Income Effect

Updated on January 29, 2024
Article byAswathi Jayachandran
Reviewed byDheeraj Vaidya, CFA, FRM

What is Income Effect?

The income effect is the change or shift in the level of consumption of goods and services when the purchasing power of consumers changes. This can be due to the fluctuations in the consumer’s income, which changes their consumption patterns which in turn changes the prices of goods.

The demand change for the chosen goods or services depends on the consumer’s purchasing power. If the consumer’s income increases, they tend to purchase more goods and services, provided other things remain constant. Similarly, if income decreases while other things remain constant, the demand also decreases.

Income Effect

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Key Takeaways

  • The definition of income effect in economics states that it is a change in the consumer’s purchasing power as a result of the price changes of the commodity.
  • If a consumer’s income rises, they are more likely to buy more goods and services as long as other factors remain constant.
  • A negative income effect occurs when an increase in the consumer’s income has a negative impact on the items produced. Here, the income and substitution effects are not in the goods’ favor. The positive income effects have a positive impact on the price of goods.

Income Effect Explained

Income effect in economics is stated as the increase or decrease in the consumer’s purchasing power due to the price change. The income effect and substitution effect are part of the demand curve. They are used to explain the negative slope of the demand curve. Income effect in economics is considered in cases of normal goods.

The demand for normal goods rises when the consumer’s income increases. For example, suppose Mr. A buys his favorite fruit- apples for $100($1*100 apples) when his income is $10000. He would continue to buy higher amounts of apples even if the price of the apple increases, provided his income increases. The demand of inferior goods decreases as the income of the consumer increases. In other words, their demand increases as consumer income fall. For example, if a consumer has very little income and cannot afford fresh produce hence will opt for frozen foods or canned products that are cheap. These products are not necessarily healthy, but it helps them survive. So naturally, they will buy healthy, fresh produce when their income increases. Another concept that needs clarity is the income effect vs. substitution effect. They are different effects that may sound similar but are not.

The income effect vs. substitution effect is always a topic of debate even though they are two different concepts. The former is concerned with quantity bought due to price and demand change of the commodity. The substitution effect, on the other hand, is the act of the consumer where they go for other alternatives when the price of one good is increased.

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Graph

Income Effect Graph

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An indifference curve is a point that represents the indifference of a consumer between two goods. The products provide the same utility to the consumers, implying that the consumer has no preference for one brand of goods over another. Here, the X and y-axis represent two goods, and the point where they both meet (Q1 and Q2), along with the price (p1 and p2), is the equilibrium point. When the points of N1 of good Y and L1 of good X (the points where the price touches on either axis) meet, they form an indifference curve along with the equilibrium. This is where the customer buys the product. As income rises, so do the prices of goods, and a shift is seen at point Q2. This shift is known as the income shift.

Example

Let’s take the example of Dan, who earns a salary of $2000 a month. He spends $500 on his favorite drink, “peppy” juice, which is priced at $1 a can. He drinks 500 cans of juice a month and spends 1/4 of his salary on them. Suppose his salary is going to decrease by 50%. And there was an increase in the can’s rate to $2. He can buy 250 cans now for the same $500, which will be 1/2 of his current salary of $1000. For Dan, the juice cans have become unfavorable due to the changes in the price and his income.

Negative Income Effect

A negative income effect is generally seen on normal goods. It means the consumer’s increased income has a negative impact on the goods produced. In normal goods, the demand for the products tends to decrease when the income of the consumer’s decreases and vice versa. Here, the income effect and substitution effect do not work in favor of the goods. If the consumer’s income decreases, it becomes beyond their means, and they stop buying the product. They may substitute the good for a better alternative that suits their preferences. A positive income effect is where there is a positive effect on the product due to the changes in the income of the consumer as the individual’s income rises, also the demand for these goods. The income effect and the substitution effect work in favor of the product. Consumers find it more affordable as the price reduces and their spending power increases. Examples include mobile phones, air conditioners, etc.

Frequently Asked Questions (FAQs)

What are the income effect and substitution effect?

Income effect in economics is the changes in the quantity bought in goods due to the shift in the consumer’s income. The substitution effect, on the other hand, is the phenomenon where the consumer forgoes a good for another alternative of this good when its price rises. 

When is the income effect negative?

It is negative when the demand for the product decreases as the consumer’s income decreases. The income effect and substitution effect work against the goods. Consumers tend not to buy such goods as they feel it’s beyond their capacity to afford.

Can the income effect be negative?

Income effects on goods can be negative when the goods purchased are inferior (including Giffen goods). There is an inverse relationship between the consumer’s income and the quantity demanded here.

Can the income effect be zero?

Income effects on goods can be zero when the nature of the goods is neutral. Here, the quantity demanded by the consumers is fixed.

This has been a guide to Income effect and its definition. Here we discuss how income effect works along with a graph, example and its negative effect. You can learn more from the following articles – 

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