Definition and Examples of the Income Effect
The income effect is a change in the demand for a good or service due to a change in the consumer’s purchasing power, which in turn is caused by a change in the consumer’s real income. It is part of the theory of consumer economic choice that concerns how wealthier consumers behave.
How Does the Income Effect Work?
As your income increases, you are likely to change the amount you spend on different goods and services. A good is considered a “normal good” if you buy more of it when your income or purchasing power increases. A good is considered an “inferior good” if you buy less of it when your income or purchasing power increases.
The Income Effect vs. The Substitution Effect
The substitution effect is a change in the demand for a good or service that depends solely on its price compared to similar goods. You are likely to buy less of something that has a relatively higher price and more of something that has a relatively lower price. The change in demand depends on both the income effect and the substitution effect. Sometimes, the income effect and the substitution effect predict that the quantity demanded will move in opposite directions. If that is the case, it will depend on which effect is stronger.
Sources:
– Iowa State University Department of Economics.
– Congressional Budget Office.
– Steven A. Greenlaw and David Shapiro.
Source: https://www.thebalancemoney.com/income-effect-5216807
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