The following article will guide you about how do income and substitution effects help to explain law of demand.
The utility approach helps explain the law of demand. In fact, the demand curve for a normal good is downward sloping due to the law of diminishing marginal utility. Alfred Marshall and other members of the English neo-classical school developed the concept of marginal utility which helps explain the fundamental law of downward sloping demand.
However, modern economists like J.R. Hicks and R.G.D. Allen developed an alternative approach which also helps explain the law of demand. This new approach introduces two new concepts, viz., the substitution effect and the income effect of a change in price. These two effects together explain why the quantity demanded of a commodity increases when its price falls. A fall in the price of a product normally results in more of it being demanded. A part of this increase is due to substitution effect.
The Substitution Effect:
The first factor explaining increasing consumption when price fall is known as the substitution effect. The substitution effect refers to the substitution of one product for another resulting from a change in their relative prices. A lower price of good X, with the prices of other goods remaining unchanged, will increase its relative attractiveness, inducing consumers to substitute good X in place of some of the new relatively more expensive items in their budgets. If the price of coffee increases while other prices (including the price of tea) do not, then coffee appears to be relatively more expensive.
When coffee becomes more expensive relative to other items, less coffee and more tea will be consumed. Similarly, a fall in the price of video cassettes relative to movie tickets will induce people to seek more of their amusement in the cheaper direction.
As a general rule, the substitution effect of a fall in the price of a commodity is to induce consumers to substitute other goods for the more expensive good in order to acquire the desired satisfaction as cheaply as possible. Thus, when consumers substitute less expensive goods for more expensive ones, they are buying desired satisfaction (utility) cheaply (i.e., at least cost).
The Income Effect:
Moreover, when a consumer’s money income is fixed, a fall in the market price of one of the purchasable commodities is just like an increase in his real income or purchasing power. To be more specific, the income effect signifies the impact of a price change on the real income of a consumer.
When a consumer’s money income is constant, a fall in the price of a commodity is equivalent to an increase in his real income.
The income effect refers to changes in consumer’s real income resulting from a change in product prices. A fall in the price of a good normally results in more of it being demanded. A part of this is done to real income effect (i.e., income adjusted for changes in prices to reflect current purchasing power).
If a consumer has a money income of, say, Rs. 10 and price of X is Re. 1 he can buy 10 units of the good. If the price of the good now falls to 50 paise, he can buy the same 10 units with only Rs. 5. The consumer now has an extra Rs. 5 to spend in buying more of good X and other goods.
This will induce the consumer to buy more of almost every commodity, including the one whose price has fallen. With a higher real income, our representative consumer will want to buy more of both tea and coffee (provided both are normal goods). Thus, in the most usual situation, the income effect will normally reinforce the substitution effect in making the demand curve for a normal good downward sloping.
To sum up, as the price of a commodity falls people may buy more of it for two reasons:
(1) It is cheaper (substitution effect).
(2) The fall in price in effect leaves more income with the consumers to spend (income effect).
The two effects together constitute the price effect or the total effect of price change on the purchase of a commodity. By using indifference curve approach we can distinguish between the magnitude of these effects. The income effect, together with the substitution effect, provides an explanation of why demand curves are usually downward sloping.