Income Effect and Substitution Effect

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Table of Contents

Introduction
Prices, demand, and supply in everyday life
Consumer’s demand
Substitution effect
Income effect
Conclusion
Works Cited

Introduction

People’s desire and ability to buy some goods and services comprise the basis of current marketing. Even more, the task of every marketing campaign is to increase one’s desire to buy a particular product. One’s income is a crucial aspect when it comes to the purchasing capacity of the individual or the particular target audience. Changes in prices, supply, and the quality of goods influence consumers’ preferences.

These variations have always been of special interest to economists. Consumer behaviors are interesting topics for investigation as far as they explain the peculiarities of human nature and the human factor in economics. On the other hand, these behaviors form a larger part of economic processes and phenomena. In the following paper, the income effect and substitution effect will be investigated and explained.

Prices, demand, and supply in everyday life

It is necessary, to begin with, the evaluation of the role of prices, demand, and supply in everyday lives to understand the nature of income and substitution effects. Many people consider prices to be a simple requirement of a particular amount of money for the good or service. However, everything is much more difficult when it comes to pricing. The ideal price should be a crossing of demand and supply. Demand means how much of something is needed.

For example, the demand for ice cream varies depending on the season. Supply is the availability of something that is needed. Thus, the amount of available ice cream is lower in winter in comparison to summer. That is why prices for ice cream are different in various seasons. This correlation of demand and supply predetermines the pricing for products. It is important in real life situations because it is directly connected to one’s capacity to buy or avoid buying something.

Consumer’s demand

Consumer demand refers to the need to buy a desired good for the most competitive price. The law of consumer demand derives from the intersection of demand and supply and, consequently, pricing. This law of demand presupposes that the needed quantity depends on the price drastically. If the price is high, the demand is low. Logically, when the price is low, demand increases.

One should also differentiate between the ability to buy something and willingness. Willingness does not always mean the ability. Willingness is only a desire, but it cannot be fulfilled unless the consumer has a necessary amount of money to buy something. The ability to purchase something means that one has an available sum of money.

A consumer’s demand curve is a graph used to visualize the described information. Thus, the horizontal axis is used to depict the quantity of demand, while the vertical axis is used for pricing. For instance, the boy visits the cinema once per week for the price of twenty dollars. In case the price falls to ten dollars per visit, the demanded quantity increases to two times per week.

Substitution effect

It has been already demonstrated that changes in prices influence the demand and supply. Alternations in prices have other effects that are usually referred to as income effect and substitution effect. These two concepts are used to provide an explanation of reasons for such changes. The central question is, “Why does the demand increase when the price falls?”.

William McEachern tries to explain this phenomenon. The author writes that the explanation starts from the understating of the relation between human wants and available resources. Thus, needs or wants cannot be satisfied. It has been proved numerous times that people’s wants are unlimited. They constantly change or appear but never stop existing.

Goods are created to satisfy particular needs. For example, the desire for freshness and coolness in summer may be satisfied with the help of a drink, a trip to the sunny beach, or air-conditioner in the house. However, a scarcity of resources requires the establishment of the system of pricing for services or products.

Prices are significant determinants of consumers’ purchasing behaviors. The substitution effect is a possible reaction towards the price change. McEachern writes that the substitution effect of a price change is “when the price of a good falls, that good becomes cheaper compared to other goods, so consumers tend to substitute that good for other goods” (68).

The author takes pizzas to illustrate this notion. Pizza is used to satisfy hunger. If the price of pizza falls, consumers are more likely to buy more pizzas due to the decreased price. Even more, they substitute this food for other products because they can buy more pizzas than other food.

In case the price for pizza increases, consumers have to give up buying some products to continue buying the same amount of pizzas. As a result, the demand for pizza decreases. The most important thing to remember is that these rules work only if other prices remain stable. When all prices fall or increase by the same percentage, no substitution effect will be observed. Everything remains the same under such conditions.

Income effect

The second reason for the increased quantity demand when prices have fallen refers to the income effect. It is necessary to start with the explanation of such terms as money income and real income. Money income is the number of currency notes one receives for work. For example, one’s money income is fifty dollars a week.

That person can buy five Pepsis if the price for a bottle is ten dollars. In case the price for a bottle falls, one may buy more Pepsis for the same sum of money. This example demonstrates a real income — actual goods one can buy for the money. As the real income increases, consumer’s demand for Pepsi is more likely to increase too.

Hall and Lieberman write about consumer’s purchasing power instead of real income. The authors state, “The income effect of a price change arises from a change in purchasing power over both goods. A drop in price increases is purchasing power, while a rise in price decreases purchasing power” (Hall and Lieberman 166).

There is a difference in both the income and substitution effects when it comes to normal and inferior goods. When the price of normal goods falls, both effects are the same as they have been described. However, when the price for inferior goods changes, the situation may be rather different. The usage of bus services instead of trains or airplanes is regarded as an inferior good. When the price for buses decreases, most clients tend to choose a more comfortable way of traveling because of the increased purchasing power or real income.

Conclusion

Prices measure the relation between the demand and supply of particular goods or services. Also, prices predetermine one’s ability to purchase something. The change in prices may have income or substitution effect. Both effects explain the reason for the increasing or decreasing demand as a result of the price change.

Works Cited

Hall, Robert, and Marc Lieberman. Microeconomics: principles and applications. Boston, Massachusetts: Cengage Learning, 2009. Print.

McEachern, William. Economics: a contemporary introduction. Boston, Massachusetts: Cengage Learning, 2012. Print.

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