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Economics Terms A-Z

Substitution Effect and Income effect

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When the price ratio between items changes this can induce a change in consumption. The part of such a change in consumption that is attributable purely to the change in the price ratio (and not to the associated change in purchasing power) is known as the substitution effect. The remaining part of the change in consumption that is not directly due to the change in the price ratio but is rather 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 price ratio between item A and item B is such that the individual could devote all income to purchasing QA of A and nothing of B, or QB of B and nothing of A. In this situation, all points along the budget line QBQA are affordable for the individual.

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 (the individual is indifferent between these combinations). It is assumed that the individual seeks to maximise utility and that utility increases in line 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.

Substitution Effect and Income effectNow 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 along 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’. This may be expected as item A has just become cheaper relative to item B. However, it is not the full story.

Not all of the change in consumption is directly due to the change in the price ratio. The fact that item A has become cheaper while item B’s price has remained the same means that the individual’s purchasing power has increased. Were the individual to continue to consume qA of A and qB of B in this new situation, the individual would have surplus income. Instead, in the grand quest to maximise 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?

In order to provide an answer to 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 tangential to the original indifference curve IC.  In the graph, this imaginary budget line is the grey, 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).

Yet the individual is not content to remain at the original level of utility and 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 part of the change in consumption is known as the income effect. Note how the income effect complements (moves in the same direction as) the substitution effect for the individual’s consumption of item A while the income effect compensates (moves in the opposite direction to) the substitution effect for the individual’s consumption of item B. This is logical insofar as both items A and B are normal goods: the individual consumes more of item A both due to it replacing consumption of item B and due to greater purchasing power, but while the individual consumes less of item B due to greater consumption of item A, 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 curves 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, or completely unrelated to each other.

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 (greater output for the same cost) labour 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 new or more enjoyable jobs!