Free Market and its Self-Correcting System: A glimpse at Income Effect and Substitution Effect (Featuring Zombies)
August 7, 2014
In economics, nothing is more fun than observing words and thought of economists being animated in the real world, in our everyday life. One of the earliest economic concepts I came across was none other than income effect and substitution effect, the two popular terms which every economist is so fond of. They are very simple and easy-to-digest concepts, to be honest.
Income effect basically states that the more you earn or the more income you generate, the more you consume. For example, assuming you really like cake. When you earn $1000/month, you can only buy 1 cake/week. That is the budget cap because you need to spend your money on other necessities like utilities (water, electricity, internet...), healthy food, gas for your car, etc. But once you get promoted to a much much higher position and end up earning $10,000/month? Your entire house rains cake. You might even buy a fridge solely dedicated to storing cake. You will get really fat and have a stroke from all the cake you consume.
Substitution effect, on the other hand, focuses on the change in price and change in consumption pattern, or simply put, the higher the price of a certain product, the more likely you are to consume none or less of them and switch to purchasing their substitutes, if there is any; and the reverse is also true. For example, let's say you are the same person who likes cake to the point that you can die for it, literally. Suddenly, without any warning, World War Z happens. Zombies apocalypse befalls your country (but for some unknown and inexplicable reason, it is a special type of zombies in a way that they are only attracted to cakes and bakers in your country...), and so, all the bakers in your country have been, unfortunately, turned into zombies. And for some other unknown reason, your company is still running and you still get paid $10,000/month (because I say so). Well, the crisis your country faces now is severe cake shortage (Of course, let's just ignore all the zombies that are running around. Who cares?). Wait, I should have mentioned also that every other country puts up huge and impregnable walls, blocking the way of anyone, let alone zombies, that can inflict even the slightest injury on their bakers. So yes, you can still get the cake you love so much by importing it. If you really want to eat cake, you need to talk to the importers who will have to risk their life to import the cake from the neighboring countries. A cake now will costs you $9,000 (I am just making it up on the spot). So you see the point. You will now consume less cake simply because the domestic market price of the cake has risen up so much due to the cake zombies crisis. And that is Substitution Effect.
All the hassles it takes to get cake might then change you into a new person. You might start to develop a new liking to your new cake's substitute, probably, ice-cream. Sadly, this new favorite will not make you get any thinner than your previous cake-loving self. But at least, it has taught you something about economics, to be specific, substitution effect.
So to you, ice-cream is probably a substitute product. Just like how some people see Pepsi as a substitute to Coke or vice-versa.
With the zombies apocalypse crippling the cake market operation, it negatively affects many cake ingredients suppliers such as flour seller, sugar farmer and so forth. This might force some of them out of business, but don't lose hope because the lower demand for sugar in the cake industry will push sugar price down, NOT out of the market, yet. Instead, the economy will re-adjust itself. Lower price of sugar will enable more ice-cream makers to make cheaper ice-cream, and thus, increase the demand for ice-cream and expand ice-cream industry.
At the same time, I forgot to mention earlier that along with substitute products, we also have something called complementary products. Assuming cake is just so expensive, so unaffordable that the whole country is now starting to consume more ice-cream as a replacement and coming to like it. As ice-cream becomes more popular, there are bound to be some products that also tag along in this growth spurt. For example, cookies! Some people like to have their ice-cream with some cookies as their side dish. So when the demand for ice-cream rises, cookies business is also doing great, much better than when people were stuffing their face with cake. In this scenario, cookies represent a complementary product because the demand for cookies and the demand for ice-cream are positively correlated. In other words, when people consume more (or less) ice-cream, they also consume more (or less) cookies.
The interesting part is that even if the economy is to be extensively damaged by zombies invasion (causing unemployment, food shortage...), and everyone could barely earn enough income to survive, there are still people who see this as their opportunity to earn money, and thus, introducing a simple economic solution (without knowing it is one), the production of inferior goods.
Inferior goods are those goods that people need more when they become poorer and less when richer (its example is the entire paragraph below). Normal goods is the opposite. Normal goods are something that you consume more as you get richer and less as you get poorer. For example, movies.
Inferior goods are produced within an industry that seeks its profit from people with low income. With rising food price, due to food shortage (substitution effect) and lower income (income effect), people are now facing starvation. So to meet their desperate need for food, people will pretty much consume anything edible (so do the zombies, I guess... brain?), caring less about the quality of the product. This is when mass production of cheap and low-quality food is hugely rewarding, and those who realize that and dare to follow their ambition to become the richest man in town might start a business that produces inferior goods, for example, instant noodle. People are suffering from zombies attack, the economy crippled, so in time like this, when you can buy your lunch (a pack of instant noodle) for (just an example) $0.25, who wouldn't want it? Assuming the cost to make a pack of noodle is $0.1, so as long as the government doesn't decide to involve itself by, for example, reducing the price even further to, say, $0.09 for a pack of noodle rendering the business unprofitable, then the people can be saved. Believe me, there have been instances that the government did something similar to what I described and ended up starving many people to death (because with $0.09 a pack, no one would be irrational enough to continue producing instant noodle as it might not even cover the cost of doing it).
So what does this tell you about Economics? It tells you about beauty of free market that it allows resource ownership and freedom of choice. Individuals are the one to make their own decision, unlike within a centrally planned economy in which the government or some supreme ruler makes arbitrary decision for the rest of the country (we will discuss more about it in our next article).
Even without much government interference, an economy always has a self-correcting system that allows it to be quite resilient in the face of any foreseen or unforeseen crises. In economics, we have alternative choices; hence, when one door closes, one or many more open. With top-down approach, with too much intervention from the government, there were times when people suffered greatly due to economic hardship (and that is undeniable) as bad economic decisions have led to political turmoil, public outrage, rebellion, war and destruction. Of course, that doesn't mean we need no regulations. Free market is favorable but only with appropriate rules and regulations to level the playing field because sometimes, the self-correcting does not bring us to the state of recovery fast enough (I will talk more about it in our future articles as well). We need people with sufficient knowledge of economics to aid the decision makers. Likewise, we need decision makers who are, at the very least, well-trained in the basics of economics.