What is the Income Effect?

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Definition:

The income effect explains how changes in income impact the levels of consumption of goods and services.

🤔 Understanding the income effect

The income effect is an economic theory that describes how consumption of a good or service adjusts with changes in income. It also explains how changes in the price of a good or service impacts consumers’ discretionary income (money left after taxes and spending on necessities, like housing). Generally, as someone’s income increases, they spend more on goods and services, increasing consumption. There are some exceptions, such as inferior goods, where higher income typically reduces demand. Similarly, an increase in the price of a product will often lead to consumers having less disposable income, reducing their consumption of other goods.

Takeaway

The income effect is like having money burning a hole in your pocket…

Sometimes, when you have some extra cash, it can be tempting to spend it instead of saving it. The income effect theory argues that this is a widespread phenomenon and that consumption tends to increase as people have more money available. Similarly, consumption usually decreases when people make less.

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What is the income effect?

The income effect is an economic theory that helps describe how changes in income or changes in the prices of goods affects the demand for a product.

According to the income effect, if someone’s income increases, he or she now has more discretionary income to use when buying goods. Therefore, the increased income should lead to increased demand for most products and services.

Similarly, if a product that someone typically buys falls in price, that person no longer has to spend as much money on that item. That leaves him or her with more money to spend on other things, increasing the demand for goods.

Falling income or rising prices have the opposite effect, reducing demand.

There are some exceptions to the income effect. For example, the demand for inferior goods will typically drop when someone’s income rises because that person no longer has to settle for a lower-quality product. Someone who purchases one-ply toilet paper out of necessity likely won’t increase his or her consumption of one-ply toilet paper when they begin to earn more. Instead, they will probably purchase higher-quality toilet paper.

What are examples of the income effect?

Economists often use the income effect to compare the changes in demand for two different products or services based on a change in real income. They create an income-demand curve that shows the level of demand based on income.

For example, suppose Jane enjoys both video games and movies. A trip to the movies costs $15 while a new video game costs $60. Jane has $150 to spend on video games and movies each month.

Jane could budget her money in a variety of ways. For example, she could see 10 movies and buy zero games, watch two movies and buy two games, or watch six movies and buy one game.

If Jane’s income increases, she could increase her entertainment budget to $300 per month. This increases her income, giving her the freedom to see 20 movies a month, buy five games per month, or any mixture of the two.

If her income decreases, she may have to restrict her entertainment spending to just $60 per month, letting her see only four movies or buy one game.

How Jane will allocate her spending depends on her personal preferences. For example, Jane may like video games more than movies. However, she buys movie tickets because her limited income only lets her buy a game or two each month. If her income increases, she may increase her consumption of games and decrease the number of movies she sees because she views movies as an inferior good.

How does the income effect create changes in demand?

The income effect creates changes in demand by giving people more money to spend. In theory, people seek to maximize the utility, or value, that they get from their money. Once people pay for necessities like housing and food, any remaining money can be used for leisure goods. Based on different consumer preferences, leisure goods provide different levels of utility.

Generally, consuming more of a good produces more utility. For example, if someone enjoys buying one book, that person will probably derive more enjoyment from two books, three books, five books, or even 10 books. Eventually, the law of diminishing marginal utility argues that additional consumption won’t provide additional utility.

However, there is a huge variety of goods and services that people can purchase, which helps them avoid the effect of diminishing marginal utility. For example, someone seeking entertainment may purchase books, movies, video games, comics, DVDs, sports tickets, concert tickets, hotel stays, or any other number of entertaining things. Someone who enjoys food can spend money at restaurants, on delivery food, high-quality groceries, and so on. Someone can reduce the effect of the diminishing marginal utility of one product by purchasing any of several similar ones.

Because people want to maximize the value they get, they will tend to increase their consumption of the things they enjoy when they have more money available to spend.

What is the negative income effect?

The negative income effect describes a scenario where demand for a product falls even when a consumer’s income increases.

Some people may purchase an inferior product out of need or because they do not make enough money to purchase a sufficient quantity of a higher-quality product.

For example, someone who enjoys cheese may purchase store-brand cheddar cheese because of his or her limited income available for spending on cheese. If that person gets a new job that pays more, he or she might be able to start purchasing different types of cheese from a specialty cheese store. Instead of spending money on the lower-quality cheddar from the grocery store, that person will focus their spending on high-quality specialty cheese.

Despite the increase in income, demand for the store-brand cheddar decreases because it is an inferior good.

Another example of the negative income effect is methods of travel. Someone who does not have much money may have to commute to work using the subway or a bus. Someone with a higher level of income may purchase a car and drive to work. That person’s demand for goods like gas will increase, while his or her demand for public transportation drops.

What is the difference between income effect and substitution effect?

The substitution effect is an economic theory that argues that as the price of a good or service increases, people will increase their demand for cheaper alternatives. For example, if the price of beef rises, consumers may purchase more pork or chicken because it is a cheaper meat.

The income effect describes how a change in a consumer’s purchasing power changes their demand for products. Generally, higher levels of purchasing power lead to higher demand and more demand for high-quality goods. Increases in purchasing power can come from increased income or from decreased prices for goods. Decreases come from falling income or increased prices.

The two effects are highly related. Changing prices can lead to both effects, as higher prices for a product can cause consumers to substitute a cheaper alternative and reduce their demand. A major difference is that the substitution effect describes how the demand for alternative products changes, while the income effect mainly describes changes in demand for the originally desired goods.

What is the price effect?

The price effect is an economic theory that describes the change in demand for a good when its price changes. While the income effect describes how changes in income affect demand, and the substitution effect describes how price changes affect demand for alternatives, the price effect concerns the change in demand for the product that experiences a price change.

Typically, as the price of a good or service increases, demand for it will fall. As prices fall demand increases.

The price effect is related to the law of supply and demand. Typically, when prices fall, demand increases — and supply decreases until supply, demand, and price reach equilibrium. The opposite happens when prices rise.

How do you calculate income effect?

You can calculate the income effect using this formula:

Change in demand / change in income = income effect

Economists often use charts to demonstrate the income effect, especially when comparing the consumption of two different goods at different levels of income.

Normal goods and services will generally have a positive income effect. As income increases, demand also increases; and as income falls, demand falls. When demand falls in response to an increase in income, the good or service is likely an inferior good, and it is said to have a negative income effect.

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Sign up for Robinhood and get your first stock on us.Certain limitations apply

The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory. Securities trading is offered through Robinhood Financial LLC.

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