In microeconomics, the income effect is the shift in demand for a commodity or service produced by a shift in a consumer’s purchasing power as a result of a shift in real income. This can be due to an increase in pay or because existing income is freed up due to a fall or increase in the price of a product on which money is spent.
The income effect is a concept in consumer choice theory that describes how changes in relative market prices and incomes affect consumer spending patterns. When real consumer income rises, customers will desire a larger number of items to buy.
The Income Effect: An Overview
In consumer choice theory, the income impact and the substitution effect are two related economic concepts. The income effect describes how a change in relative prices can change the pattern of consumption of related goods that can substitute for one another, whereas 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.
Nominal income changes, price changes, and currency fluctuations can all cause changes in real income. When nominal income rises without a change in pricing, consumers can buy more things for the same price, and consumers will want more for most goods.
When all prices decline (deflation) and nominal income remains constant, consumers’ nominal money can be used to buy more items, which they usually do. Both of these situations are relatively simple.
However, as the relative prices of different items vary, the purchasing power of a consumer’s income relative to each good changes as well—this is when the income impact truly kicks in. The features of the good have an impact on whether the income effect causes demand for the good to rise or fall.
Normal Goods vs. Inferior Goods
The demand for ordinary products rises as people’s earnings and purchasing power rise. A normal good is characterized as having a positive but less than one income elasticity of demand coefficient.
The income and substitution effects both work in the same direction for normal goods; a decrease in the relative price of the good will increase quantity demanded both because the good is now cheaper than substitute goods and because the lower price means that consumers have more total purchasing power and can increase their overall consumption.
Consumer demand for inferior items decreases as actual incomes grow, or increases as incomes fall. When a good has more expensive substitutes, demand for the good rises as society’s economy improves. The income elasticity of demand is negative for inferior items, and the income and substitution effects operate in opposite directions.
Because of their lower real income, consumers will want to buy other substitute goods instead of the inferior commodity. They will also wish to consume less of any other substitute normal products.
Inferior goods, such as generic bologna or coarse, scratchy toilet paper, are things that are perceived as poorer quality yet can get the job done for individuals on a short budget. Consumers demand a higher-quality product, but they must have a higher income to afford it.
Income Effect Example
Consider a customer who buys an inexpensive cheese sandwich for lunch at work on a regular basis but occasionally splurges on a sumptuous hot dog. If the price of a cheese sandwich rises in comparison to the price of a hotdog, they may feel unable to splurge on a hotdog as frequently because the greater price of their everyday cheese sandwich reduces their real income.
In this case, the income effect outweighs the replacement effect, and a price increase for the cheese sandwich increases demand while decreasing demand for a substitute typical good, a hotdog, even though the hotdog’s price remains same.
What Does the Income Effect Depict?
The income effect is a concept in consumer choice theory that describes how changes in relative market prices and incomes affect consumer spending patterns. In other words, a change in a consumer’s purchasing power as a result of a change in real income causes a change in demand for a good or service.
This can be due to an increase in pay or because existing income is freed up due to a fall or increase in the price of a product on which money is spent.
What Does the Substitution Effect Mean?
When a product’s price rises, the substitution effect causes buyers to switch to cheaper alternatives, resulting in a loss in sales. A product’s market share may be lost for a variety of causes, but the substitution effect is only due to frugality. Some customers will choose a cheaper option if a company raises its pricing.
What exactly are normal goods?
The demand for ordinary products rises as people’s earnings and purchasing power rise. As a result, a normal good’s income elasticity of demand coefficient will be positive, but smaller than one.
This indicates that a fall in the relative price of the good will lead to an increase in the amount demanded, both because the commodity is now cheaper than substitute goods and because the lower price means customers have more total purchasing power and can raise their overall consumption.
What Are Inferior Goods?
Consumer demand for inferior items decreases as actual incomes grow, or increases as incomes fall. When a good has more expensive substitutes, demand for the good rises as society’s economy improves. The income elasticity of demand is negative for inferior items, and the income and substitution effects operate in opposite directions.
