Loading the player...

What is the 'Income Effect'

The income effect represents the change in an individual's or economy's income and shows how that change impacts the quantity demanded of a good or service. The relationship between income and quantity demanded is a positive one; as income increases, so does the quantity of goods and services demanded. For example, when an individual's income increases, that person demands more goods and services, thus increasing consumption, all things equal.

BREAKING DOWN 'Income Effect'

The income effect is the change in demand of a good or service brought on by a change in a consumer's discretionary income. The income effect can be observed under two scenarios: if a person's aggregate level of income increases or if the relative price of goods decreases. Both situations increase the amount of discretionary income available.

The Income Effect on a Single Good

If, for example, a consumer spends 50% of his paycheck on bread and the average price of bread decreases, he has more free capital to spend on the food, increasing its demand. Conversely, if the price of bread remains the same but the consumer receives a pay raise that increases his discretionary income, he is able to purchase more food and increase its demand.

The income effect can also increase average prices. If a consumer is willing to spend $1 on a hot dog at his current income level, any increase in discretionary income can increase that consumer's willingness to spend more money on the same hot dog. The degree to which a person or economy spends more of its income on consumption is called the marginal propensity to consume (MPC). The MPC depends on the individual's or economy's saving characteristics.

The Income Effect on Two or More Goods

The income effect can also impact two or more goods, even if they seem unrelated. When the price of a sandwich increases relative to a consumer's discretionary income, it makes him feel like he cannot afford other similar goods. Even if the price of a substitute good, such as a hotdog, remains the same, consumers may be psychologically inclined to decrease demand and consumption of both goods.

The Income Effect on Luxury Goods and Inferior Goods

The income effect also impacts luxury goods and inferior goods. Luxury goods are items, such as boats, that have a positive correlation between demand and income. Inferior goods, such as bus passes, are goods that increase in demand when income decreases. It is easy to see that any increase in discretionary income increases the aggregate demand for luxury goods and decreases the aggregate demand for inferior goods, and vice versa.

RELATED TERMS
  1. Normal Good

    An economic term used to describe the quantity demanded for a ...
  2. Income Elasticity Of Demand

    A measure of the relationship between a change in the quantity ...
  3. Discretionary Income

    The amount of an individual's income that is left for spending, ...
  4. Substitution Effect

    The idea that as prices rise (or incomes decrease) consumers ...
  5. Inferior Good

    A type of good for which demand declines as the level of income ...
  6. Income

    Money that an individual or business receives in exchange for ...
Related Articles
  1. Investing

    What is the Income Effect?

    In economics, the income effect is the change in the consumption of goods caused by a change in income, whether income goes up or down.
  2. Investing

    What is Discretionary Income?

    Discretionary income is an economic term referring to income left over after a person pays taxes and living expenses.
  3. Insights

    Calculating Income Elasticity of Demand

    Income elasticity of demand is a measure of how consumer demand changes when income changes.
  4. Insights

    What is Demand?

    Demand is the economic term for the cumulative wants and desires of consumers as they relate to a particular good or service. Generally speaking, if all other factors remain constant, as demand ...
  5. Personal Finance

    All About Income

    Income is the money you or a business earns by providing goods or services, or through investments.
  6. Insights

    Explaining Marginal Propensity to Consume

    The marginal propensity to consume is a measure of how much consumption changes when income changes.
  7. Insights

    What's Aggregate Demand?

    Aggregate demand is a macroeconomic term describing the total demand in an economy for all goods and services at any given price level in a given time period.
  8. Insights

    Understanding the Substitution Effect

    The substitution effect is an economic term used to describe consumer behavior relative to price or income changes.
  9. Investing

    Understanding the Income Statement

    The best way to analyze a company—and figure out if it's worth investing in—is to know how to dissect its income statement. Here's how to do it.
RELATED FAQS
  1. What's the difference between the income effect and the substitution effect?

    Learn more about the income effect and substitution effect in economics. Find out how these two principles impact consumer ... Read Answer >>
  2. Is there a way to invest in the income effect?

    Learn how to invest in the income effect. Explore the possible sectors where the income effect results in higher earnings ... Read Answer >>
  3. How do you calculate the income effect distinctly from the price effect?

    Learn more about how the income and substitution effects operate in economics. Find out how to separate either of these while ... Read Answer >>
  4. What's the difference between the substitution effect and price effect?

    Learn how the increase in an item's price affects consumer demand. Explore the differences between the substitution and price ... Read Answer >>
  5. Why do economists think it is important to track discretionary income?

    Learn about the importance of discretionary income to economists, particularly for economists who emphasize consumer spending ... Read Answer >>
  6. What is the difference between disposable income and discretionary income?

    Learn about disposable and discretionary income, including why these measures are important, the main difference between ... Read Answer >>
Hot Definitions
  1. Graduate Management Admission Test - GMAT

    A standardized test intended to measure a test taker's aptitude in mathematics and the English language. The GMAT is most ...
  2. Magna Cum Laude

    An academic level of distinction used by educational institutions to signify an academic degree which was received "with ...
  3. Cover Letter

    A written document submitted with a job application explaining the applicant's credentials and interest in the open position. ...
  4. 403(b) Plan

    A retirement plan for certain employees of public schools, tax-exempt organizations and certain ministers. Generally, retirement ...
  5. Master Of Business Administration - MBA

    A graduate degree achieved at a university or college that provides theoretical and practical training to help graduates ...
  6. Liquidity Event

    An event that allows initial investors in a company to cash out some or all of their ownership shares and is considered an ...
Trading Center