The income effect states that when the price of a good decreases, it is as if the buyer of the good’s income went up. The substitution effect states that when the price of a good decreases, consumers will substitute away from goods that are relatively more expensive to the cheaper good.

The income effect expresses the impact of increased purchasing power on consumption, while the substitution effect describes how consumption is impacted by changing relative income and prices.

The substitution effect This states that an increase in the price of a good will encourage consumers to buy alternative goods. The substitution effect measures how much the higher price encourages consumers to buy different goods, assuming the same level of income.

What is the Substitution Effect? The substitution effect refers to the change in demand for a good as a result of a change in the relative price of the good compared to that of other substitute goods. For example, when the price of a good rises, it becomes more expensive relative to other goods in the market.

The substitution effect is the decrease in sales for a product that can be attributed to consumers switching to cheaper alternatives when its price rises. If a brand raises its price, some consumers will select a cheaper alternative.

In microeconomics, the income effect is the change in demand for a good or service caused by a change in a consumer’s purchasing power resulting from a change in real income.

The income effect is straightforward: as taxes go up, households are poorer and behave that way. For ex- ample, if leisure is a normal good, then higher taxes will induce consumers to consume less leisure. For example, governments often tax consumption of gasoline and profits from sales of capital assets, like houses.

By influencing incentives, taxes can affect both supply and demand factors. Reducing marginal tax rates on wages and salaries, for example, can induce people to work more. Expanding the earned income tax credit can bring more low-skilled workers into the labor force.

Tax cuts increase household demand by increasing workers’ take-home pay. Tax cuts can boost business demand by increasing firms’ after-tax cash flow, which can be used to pay dividends and expand activity, and by making hiring and investing more attractive.

Avoiding tax is avoiding a social obligation. Tax avoidance can make a company vulnerable to accusations of greed and selfishness, damaging its reputation and destroying the public’s trust. Starbucks and Amazon, for example, were vilified and boycotted as a result of their tax policies.