Income Effect
March 31, 2009
Overview
According to economics, income effect depicts the effects of alterations in the prices on consumption. It is the change in an individual’s income or an economy’s income, and how that change will have an impact on the demand of the quantity of good or service. Therefore, the relationship that exists between the quantities demanded and income is such that when the price of good or service increase, naturally the consumer will feel poorer, thus the quantity demanded will go down.
If on the other hand the price of goods or services in demand goes down, the quantity demanded will increase. Note that the consumer’s actual earnings have not changed, but the alteration in prices makes the buyer feel as if the actual income has changed. It is very normal for a consumer to buy goods or services when the prices reduce, therefore creating an income effect because purchasing an equal quantity of good or service at a lower price will create a difference and leave the buyer will more income left over. Part of this income will be used to buy more of the same good or product, eventually increasing the total quantity of the product bought.
Consumer Theory
If a person’s income or earnings increases, and all other things remain constant, the person’s demand for more goods and services will increase, consequently increasing the consumption. Thus, the consumer’s income becomes another vital item that also changes. The income effects are the occurrences observed through changes in the purchasing power.
It discloses the changes in quantity demanded as a result of changes in utility or real income. Thus if all matters, in this case the prices, remain constant, slight alterations in the income will create a parallel swing of the budget constraint. Increasing the income, shifts the budget constraint on the positive, because more of both can be utilized, and decreasing the income consequently shifts the budget constraint to the negative. It is therefore right to say that the amount of goods consumption can increase, decrease or remain constant when the income is increased.
Quantity Demanded
Quantity demanded describes the total amount of goods or services demanded by consumers at any given point in time. Quantity demanded is dependent on the prices of the goods or services in the market, irrespective of whether the marketplace is in equilibrium.
Substitution Effect
People tend to confuse the application of income effect and substitution effect. Whereas income effect is brought about by the changes in prices that ultimately affect the consumer’s purchasing decisions, substitution effects is basically the tendency to change your purchasing decision depending on the changes in the relative prices.
This is to say, if one of two goods, which serve the same purpose, escalates in price, and the other remains constant, the buyer will be more inclined to buy the one with the constant price, thus substituting it. Note that the income effect also affects buyer’s purchasing decisions when there is more than one good in the market.
The imbalance of income effect in relation to consumption
It is deduced that the main cause of asymmetry of income effect in relation to consumption are the factors that determine the reaction to income rise and decline. This is to say that in cases where the income fall, the disadvantage risks of income play the vital role in intensifying the rate at which consumption goes down, in response to income falling.
Conversely, in cases of escalating incomes, the main determinant factors are the supply factors. This is to say that if one wished to have a particular good or product but could not, will accelerate the rate of consumption southwards, in response to income escalate.
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