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.