What Is the Income Effect?
Key Takeaways
- The income effect is the change in demand for a good or service created by a change in your income.
- The income effect is also the change in buying power as the price of a good or service falls that makes consumers feel more or less wealthy.
- The substitution effect is when you want to replace, or substitute, a more expensive good with a less expensive one.
- The change in quantity demanded for a good or service depends on both the income effect and substitution effect.
Definition and Examples of the Income Effect
The income effect explains how the demand for a good or service changes when a consumer’s purchasing power changes. Purchasing power refers to what you are able to purchase, and it changes when your real income changes. This is part of consumer choice theory.
For example, if your income goes up by $500 a month, you might decide to put part of that money toward eating out at a restaurant twice a month instead of once a month. Since your income directly rose, and there was an effect on the demand for restaurant meals, this is an example of the income effect.
By contrast, if your favorite restaurant cuts the price of your favorite meal in half, you can suddenly afford to buy it twice as often. Your buying power has risen, even if your income doesn’t change at all. You now feel wealthier and can eat out more than you could afford previously. This is another example of the income effect even though your real income didn’t directly change; your purchasing power did.
note
An economic theory doesn’t predict exactly what any one person will do, but it does describe what behavior is likely overall.
The income effect is important for everyday consumers because it relates to what and how much you can afford to buy. It also relates to the economy as a whole. When legislatures pass new laws that impact household income or taxes, they often look at how the income effect will play out and what this will do to the economy.
How Does the Income Effect Work?
As your income rises, you will likely change how much you spend on different goods and services. A good is considered to be “a normal good” if you buy more of it when your income or buying power increases. A good is considered to be “an inferior good” if you buy less of it when your income or buying power increases.
For example, you may often buy generic cereal at the grocery store because it costs less. But if your income goes up, you might switch to name-brand cereals. In this case, generic cereal would be an inferior good, while name-brand cereal would be a normal good.
The income effect is a direct income effect. This means it is affected by a change in your real income. An indirect income effect occurs when your buying power changes due to factors unrelated to your income that make you feel more or less wealthy.
Some of these factors are:
- Changes in price
- Currency exchange fluctuations
- Supply and demand
For example, a change in the price of a good will alter the effective buying power of your income. Even if your income stays the same, if the price of something that you buy frequently goes down, you can afford to buy more of it. This means your buying power has risen.
By contrast, if the price goes up, you can buy less of it; or if it is something you need to continue purchasing, you may buy the same amount, but decrease how much of something else you purchase.
A direct income effect, however, means you are making more or less money. As a result, you can buy more or less of something.
Income Effect vs. Substitution Effect
The substitution effect is the change in demand for a good or service solely based on its price relative to similar goods. You will likely buy less of something with a relatively higher price and more of a good with a relatively lower price. Essentially, when something becomes more expensive, you’ll look for a less expensive substitute.
The change in demand depends on both the income and substitution effects. Sometimes the income effect and substitution effect predict that the quantity demanded will move in opposite directions. If this is the case, it will depend on which effect is stronger.
For example, as people earn more income, they often demand a higher quantity of leisure time, since leisure is considered to be a normal good. But when your income rises, the opportunity cost for leisure also rises. This means that the more money you can make for every hour of work, the more money you lose out on for every hour spent on a leisure activity.
The substitution effect states that people will want to work more hours because working is now more valuable than leisure. Whether the income effect or substitution effect dominates depends on which effect is bigger.
If the income effect is larger, then as people earn more income, they will choose to work less than before and take more leisure.