The income effect refers to the way consumers actually choose to buy a product or service. In economics, the income effect takes the data on consumer spending habits into account and attempts to provide insight into what people are prepared to spend their money on. This concept is not unique to economics. In psychology, the concept also plays a significant role. In business, it also helps us to measure the performance of the company and judge whether we are making the right investment or not.
The income effect dominates a large portion of the literature on economic theory and its measurement. Basically, the idea is that because something costs more to produce in relation to what it will cost to buy, the price level will also be adjusted upward in response to increasing demand. This is known as the substitution effect. The substitution effect controls the dynamics of demand and supply in the economy.
Let’s take an example of the real world to understand this theory in a simplified form. Assume that the price of some normal, good increases. But, suppose that the increase in the price of normal good doesn’t keep up with increases in labor supply. Since there is enough labor supply to absorb the increase in demand, the price of the good should decrease to reflect the change in supply. But, if demand stays constant, then the price of the good should increase. We call this the income effect.
How does the income effect play out in the real world? More purchasing power for some is always beneficial. And, when there is more purchasing power, companies can offer more products at higher prices. The elasticity of demand determines how consumption patterns are set through changes in income. If the elasticity of demand is high, prices go up and if the elasticity of supply is low, prices go down.
In short, the income effect occurs because people have to pay more for items if demand is greater than supply. This means that individuals choose to buy more things if demand is high than they would have if demand were lower. In simple terms, individuals have to adjust their personal preferences in order to match increases in income. If they don’t, they can “substitute” the item with something else.
A good example of the consumption side of the equation is the amount of money that a family or individual will spend on different goods. An increase in income means either more income or more consumption. If consumption is increasing, individuals will likely have to spend more. But, if consumption is decreasing, individuals will have to spend less.
Another example of the consumption side of the equation is the amount of money that is saved or spent. If an individual saves more money and decides to purchase less, they are reducing the amount of income effect because they have spent the saved money. However, when they purchase the same item at a higher price, they are increasing the income effect because they are saving more.
Price elasticity also affects the income effect of demand. When the price of an item changes rapidly, consumers will have to substitute the item for something else. For example, if an item has been cost $5 and it now costs $4, consumers will likely have to change the item they are purchasing for a more cost-effective item. Because the economy is so sensitive to changes in the price of most items, substitution is an important part of the overall economic demand process.
Price elasticity is affected by changes in the distribution of prices across the distribution of goods and services. If there are only a small number of goods and services in a market, consumers will be sensitive to changes in price. For instance, when a new product has been created and it has to compete with similar products already available, consumers will not likely change their consumption habits just because a new product is cheaper. Instead, they will change their utility cost, which will result in a decrease in consumption. The same thing goes for when there is a drastic change in utility costs, like a gasoline tax.
On the supply side of the economy, changes in relative prices will have an income effect on individuals because they will change the amount of money that they can buy with their income. However, changes in relative prices will not necessarily have an income effect unless they are large enough to change the purchasing power of the individuals. The price elasticity of demand is dependent upon whether consumers have access to different goods at the same price. When consumers have access to different goods at the same price, their willingness to spend changes. In short, if consumers do not have the income they need to purchase the same amount of goods, they will postpone consumption and increase their saving, and eventually, reduce their income.
Consumption is the sum of all transactions involving the production of wealth or value and the reduction or elimination of wealth or value. Changes in consumption can be stimulated by increases in income or by decreases in income. Increases in income can be caused by increases in productivity, improvements in technology, expansion of markets, or some other factor. Decreases in income can be caused by decreases in production, employment, consumer price inflation, or other factors. Thus, changes in consumption are reflected in changes in relative prices and can have an income effect on the level of consumption.