Tag: Purchasing Power

When the price of a good changes, a consumer’s purchase decision changes through two distinct channels. The substitution effect is the change in quantity demanded because the good becomes relatively cheaper or costlier than its alternatives, prompting the consumer to switch between goods. The income effect is the change in quantity demanded because a price change alters the consumer’s real income, or purchasing power. The price effect is the total change in quantity demanded, equal to the sum of the substitution and income effects. Together they explain the shape of the demand curve, the behaviour of normal, inferior, and Giffen goods, and consumer responses in domestic and global markets.

Price, Income, and Substitution Effects

1. Price Effect

The price effect refers to the change in quantity demanded of a commodity due to a change in its price, assuming other factors remain constant. When the price of a commodity decreases, consumers generally purchase more of it. When its price increases, they usually purchase less. The price effect consists of two components: the income effect and the substitution effect. The income effect occurs because a price change affects consumers’ real purchasing power, while the substitution effect occurs because the commodity becomes relatively cheaper or more expensive than alternatives. Thus, the price effect explains how price changes influence consumer demand.

2. Income Effect

The income effect refers to the change in quantity demanded of a commodity resulting from a change in consumers’ real income or purchasing power due to a price change, while other factors remain constant. When the price of a commodity falls, consumers can purchase more with the same money income, increasing their real purchasing power. For a normal good, demand generally increases as real income rises. However, for an inferior good, demand may decrease as real income rises because consumers switch to better alternatives. The income effect helps explain consumer behaviour and the relationship between purchasing power and demand.

3. Substitution Effect

The substitution effect refers to the change in quantity demanded of a commodity when its relative price changes, while the consumer’s utility or satisfaction is held constant in the standard compensated analysis. When the price of one commodity falls compared with its substitutes, consumers tend to purchase more of the relatively cheaper commodity and less of its alternatives. For example, if tea becomes cheaper than coffee, some consumers may substitute tea for coffee. The substitution effect generally works against the price change: demand tends to rise when a commodity becomes relatively cheaper. It helps explain consumer choices and the effects of changing relative prices.

Difference Between Income Effect and Substitution Effect

Relationship Among the Three Effects:

• Price effect is the total change in quantity demanded caused by a price change.
• Income effect arises because the price change alters the consumer’s real purchasing power.

• Substitution effect arises because the price change alters the commodity’s relative price.