The effect of income and the substitution effect: the features and interrelation of concepts

The income effect is the impact on the structure of consumers' demand, which is provided by the change in real income by changing the value of the good.

The essence of the effect is that as a result of reducing the cost of some good, a person can acquire a greater amount of it, while not denying himself the purchase of other benefits. This concept reflects the impact of changes in real income on the amount of demand. The fall in the cost of a single product will have, albeit insignificant, an impact on the overall price level, which will make the consumer relatively richer. His real incomes will increase slightly . The additional income that is generated as a result of the fall in the value of this good, the consumer can use both to purchase additional units of this good, and to increase the consumption of other goods.

The substitution effect is a change in the structure of demand due to a change in the value of one of the benefits from the consumer set. The essence of the effect is that with an increase in the value of one commodity, the consumer reorientates to another product having similar consumer properties, but with a fixed value. In other words, consumers tend to replace more expensive goods and goods with cheaper ones. As a result, the demand for good, the value of which has increased, will fall.

The relationship between income and replacement effects

The effects of income and substitution work not in isolation, but in interaction with each other. As for normal goods, for them the effects will be added up, as a decrease in value will lead to an increase in demand for these goods.

For example, the consumer has a specific unchanged income. He buys in a certain ratio of coffee and tea, which are normal goods. Then the effect of income and substitution will act as follows. Decrease in the cost of tea hi to the fact that the demand for it will increase. Since the cost of coffee has remained unchanged, then this drink becomes relatively more expensive than tea. Any rational consumer would prefer to replace the relatively cheap tea with expensive coffee. The effect of income will work as follows: a decrease in the cost of tea made the buyer a little richer, that is, it caused a rise in real incomes. Since the higher the income level, the higher the population's demand for a normal commodity, and the increase in income can be spent on both the purchase of additional tea units and the purchase of coffee.

The effect of income and substitution work unidirectionally. For a normal product, this figure explains the growth in demand when the price decreases.

For the benefits of the lower category, the effects of income and substitution are determined by the difference between them.

For example, the buyer, having a certain income, gets a specific ratio of natural coffee and coffee drink. The latter refers to the goods of the lowest category. Then, according to the substitution effect, a drop in the price of a coffee drink will lead to an increase in demand for this benefit, as it will become a relatively cheap commodity. A rational buyer will replace a relatively cheap drink with expensive natural coffee. The effect of income will work as follows. Reducing the cost of a coffee drink made the buyer a little richer, that is, this led to an increase in real income. As with the growth of incomes the demand for lower goods decreases, the increase in real income will be spent on the acquisition of natural coffee. Thus, a drop in the price of a coffee drink will lead to a decrease in demand for it and an increase in the demand for natural coffee. In this case, the substitution effect and income effect operate in different directions.