The income effect in microeconomics is the change in demand for a good or service caused by a change in a consumer's purchasing power resulting from a change in real income. This change can be the result of a rise in wages etc., or because existing income is freed up by a decrease or increase in the price of a good that money is being spent on.
The income effect is a part of consumer choice theory—which relates preferences to consumption expenditures and consumer demand curves—that expresses how changes in relative market prices and incomes impact consumption patterns for consumer goods and services. For normal economic goods, when real consumer income rises, consumers will demand a greater quantity of goods for purchase. The income effect and substitution effect are related economic concepts in consumer choice theory. The income effect expresses the impact of changes in purchasing power on consumption, while the substitution effect describes how a change in relative prices can change the pattern of consumption of related goods that can substitute for one another. Changes in real income can result from nominal income changes, price changes, or currency fluctuations. When nominal income increases without any change to prices, this means consumers can purchase more goods at the same price, and for most goods, consumers will demand more. If all prices fall, known as deflation and nominal income remains the same, then consumers’ nominal income can purchase more goods, and they will generally do so. These are both relatively straightforward cases. However in addition, when the relative prices of different goods change, then the purchasing power of consumer’s income relative to each good changes—then the income effect really comes into play. The characteristics of the good impact whether the income effect results in a rise or fall in demand for the good.
When the price of a product increases relative to other similar products, consumers will tend to demand less of that product and increase their demand for the similar product as a substitute. Normal goods are those whose demand increases as people's incomes and purchasing power rise. A normal good is defined as having an income elasticity of demand coefficient that is positive, but less than one. For normal goods, the income effect and the substitution effect both work in the same direction; a decrease in the relative price of the good will increase quantity demanded both because the good is now cheaper than substitute goods, and because the lower price means that consumers have a greater total purchasing power and can increase their overall consumption. Inferior goods are goods for which demand declines as consumers' real incomes rise, or rises as incomes fall. This occurs when a good has more costly substitutes that see an increase in demand as the society's economy improves. For inferior goods, the income elasticity of demand is negative, and the income and substitution effects work in opposite directions. An increase in the inferior good’s price means that consumers will want to purchase other substitute goods instead but will also want to consume less of any other substitute normal goods because of their lower real income. Inferior goods tend to be goods that are viewed as lower quality, but can get the job done for those on a tight budget, for example, generic bologna or coarse, scratchy toilet paper. Consumers prefer a higher quality good, but need a greater income to allow them to pay the premium price. Consider a consumer who on an average day buys a cheap cheese sandwich to eat for lunch at work, but occasionally splurges on a luxurious hot dog. If the price of a cheese sandwich increases relative to hotdogs, it may make them feel like they cannot afford to splurge on a hotdog as often because the higher price of their everyday cheese sandwich decreases their real income. In this situation, the income effect dominates the substitution effect, and the price increase raises demand for the cheese sandwich and reduces demand for a substitute normal good, a hotdog, even if the hotdog's price remains the same.
The income effect is a part of consumer choice theory—which relates preferences to consumption expenditures and consumer demand curves—that expresses how changes in relative market prices and incomes impact consumption patterns for consumer goods and services. In other words, it is the change in demand for a good or service caused by a change in a consumer's purchasing power resulting from a change in real income. This change can be the result of a rise in wages etc., or because existing income is freed up by a decrease or increase in the price of a good that money is being spent on.
The substitution effect is the decrease in sales for a product that can be attributed to consumers switching to cheaper alternatives when its price rises. A product may lose market share for many reasons, but the substitution effect is purely a reflection of frugality. If a brand raises its price, some consumers will select a cheaper alternative.
Normal goods are those whose demand increases as people's incomes and purchasing power rise. As such, a normal good will have a positive income elasticity of demand coefficient but it will be less than one. This means that a decrease in the relative price of the good will result in an increase in quantity demanded both because the good is now cheaper than substitute goods, and because the lower price means that consumers have a greater total purchasing power and can increase their overall consumption.
Inferior goods are goods for which demand declines as consumers' real incomes rise, or rises as incomes fall. This occurs when a good has more costly substitutes that see an increase in demand as the society's economy improves. For inferior goods, the income elasticity of demand is negative, and the income and substitution effects work in opposite directions.
All consumer goods are governed by the laws of supply and demand, so every type of consumer good demonstrates the price elasticity of demand. However, this does not mean the relationship between demand and price is equal across all types of consumer goods. Some types of consumer goods display high price elasticity of demand, while others show very little. There are a variety of factors that determine a good's price elasticity of demand. These include such things as the essential or non-essential nature of certain goods, the availability of competitive substitutes, and the effect of a good's brand name and marketing.
Consumer staples are a sub-category of consumer goods that are regarded as essential products. Examples of this include food, beverages, and certain household goods. Consumers view these goods as primary and essential for life. These are the staples people are unable (or are unwilling) to eliminate from their budget. Additionally, these products are non-cyclical, meaning they are needed and used year-round, not just seasonally. Non-essential goods, on the other hand, are products that are not absolutely necessary. Examples of non-essential items that consumers spend money on are impulse purchases, dining out, jewelry, and electronics. During financially difficult times, consumers frequently cut spending on non-essential goods, eliminating them from their budget. As a category of goods, essential goods have a low elasticity of demand. There will always be a need for consumer staples and a change in price is unlikely to impact demand. On the other hand, the demand for non-essential goods can fluctuate greatly. The demand can plummet depending upon the economy and the overall financial situation of consumers. Because of this, non-essential goods have a high elasticity of demand. There are several important factors that influence a good's price elasticity of demand. If the good has plenty of competitive substitutes, elasticity tends to be greater because consumers can easily make a switch when prices rise too much. More expensive goods also tend to be more elastic since consumers are more sensitive to purchases that take up larger proportions of their income. Within the category of consumer staples, the price elasticity of demand changes if the marketplace has responded by offering competitive substitutes or if the consumer is willing to accept a lower-priced product over another. For example, hamburgers have a relatively high elasticity of demand because there are plenty of alternatives for consumers to choose from, such as hot dogs, pizza, and salads. Gasoline and oil, however, have no close substitutes and are necessary to power equipment and transportation. These have a low price elasticity of demand. Brand names and marketing have a large impact on the price elasticity of demand as well. When comparing similar products with different price points, consumers may purchase the higher-priced product if their brand loyalty to that product is high. Because of this, a 5% increase in the price of well-known brands—such as Coca-Cola drinks or Nike shoes—has less impact on demand than a 5% increase in a lesser-known and less-trusted competitor. Goods that are considered essential have a low elasticity of demand. Electricity, gas, oil, and water are all relatively inelastic because consumers rely on these as necessities rather than luxuries. Also, keep in mind that the price elasticity of demand is very time-sensitive. More consumers notice and react to price changes as time goes on, meaning price elasticity of demand tends to increase as time passes. |
Industrial demand is unaffected by changes in consumer demand. group of answer choices true false
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