeed, as technology progresses and machines become cheaper or more efficient in terms of their output, labor becomes a relatively expensive input. Firms may thus seek to replace workers with machines (substitution effect; see also the article on elasticity of substitution). However if the technology has improved then the firms should also be more profitable (income effect) and workers can lobby for the creation of better jobs or higher pay!

By Indeed Editorial Team

Published June 8, 2021

Learning popular economic concepts can help you understand buyer behavior, business decisions and market changes. Substitution effect and income effect are two concepts in economics that can reveal a lot about the spending habits of consumers. Understanding their differences can help you identify instances of both effects in real-world scenarios. In this article, we explain what the substitution effect and the income effect are, discuss how they work, provide examples of each effect and discuss which effect has a larger impact on consumers.

What is the substitution effect vs. the income effect?

The substitution effect and the income effect are two economic concepts that identify how changes in the market affect consumers' buying habits for certain products and services. However, they have several key differences between them. The income effect shows how a change in expendable income or purchasing power affects buyers' consumption habits, whereas the substitution effect shows how changes in the prices of goods and services can encourage buyers to seek alternative products.

Products and services can experience these changes in unique ways. For example, when a consumer's income or purchasing power increases, they often choose to invest more in products and services. However, some goods, called inferior goods, see diminished sales when incomes increase. The substitution and income effect concepts allow economists and business to understand the underlying reasons behind these sorts of buyer behaviors.

Related: Demand: Definition in Economics and 7 Types of Economic Demand

How does the income effect work?

The income effect works by evaluating how consumers spend their money following a change in income. Buyers who see an increase in their incomes often choose to invest in more expensive or higher-quality products. The reverse is also true. When incomes decrease, usually so does spending. The effect can't predict the goods consumers buy, however. Personal preferences still inform specific choices. For example, they may choose to invest in higher quantities of lower-priced goods rather than lower quantities of higher priced goods or vice versa.

Income effects can be direct or indirect. When the effect is direct, a consumer's increase or decrease in income changes the way they spend their money, like consumers who choose to spend less money on non-essentials like dining out after experiencing an income reduction. Indirect effects occur when a change to the buyers' actual income isn't the deciding factor in their purchasing behavior. Instead, maybe the rising prices of certain goods are influencing their buying habits.

Related: Economic Systems: Definition and Types

Income effect examples

Here are examples for both direct and indirect income effects:

Direct example

If a consumer receives a pay increase at work, they might have more disposable income. As a result, they could choose to spend more money than they normally would on certain products, like groceries. Maybe they buy organic or name brand items at the grocery store rather than generic brands. Even after spending more money on goods, the consumer's additional income allows them to have the same amount of money left over.

Indirect example

An indirect example of the income effect might be a shopper who purchases meat at the grocery store each week. If meat prices rise but they receive no corresponding increase in income, the consumer might have to buy less meat. This can cause the demand for meat to fall because consumers have less disposable income to pay for it.

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How does the substitution effect work?

The substitution effect works to explain that a price increase on goods and services can encourage consumers to find alternative products. Retailers that offer goods and services at lower prices than their competitors can benefit from the substitution effect. The reverse can be true of the substitution effect as well. If a consumer receives additional income, they may choose to upgrade a current product or service with something more expensive.

The substitution effect differs from the income effect because the effect only exists when there are alternatives on the market. Products with no substitutions, like gasoline, are immune to the substitution effect because consumers aren't able to replace them with alternate goods.

Read more: A Guide to the Substitution Effect

Substitution effect examples

Here are two examples of the substitution effect:

Consumer substitution effect

For consumers, an example of the substitution effect might be if the price of a building material like wood rises. A consumer looking to buy wood for a building project may choose to buy an alternative product because the prices are too high. Cheaper substitutions like laminate or composite materials may be more appealing because of their affordability. When money is a concern, consumers often search for cheaper alternatives to expensive products.

Business substitution effect

Individuals aren't the only ones who experience the substitution effect. Businesses use the substitution effect as well if they search for cheaper alternatives. For example, if a company hires freelance workers rather than benefited staff, that might be an instance of the substitution effect. Outsourcing labor to other countries where costs are cheaper is another example.

Related: Understanding Economics: Definition and Application

Which effect has more influence over consumers?

The income and the substitution effect can influence customers in different ways. If prices rise and there is no substitution in the market, the income effect may have more influence. For example, some places only have access to a single internet service provider. If the provider's prices rise, consumers may have to choose between abandoning their service or having less disposable income. Here, the income effect has more influence on service demand.

In situations where there are a lot of alternatives available, the substitution effect may have a larger impact on consumers. If a consumer wants to purchase a product like a vehicle, for example, they may choose an option that's more affordable. Because there are alternatives in the market, buyers have the choice to perform their own research and find the options with the greatest value. Industries with lots of competitors can use the substitution effect to inform their pricing strategies. Lower prices can often attract customers to products and services if they think the alternative is too expensive.