The situation of price change for any good or service on the market is well known in any model of national economy. It occurs constantly and for various reasons. The change in prices of goods particularly affects the welfare of the consumer: when the price of a product that one buys increases — consumer welfare is reduced, and vice versa. The behavior of rational consumers (meaning they strive to maximize the utility) in the situation of price changes on the market (either increase or decrease in price) is described in the given essay. For example, if consumer spends all the funds, released after decrease in price for purchasing the same product — an income effect will take place or in case his/her behavior is different, most likely the substitution effect will take place.
The purpose of the given paper is to provide the detailed review of income and substitution effects of a price change and to define the exceptions to the rules of demand, related to these effects.
Indifference curves and budget lines
In order to describe income and substitution effects in the graphic demonstration, indifference curves and budget lines (constrains) should be introduced first.
The indifference curve is a graph, representing “the combination of goods X and Y that give the consumer the same level of satisfaction”, assuming that consumer is indifferent to any combination of goods on the curve.
Budget constraint is a line that represents combination of goods X and Y available for purchase by consumer depending on his/her budget (income).
In case indifference curve and budget constraint intersect, consumer equilibrium takes place. A situation of consumer equilibrium can be described as a combination of certain amounts of goods X and Y that satisfy consumer needs and that is affordable within his/her budget.
Intersection of budget constraint line (BC) and indifference curve (I2) on the Figure 1 defines the point of consumer equilibrium.
Changes in a price of goods and services
Changes in a price can have two different effects on consumer choices. There can be an income effect that occurs because the change in a price influences consumer purchasing power, increasing or decreasing it. In a graphic demonstration this would mean that consumer has to move to a new indifference curve since the combination of goods and services they can currently buy, has changed. There can also be a substitution effect that takes place because consumers can choose to buy another product or service if the price for the given product/service was changed. In this case consumer can stay on the same indifference curve, moving along it.
Summarized effect of changes in a price of a normal good is a change of demand volume that is equal to sum of income and substitution effects.
Income and substitution effects caused by a decrease in price
Income effect. When the price decreases, product in relation to the total volume of a consumer income becomes less expensive, and therefore consumer is able to purchase larger quantities of this product, without abandoning their other usual purchases. It is also possible that consumer can spend his additional income on the consumption of other products.
Substitution effect. It can be defined as a consumer willingness to buy more goods for which price has declined, instead of those goods for which prices have remained the same and as a result they have become relatively more expensive.
In case the price for the good X decreases, substitution effect is reflected in the movement along the indifference curve U1 from the point A to the point B, which results in higher consumption of a good X within the same budget constraint. The consumer that strives to maximize utility, then shifts his choice from the point B on the indifference curve U1 to the point C on the indifference curve U2 (income effect). There is also a new budget constraint that represents higher level of utility due to the increase of the real income.
Thus, in case price of a product or a service declines, the volume of its purchase grows — both income and substitution effects caused more quantity of good X to be bought per week.
Income and substitution effects caused by an increase in price
Income effect. Since consumer purchasing power is reduced by an increase in price of a good, it forces him to switch to lower level of utility and to buy smaller amount of expensive good.
Substitution effect. Consumer demand drops for a good, which price has increased. In this situation consumer is willing to buy higher amount of less expensive substitute goods.
With the increase of a price for good X the consumer budget becomes restricted by a new constraint. A movement along the initial indifference curve U2 from the point A to the point B represents substitution effect, resulting in less purchases of good X and more purchases of good Y instead. A loss of purchasing power results in a movement to the new consumer equilibrium point C and represents an income effect.
Thus, in case the price for the good increases, income and substitution effects combined result in a decline in purchases of this good.
Giffen’s paradox. A situation when increase of a price of product or service results in its higher consumption, is known as Giffen’s paradox.
Income and substitution effects in theories of J. R. Hicks and E. Slutsky
Income and substitution effects were initially researched and studied by J.Hicks and E.Slutsky that evaluated the value of each effect in their total impact differently. According to Hicks, real income can be considered invariable, if under a new price ratio consumer has that amount of income available, which provides him with the previous level of utility. In Slutsky’s interpretation invariance of the real income means an opportunity for a consumer to purchase that set of goods under a new price ratio, which corresponds to a rational choice under an old price ratio.
A budget constraint line (1) corresponds to the initial prices of goods and consumer’s income. In this case consumer choice is in the point A and provides a total utility U1. If a price for good X decreases, there will be a new budget constraint line (2) and a rational choice will be moved to the point C on the indifference curve U2. Income and substitution effects are shown with the help of fictive constraint line (3). Movement from the point A to point B shows substitution effect, caused by decrease in prices while movement from the point B to point C is the result of real income growth.
Initial budget constraint line (1) provides a maximum level of utility U1 in the point A. If the price for good X declines, new budget constraint will allow moving rational consumer choice to the point C on the indifference curve U3. Fictive budget line (2) shows income and substitution effects volume and characterizes income needed to provide consumer with the previous level of utility under a new price ratio. With the constant real income and new price ratio a higher welfare can be achieved if consumer buys a set of goods B. Therefore movement from the point A to the point be defines a substitution effect and movement from the point B to the point C shows real income growth effect.
Income and substitution effects for inferior goods
When prices for inferior goods decline, income and substitution effects act in opposite direction. On the one hand, demand for less expensive commodity theoretically rises. At the same time, when prices decline and income remains the same, a wealth effect appears. As a result, consumers will shift their preferences to more expensive goods with better quality. Consequently, income effect for inferior goods is positive: the more real income consumer has the less inferior goods he will purchase.
With the increase of price for inferior good X the demand for it drops that is illustrated by movement from point A to point B on the indifference curve U2, please see Figure 6. Because of the low quality of good X, an increase of its price results in the lower real income. This causes the quantity of purchased good X to increase, moving from the point B to point C. Thus, the substitution effect overweighs the income effect and the quantity of purchased good X declines from X* to X**.
Conclusion
Summarizing all the above one can conclude that both income and substitution effects work in the same direction to achieve the expected result: consumers will buy more goods, which prices has declined and less goods, which prices has risen.
The only exception to the general rule is the case when these two effects work in the opposite direction — on the inferior goods market.
In case the price for the good increases, income and substitution effects combined result in a decline in purchases of this good and vise versa.
Any price change leads to these two effects simultaneously. However the majority of economists believe that in relation to studying consumer behavior when people respond more to changes in the prices of some kinds of goods than they do to changes in the prices of other kinds of goods, substitution effects are more important.