Income Effect vs Income Elasticity of Demand
Income Effect and Income Elasticity of Demand are related concepts in AP Economics that students often mix up. The income effect is the change in quantity demanded caused by a price change altering a consumer's real purchasing power. Income elasticity of demand measures how responsive the quantity demanded is to a change in consumers' income. Here is how they compare side by side.
When a good's price falls, real income rises, so consumers can buy more. For normal goods the income effect raises quantity demanded; for inferior goods it works in the opposite direction. It is one of the two reasons demand curves slope downward.
It is calculated as the percentage change in quantity demanded divided by the percentage change in income. Demand is considered a normal good if the ratio is positive, meaning demand increases as income increases. Demand is considered an inferior good if the ratio is negative.
Income Effect vs Income Elasticity: One Follows a Price Change, the Other an Income Change
| Income Effect | Income Elasticity of Demand | |
|---|---|---|
| What actually changed | The price of a good, which altered real purchasing power | The consumer's money income, with all prices held constant |
| What it is | One half of the response to a price change | A single measured number |
| Its partner concept | The substitution effect | The Engel curve |
| Formula | None, it is a decomposition rather than a calculation | Percentage change in quantity demanded divided by percentage change in income |
| What an inferior good does to it | Pushes against the substitution effect, shrinking the total response | Makes the coefficient negative |
| Why it is taught | To explain why demand curves slope downward, and the Giffen exception | To classify goods as normal, inferior, luxury or necessity |
| What it looks like on paper | A movement along a demand curve, split into two parts | A unitless ratio, positive or negative |
Real income can rise while your paycheque never moves
The income effect trips students up because nobody in the story gets a raise. Suppose a household sets aside an illustrative $60 a week for rice and the price falls from $3 a kilogram to $2. At the old price that budget bought 20 kilograms. At the new one it buys 30. Nobody handed the household a cent, yet it can now afford half as much again of the same good, and that gain in purchasing power is the income effect. It pushes quantity demanded of a normal good up when a price falls. Alongside it runs the substitution effect, which pushes the same way for a different reason: rice is now cheaper relative to pasta, so the household switches toward it regardless of purchasing power. Both parts explain one movement along the demand curve. For an inferior good the two parts fight. A cheaper bus fare makes travel relatively cheaper, encouraging more trips, while the extra real income tempts the household toward a car instead. Demand still slopes downward as long as the substitution effect wins, which it almost always does. See /glossary/substitution-effect for the other half.
Income elasticity is a number you calculate, not a force you decompose
Nothing is being split apart here. You take two income levels, two quantities, and divide. Suppose weekly household income rises from an illustrative $500 to $700 and restaurant meals per month go from 4 to 6, with menu prices untouched. Using the midpoint method, income changes by 200 over the average of 600, which is 33.33 percent, and quantity changes by 2 over the average of 5, which is 40 percent. Dividing 40 by 33.33 gives 1.2. Positive means normal, and above 1 means the household treats restaurant meals as a luxury. Notice the detail that separates this from the income effect entirely: no price moved at any point. Prices were nailed down so that income could be the only thing varying. The income effect is the opposite arrangement, where money income is nailed down and a price moves. Get those two set ups the wrong way round and every conclusion inverts. One more caution about the figure you produce. It belongs to that household over that stretch of income, so the same family might return a value below 1 for restaurant meals once it is much richer and eating out has become ordinary. Nothing about the meals changed; the position on the income scale did. Run your own figures at /calculate/income-elasticity-of-demand.
Frequently asked questions
Is the income effect the same as income elasticity of demand?
No, the income effect is part of a consumer's response to a change in a good's price, working through the purchasing power that price change creates, while income elasticity is a number measuring how quantity demanded responds to a change in actual income with prices held constant. One is a theoretical split of a single movement, the other is a calculation. The trigger is different in each case: a price change for one and an income change for the other.
Does the income effect require your income to change?
No, money income stays exactly the same and only real income changes, because a lower price means the same money buys more. Economists call this a change in purchasing power. It is why a fall in the price of something you buy often makes you better off than an equal fall in the price of something you never buy.
What income elasticity does an inferior good have?
An inferior good has a negative income elasticity, because quantity demanded falls as income rises. A value of negative 0.5 would mean a 10 percent rise in income cuts purchases by 5 percent. The label applies to the household and the income range being examined, not to the good in every situation.
Live Elasticity graph. Drag the curves, or open the full version.
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