Income Effect

Published Jan 2, 2023

Definition of Income Effect

The income effect is an economic concept that describes the change in the demand for a good or service due to a change in the consumer’s income. That means it is the effect of a change in income on demand for a good or service because the consumer moves to a higher (or lower) indifference curve.

Example

To illustrate this concept, let’s look at an example. Imagine a young couple, John and Jane, who both work full-time and have a combined monthly income of USD 5,000. They have a limited budget and can only afford to buy basic necessities.

Now, let’s assume that John and Jane both receive a pay raise, and their combined monthly income increases to USD 7,000. With the extra money, they can now afford to buy more luxury items, such as a new car or a vacation. As a result, their demand for luxury items increases due to the increase in their income. This is an example of the income effect.

Why Income Effect Matters

The income effect is an important concept in economics, as it helps to explain how changes in income affect consumer behavior. It is also closely related to the concept of elasticity of demand, which is the measure of how sensitive the demand for a good or service is to changes in price or income. Thus, understanding the income effect can help economists and businesses to better predict consumer behavior and make more informed decisions.