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Income Effect

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Summary

What is the Income Effect? Meaning.

The Income Effect is an economic term that refers to the change in demand for a good or service caused by a change in a buyer's purchasing power resulting from a change in real income.

This change in real income can be the result of:

  • A rise in wages etc.
  • Freeing up income due to a decrease in the price of goods or services that money is being spent on.

In other words, it is the phenomena that people are inclined to buy more (or less) of a product or service if its price falls, because their real purchasing power has risen, so they have more funds to spend on everything, including the product or service.


In still other words: it is the portion of the effect of a price change of some product on the quantity demanded of that product that reflects the change in real income.


The income effect and substitution effect are related economic concepts in consumer choice theory:

  • The income effect expresses the impact of changes in the purchasing power on consumption.
  • The substitution effect describes how a change in relative prices can change the pattern of consumption of related goods that can substitute for one another.

For normal economic goods and services, when real consumer income rises, they will demand a greater quantity of the goods or service for purchase.

However for inferior economic goods and services, when real consumer income rises, they will demand a smaller quantity of the goods or service for purchase. Inferior goods or services are typically those that are viewed by buyers as lower quality, but 'can get the job done' when on a tight budget.


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