What is the substitution effect in microeconomics

Substitution, Income, & Overall Effect

Two known effects in the national economy, which as a rule have completely opposite effects, are on the one hand the Substitution effect and on the other hand the Income effect. Roughly speaking, both effects deal with the relationship between price and demand.

But how do these two effects differ and what does the overall effect have to do with them?

Substitution effect

The so-called Substitution effect is usually always present when adjusts demand accordingly as a result of a change in the price of a good. But what does that mean?

Example: Specifically, it could look like someone eats pasta and potatoes. The prices for both products are roughly the same. But after a while, the price of potatoes drops enormously. Means: If you do without the relatively expensive pasta in the example, you can buy all the more potatoes for it. So you can replace the corresponding good or, in economic terms, you can substitute it. If the result of this example were that one would almost completely avoid pasta, the substitution effect would have predominated in this case.

If you want to show the substitution effect graphically, you can do it along the indifference curve. In contrast to the substitution effect just presented, there is the so-called income effect. But what is it?

Income effect

At the Income effectthe intensity of the respective demand changes - as the name suggests - depending on the level of real income. The substitution effect and the income effect usually occur in parallel. Why it is like that?

If the price of a certain good drops, real income naturally rises again accordingly. Those who have to pay less for their goods naturally have more money available than real income. The result: You can afford both pasta and potatoes of both desired goods - as in the previous example.

Roughly speaking, the consequence of the income effect is a change in real income. So it has the opposite effect on the demand for a certain good.

Overall effect

In terms of the overall effect, on the one hand the substitution effect and on the other hand the income effect are taken into account. The calculation then makes it fairly easy to find out whether it is a negative or positive overall effect.

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The article "Substitution Effect / Income Effect / Overall Effect" is in the category: Microeconomics