Income Effect
What is Income Effect?
The income effect is the change in quantity demanded caused by a price change altering a consumer's real purchasing power.
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.
Income Effect: a worked example
A student budgets $40 a week for lunch. Sandwiches cost $8, so the budget covers 40 ÷ 8 = 5 sandwiches. The price then falls to $5. Those same five sandwiches now cost 5 × $5 = $25, freeing $15 out of the unchanged $40. Measured in sandwiches, purchasing power rose from 5 to 40 ÷ 5 = 8, a 60 percent gain, even though the paycheck never moved. For a normal good that freed purchasing power pushes quantity demanded up. Now take an inferior good. Instant noodles fall from $2.00 to $1.50 and the student was buying 10 packs. The substitution effect pulls purchases up by 5 packs, while the income effect works against it: feeling richer, the student trades noodles for sandwiches and cuts back 3 packs. Purchases settle at 12.
The mistake students make with income effect
The name convinces students that the consumer's income actually rose, so they write that a lower price puts extra money in the buyer's paycheck. Nominal income never moves in this analysis. What changes is real purchasing power, since the same dollars now stretch across more units. The second slip is assuming the effect always points the same way for every good. With a normal good, cheaper means more purchasing power and more units bought. With an inferior good the income effect pushes purchases down, and only the substitution effect keeps quantity demanded rising.
Income Effect questions
Does the income effect always increase quantity demanded when price falls?
Direction depends on whether the good is normal or inferior. For a normal good, a price cut raises real purchasing power and the consumer buys more, so the income effect reinforces the law of demand. For an inferior good the extra purchasing power pulls the consumer toward preferred alternatives, so the income effect reduces quantity demanded. The substitution effect still pushes upward, and for nearly every inferior good it wins, so quantity demanded rises on net.
Why is it called an income effect if income does not change?
Real income changes even when the number on the paycheck is fixed. A price cut means the same dollars command more goods, which works on spending the way a gift of extra money at the old prices would. Economists name the channel after that purchasing power change rather than after the source of the funds. Separating it out means asking how much income would have to be taken back so the shopper can just barely afford the original bundle at the new prices. Handing that amount back afterward is the income effect on its own.
How large is the income effect for a small purchase?
Size scales with the share of the budget the good absorbs. A price cut on something taking a tiny slice of spending, such as a pack of gum, frees so little purchasing power that the income effect is negligible and the substitution effect carries almost the whole response. A price cut on rent or tuition, which swallow a large share of a budget, frees enough purchasing power to reshape spending across many other goods at once.
Related terms
Common comparisons
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