What Is the Income Effect?

Learn about this topic in these articles:

individual income tax

  • In income tax: Rationale for taxation In income tax: Rationale for taxation

    …established standard of living (the income effect). To the extent that the tax reduces the reward for an extra hour’s work, it may make the taxpayer decide to work less and to indulge in more leisure (the substitution effect); presumably, the larger the income and the more steeply progressive the…

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utility and value

  • In utility and value: Income and substitution effe In utility and value: Income and substitution effects

    …purchasing power is called the income effect of the price change. Its effect via the relative price change is called the substitution effect. The division can be carried out graphically as follows: let the price of X increase so that the price line in Figure 7 moves from PP′ to…

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Income Effect

The income effect is the change in the consumption of goods based on income. This means consumers will generally spend more if they experience an increase in income. They may spend less if their income drops.

The effect doesn't dictate the kinds of goods consumers will buy. They may opt to purchase more expensive goods in lesser quantities or cheaper goods in higher quantities, depending on their circumstances and preferences.

The income effect can be both direct or indirect. When a consumer chooses to make changes to the way they spend because of a change in income, the income effect is said to be direct. For example, a consumer may choose to spend less on clothing because their income has dropped.

An income effect becomes indirect when a consumer is faced with making buying choices because of factors not related to their income. For instance, food prices may go up, leaving the consumer with less income to spend on other items. This may force them to cut back on dining out, resulting in an indirect income effect.

The marginal propensity to consume explains how consumers spend based on income. It is a concept based on the balance between the spending and saving habits of consumers.

The marginal propensity to consume is included in a larger theory of macroeconomics known as Keynesian economics. The theory draws comparisons between production, individual income, and the tendency to spend more of it.

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What Is Substitution Effect?

The substitution effect is the decrease in sales for a product that can be attributed to consumers switching to cheaper alternatives when its price rises. A product may lose market share for many reasons, but the substitution effect is purely a reflection of frugality. If a brand raises its price, some consumers will select a cheaper alternative.

How Does the Income Effect Work?

As your income rises, you likely will 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 Examples

Example #1 – Higher disposable income, higher demand

Let us say that Mr. Bloggs travels to work each day and, on his journey, he buys a bagel for $3 from the local cart. After many years of going to the same cart, it is struggling for business, so reduces its prices to attract more custom. Mr. Bloggs is now paying $1.50 for the same bagel he used to purchase. This now saves him $1.50. With the newfound disposable income, he now purchases two bagels instead, thereby increasing demand.

Example #2 – Lower disposable income, lower demand

Let us say Miss Jones goes out with her friends to eat at a local restaurant three times a week – costing her $30, at $10 a visit. The restaurant is doing well and is busy every day, so increases its prices. In turn, the cost to Miss Jones to visit the local restaurant increases to $15 a visit. Therefore, the initial $30 she spent on three visits will only be able to afford her two. We then see Miss Jones cut back on her restaurant visits as a result of the lower level of disposable income she has – thereby reducing demand.

Example #3 – Increase in disposable income, higher demand

Mr Ryan is on a wage of $30,000 a year and buys $20,000 worth of goods. After tax and his expenditures, he is only left with $1,000 which he saves each year. He has been working hard all year and his manager decides to give him a promotion which takes his pay up to $35,000 a year – which increases his disposable income by around $3,000 after tax. He then has that money to spend on a number of goods such as video games or a new jumper.

What Occurs Simultaneously With an Income Effect?

The income effect involves a change in purchasing power and a change in demand or consumption. So, for instance, if purchasing power decreases, demand for a product usually decreases.

General FAQs on the Income Effect

What does income effect mean?

The income effect is where a change in disposable income affects the demand for the good. For instance, a price cut will give customers more disposable income by which they may look to actually buy more.

What is an example of income effect?

If Starbucks reduces the price of its coffee by 20 percent, it will give its loyal customers a boost in disposable income. In turn they may visit the store more often.

What does positive income effect mean? A positive income effect is where consumers disposable income has increased, so they start to demand more goods and services.

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