Income and Substitution Effects

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Income and Substitution Effects

What It Means

The income effect and the substitution effect are distinct but closely related principles in the study of economics. Both effects can be measured when a person’s income changes (when he or she begins taking in either more or less money) or when the price of a good changes. According to the principle of the income effect, if a person has more money to spend, that person will purchase more goods. Two factors can cause a person to have more money to spend: he or she can begin taking in more money (from an increase in salary, for instance), or the price of goods that a person normally buys can fall. The latter will allow a consumer to buy more, even though income has not changed. For example, if one Saturday morning a shopper noticed that the price of beef had dropped from $5 per pound to $4.50 per pound, that shopper would likely purchase more beef than he or she normally buys because the price was lower.

The substitution effect is slightly more complicated because it concerns at least two items that are similar in some way and are of equal, or nearly equal, value to the consumer. According to the principle of the substitution effect, if the price of the first item (the one the consumer normally buys) goes up, but the price of second item remains the same, the consumer will be more likely to substitute the second item for the first. To understand the substitution effect, consider a person who eats lunch at the same cafeteria everyday. Normally at this establishment, both ham and turkey sandwiches cost $5. This person likes ham sandwiches as much as he likes turkey sandwiches but nonetheless orders turkey sandwiches more often than he orders ham sandwiches. If the cafeteria were to raise the price of turkey sandwiches to $5.50 per sandwich but keep the price of ham sandwiches the same, this person (assuming that his income remained the same) would likely substitute ham sandwiches for turkey sandwiches.

Income and substitution effects also exert a powerful impact on an economy’s labor supply. For example, imagine a person in an office making $10 per hour who is offered two options: to work 20 hours a week, thus earning $200 each week, or 30 hours a week, raising her pay to $300. If she chose the schedule of 20 hours instead of 30 hours, she would lose the possibility of making $100 extra per week. But if her pay were to increase to $15 an hour, her choice between 20 hours and 30 hours per week would look different; with the first she would make $300, and the second, $450. Thus, if she chose to work 20 hours instead of 30 hours per week, she would now lose $150 per week ($450 - $300), not $100. In other words, as her wage rises, the cost of not working more hours increases, and she might be less likely to choose free time over additional pay. As a result, an increase in wages makes some people want to work more hours. A higher wage rate also draws some people who do not work into the labor market (for example, a stay-at-home parent might find it worthwhile to work at a higher wage but will stay home with the children if only low wage jobs are available).

When Did It Begin

The income effect and substitution effects are part of a larger set of ideas known collectively as consumer theory, which was formulated by several economists researching and writing in various countries throughout Europe in the second half of the nineteenth century. Consumer theory attempts to chart buying patterns by studying the relationship between consumer preferences and consumer budget constraints (the combination of goods and services that a consumer can afford, depending on his or her income and the prices of those goods and services).

Manufacturers identified the need to understand consumer buying patterns during the second half of the nineteenth century. By the end of the Industrial Revolution (which began in the 1780s in England and spread to the rest of Europe and the United States during the nineteenth century), there was a dramatic increase in the number of goods available on the market and the number of people who had the money to buy those goods. During this time production costs (the money required to make and distribute a product) also rose steadily; therefore, in order to maximize profit (the money left over from sale of a product after all costs of production have been paid), manufacturers needed to understand how their customers tended to spend their money. Though numerous economists working separately throughout Europe contributed ideas to consumer theory, many contemporary economists agree that London-born economist Alfred Marshall (1842–1924) explained all of these complex ideas best when he published Principles of Economics in 1890.

More Detailed Information

The income and substitution effects are based on two related assumptions. Provided there is no change in a consumer’s salary or wage (the amount of money he or she earns), these principles assume that, first, if the price of a good rises, a consumer will purchase less of that good; and that, second, if the price of a good falls, a consumer will buy more of that good. After years of charting consumer buying patterns, economists realized that these assumptions only hold true with certain types of goods. Therefore, in order to fully understand the concepts of income and substitution effects, it is necessary to take a closer look at the types of goods that consumers purchase and at how buying patterns change when prices rise and fall. Economists have divided the goods consumers buy into many different categories. The two most important categories for this discussion are normal goods and inferior goods.

A normal good is a commodity that consumers purchase more of when their income increases. It is important to note that income can increase in two ways. First, a person can start earning more money, either by securing a raise (an increase in salary or wages) or by taking a different job that pays more money. The second way people’s income can increase is in relation to a drop in the prices of goods and services. In this case people are not actually earning more money, but the value of their money increases, allowing them to buy more goods. Technological equipment (computers, cell phones, iPods) and cosmetics are examples of normal goods. When people have less money to spend (either because of a loss of wages or a rise in prices), they buy fewer normal goods.

An inferior good is one that consumers buy more of when they have less money to spend. When consumers have more money to spend, however, they buy less of the inferior good. Instant noodles and canned goods are two examples of inferior goods. Studies have shown that college students earning little or no money tend to purchase large quantities of instant noodles. After these students graduate and take well-paying jobs, however, they tend to buy fewer boxes of instant noodles and instead purchase other foods, such as fresh fruits and vegetables, butchered meats, and specialty cheeses. Public transportation (buses and subways, which are actually services rather than goods) is also an inferior good. People with little money tend to ride buses and subways more frequently than people with more income. Consumers who use public transportation will often buy their own automobiles or take taxis if their circumstances change and they acquire more money; then they may stop using public transportation altogether.

In the case of a few goods, people may buy more of the commodity when its price increases. This phenomenon is called the Veblen effect after Norwegian-American economist Thorstein Veblin (1857–1929), who studied the buying patterns of newly wealthy Americans at the beginning of the twentieth century. The Veblen effect tends to occur with luxury items, such as fashionable clothes, fine wines, and fancy cars, because these goods give status to their owners. For example, a Lexus is an expensive car, and because it costs so much money, people recognize the owners of these vehicles as successful and important individuals. Many people want to be recognized as successful and important by the rest of society. Consequently, when the price for a Lexus increases, owning one becomes more prestigious, and therefore more wealthy people buy one of these cars. If the cost of a Lexus were to decrease, owning this car would be less prestigious, and fewer wealthy people would purchase them.

Recent Trends

The process of globalization (the development of an increasingly integrated world economy) took hold in the early 1980s, making more goods available in more markets throughout the world. Since then there have been noticeable changes in buying patterns in rural China, one of the areas most affected by this worldwide expansion of the economy. For example, there have been dramatic increases in the purchases of food and appliances in rural China. Before 1980 rural Chinese citizens bought just 30 percent of their food with cash. The rest they either raised themselves or acquired by bartering, or trading, with fellow rural dwellers. By 2003 the rural Chinese were acquiring 82 percent of their food with cash. During this time ownership of refrigerators, which consumers used to store food, rose from 1.2 refrigerators per 100 households to more than 16 refrigerators per 100 households.

The economy changed in rural China because of a series of interrelated factors. First, an increase in industrial production in China brought more opportunities for rural citizens to obtain more lucrative jobs in urban centers away from home. The large number of jobs available in China’s cities led to large-scale migration out of rural China. Increased urban populations caused the cities to extend outward, however, bringing the urban centers closer to the countryside. This meant that food-producing farmers found more buyers to purchase their products. These buyers were earning more money in their jobs and also needed to buy food because they were no longer producing it for themselves.

These trends followed the basic ideas of the income and substitution effects. On the one hand, people purchased more goods (in this case, food and refrigerators) with their increased income, thus reflecting the income effect. On the other hand, they substituted the food they raised themselves with food produced by other farmers, as the cost of growing food had become more expensive. More time growing food meant less time working at a job, resulting in an overall increase in real price of their home-grown food.