Income effect and substitution effect are the terms used in the context economics with respect to changes in consumption pattern of consumers. While both have the effect of change in consumer behavior but there are many differences between the two, let’s look at some of the differences between income and substitution effect –
- Income effect refers to that effect which is caused by the change in the income of the consumer, hence when the income of the consumer increase or decrease his or her consumption behavior will change accordingly whereas substitution effect refers to that effect which is caused by changes in prices of relative or substitute products and not by the change in the price.
- In income effect when income of the consumer increases he or she will reduce the expenditure on inferior goods and increase the expenditure on normal goods whereas when income of the consumer decreases he or she will increase the expenditure on inferior goods and reduce the expenditure on normal goods. However under substitution effect when price of substitute increases consumer will reduce expenditure on substitute good and if price of substitute decreases consumer will increase expenditure on substitute good.
- Example of income effect is suppose monthly income of consumer is $5000 and it increases to $6000 then consumer will naturally spend extra $1000 on various normal goods like cloths, perfumes, shoes and so on whereas if the monthly income of the consumer falls from $5000 to $4000 then consumer will decrease unnecessary expenditures . Example of substitution effect are cold drinks competitors Coca Cola and Pepsi, suppose Pepsi decides to increase the price of per bottle from $1 to $2 and Coca Cola keeps the price unchanged to $1 then consumers will drink less Pepsi and buy Coca Cola as it is close substitute of Pepsi and hence demand for Coca Cola will increase without company doing anything and this is called substitution effect.
- Income effect affects the whole basket of goods available in the market because when income of the consumer increase or decrease he or she will buy more or less of everything available in the market whereas substitution effect affects only few products and it does not affect the whole market. Hence one can say that while income effect happens on wide scale whereas substitution effect is limited in scope.
- In a competitive market substitution effect is far more significant than income effect as far as companies are concerned and in a monopoly or oligopoly market conditions income effect is more important than substitution effect as far as companies operating in industry are concerned.
- Income effect happens few times because the income of the consumer does not rise or fall that often whereas substitution effect happens more frequently because companies keep changing the price frequently in response to competitors.
As one can see from the above that both income and substitution effect are different from each other as both of them effect consumers and demand for goods differently. While income effect is more widespread, less frequent and it depends on general economic conditions whereas substitution effect is limited in scope, happens more frequently and it depends on industry or companies.