The Difference Between Income & Substitution Effect

The microeconomic concepts of income effect and substitution effect are closely related. They show how an increase in cost may reduce demand for a specific product and increase demand for alternatives. Cost increases may affect consumer budgets, spending habits, satisfaction and product perception.

Income Effect

The income effect is defined as the result of a change in a product's price relative to the consumer's disposable income. When the price of a good changes, the real, or actual, income of the consumer who wants that good changes. If the price goes up, then the consumer is worse off, since he has less disposable income. Therefore, he can buy less of the good, or not buy it at all.

Substitution Effect

The substitution effect occurs when, as the result of a price increase, the consumer will substitute another product in its place, or forgo the product altogether. This concept, however, depends on what sort of product has gone up in price, and how the consumer views that product. If the product is a necessity, then the substitution effect will become clear, since the consumer, who cannot do without the product, will shift, or substitute, a lower-cost version of the same item.

Budgeting

Both income and substitution effects matter when in the context of a personal budget. If you had unlimited money, then neither effect would matter at all. Since that is not the case, consumers on a budget must weigh expected gains versus expected losses when a good changes in price. The balance is between the price of the object and the expected utility, or satisfaction, that good will bring. If the price rise is steep and rapid, then the effects of paying much more money for the good will likely overwhelm any expected utility that is to be derived from the product.

Elasticity

When a product is a necessity, it is called inelastic, since the demand for it remains constant. An elastic good is one that is more of a luxury, a product whose demand goes down when the economy does. Bread is inelastic; leather jackets are elastic. In the latter case, the product might be ignored totally if the price goes up, meaning that, since it is a luxury, many consumers will simply forgo buying the product because the "pain" caused by the increase in price will overwhelm the pleasure of buying such a luxury.

Variables

The three variables in these two effects are price changes, budget constraints and the perception of the good in the eyes of the consumer. An elastic good that the consumer loves will still be bought even when the price rises substantially. An inelastic good whose price goes up substantially might simply put a larger dent in the consumer's budget, since the household cannot live without it. Therefore, when the economy is in a recession and fuel prices rise, the prices of most products rise as well. Budget constraints get tighter, so this kind of rational weighing of utility becomes more significant.

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