Economics Q

caroline1111

Could anyone please explain to me the difference between the income and substitution effect? Thanks.

Keano!

Income effect is where a change in your income is the cause for you spending your money differently on products - Buying less of one/more of one or changinf to a different product.

Substitution effect is where another product alters your spending.



Thats pretty much it I think. Can't stand feckin' micro!!

Ashashi

I thought income effect is where your income is affected by a good's changing price, and substitution is where other goods are affected by a change in price of a good?

caroline1111

Mmm its really confusing, I think substitution effect is when the price of a good decreases, so you buy more of it as you're getting better value for money. And income effect is when the price of a good decreases so you have a bigger real income so can spend more on that good Or other goods. Really not sure though.

Ashashi

Well if you are talking about a good, for example, and it's price rises.

The income effect would be that you have less income if you buy the good.

The substitute effect would be it would be more expensive now compared to other goods.

That is my take on it anyway

MavisDavis

Directly from my notes:

When the price of a good, good X, falls, two things are perceived to happen:

Substitution Effect:
that consumers will demand more of the item that has fallen in price as they substitute the lower priced item for items that do a similar job.

Income Effect:
that when the price of good X falls, it increases the real income/spending power of the consumer.

So, basically, the substitution effect means that when a good falls in price, consumers will want to buy it instead of similar, more expensive goods and the income effect means that consumers will have a greater real income because they're now buying a cheaper good.

Hope that helps!

Oh yes and the subsitution effect + the income effect = the price effect.