Income and Substitution Effects

Changes in price can affect buyers' purchasing decisions; this effect is called the income effect. Increases in price, while they don't affect the amount of your paycheck, make you feel poorer than you were before, and so you buy less. Decreases in price make you feel richer, and so you may feel like buying more.

What if we're looking at two goods at once? For instance, a fast food chain sells hamburgers and hot dogs. If the price of hamburgers goes up, but the price of hot dogs stays the same, you might be more inclined to buy a hot dog. This tendency to change your purchase based on changes in relative price is called the substitution effect. When the price of hamburgers goes up, it makes hamburgers relatively expensive and hot dogs relatively cheap, which influences you to buy fewer hamburgers and more hot dogs than you usually would. Likewise, a decrease in hamburger price would cause you to eat more hamburgers and fewer hot dogs, according to the substitution effect.

The income effect also affects buying decisions when there are two (or more) goods. When the price of hamburgers goes up, it makes you feel relatively poorer, so your tendency might be to buy fewer of both hamburgers and hot dogs.

If you look at the combined results of the income effect and the substitution effect, the total effect is a little unclear. According to the income effect, an increase in the price of hamburgers decreases consumption of both hamburgers and hot dogs. According to the substitution effect, however, hamburger consumption drops, but hot dog consumption rises. Thus, while it is clear what happens to hamburger consumption, since both effects tend to cause a decrease, we cannot be sure what happens to hot dog consumption, since there is both an increase (substitution effect) and a decrease (income effect).

Table of Income and Substitution Effects

While we cannot be absolutely certain about the net result, in general, the substitution effect is stronger than the income effect. That is, when the price of hamburgers goes up, you will most likely eat fewer hamburgers and more hot dogs, since the change in relative prices (substitution effect) affects you more than the perceived change in your income (income effect).

Another factor influencing demand is one which marketers and advertisers are always trying to understand and target: buyers' preferences. What do people like? When and how do they like it? Still looking at soda, it makes sense that people drink more soda when it's hot, or when they're eating a meal, or when they've been exercising. In these cases, buyers' preferences have changed: they want the soda more, and are therefore willing to pay more for the same good. Likewise, if it's snowing, fewer people will crave a cold soda, and the price they are willing to pay for a cold soda is lower, although they may be willing to pay a little extra money for a hot coffee.