Economics

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 the purchasing power of consumers due to a change in real income. This change may be the result of rising wages, etc., or it may be due to the release of existing income due to a fall or rise in the price of goods spent.

key takeaways

  • The income effect describes how a change in the price of a good changes the quantity consumers demand for that good and related goods, based on how the change in price affects their real income.
  • Changes in quantity demanded due to changes in commodity prices may vary due to the interaction of income and substitution effects.
  • For inferior goods, the income effect dominates the substitution effect, causing consumers to buy more of the goods and less substitutes when prices rise.

Understanding the income effect

The income effect is part of the theory of consumer choice – which links preferences to consumer spending and consumer demand curves – and it expresses how changes in relative market prices and income affect consumption patterns of consumer goods and services. For normal economic goods, when real consumer income increases, consumers buy more goods.

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

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

If all prices fall, called deflation, and nominal income stays the same, consumers can buy more with their nominal income, which they usually do. These are relatively simple cases. But beyond that, when the relative prices of different goods change, so does the purchasing power of consumer income relative to each good—the income effect really kicks in. The characteristics of the commodity affect whether the income effect causes the demand for the commodity to rise or fall.

When the price of a product increases relative to other similar products, consumers tend to reduce their demand for that product and increase their demand for similar products as substitutes.

Ordinary goods and inferior goods

Ordinary goods are goods that increase in demand as people’s income and purchasing power increase. A normal good is defined as an income elasticity of demand that is positive but less than 1.

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

Inferior goods are goods for which demand falls as consumers’ real income rises or increases as income falls. This happens when a commodity has a more expensive alternative, and as the economy improves, so does the demand. For inferior goods, the income elasticity of demand is negative, and the income and substitution effects are opposite.

A rise in the price of inferior goods means that consumers will want to buy other substitutes, but since their real income is lower, they will also want to reduce their consumption of any other substitute for normal goods.

Poor quality items tend to be those that are seen as lower quality but can get the job done for someone on a tight budget, such as regular bologna or rough, itchy toilet paper. Consumers prefer higher quality goods but need higher incomes to pay the premium.

example of income effect

Consider a consumer who usually buys cheap cheese sandwiches for lunch at work, but occasionally splurges on luxurious hot dogs. If the price of cheese sandwiches rises relative to hot dogs, it may make them feel like they can’t afford to splurge on hot dogs so often, as the higher price of their everyday cheese sandwiches reduces their real income.

In this case, the income effect dominates the substitution effect, and rising prices raise demand for cheese sandwiches and reduce demand for the substitute hot dog, even though the price of the hot dog remains the same.

What does the income effect describe?

The income effect is part of the theory of consumer choice – which links preferences to consumer spending and consumer demand curves – and it expresses how changes in relative market prices and income affect consumption patterns of consumer goods and services. In other words, it is a change in demand for a good or service caused by a change in the purchasing power of consumers caused by a change in real income. This change may be the result of rising wages, etc., or it may be due to the release of existing income due to a fall or rise in the price of goods spent.

What is the substitution effect?

The substitution effect is a decline in sales of a product that can be attributed to consumers switching to cheaper alternatives when prices increase. A product can lose market share for a number of reasons, but the substitution effect is pure frugality. If a brand raises prices, some consumers will opt for cheaper alternatives.

What is a general commodity?

Ordinary goods are goods that increase in demand as people’s income and purchasing power increase. Therefore, the income elasticity of the demand coefficient for normal goods is positive, but less than 1. 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 good, and because the lower price means that consumers have more aggregate purchasing power and can increase their overall purchasing power. Consumption.

What are inferior goods?

Inferior goods are goods for which demand falls as consumers’ real income rises or increases as income falls. This happens when a commodity has a more expensive alternative, and as the economy improves, so does demand. For inferior goods, the income elasticity of demand is negative, and the income and substitution effects are opposite.

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