Hi there, here's a short topic video looking at the difference between income effects and substitution effects in markets. Let's take a demand curve for a product, in this case it's coffee. Normally if the price of coffee went down, other things being the same, we'd expect to see consumers buy more coffee.
There will be an expansion down the demand curve. But if coffee became more expensive, we'd expect to see a contraction of demand as consumers move up their demand curve for coffee. Only changes in market price bring about a movement along the demand curve.
Keep in mind that changes in the other conditions of demand will cause a shift in the demand curve. But what we're going to focus on in this short video is why it is that people might buy more of a product if the price goes down and might buy less if the price goes up. And to do that, we have to think about income and substitution effects.
Let's take an example. We'll move away from coffee. Let's look at the market for lamb. This chart shows the average, if you like, farm gate price for lamb as it leaves the farmer heading towards the retail market.
And it's the price in pence per kilo. Now from June 2014 through to November 2015, although there was an uptick in the middle of 2015, overall there was a big fall in the price of lamb from around £5 per kilo down to £3.50. That's about a 30-35% change in price.
Now according to economic theory that should increase the market demand for lamb because of income and substitution effects. Let's talk through the income effect. So if the price of lamb goes down then the real purchasing power of consumers of lamb goes up.
They can buy more lamb with 100 pounds of that's a monthly budget allocated between different products. They could buy more lamb with that £100. So because that allows more people to buy with a given budget Providing lamb is a normal good with positive income and assistive demand then demand will go up if real income increases That's not true of all goods of course. There could be inferior goods Whereas income goes up in real terms people buy less the product. Now the second effect of a price change is the substitution effect So in our example, a fall in the price of lamb makes it relatively cheaper compared to substitute meats.
Beef, pork, chicken, for example. So some consumers who might have been consuming beef or chicken will possibly switch towards lamb. And that's what's called the substitution effect.
The relative price difference provides an incentive for choices and behaviour to change. The key really is how close are the two products as substitutes. So if two products, for example lamb and chicken, are regarded by consumers as close substitutes, then the cross-price elasticity effect will be pretty high and the substitution effect will be pretty strong.
Quite a few chicken consumers will decide to buy more lamb. So the overall effect on the demand for lamb depends on the size and direction of the income effect. The income effect can go both ways.
For normal goods you buy more, as real income goes up. For inferior goods you buy less. It also depends on the size of the substitution effect, which will cause some people to buy more lamb.
Other factors remain the same. Of course, evaluation is, well, to what extent will demand for lamb go up? And one of the factors that actually affects the demand is the age profile of consumers.
This chart shows the quantity of lamb and lamb dishes. consumed per day in the UK. It does a few years old but it won't have changed much. Look at the demographic profile here. Lamb is a product that is dominated in terms of consumption by older people.
Presumably this is because tastes and preferences have changed over the years. And if you're, well, not many three-year-olds going to the supermarket and buy lamb, but if you're less than 18 years old for example, your consumption of lamb is significantly lower than if you're a pensionable age. So the impact on the demand for lamb does depend in part on the age structure of the population.
It's by no means certain that a fall in the price of lamb will lead to a surge in the consumption of lamb, which is probably good news for this little fella. This has been a revision topic on the difference between income and substitution effects.