Understand The Income And Substitution Effect

Understand The Income And Substitution Effect

If you've ever been to any form of market, chances are, you've encountered coursing through several choices based on your budget. You might have chosen to buy flank steak on low-income seasons. On the other hand, you may have chosen to buy fillet for dinner in high-income seasons. This is the income effect on the decision to buy goods. On high-income periods, one tends to purchase normal goods or those which one would normally choose given no restrictions. In low-income periods, one is more likely to go for the second choice considering the budget, which is the inferior good.

The income and substitution effect has a simple cause-and-effect relationship. In times where income levels are low, you tend to settle for less. If income levels are high, you tend to live normally, even luxuriously at times. The inferior good, which is the choice during low-income periods, has a reversely proportionate relationship with the normal goods, which tends to be the choice during normal or high-income levels. If we consider income as the variable factor between the two, the demand relationship between the inferior and the normal good would be reversed. In layman's terms, it always comes to a choice between the two for a household.

The illustration of the income and substitution effect is an overly simplified model, but it does help in predicting the behavior of the market. If a population expects a decline in income levels due to economic distress, the demand for cheaper or more inferior goods would be expected to rise. If an overall income increase is expected, then the demand for normal goods would be higher. How does this affect government, fiscal, and economic decision-making?

Government projections on these types of economic situations are so important because they need to intervene at times where there might be large shortages. For instance, a high inflation rate and low-income levels may require people to buy chicken over beef because it is cheaper. In this case, easing tariffs on chicken importation may make it easier for consumers to find cheap chicken as an option for daily living. Apart from tax and tariff laws, there are also subsidy programs that could be affected by these movements in the economy.

Government policies on sales and consumption are also partly dependent on income and substitution analysis. The government's imposition of price floors and price ceilings are used to help and protect the interests of both buyers and sellers. On low-income seasons, for instance, the government would impose a price floor on inferior goods to make sure that no severe shortage would occur. It could also impose a price ceiling to avoid abusive sellers from overpricing. Depending on the situation at hand, the behavior of the market can be analyzed based on the income and substitution effect.

Household planning and budgeting are also affected by this concept. If you have tried cooking or purchasing items for an entire household, you usually have a budget based on that period's income levels. If you intend to furnish a house or an apartment, you may be able to choose better selections at periods with higher income levels. On the other hand, you may have to settle for less during periods with low-income levels. While this may be simple logic, a knowledgeable homeowner would have a plan at hand because of a deeper understanding of the concept. For instance, having a consumption plan for each month depending on income levels would help because it would create a basis of success in budgeting. A deeper understanding of the relationship between inferior and normal goods is a good tool to analyze the practicality of buying different items for consumption.

The logic of the income and substitution effect cannot be any simpler. We are all aware of what happens during seasons with tighter budgets and seasons with higher income levels. However, having a deeper understanding of this concept may just help save more than just trying to make ends meet every time.

Is there a definitive way of determining when to buy inferior and normal goods?

No, there isn't. But, having a trend analysis or at least an image of how income levels decline for a household may help. When the curve goes down, settling for inferior goods may be the appropriate choice.

How does the income and substitution effect affect services?

Products and services move in the same way when analyzing economic graphs. If there are normal and inferior goods, there are also normal and inferior services.

Does the analysis take inflation into account?

On simpler representations, no. However, higher-level analyses may indicate changing price levels for both goods relative to the income. In this case, inflation rates do not play that much of a role because the choice is between two items which have both increased/decreased in price.