Income and Substitution Effect
Income Effect
Income effect occurs when there is rise in income of the
customers or declines in price of the good. It is basically the change in
consumption pattern due to change in purchasing power of the customers. It happens
due to income increase or price change.
For Example, I am consuming 4 eggs/day, which
costs me 32 Rs. i.e. my income to spend on eggs. Now I got an increment in my
income due to which my disposable income on eggs rises to Rs. 40/day. So due
tom this I am able to consume 1 more egg/ day. So now I consume 5 egg/day.
In short, as my income increases I started consuming more of
a product than I was consuming earlier due to low income.
Substitution Effect
Substitution Effect occurs due to change in consumption
pattern because of change in relative prices of goods or substitute goods.
For Example, I have two vehicles, one runs on
petrol and other runs on diesel. So as the price of petrol rises, I started
consuming more of diesel vehicle then petrol vehicle, whereas when price of
diesel rises I stared consuming more of petrol vehicle due to limited income &
availability of substitute product at lower price. (Petrol as substitute of
diesel and vice versa).
In short, substitution effect happens due to availability of similar product at cheaper prices or due to consumption of a product by the consumers.
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