Definition of income effect


What is the income effect?

The income effect in microeconomics 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. This change may be the result of an increase in wages, etc., or because existing income is released by a decrease or increase in the price of a good for which the money is spent.

Key points to remember

  • The income effect describes how a change in the price of a good can change the amount that consumers will demand of that good and related goods, depending on how the change in price affects their actual income.
  • The change in quantity demanded resulting from a change in the price of a good may vary depending on the interaction of income and substitution effects.
  • For lower quality goods, the income effect dominates the substitution effect and leads consumers to buy more goods and less substitute goods when the price increases.

Understanding the effect of income

The income effect is part of consumer choice theory, which relates preferences to consumer spending and consumer demand curves, which expresses the impact of changes in relative market prices and incomes on patterns of consumption of consumer goods and services. For normal economic goods, when consumers’ real income increases, consumers will demand more goods to buy.

The income effect and the substitution effect are related economic concepts in consumer choice theory. The income effect expresses the impact of changes in purchasing power on consumption, while the substitution effect describes how a change in relative prices can change the pattern of consumption of related goods that can substitute for each other.

Changes in real income may be the result of changes in nominal income, price changes or currency fluctuations. When nominal income increases without any price change, it means consumers can buy more goods at the same price, and for most goods consumers will demand more.

If all prices fall, which is called deflation, and nominal income stays the same, then the consumer’s nominal income can buy more goods, and usually will. These are two relatively simple cases. However, in addition, when the relative prices of different goods change, then the purchasing power of the consumer’s income relative to each good changes — then the income effect really kicks in. The characteristics of the good have an impact, which the income effect translates into a rise or fall in demand for the good.

When the price of a product increases relative to other similar products, consumers will tend to demand less of that product and increase their demand for the like product as a substitute.

Normal goods vs inferior goods

Normal goods are those whose demand increases as people’s incomes and purchasing power increase. A normal good is defined as having a coefficient of elasticity-income of demand that is positive, but less than one.

For normal goods, the income effect and the substitution effect both work in the same direction; a decrease in the relative price of the good will increase the quantity demanded both because the good is now cheaper than the substitute goods, and because the lower price means that consumers have greater total purchasing power and can increase their overall consumption.

Inferior goods are goods for which demand decreases as consumers’ real incomes increase, or increases as incomes decrease. This happens when a good has more expensive substitutes that see an increase in demand as the economy of the company improves. For lower quality goods, the income elasticity of demand is negative, and the income and substitution effects work in opposite directions.

An increase in the price of the lower good means that consumers will want to buy other substitute goods instead, but will also want to consume less of any other normal substitute good because of their lower real income.

Lower quality products tend to be considered lower quality, but can do the job for those on a tight budget, for example, generic bologna or coarse, rough toilet paper. Consumers prefer better quality good, but need more income to enable them to pay the full price.

Example of income effect

Take the example of a consumer who, on the average, buys an inexpensive cheese sandwich for lunch at work, but sometimes splurges on a luxury hot dog. If the price of a cheese sandwich goes up relative to hot dogs, it can make them feel like they can’t afford to splurge on a hot dog as often because the higher price of their daily cheese sandwich decreases their real income.

In this situation, the income effect dominates the substitution effect, and the price increase increases the demand for the cheese sandwich and reduces the demand for a normal substitute, a hot dog, even though the price of the hot dog remains the same.

What does the income effect represent?

The income effect is part of consumer choice theory, which relates preferences to consumer spending and consumer demand curves, which expresses the impact of changes in relative market prices and incomes on consumption patterns consumer goods and services. In other words, it 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. This change may be the result of an increase in wages, etc., or because existing income is released by a decrease or increase in the price of a good for which the money is spent.

What is the substitution effect?

The substitution effect is the decrease in sales of a product which can be attributed to consumers turning to cheaper alternatives when its price increases. A product can lose market share for many reasons, but the substitution effect is purely a reflection of frugality. If a brand increases its price, some consumers will choose a cheaper alternative.

What is a normal good?

Normal goods are those whose demand increases as people’s incomes and purchasing power increase. As such, a normal good will have a positive elasticity-income coefficient of demand, but it will be less than one. This means that a decrease in the relative price of the good will lead to an increase in the quantity demanded both because the good is now cheaper than the substitute goods, and because the lower price means that consumers have greater power. total purchase and may increase their consumption.

What are the inferior goods?

Inferior goods are goods for which demand decreases as consumers’ real incomes increase, or increases as incomes decrease. This happens when a good has more expensive substitutes that see an increase in demand as the company’s economy improves. For lower quality goods, the income elasticity of demand is negative, and the income and substitution effects work in opposite directions.


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