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 can be the result of a rise in wages etc., or because existing income is freed up by a decrease or increase in the price of a good that money is being spent on.
- The income effect describes how the change in the price of a good can change the quantity that consumers will demand of that good and related goods, based on how the price change affects their real income.
- The change in the quantity demanded resulting from a change in price of a good can vary depending on the interaction of the income and substitution effects.
- For inferior goods, the income effect dominates the substitution effect and leads consumers to purchase more of a good, and less of substitute goods, when the price rises.
Understanding Income Effect
The income effect is a part of consumer choice theory—which relates preferences to consumption expenditures and consumer demand curves—that expresses how changes in relative market prices and incomes impact consumption patterns for consumer goods and services. For normal economic goods, when real consumer income rises, consumers will demand a greater quantity of goods for purchase.
The Substitution Effect
The income effect and 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 one another. When the price of a good increases relative to other similar goods, consumers will tend to demand less of that good and increase their demand for the similar goods to substitute.
The Income Effect and Changes in Demand
Changes in real income can result from nominal income changes, price changes, or currency fluctuations. When nominal income increases without any change to prices, this makes consumers able to purchase more goods at the same price, and for most goods consumers will demand more.
If all prices fall, known as deflation and nominal income remains the same, then consumer’s nominal income can purchase more goods, and they will generally do so. These are both relatively straightforward cases. However in addition, when the relative prices of different goods change, then the purchasing power of consumer’s income relative to each good changes and the income effect really comes into play. The characteristics of the good will impact whether income effect results in a rise or fall in demand for the good.
Normal goods are those whose demand increases as people's incomes and purchasing power rise. A normal good is defined as having an income elasticity of demand coefficient 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 result in an increase in quantity demanded both because the good is now cheaper than substitute goods and because the lower price means that consumers have a greater total purchasing power and can increase their overall consumption.
Inferior goods are goods for which demand declines as consumers real incomes rise, or rises as incomes fall. This occurs when a good has more costly substitutes that see an increase in demand as the society's economy improves. For inferior goods, income elasticity of demand is negative, and the income and substitution effects work in opposite directions. An increase in the inferior good’s price means that consumers will want to purchase other substitute goods instead but will also want to consume less of any other substitute normal goods because of their lower real income.
Inferior goods tend to be goods that are viewed as lower quality, but can get the job done for those on a tight budget, for example generic bologna or coarse, scratchy toilet paper. Consumers prefer a higher quality good, but need a greater income to allow them to pay the premium price.
Example of Income Effect
For example, consider a consumer who on an average day buys a cheap cheese sandwich to eat for lunch at work, but occasionally splurges on a luxurious hot dog. If the price of a cheese sandwich increases relative to hotdogs, it may make them feel like they cannot afford to splurge on a hotdog as often because the higher price of their everyday cheese sandwich decreases their real income.
In this situation, the income effect dominates the substitution effect, and the price increase raises demand for the cheese sandwich and reduces demand for a substitute normal good, a hotdog, even if the hotdog's price remains the same.