The Substitution and Income Effects

In microeconomics, consumer choice one important theory that attempts to relate personal preferences to trends exhibited in consumer demand curves. The relationship between consumption trends, personal preferences and demand curve is one of the most important relations in economics. Preferences are the desires that respective individuals have for the consumption of particular goods and services. Their ability to consume these goods and services is however pegged on their levels of income and as such consumers are always sensitive to changes in incomes and price (Thomas & Maurice, 2011).

The models that constitute the consumer theory are collectively used to represent prospective and observable demand patterns that result from either an increase or decrease in income and what impact these changes will have on the respective consumer’s choice and use of substitute goods. Several variables are used to explain the rate at which goods and services are purchased and also the rate at which their substitutes are purchased at times of economic downturns. The fundamental theory of economics states that the rate of consumption of goods and services falls as the prices of goods increase. Corollary to this, the demand of substitute goods increases also. This happens to be the case as in most cases, substitute products come at considerably cheap prices. It is however important to note that not only does the demand of alternative goods and services increase at such times but also people tend to spend considerably less money and tend to forego some of their day to day pleasantries during such moments (Mankiw, 2008).

As prices skyrocket, consumers will naturally substitute away from higher priced goods and services and chose less costly goods and services. Subsequently, as the wealth levels of individuals increase, demand for gods and services increases and this has the effect of pushing the demand curve higher at all rates of consumption. This is what in macroeconomics is called the income effect. As wealth increases, consumers tend to substitute away from less costly inferior commodities and choose highly priced alternative products (Thomas & Maurice, 2011).

Price effects and income effects deal with how changes in price of a commodity change the consumption trends of the commodity. The theory of consumer choice on the other hand examines the decisions and trade-offs people make in their respective roles as consumers when prices of gods and services and their incomes change (Hirshleifer, Glazer, Hirshleifer & Hirshleifer, 2007).

The Substitution Effect

The substitution effect is the effects observed in consumption trends in respect of changes in relative prices of goods and services. This effect mainly affects the movement along the demand curve. In the graph below the effects of price increase for product Y is shown. If the price of the product increases, the budget constraint will shift from point BC2 to pint BC1. But since the price of product X does not change, the consumer can still buy same quantity of product X if they choose to buy only product X. however, the consumer will be able to buy less of product Y because its price has increased.

Figure SEQ Figure * ARABIC 1

To maximize the utility of his consumption patterns with the reduced budget constraint, the consumer will have to re-allocate his consumption to the highest available indifference curve which in this case is I1. Consequently, the amount of product Y bought will shift from Y2 to Y1 and the amount of product X bought will shift from X2to X1. The opposite scenario of this effect will occur if the price product Y decreases thereby causing a shift to BC3 from BC2.

The Income Effect

One other important in microeconomics that can change is the income levels of the consumers. The income effect is a common phenomenon that is observed through changes in purchasing power. This effects shows changes in quantity demanded as brought about by changes in utility or real income. Demonstrated graphically, if prices remain constant, changes in income levels will only create a parallel shift on the budget constraint. A decrease in income levels shifts the budget constraint to the left since less of a product can be bought and an increase in income will shift it to the right as more of the commodity will be bought (Hirshleifer, Glazer, Hirshleifer & Hirshleifer, 2007).

Income effect has a serious implication in the theory of consumption. We can for instance find out the impact of changes in income level on an individual on their monthly expenditure on car fuel. Instinct has it that if the income of these individuals decrease, then they are likely to spend less on car fuel, say gasoline. The reduced expenditure on the commodity can be as a result of their decisions to drive less, use alternative sources of transport such as public transport or even buy a motor cycle which is economical in fuel consumption. Equally if the prices of the fuel increase, the consumer will opt for the same reaction. The in thing here is all consumers are expenditure averse and as such are always keen to spend least amount of money possible more especially when economic conditions are not promising (Mankiw, 2008).

Increase in fuel costs comes with its own share of associated costs such as eating less often, spending less on maintenance costs for the car, buy less or cheap clothes and avoiding expensive vacations.

Every aspect of price change can be decomposed into a substitution effect and price effect. The price effect then becomes the sum of the substation and income effects. Substitution effect is a change in price that only changes the slope of the budget constraint but leaves the consumer on the same consumption curve they were in before the change in price. For the case of gasoline, the substitution effect explains the car owner’s new consumption trend after a change on price while being compensated to allow the car owner to happy as he was before the price change. With this effect, the car owner is poised to substitute for the product that becomes comparatively less expensive such as buying a bicycle or using public transport (Thomas & Maurice, 2011).

In the diagram that follows the substitution effect is the change in quantity demanded for product Y which in our case could be gasoline when the price of the product falls, thereby increasing the purchasing power of the consumers of the commodity. An opposite scenario will be the case when the price of the product is increased. The substitution effect increases the quantity demanded for product Y to Ys from Y1.

Figure SEQ Figure * ARABIC 3

Assumptions of the price effect.

The behavioural assumption of the consumer theory with regard to substitution and income effects is that all consumers of whichever category of products are rational decision makers who seek to maximize the utility of their wealth. Specifically, consumers tend to maximize their utility functions subject to a budget constraint.

This then means that consumers will purchase the combination of goods and services that will make them remain happy given the amount of money that they will have to spend in purchasing these goods and services. The price substitution can also be used to explain the rational consumer’s choice of leisure and labour. Consumption is often considered as one good and leisure as another. Since a consumer has a finite and often scarce amount of money, they must make a choice between spending on leisure and labour. This explains why the car owner in our example can opt to forego vacations but buy a bicycle when gasoline price increases. The logic is a vacation which is leisure in this case earns nil income for consumption but a bicycle earns an income for consumption in terms of savings on fuel expenditure.

Reference

Hirshleifer, J., Glazer, A., Hirshleifer, D. A & Hirshleifer, D., (2007). Price theory and applications: decisions, markets, and information. Cambridge university press

Mankiw N. G., (2008). Principles of Microeconomics. Cengage learning.

Thomas, C. & Maurice, S. (2011). Managerial economics: Foundations of business analysis and strategy (10th ed.). New York: McGraw-Hill