This video explains what the income and substitution effects are, and how to analyse them in order to understand why we buy more goods when their price goes down.
Generally, if the price of something goes down, we buy more of it. This is down to two effects:
- Income effect: because it’s less expensive, we have more purchasing power because it is a smaller drain on our personal finances.
- Substitution effect: because it offers more utility per unit of money, other alternatives become less attractive.
What Eugen Slutsky managed to do was find an equation that decomposes this effect based on Hicksian and Marshallian demand curves.
It is not always possible to tell what the total effect will be – if we are talking about inferior complementary goods, for example, the substitution and the income effects pull in opposite directions. In this case, the total effect will depend on which effect is stronger.
Learn more by reading the dictionary entry.