Income Effect

Often, people seem set in their ways, buying the same coffee at the same price everyday, taking the same bus at the same time everyday, buying entertainment mags every day, and so on. That is, until prices change, or our pay changes, which makes us do a double-take.

The income effect describes how a change in income changes a consumer’s demand. Getting a pay raise increases purchasing power, which increases demand for goods and services...while taking a pay cut will lower purchasing power and consumer demand.

The substitution effect, on the other hand, describes how people substitute one good for another, when either prices, income changes, or a new rival good arrives on the market. For both the income and substitution effect, it’s common that, as income rises, “inferior goods” are replaced with “normal goods,” which include fancy “luxury goods.” Inferior goods are goods whose demand decreases when income rises. Normal goods are the opposite: demand increases for them as incomes rise.

If we look at coffee, McDonald’s coffee is an inferior good, while Starbucks is a normal good. For getting a ride to work, bussing is an inferior service compared to getting a taxi or an Uber. The richer we get, the more we spend, and the more we switch out inferior goods for normal goods.

For instance, you’re shopping for toilet paper. Last week’s pay raise might mean you stock up more on toilet paper like never before, using it to line the walls of your house...because you can. Mo’ money, mo’ TP. The income effect at work. Or your pay raise might mean you buy the same amount of TP as before, but you buy the super-soft (yet super-sturdy), gold-lined, fancy toilet paper. To go with your new golden toilet, of course.

Because you’re substituting your inferior toilet and toilet paper with a luxury toilet and toilet paper, we’re looking at the substitution effect. But hold up: buying a gold toilet and gold-lined toilet paper because you got a raise also falls under the “income effect” umbrella, since it’s a change in your consumption caused by a change in your income.

Yep, the income effect and substitution effects can both apply to the same situation. Let’s take a look at a price change instead of an income change.

Your favorite wine is a nice Napa Valley cabernet that usually retails at $50 a bottle. Unfortunately, California is hit by another set of wildfires and half the inventory of your favorite wine is destroyed. Prices skyrocket. Was $50 a bottle. Now it’s $100 a bottle. More than you're willing to pay for a bottle of hooch. You switch to Limoncello shots until prices get back to normal.