Economics and Business Strategy: Income and Substitution Effects, Return to Scale, and Consumer Equilibrium

This document discusses the concepts of income and substitution effects, return to scale, and consumer equilibrium in economics and business strategy. It explains their importance and applications in the field, and provides examples to help readers understand the concepts better.

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Income and Substitution Effects
Income effect is directly related to change in income of the consumer as income increasing an
individual is able to spend more that means purchasing power increases, whereas substitution
effect is directly related to analyzing the impact of price change and income change on the
consumption patterns of consumer or how income and price change affect the demand of goods
and services in the market (Canto and Wiese 2018). Generally, if income of consumer decreases
their purchasing power decreases as they have less money to spend and if income of consumer
increases this relate to increase in their purchasing power. This effect can be seen on normal and
inferior goods as when income increases demand for inferior goods decreases that shows the
inverse relationship between income and demand. On other side when income increases demand
for normal goods increases because consumer are able to spend more or their purchasing power
increases that create a direct relationship between demand of normal goods and income.
Substitution effect is mainly applicable when consumer replaces cheaper item with more
expensive item because of change in income level. For example; consumer income increases and
price of Apple phone decreases slightly then there might be chances that with that increased
income consumer can afford to buy an IPhone. In this effect all things are related to affordability
even a small drop in price of luxury goods make product attractive to consumers (Baumol and
Blinder 2009).
The importance of this concept is that it helps in understating the impact of price change on
consumer consumption behavior, as if price of good increases then it can be understood that
there are two major impact that is known as substitution and income impact. Firstly, good
become expensive and due to that consumer shift to another substitute that is stated as
substitution effect. Secondly, price increase drop the disposable income of consumer and this

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decreases the purchasing power of individual and at last demand of goods may reduce. So with
the help of income and substitution effect impact of price change on demand and purchasing
power of individual can be understood and forecasting can be done accordingly about demand of
goods and services. Further, understanding substitution and income effect is important because it
gives explanation of law of demand and negative slope of demand curve as substitution effect
can be seen when there is “movement along the demand curve” and income effect gives the
insight of impact of price change on purchasing power of consumers. Thus understanding
income and substitution effect is taken as an important mean to know demand curve and impact
of price change on quantity demanded (McEachern 2009).

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Return to Scale
When all the factors of production in long run are variable and there is no fixed factor of
production due to that scale of production changes and that depend on the quantity change in all
the variable factor of production. In a nutshell, return to scale is considered as the change in
output due to change in variable input in a long run. Further this is divided into three stages,
increasing return to scale, decreasing return to scale and constant return to scale (Hirschey 2009).
Increasing return to a scale is a situation when all the factors of production increased and that
resultant in higher rate of return or output increases at higher rate that means if all the inputs are
doubled than output will be more than doubled. This situation exist for a particular phase as any
addition after a certain point will decrease the return and take it to a saturation point or
economies to scale (Walshaw 2014). Constant return to a scale is a situation when input increase
in the same proportion and due to that increases in output is seen in the same proportion. In a
simple way, “when factor of production like labor and capital are doubled than output will also
be doubled”. This shows a situation when return on scale is constant at a particular situation and
after a point it starts declining. Then starts the diminishing return to scale that is the situation
when increase in output at a given proportion resultant in increase in input but at decreasing rate
such as labor and capital are increases in equal proportion but production increased
comparatively less that is considered as the situation of diminishing return to a scale (Samuelson
and Nordhaus 2016).
The concept of return to scale has great importance for producers mainly for long run as in short
run growth of a firm depend on the marginal product of labor but in long run all the factors of
production are variable and it is important for producer to know that to what extent factor of

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production or output can be increased to attain economies of scale where revenues are more than
the cost or to ensure desired input. In simple words, “return of scale helps the firm to choose a
particular scale of production as it is important to understand whether a firm loses or gains
efficiency in its production processes as it grows in scale”. Furthermore, this is considered as the
law of production that gives explanation on relationship between output employed and input
produced. Thus, for producers it is important to gain insight on the concept of return to scale to
ensure efficiency in its production process and to maintain economies in scale (Shephard 2017).

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Consumer Equilibrium
Consumer equilibrium is a state when a consumer gets high satisfaction from consumption of
goods or services from their income or it is a stage where consumers get satisfied with the price
and they can purchase goods at their present income level. The concept of consumer equilibrium
is related to situation “when consumers make choices about the quantity of goods and services to
consume, it is presumed that their objective is to maximize total utility and in this two factors are
most important price of goods and income of consumer. Consumer equilibrium can be attained
when consumer get maximum utility from the amount spend by them at their present income
level or in a simple words it is decision about how much a consumer should consume to get
maximum satisfaction (Mandy 2017).
Consumer equilibrium can be calculated using marginal utility derived from consumption, for
instance, consumer at a given income level can spend a fixed amount on two goods that is X and
Y and quantity that consumer buy depend on the marginal utility derived from consumption of
these goods. At a particular stage marginal utility from X will decline and become equal to
marginal utility of good Y that is considered as the consumer equilibrium. Consumer equilibrium
is calculated by “the ratio of marginal utility to the price of goods” or at this stage consumer
decide how much to consume of many different products and a combination where consumer
gets higher satisfaction at given budget is considered as consumer equilibrium.
On other side, if marginal utility is greater than the price of goods it indicate consumer
satisfaction from consumption of each unit, this will influence consumer to spend more amount
on purchase of goods and consumer get satisfaction till the marginal utility fall and become equal
to price of goods. This point where marginal utility and price of goods become equal is the

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situation of consumer equilibrium and below that if consumer consumes or spends the marginal
utility become negative or less than the price spend by the consumer this is a rare situation as
consumer stop consumption where he gets maximum or equal satisfaction. The importance of
this concept is that it helps n understanding the consumer choice and factors that consumer
consider while spending hiss money on his needs and interests. Further consumer equilibrium
helps a consumer to best choose the combination where satisfaction derived is more at a given
income level or spending. This combination of commodities is seen in the indifference curve as
this help in choosing the appropriate combination that fits in the budget line so the consumer
equilibrium in case of indifference curves lies on a budget line on the higher indifference curve.
So in a nutshell consumer equilibrium is of greater importance because it helps in understanding
the spending and behavior of consumption of consumer so that maximum satisfaction can be
attained (Amold 2008)

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References
Amold, Roger A. Economics. Australia: Cengage Learning, 2008.
Baumol, William, and Alan Blinder. Economics: Principles and Policy. Australia: South
Western Cengage Learning, 2009.
Canto, Victor A, and Andy Wiese. Economic Disturbances and Equilibrium in an Integrated
Global Economy. UK: Elsevier, 2018.
Hirschey, Mark. Fundamental of Managerial Economics. Australia: Cengage Learning, 2009.
Mandy, David. Producers, Consumers, and Partial Equilibrium. Singapore: Elsevier, 2017.
McEachern, William A. Economics: A contemporary introduction. Australia: Cengage Learning,
2009.
Samuelson, Paul A, and William D Nordhaus. Economics. Singapore: McGraw Hill, 2016.
Shephard, Ronald William. Theory of Cost and Production Functions. New Jersey: PrinceHall,
2017.
Walshaw, Tim. Increasing Return to Scale. Australia: Cengage Learning, 2014.