Substitution & Income Effects: Impacts on Supply & Demand

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  • 0:03 What Is Substitution Effect?
  • 1:32 What Is Income Effect?
  • 2:30 Impact of These…
  • 4:18 Lesson Summary
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Lesson Transcript
Instructor: Kevin Newton

Kevin has edited encyclopedias, taught middle and high school history, and has a master's degree in Islamic law.

Have you ever changed your mind about buying something because they raised the price? Or maybe opted for an upgrade because you got a raise? This lesson explains the substitution and income effects, the terms economists use to describe those actions.

What Is Substitution Effect?

Let's say that you and a friend have decided to go grab coffee. You walk into the coffee shop and search the menu for your favorite drink. However, you see that the price on it has jumped significantly. Flabbergasted, you decide to order your next favorite drink, which luckily still has a reasonable price, although even it has increased slightly.

Unknowingly, you have just demonstrated the substitution effect by replacing one product with a similar, lower-priced option. However, the impact of this price hike doesn't stop there. Before, you had planned on getting a cake pop as well, but now you feel that if you don't have enough money to afford your favorite drink, maybe you should avoid the treat too.

We humans are a pretty emotional bunch when it comes to our money, and try as economists may to get us to act rationally, sometimes we still let emotion get the better part of us when it comes to exactly this type of transaction. But is it really emotion? Remember, the real currency of economics isn't dollars or pounds or Euros; it's utility. Is the feeling of having saved money worth more to us than a cake pop, in light of the fact that we couldn't afford, or didn't want to pay for, our favorite drink? In this case, the answer is a resounding yes. And since a cake pop is often purchased with coffee, it is a complementary good in this case.

What Is Income Effect?

At its core, the earlier example was about a percentage of income being spent on a good. Because the price was raised, we weren't as willing to spend such a percentage of our income. Consider for a second that you went to the coffee shop every day to get the same thing. Getting your breakfast at a coffee shop costs exactly 3% of your income. However, the company you work for has fallen on hard times and chooses to cut wages by 3%. Many people may feel poorer because of this and choose to cut out 3% of their spending - namely, the breakfasts. This ability of earnings to impact purchasing decisions is known as the income effect.

As you might expect, the exact opposite can happen. If you get a 10% raise, you may be willing to spend 10% more on goods and services you were already purchasing. If your coffee cost $3.00, suddenly paying $3.30 for that extra shot of espresso or flavor isn't such a bad idea.

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