Income Effect Definition
Income Effect is the change in demand of a good when the consumer’s disposal income changes. Disposable income could change as a result of a change in income or due to a change in the prices of the goods that the consumer uses. For instance, a decline in the price of other goods used by a consumer, frees up their income that could be expended on other things, even when their actual income/salary has not changed.
Income Effect Example
When the disposal income of people increases, their demand for certain goods might go up, which implies that the income effect for these goods is positive. For example, assume someone with an income of $1000 spends their entire income on three commodities – Commodity A, B and C. Now the income of this person increases to $1200, while prices of commodities A, B and C remain the same. If as a result of this increase in income, their consumption of Commodity A increases, then the income effect on Commodity A is positive or the income elasticity of demand is positive. Commodity A would be considered as a Normal Good – a product whose demand increases with increase in income.
Now consider that as this person’s income increases to $1200, they feel that they can afford to consume a better-quality substitute of Commodity B. Thus, instead of consuming more of Commodity B, they demand less of it. In such a case, commodity B is called an Inferior Good and income elasticity of demand for commodity B is negative.
Income Effect vs Substitution Effect
Substitution effect is the change in demand as relative prices of goods changes. Taking the above example forward, say the income of the consumer remains $1000 but the price of Commodity C drops by 20% due to greater availability of raw materials. As a result of this, the consumer begins to consume more of commodity C (let’s assume this is croissant) and less of commodity A (let’s assume this is bread), which might be a close substitute of Commodity C. This switch, which is a result of change in prices, is called substitution effect.
Income and Substitution Effect
However, we discussed initially that a drop is prices is another factor that leads to an increase in the disposable income of a consumer. With increase in the disposable income, the consumer might decide to consume more of commodity A and C. This new consumption pattern, where the consumer is consuming more of both commodities A and C is a result of both income and substitution effect. Wherein, a decline in prices of commodity C, frees up their income and allows them consume not only more of commodity C (substitution effect) but also more of commodity A (income effect). For a more detailed graphical analysis of this, you may read here.
Substitution effect is closely related to cross price elasticity which shows how demand of one good changes with change in the prices of another. Both income and substitution effects are elements of consumer choice theory which attempts to explain how consumer preferences and budgets are related.