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The effect of income and the substitution effect is the key to understanding the change in demand

The change in the price of the commodity leads, in the general case, to a decrease in the demand for it. This is explained by the fact that there is an income effect and a substitution effect, which determine this type of equilibrium on the market. These two phenomena are so interconnected that scientists are still engaged in developing methods that will help quantify their impact.

The effect of replacement is that the buyer seeks to purchase more goods, the value of which has decreased, replacing them with more expensive goods. This is how the prices of substitute products affect demand, and consumers' desire to buy certain products. If substitutes are more expensive, then it will grow, and if cheaper, then fall. However, the income effect and substitution effect do not apply to luxury goods and so-called Giffen products. This is due to the fact that in the case of them one of the vectors acts stronger than the other, so the demand will change, all other things being equal, in the same direction as the price of the goods.

In a word, the income effect consists in the fact that when the cost is reduced, the part of the consumer's budget is released, which makes it relatively richer. If the price of one of the goods necessary for the subject increases, then it becomes relatively poorer, which leads to the fact that it reduces consumption of almost all the usual goods. Here, the effect of replacement also comes into play, which forces the buyer to look for substitutes for more expensive products in order to be able to satisfy all of his needs in fuller volume. Therefore, the cumulative effect of income and the substitution effect have a significant impact on the level of prices and competition in the industry, and therefore, on market conditions.

As already mentioned above, in the economy there is a problem associated with the differentiation of the influence on the demand value of data from two oppositely directed vectors. The income effect and the substitution effect are usually considered on the basis of two approaches. Adherents of the first approach, developed by E.E. Slutsky, insist that only the level of income that provides the same set of goods can be called unchanged. Slutsky's graphic model indicates that the optimal choice of the consumer is determined by the point of touch of the indifference curve and the budget line. In order to consider the effect of income and the substitution effect separately, Slutsky draws an additional budget line associated with a change in the relative income of the consumer caused by a decrease or increase in the price of the goods. Then the scientist conducts another budget line, but without taking into account the first factor, which makes it possible to calculate the substitution effect using this graphic model.

A similar approach is demonstrated by the foreign economist J. Hicks, who proceeds from the assumption that the relative level of income depends on the usefulness of the benefits that are acquired on it. Therefore, if the various amounts in absolute terms provide the same satisfaction of needs, then in relative terms they are equal.

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