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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 (or soaked up) by a decrease (or increase) in the price of a good that money is being spent on.

BREAKING DOWN 'Income Effect'

The income effect and substitution effect are economic concepts in consumer choice theory – which relates preferences to consumption expenditures and consumer demand curves — that express how changes in relative market prices and incomes impact consumption patterns for consumer goods and services. The income effect expresses the impact of changes in purchasing power on consumption, while the substitution effect describes how consumption is impacted by changes in relative prices.

The Income Effect

Changes in purchasing power can result from income changes, price changes or currency fluctuations. Price decreases increase purchasing power, allowing a consumer to buy a better product or more of the same product for the same price. However, different goods and services experience these changes in different ways.

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. Inferior goods are goods for which demand declines as consumers real incomes rise. This occurs when a good has more costly substitutes that see an increase in demand as the society's economy improves.

The income effect results in consumers spending more or less in general and does not necessarily indicate that they will buy higher or lower value goods. For example, if the price of a sandwich increases relative to a consumer's discretionary income, it may make them feel like they cannot afford other similar goods, which might even reduce demand for a substitute, like a hotdog, even if the hotdog's price remains the same. A consumer may opt to purchase more expensive goods in lesser quantities or cheaper goods in higher quantities. Or they might choose to take more vacations.

A concept called marginal propensity to consume explains how consumers spend based on income. It is based on the balance between the spending versus saving habits of the consumer. Marginal propensity to consume is included in a larger theory of macroeconomics known as Keynesian economics. The theory draws comparisons between production, individual income and the tendency to spend more of it. For example, rising incomes may increase the amount consumers are willing to pay for a good, leading causing prices to rise.

The Substitution Effect

The substitution effect describes how consumption patterns may change when real incomes change or there is a change in relative prices. Consumers may seek lower cost alternatives, when the price of a good or service increases, or if their income falls, so they can maintain their lifestyle. Alternatively, if their real income rises, they may buy more expensive goods. A modest reduction in the price of an expensive good relative to other goods, may cause consumers to switch up to the higher quality product.

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