Income Effect - Definition

Updated at December 19th, 2020

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Income Effect Definition

The income effect is an economic theory that describes how changes in wages and prices affect the demand for goods and services. Income effect is seen when there is a change in the demand for commodities and services as a result of a change in the disposable income available to consumers. There can be a higher or lower demand for goods and services as a result of increase or decrease in wages or prices. Hence, income effect can either have a positive effect or a negative one.

A Little More on What is the Income Effect

The amount of money that an individual can spend and the level of consumers purchasing power have an effect on the rate of demand for goods and services. The income effect is an economic theory that examines how changes in wages and income of consumers, as well as changes in the price of goods affect the demand for goods and services. In microeconomics, there are noticeable impacts of prices and wages on the demand for goods and services, the impact can be either positive or negative. Demand can increase or decrease based on the effect of wages and prices.

The Income Effect

A change in the real income of consumers can cause changes in their purchasing power which in turn has an effect on how much they demand for goods and services. Also, changes in the prices of goods can also fuel consumer's purchasing power, for instance, when goods are cheaper, consumers want to buy more but when they are expensive, there is a reduction in the demand for goods. In the case of normal goods, an increase in consumers purchasing power causes an increase in demand. On the contrary, increase in comcumers purchasing power causes a decline in the purchase of inferior goods. It is however important to know that increase in comsumers purchasing power as a result of increase in wages (real income) or decline in the prices of goods does not necessarily translate to an increase in demand an expensive or cheap product. That means that purchasing power might increase and the demand for high or low value goods and services will not increase. For instance, a consumer might decide to buy high-value goods rather than buy low-value goods. The high value goods can however be purchased at a low quantity. According to the concept of marginal propensity to consume, consumer's spending is dependent on how much he saves, this also has an effect on the demand for goods and services.

The Substitution Effect

Consumers have the tendency of changing their purchase or consumption patterns when their wages (real income) increase or decrease. This change can also occur when there is a change in the process of goods. The tendency of consumers to change their consumption and purchase patterns is explained using the substitution effect. If there is a decline in real income, consumers can change to low-value goods. An increase in real income can also cause them to change to expensive products or products that have more quality than what they previously buy.

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