key term - Income Effect

Definition

The income effect is the change in the quantity demanded of a good or service resulting from a change in a consumer's real income, while holding the price of the good or service constant. It describes how a consumer's purchasing power and consumption patterns are affected by changes in their available income.

5 Must Know Facts For Your Next Test

1. The income effect explains how a change in a consumer's real income affects their consumption of a good, independent of any substitution effect.
2. For normal goods, the income effect causes demand to move in the same direction as the change in income. As income rises, demand for normal goods increases, and vice versa.
3. For inferior goods, the income effect causes demand to move in the opposite direction as the change in income. As income rises, demand for inferior goods decreases, and vice versa.
4. The income effect, combined with the substitution effect, determines the overall change in quantity demanded in response to a price change.
5. Understanding the income effect is crucial for analyzing consumer behavior and predicting how changes in income will impact consumption choices.

Review Questions

• Explain how the income effect relates to a consumer's budget constraint and consumption choices.
  • The income effect describes how a change in a consumer's real income, while holding prices constant, affects their consumption choices within their budget constraint. For normal goods, an increase in income allows the consumer to purchase more of the good, shifting their consumption bundle along the budget line. For inferior goods, an increase in income reduces the demand for the inferior good as the consumer substitutes towards higher-quality alternatives.
• Analyze how the income effect impacts a consumer's consumption choices for different types of goods.
  • The direction of the income effect depends on whether a good is normal or inferior. For normal goods, the income effect causes demand to increase as income rises, as the consumer can afford to purchase more of the good. For inferior goods, the income effect causes demand to decrease as income rises, as the consumer substitutes towards higher-quality alternatives. Understanding these differences in the income effect is crucial for predicting how changes in a consumer's income will impact their consumption patterns.
• Evaluate the role of the income effect in explaining how changes in income and prices affect overall consumption choices.
  • $$The income effect, together with the substitution effect, determines the total change in quantity demanded in response to a price change. The income effect describes the change in consumption due to the change in the consumer's purchasing power, while the substitution effect describes the change in consumption due to the change in relative prices. Analyzing both the income effect and substitution effect is necessary to fully understand and predict how changes in income and prices will impact a consumer's consumption choices across different goods and services.$$

Related terms

Substitution Effect:

The change in the quantity demanded of a good or service resulting from a change in its price relative to the price of other goods, while holding the consumer's real income constant.

Normal Good: A good for which demand increases as a consumer's income increases, and decreases as a consumer's income decreases, holding all else constant.

Inferior Good: A good for which demand decreases as a consumer's income increases, and increases as a consumer's income decreases, holding all else constant.