Intertemporal Substitution Effect

  

Categories: Econ, Financial Theory

The substitution effect is what happens when something you buy gets too expensive, so you buy a cheaper alternative instead. Similarly, if you had to take a pay cut, you choose less expensive alternatives to compensate for a more expensive version you would’ve bought if you had more money.

Who needs a TV when you can just watch videos on your laptop? Who needs ice cream parlour ice cream when you can buy cheaper ice cream from the grocery store? Who needs (legal) pot from a dispensary when you can just buy the seeds and grow your own grass (again, if it’s legal)?

A more unconventional example: dog-people adopting a cat instead of a dog. Many people grow up with dogs, and feel themselves to be true dog-people. But with crushing student debt and apartment city living, many dog-people want a dog...but find owning a dog too expensive. Dogs take more time (time is money) and more space. Cats are easier to care for, and still make great companions (in their own way), making cats a substitute for dogs among many dog-people.

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Econ: What are Income and Substitution E...8 Views

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And finance Allah shmoop what our income and substitution effects

00:09

Often people seemed set in their ways buying the same

00:12

coffee at the same price every day taking the same

00:15

bus at the same time every day buying you know

00:18

entertainment magazines every day and so on That is until

00:22

prices change or our pay changes like our salaries which

00:26

makes us then do a double take right Well the

00:28

income effect describes how a change in income changes a

00:31

consumer's demands Getting a pay raise increases purchasing power which

00:37

increases demand for goods and services while taking a pay

00:40

cut will lower purchasing power in consumer demand The substitution

00:44

effect describes how people substitute one good for another when

00:47

either prices income changes or a new rival good arrives

00:52

on the market For both the income in substitution effect

00:55

it's common that as income rises inferior goods are replaced

00:59

with normal goods which includes you know fancy luxury goods

01:03

Well inferior goods are goods whose demand decreases when income

01:07

rises Right like people want less of that crappy box

01:11

Rice and more of the freezer frozen expensive good rice

01:14

Normal goods are the opposite Demand increases for them as

01:18

income rises Like if we look att coffee in the

01:21

McDonald's coffee is an inferior good while Starbucks coffee is

01:25

a normal good rights more expensive more lavish more lugs

01:28

for getting a ride to work while busing is an

01:31

inferior service compared to getting a taxi If anyone drives

01:34

those things anymore or anywhere the richer we get the

01:37

more we spend in the more we switch out inferior

01:40

goods for normal goods For instance you're shopping for toilet

01:44

paper Yes we all do Last week's pay raise might

01:46

mean you stock up more on toilet paper like never

01:49

before using it to line your walls of your house

01:52

because well you can mo money mo tp write thie

01:55

income effect is then at work or your pay raise

01:58

might mean you buy the same amount of toilet paper

02:01

as before But you buy the super soft yet super

02:04

sturdy gold lined fancy toilet paper with the talcum powder

02:08

All in it Yes cream oblique soft to go with

02:10

your you know new golden toilet of course because you're

02:13

substituting your inferior toilet and toilet paper with a luxury

02:17

toilet and toilet paper We're looking at the substitution effect

02:21

but hold up Buying a gold toilet in gold lined

02:24

toilet paper because you've got a raise also falls under

02:28

the income effect umbrella since it's a change in your

02:31

consumption caused by a change in your income Yet the

02:34

income effect and substitution of facts can both apply to

02:37

the same situation So let's take a look at a

02:39

price change instead of any income change in this parallel

02:43

universe You did not get a raise Let's say the

02:46

gold lined toilet paper wasn't selling too well on the

02:49

market for some odd reason it kind of itches there

02:52

So it went on mega sale In fact the gold

02:54

lined toilet paper was cheaper than the toilet paper you

02:57

usually buy so you substitute your normal teepee with the

03:00

luxury TP Since your income stayed the same Well there's

03:03

no income effect to be found here and no gold

03:06

toilets Unfortunately this is another example of the substitution effect

03:10

at work Your favorite wine is a nice Napa Valley

03:13

cab cabernet there that usually retails for fifty bucks a

03:17

bottle Unfortunately California's hit by yet another set of wildfires

03:21

and half the inventory of your favorite wine is destroyed

03:24

prices skyrocket was fifty bucks a bottle Now it's one

03:28

hundred more than you're willing to pay for a bottle

03:31

of hooch So you switch to two buck chuck until

03:34

prices get back to normal So to recap the income

03:37

effect is changes in consumption based on changes in your

03:40

income More money more buying power which means greater demand

03:43

in the consumer market less money less buying power which

03:46

means lower demand in the market Whether the quantity or

03:49

quality of what you're buying changes doesn't make a whole

03:51

lot of difference is just a change in how much

03:54

you're spending We're talking about here Well the substitution effect

03:57

is when you switch out one good for another whether

03:59

from an income change or a price Change more money

04:02

or slashed prices while time to trade up less money

04:05

or prices than rose Well time to trade down And

04:09

then you get laid off from your job and have

04:11

to take a gig working at a call centre for

04:14

half your previous salary The dark side of the income

04:17

effect No more gold lined toilet paper for Gyu Instead

04:21

you're stealing TP from the bathroom at McDonald's trade in

04:24

that Cadillac you releasing Switch to a line scooter instead

04:28

Also no more sushi lunches Instead Gore buying canned tuna

04:32

in bulk at Walmart for ninety nine cents a serving

04:34

and brown bagging homemade tuna salad sandwiches toe work and

04:38

forget the weekly massages at the spa Yeah Instead you're

04:42

plunking quarters into the massage chair they have at the

04:45

malls here So good luck with that Yeah So those

04:47

are income and substitution effects there Yeah Pretty sexy or 00:04:52.519 --> [endTime] not What

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