Economic factors that determine the level of prices, supply and demand in the market can be very different. In some cases, their action may predetermine the appearance of the so-called effects of income and substitution. They can be observed in various fields of business. What is the essence of the noted effects? How can they interact with each other?
The essence of the effects of income and substitution
What is income effect and substitution effect? Consider their specifics sequentially.
The income effect, in accordance with a common definition, is an impact on the structure of consumer demand by changing the solvency of the buyer, which is also accompanied by an adjustment in the price of a public good. That is, as soon as the value of the goods decreases, a person gets the opportunity to purchase a larger number of relevant products, while he still has the money to purchase other goods. The effect of income occurs in the following case - if one or another supplier offers the goods cheaper than the competitive one.
In turn, the substitution effect is an indicator characterizing the change in the demand structure, accompanied by the desire of buyers to make cheaper purchases on typical commodity items.
The effect of income is a criterion that reflects how the change in the purchasing power of the buyer affects the amount of demand. The fact is that a person can send the freed money - due to the cheapening of some goods, to purchase other products, thereby forming additional demand in the corresponding sales segments. The income effect and the substitution effect can be considered in a single context. These economic phenomena can be observed simultaneously.
So, the income effect is characterized by a cheaper product, as a result of which the buyer, while maintaining the stability of his revenue, frees up additional funds, which he directs to buy more relevant goods that have become more affordable, or to buy other products. The price of goods falls — a person receives a certain “artificial income”, as if his salary has increased, after which he can spend it as he sees fit.
The substitution effect is characterized by the appearance on the market of cheaper goods of those categories that are familiar to a person, and he begins to acquire them, often refusing to buy previous products and replacing them with more affordable ones. We study the features of the noted economic phenomena in more detail.
The specificity of the income effect
So, the income effect implies that a person gets the opportunity to buy a larger volume of goods (due to adjustments to its price) or direct the released funds to purchase other goods. This stimulates overall market demand. There are discussions among economists about the effect of the corresponding trend on market capitalization.
On the one hand, in absolute terms, the amount of cash available to the buyer does not change. On the other hand, those companies that receive revenue from the freed up “artificial income” of a person and the activation of their purchasing activities in the respective segments get the opportunity to develop further, increase their capitalization, in particular, through new investments and loans that may be attracted to growing business. Thus, the external effects of income observed in the market may well be predetermined.
The specifics of the substitution effect
We now consider in more detail the specifics of the second trend. The substitution effect suggests that the structure of human consumer demand is changing in favor of choosing cheaper goods.It is assumed that the product familiar to him, for one reason or another, is growing in price. The result is a decrease in demand for more expensive goods.
In some cases, substitution occurs between products of a similar group, but not identical. For example, a person may equally like apples and plums. If prices for the first type of fruit begin to rise, a person can buy them less often, while buying more plums, if their price does not change so noticeably or remains the same. Thus, in the structure of consumption, apples are replaced by plums.
How can the corresponding trend affect the economy? Expert assessments regarding the phenomenon under consideration can also be very dissimilar. On the one hand, the revenue of companies that, relatively speaking, produce apples, may decrease significantly due to the fact that buyers change their priorities and they begin to actively acquire plums. On the other hand, according to economists, an increase in apple prices often causes just the same excessive demand for them. In this sense, the revenue of companies selling this type of fruit may not decrease at all.
Thus, the substitution effect can be assessed, on the one hand, as a negative economic trend (if the apple supplier is forced to increase prices, for example, due to difficulties in the corporate business model and lack of liquidity), on the other hand, as neutral or even positive, since the increase in the selling price of fruits may be due to just too much demand for them.
Effects relationship
The replacement effect and the income effect considered by us, as a rule, actively interact. The content of the relevant communications depends on the specifics of a particular product. It is quite possible that both effects can be combined, since the cheapening of some goods, as a rule, leads to an increase in the demand for them.
Cycle of substitution effect
Again, consider the apple and plum example. Suppose the former have risen in price, and the demand for the latter has accordingly grown. There may well be a situation in which in one market or another (for example, if we talk about a single city), there will simply be a rush of demand for plums. And this, in turn, will predetermine a rise in prices for them. After this, the selling price of plums can rise, after which the costs of buyers to purchase these fruits can reach the level of those as if apples were bought. After that, people who, in principle, have the same preferences, can again modify their consumption structure, in which the intensity of apple purchases is equal to the corresponding indicators for plums. Thus, in this case, a certain cyclical nature of the substitution effect is observed.
When one effect is replaced by another
In turn, due to the fall in demand for plums due to the fact that buyers begin to spend more on apples, prices for the corresponding fruits are again reduced. And here it is precisely the income effect that takes place. A person who is accustomed to spending, relatively speaking, 100 rubles a day for apples and plums, observes that expenses for the second type of fruit have fallen, let’s agree that it is 30 rubles. This amount of money is released, after which the buyer can decide to send it to purchase more plums, apples or other fruits. Thus, we can observe a situation when one effect is gradually replaced by another.
Another scenario is possible. There are products that are divided according to quality and other parameters, for example, size or color, into the categories of "prestige" - economy-class products, the middle price category, as well as premium products. A person, depending on the income level, can buy goods of each of the indicated categories, but in a certain proportion.If he has a high salary, then in the structure of his consumption premium products will be more common. If the buyer’s income is not high, then the frequency of acquiring the highest quality goods from him will most likely be incomparably lower.
Consumer preference factor
There may be an interesting trend in the market. Consider it with the example of different varieties of apples. Suppose the market sells fruits of the highest quality, medium and low quality varieties. We also agree that the consumer of apples has average incomes. Having received a salary, he first actively buys the highest quality fruits, after he has less money - he goes to the middle price category, and by the time of the next salary he begins to acquire the cheapest apples.
Situation: A new supplier is entering the fruit retail market, able to offer, albeit not very high-quality fruits, but extremely cheap ones. A person who loves apples very much, at the time of acquiring apples from a new supplier, sees that he has released cash. As we know, the effect of income occurs in the event of such situations, that is, when the buyer has “artificial” revenue. A person, having discovered more free cash, will direct it, of course, to the purchase of premium fruits - since he is a big lover of apples.
Thus, we see a “pure” income effect, which looks very entertaining. It would seem: one product is getting cheaper, and the worst grade, but the demand for another, a better one, is growing. We can observe how a significant factor is the prevailing model of human consumer preferences. If he was not a lover of apples, then perhaps he would buy them if necessary (for example, with the aim of adding to the pie), focusing on the price, and not on the variety. But since in our example a citizen has a great craving for apples, then he will buy the highest quality upon the fact of the released income. The greatest effect of income, therefore, can be seen in consumer behavior, characterized by pronounced consumer loyalty to quality goods.
Labor market: income effect
It should be noted that the economic trends we have examined can be observed not only in the retail sales segment, but also in other business areas. So, it is quite possible to observe the effect of income and substitution in the labor market. Consider an example.
Let's say a factory for the production of refrigerators and washing machines has opened in a small town. The company has created several hundred vacancies and hired workers from among the residents of the respective locality. At the same time, training of engineers was launched at the local polytechnic institute according to programs adapted for technological processes characterizing the assembly of refrigerators and washing machines.
After 5 years, the university graduated the first graduates who were ready to find a job at the factory. The management of the assembly plant for refrigerators and washing machines decided to take the opportunity to attract graduates for a small salary and published a list of relevant vacancies. However, graduates of the Polytechnic were in no hurry to find a job, since compensation of the established size did not suit them. The company, which managed to acquire investors and invested in increasing the capacity of factory lines open for new vacancies, was forced to slightly increase salary offers.
Some graduates of the polytechnic agreed to work for an appropriate level of compensation, and partly managed to close the vacancies. For some time, other engineers tried to find work at other enterprises in the city, but could not, because their specialization was adapted to the production of refrigerators and washing machines.As a result, they agreed to go to work at the plant even for the low salary that was originally proposed.
The company, which did not have to raise the salary of the "second tier" of engineers to the level of "first", freed up cash. There was an effect of income on the labor market. The company received the opportunity to spend the corresponding revenue on goals related to business development, in particular, on the modernization of production.
Labor Market: Substitution Effect
Consider another scenario. Qualified engineers from other regions of the country began to gather in a small city with a flourishing factory for the production of refrigerators and washing machines, hoping to get a well-paid job. Since there were always vacancies at a growing enterprise, and if necessary new ones were opened, engineers were easily employed. For many of them, the salary offered by the company was considered quite decent (and it also grew). But gradually the engineers coming to the city became more and more.
The company, opening new vacancies, could no longer afford to hire new engineers for a high salary. But as competition between them increased, many specialists agreed to a lower one - and new shops began to open at the plant, in which labor compensation was less than in the old ones. Moreover, the salary of engineers of the "first echelon" has stopped growing, and at some production sites it has completely decreased. Dissatisfied specialists began to quit, and in their place the factory hired other, "competing" engineers without problems. Thus, a substitution effect occurred. The company was able to not increase the cost of paying employees.
At the same time, if labor supply is formed on the market in corresponding volumes, the income effect and the substitution effect can correlate. For example, if engineers from other regions of the country, seeing that the salary at the enterprise is not growing, stop coming to a small city. In this case, further business growth becomes open to question, because the company needs personnel for opening factory lines. It is again forced to publish vacancies with high salaries, for which regular indexing is guaranteed. As a result, engineers again travel to the city - and salary offers at the entire enterprise are aligned, but after some time, specialists will come to the village who will certainly begin to “dump”. After that, the plant will again be able to take advantage of the income effect.
Universal indicator
The most interesting thing is that in the case of the labor market, a situation similar to that which we examined with the example of premium apples and those characterized by low quality can be observed. This is possible if, at the Polytechnic Institute, relatively speaking, a production training program is opened, under which students will be sent to work at the plant for half the salary. The company, having saved on relevant vacancies, will be able to open more positions for the most highly qualified engineers and hire them.
So, regardless of the market segment, the effect of income occurs in the following case: if among competitive offers any one becomes cheaper, after which the buyer receives “artificial revenue”, which he can direct for certain purposes. The substitution effect occurs if any of the competitive offers becomes more expensive - in this case, the buyer prefers to purchase a product or service (if we talk about the labor market) from an alternative supplier or from another social group, if we talk about engineers from the example considered by us above.
