Substitution Effect vs Income Effect

Article byNupur Chowdhury
Reviewed byDheeraj Vaidya, CFA, FRM

Difference Between Substitution Effect and Income Effect

When a good or service price decreases, consumers tend to prefer that good or service over others, the more expensive substitutes. This is known as the substitution effect. But on the other hand, when the price of a good or service decreases, it increases the consumer’s purchasing power. This is because the consumer can now buy more of that good with the same money. This is known as the income effect.

Substitution-Effect-vs-Income-Effect

The income and substitution effects together account for the law of demand, which states that the demand for a (normal) goodwillGoodwillIn accounting, goodwill is an intangible asset that is generated when one company purchases another company for a price that is greater than the sum of the company's net identifiable assets at the time of acquisition. It is determined by subtracting the fair value of the company's net identifiable assets from the total purchase price.read more goes up when its price decreases and will go down when its price increases.

What is the Substitution Effect?

  • The substitution effect states that when the price of a product decreases, then (all other things being equal), its demand will increase because consumers will prefer to buy the lower-priced product over its higher-priced substitutes.
  • For instance, if two closely-related products (like tea and coffee) are available in the market, then the price of each of these products will impact the demand for the other.
  • If there is a decrease in the price of tea, then consumers will prefer to buy more tea and less coffee. This is because tea is now the cheaper of the two alternatives, and the two products are quite similar and can easily be substituted for one another.
  • In short, the substitution effect measures the change in the quantity demandedQuantity DemandedQuantity demanded is the quantity of a particular commodity at a particular price. It changes with change in price and does not rely on market equilibrium.read more of a product or service due to a change in its relative price compared to other similar products or services. Other examples include closely related goods like gel pens and ballpoint pens, butter and margarine, etc.
  • All other factors (apart from price) need to be equal for the substitution effect to work. For instance, let’s imagine that chicken and tofu are two closely-related products available in the market. If a majority of the population is vegan or vegetarian, however, then a fall in the price of chicken will not lead to a rise in its demand.
  • This is because vegan consumers will not shift from tofu to chicken to take advantage of the lower price. In such cases, external factors can prevent the substitution effect from working as it normally would.

What is Income Effect?

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Substitution Effect vs Income Effect Infographics

Substitution-Effect-vs-Income-Effect-infographics

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Source: Substitution Effect vs Income Effect (wallstreetmojo.com)

Comparative Table

Particulars Substitution Effect Income Effect
Cause The substitution effect is caused by a change in the price of a product in relation to the prices of similar products. The income effect is caused by a change in the purchasing power of the consumer, as a result of a change in the product price.
Result Buyers choose to replace a higher-priced product with a similar, lower-priced substitute. Buyers choose to purchase a greater quantity of a product when its price falls since they can now get more for the same amount of money.
Type of Good The substitution effect can work on both normal goods and inferior goods. The income effect usually only works on normal goods, and not on inferior goods.
Availability For this effect to work, at least one close substitute of the product or service needs to be available in the market. For this effect to work, a greater quantity of the same product needs to be available for purchase.

This has been a guide to the substitution effect vs. income effect. Here we discuss the top 4 differences between substitution effect vs. income effect along with infographics. You may also have a look at the following useful articles –