Income Effect
The income effect describes how a change in a consumer’s real income or purchasing power alters the quantity demanded of a good or service. Real income can change because of wage changes, currency fluctuations, or price changes: when prices fall (or nominal income rises) consumers can buy more with the same money, and when prices rise (or nominal income falls) purchasing power declines.
How it works
- A change in purchasing power shifts consumer demand independently of taste.
- For most goods, higher real income increases demand; lower real income decreases it.
- The income effect operates alongside the substitution effect, which captures how consumers switch between goods when relative prices change.
Income effect vs. substitution effect
- Income effect: change in quantity demanded caused by a change in real income (purchasing power).
- Substitution effect: change in quantity demanded caused by a change in the relative price of goods, leading consumers to substitute cheaper alternatives.
When a price falls, both effects often increase demand for that good (but they can work in opposite directions for some goods).
Normal goods vs. inferior goods
- Normal goods: demand rises as real income increases. These have positive income elasticity (typically between 0 and 1). For normal goods, income and substitution effects generally reinforce each other when price changes.
- Inferior goods: demand falls as real income increases (negative income elasticity). Consumers buy them more when incomes fall and switch to higher-quality substitutes as incomes rise. For inferior goods, the income effect can oppose the substitution effect.
Example
A worker normally buys a cheap cheese sandwich for lunch (everyday item) and occasionally splurges on a luxury hot dog (higher-quality substitute). If the price of the cheese sandwich rises, the worker’s real income is effectively reduced. Because of the income effect, the worker may cut back on hot dogs (the luxury) and buy more of the cheaper sandwich—even though the substitution effect (relative price increase of the sandwich) would normally encourage switching away from the sandwich. If the income effect dominates, demand for the inferior everyday sandwich may rise despite its higher price.
Explore More Resources
Key implications
- The income effect helps explain consumer responses to wage changes, inflation/deflation, and price shifts of frequently purchased goods.
- The size and direction of the income effect depend on the good’s income elasticity and the availability of substitutes.
- In policy and market analysis, separating income and substitution effects clarifies how tax changes, subsidies, or price shocks affect consumption patterns.
Summary
The income effect captures changes in consumption resulting from changes in purchasing power. For normal goods it increases demand as income rises; for inferior goods it decreases demand. Together with the substitution effect, it determines how consumers adjust purchases when prices or incomes change.