What Is Income And Substitution Effect?

In economics, there are definitions of many relationships called effects. This article presents two of them.

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Substitution effect -Definition

Substitution effect - is caused by a change in the price of one of the goods in the consumer's basket of goods and consists in adjusting demand to this change: consumers move away from good X, whose relative price has increased, replacing them with other goods whose price compared to the price of good X has remained constant or decreased (D.Begg 2003, p. 148). This is the so-called replacing one good with another.

When there are only two goods, they are necessarily substitutes for each other, so the substitution effect will be unambiguous (the price of X increases, the demand for X decreases, the demand for Y increases). When there are more goods in the consumer's basket, the substitution effect will also cause a decrease in demand for complementary goods in relation to the one that has become more expensive, e.g. when the price of tobacco increases, it will cause a decrease in demand not only for tobacco itself, but also for pipes when the price increases significantly fuels (gasoline and diesel oil), a decrease in demand for them and for motor vehicles can be expected.

Income effect -Definition

Income effect - is associated with an increase or decrease in income. This increase/decrease may be due to both a simple decrease/increase in disposable income and an increase/decrease in price(s). When we consider ordinary (normal) goods, any decrease in income will cause a decrease in the demand for both goods. For inferior goods, the income effect works in the opposite direction. In general, an increase in income will cause an increase in the total demand reported by the consumer, and a decrease in income - a decrease in demand.

Income and substitution effect of wage change

When the money-income, at a certain stage of prices and wages held at a certain income, changes, the consumer's supply of labor also undergoes a change. In a situation where the consumer achieves a significant, so-called non-wage income (for example winning the lottery), there is a high probability that if his monetary income increases, the labor supply will decrease. If we assumed that leisure time is a normal good for the majority of society, then an increase in the monetary income of consumers will cause people to choose to consume more leisure time. The effect of changing the wage rate is an increase in the cost of consuming leisure time or an increase in income due to the extension of working time.

• Income effect of an increase in wage - however, when the normal good is leisure time and the income received is high enough, the demand for leisure time may become greater than the supply of labour. Then it comes to a situation where consumers increase their free time at the expense of working time, of course, as the wage rate increases.
• Substitution effect of increasing wages - the consumer's leisure time becomes less valuable when the wage rate increases, which means that he does not need as much of it anymore. Due to the fact that leisure time is included in the category of normal goods, it is possible to predict that an increase in the wage rate would contribute to a decrease in the demand for leisure time, which means an increase in labor supply. The change of free time in favor of working time means that the supply of labor is greater than the demand for free time for rest and unpaid housework .

If we assume that leisure is included in the category of normal goods, the labor supply curve must have a positive slope, i.e. positive.

• As the wage rate increases, the consumer may work for less or more hours. In such a situation, a certain imprecision appears, consisting in the fact that as the wage rate increases, the substitution effect encourages an increase in working time (conversion of leisure time into consumption).
• On the other hand, an increase in the wage rate causes an increase in the value of the initial income, which we can use when we have additional free time.

Individual consumer decisions regarding the amount of labor supply determine which effect will prevail.

When the labor supply curve is curved backwards, it means that an increase in the wage rate contributes to a decrease in the labor supply. The greater the supply of labor, the greater the probability that this effect occurs. As the supply of labor increases, each increase in the wage level results in additional income for the consumer, and when a certain point is reached, it may reduce the supply of labor.

• When wage rates are higher, the income effect may exceed the substitution effect, and in such a situation, an increase in the wage rate contributes to a decrease in labor supply.
• In the case of a low wage rate, the income effect is smaller than the substitution effect. An increase in the level of wages may cause a decrease in the demand for leisure time and, consequently, an increase in labor supply.

Consumers are more likely to seek more hours worked when their wage rate increases. They replace their free time with work. This is a substitution effect. The increase in consumer income due to higher wage rates (for the same number of hours worked) causes them to earn a higher income, which they can allocate to a basket of goods that provides them with a greater level of satisfaction. If the consumer reaches the target basket, the income effect works towards reducing labor. The substitution effect and the income effect work in opposite directions.

The income effect works weaker than the substitution effect at a lower level of the wage rate. On the other hand, with a higher level of the wage rate, the demand for leisure time increases. As a consequence, the income effect begins to dominate and labor supply is reduced.

Source: Begg D. (2003), Mikroekonomia