What Is the Income Effect?
Let me explain the income effect directly: it's the change in demand for a good or service that happens when your purchasing power or real income increases or decreases. If your income goes up, you'll likely demand more of most things, and the opposite if it drops.
This applies to normal goods, where demand rises with income. But for inferior goods, like generic store-brand products, demand might actually drop as you get wealthier because you switch to pricier name brands.
Understanding the Income Effect
You need to see the income effect as part of consumer choice theory, which connects your preferences to how you spend and what demand curves look like. It shows how shifts in market prices and incomes alter your consumption patterns for goods and services.
The income effect ties in with the substitution effect. The income effect covers how purchasing power changes impact consumption, while the substitution effect looks at how relative price changes make you switch between similar goods.
Real income changes can come from nominal income shifts, price changes, or currency fluctuations. If your nominal income rises without prices changing, you can buy more, and for most goods, you'll do just that.
In deflation, where prices fall but your income stays the same, you can afford more, and you generally will. But when relative prices of goods change, that's when the income effect really influences whether demand for a specific good rises or falls, depending on the good's characteristics.
Normal Goods vs. Inferior Goods
Normal goods are straightforward: their demand increases as your income and purchasing power rise. They have a positive income elasticity of demand, but less than one.
For these, both the income and substitution effects push in the same direction. If the price drops relative to substitutes, you'll buy more because it's cheaper and because you effectively have more buying power overall.
Inferior goods are different; demand for them drops as your real income rises, or increases when income falls. This is because better substitutes become affordable as the economy improves or your situation gets better.
Their income elasticity is negative, and the effects work oppositely. If an inferior good's price rises, you'll buy substitutes but might cut back on other normal goods due to lower real income.
Example of Income Effect
Consider this scenario: you usually buy a cheap cheese sandwich for lunch but sometimes treat yourself to a hot dog. If the cheese sandwich price goes up relative to hot dogs, it might feel like you can't afford the hot dog splurge as often, since your real income for daily items is squeezed.
Here, the income effect overrides the substitution effect, boosting demand for the cheese sandwich and cutting demand for the hot dog, even if the hot dog's price hasn't changed.
The Bottom Line
To wrap this up, the income effect tracks how your demand for goods and services shifts with your income levels. Generally, higher income means more demand, lower means less. We consider marginal propensity to spend and save when analyzing this.
The substitution effect factors in too, especially during income changes. It works as expected for normal goods but reverses for inferior ones.
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