The effect of income is the impact on the structure of consumer demand, provided by a change in real income due to changes in the value of the good.
The essence of the effect is that as a result of reducing the cost of a certain good, a person can acquire a greater quantity of it, while not denying himself the purchase of other goods. This concept reflects the impact of changes in real income on the value of demand. A drop in the value of one product will have, albeit insignificant, an effect on the general price level, which will make the consumer relatively richer. His real incomes will increase slightly . The additional income that is generated as a result of a fall in the value of a given good can be used by the consumer both to purchase additional units of this good and to increase the consumption of other goods.
The substitution effect is a change in the structure of demand due to a change in the value of one of the benefits from the consumer set. The essence of the effect is that when the cost of one product increases, the consumer reorients to another product that has similar consumer properties, but with a constant value. In other words, consumers tend to replace more expensive goods and benefits with cheaper ones. As a result, the demand for benefits, whose value has increased, will fall.
The relationship of income and substitution effects
The effects of income and substitution do not work in isolation, but in interaction with each other. As for normal goods, the effects will be summed up for them, since a decrease in value will lead to an increase in demand for these goods.
For example, a consumer has a specific fixed income. He buys in a certain ratio of coffee and tea, which are normal benefits. Then the effect of income and substitution will act as follows. Reducing the cost of tea hi to the fact that demand for it will increase. Since the cost of coffee has remained unchanged, then this drink becomes relatively more expensive than tea. Any rational consumer would prefer to replace expensive coffee with relatively cheap tea. The income effect will work as follows: reducing the cost of tea has made the buyer a little richer, that is, it has caused the growth of real incomes. Since the higher the income level, the higher the population’s demand for normal goods will be, and income growth can be spent both on the purchase of additional units of tea and the purchase of coffee.
The effect of income and substitution work unidirectionally. For a normal product, this indicator explains the increase in demand with lower prices.
For the benefits of the lower category, the effects of income and substitution are determined by the difference between them.
For example, a buyer, having a certain income in stock, acquires natural coffee and coffee drink in a specific ratio. The latter refers to goods of the lowest category. Then, according to the substitution effect, a decrease in the price of a coffee drink will lead to an increase in demand for this good, since it will become a relatively cheap product. A rational buyer will substitute expensive natural coffee for a relatively cheap drink. The income effect will work as follows. Reducing the cost of a coffee drink made the buyer a little richer, that is, this led to an increase in real income. Since with the growth of incomes the demand for lower goods decreases, the increase in real income will be spent on the purchase of natural coffee. Thus, a fall in the price of a coffee drink will lead to a decrease in demand for it and an increase in demand for natural coffee. In this case, the substitution effect and the income effect act in different directions.