What Is the Income and Substitution Effect?

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The income and substitution effects are microeconomic concepts that explain how consumers respond to changes in price and income. The income effect relates to increases in income or decreases in price, while the substitution effect relates to decreases in income or in price.

When income increases, consumers feel richer. As a result, they tend to purchase more of a given good. However, when income decreases, consumers feel poorer and tend to purchase less. This is the income effect. In the substitution effect, as the price of a good increases, consumers substitute lower-priced goods. The effects work together, but the substitution effect tends to be stronger than the income effect.

Economists recognize three types of goods: normal, inferior and Giffen. The income and substitution effects affect each type of good differently. The consumption of a normal good increases as income increases. The consumption of an inferior good decreases as income increases, while the consumption of a Giffen good increases as its price increases. Most brand-name goods, such as Coke, Ford, Nike and Sony, are normal goods. Inferior goods include generic store brands and other discount labels. Giffen goods are rare and include luxury goods whose perceived value increases as their price increases.