Income Effect

What is Income Effect?

The Income effect is a term used to refer to a change in demand for a product or service because of the changes in the consumer’s income. This change is subject to a raise in salary or wages because of the existing income.

The income effect is a part of the consumer choice theory which explains the changes in consumption expenditure of the consumer that affects the Demand Curve. Consumer’s demand for important goods will rise as the income rises. Note that the income effect and substitution effect are economic concepts that are a part of consumer choice theory. The income effect explains the impact of change in purchasing power on consumption. The substitution effect describes how a change in price can change the pattern of consumer’s consumption of related goods and can substitute it for another.

Income Effect on Demand

Changes in income changes demand. When there are changes in income but not change in price, the consumer will buy more goods at the same price because their income has increased.

And if the price of the goods falls, the income remains the same, the consumer will buy more goods. Fall of prices in goods indicates deflation. Inferior goods refer to goods where the consumer’s demand falls for with an increase in income.

Example of Income Effect

Jaya earns Rs. 10,000 for a month. Some of the basic essential items she purchases are onions, tomatoes and coffee powder. The price of these three essential items are listed below:

• Onion- Rs. 25 per kg
• Tomatoes- Rs. 20 per Kg
• Coffee Powder- Rs. 60 for 500 gms

Jaya’s company gives her a hike in salary and she earns Rs. 12,000 now. The increase in her salary will lead her to buy two kgs of onion along with two kgs of tomatoes. Her demand for coffee remains the same because of the need.

However, if the price of the goods falls but her salary remains Rs. 10,000 she will still buy more since she’s getting the items at a lower price. But if the price of coffee powder increases from Rs. 60 to Rs. 120 per 500 gms while her salary remains constant, Jaya might opt for tea powder since that’s the closest substitute.