The income effect is the change in quantity demanded of a good or service resulting from a change in real income, while holding prices constant. It measures the impact of a change in purchasing power on consumer behavior.
Key Facts
- Definition: The income effect is the change in quantity demanded of a good or service resulting from a change in real income, while holding prices constant.
- Calculation: To calculate the income effect, you need to subtract the price effect from the total effect. The price effect measures the change in quantity demanded due to a change in price, while the total effect measures the overall change in quantity demanded due to a change in income and price.
- Decomposition: The income effect can be decomposed into two components: the substitution effect and the income effect. The substitution effect measures the change in quantity demanded due to the change in relative prices, assuming that real income remains constant. The income effect measures the change in quantity demanded due to the change in real income, assuming that relative prices remain constant.
- Graphical representation: The income effect can be represented graphically using an indifference curve and a budget constraint. The change in real income shifts the budget constraint outward or inward, leading to a new optimal consumption point on the indifference curve. The difference between the initial and new consumption points represents the income effect.
Calculation of Income Effect
To calculate the income effect, you need to subtract the price effect from the total effect. The price effect measures the change in quantity demanded due to a change in price, while the total effect measures the overall change in quantity demanded due to a change in income and price.
Decomposition of Income Effect
The income effect can be decomposed into two components: the substitution effect and the income effect. The substitution effect measures the change in quantity demanded due to the change in relative prices, assuming that real income remains constant. The income effect measures the change in quantity demanded due to the change in real income, assuming that relative prices remain constant.
Graphical Representation of Income Effect
The income effect can be represented graphically using an indifference curve and a budget constraint. The change in real income shifts the budget constraint outward or inward, leading to a new optimal consumption point on the indifference curve. The difference between the initial and new consumption points represents the income effect.
Sources
- Investopedia: How Do You Calculate the Income Effect Distinctly From the Price Effect?
- Core-Econ: Mathematics of Income and Substitution Effects
- Social Science LibreTexts: Income and Substitution Effects
FAQs
What is the income effect?
The income effect is the change in quantity demanded of a good or service resulting from a change in real income, while holding prices constant.
How do you calculate the income effect?
To calculate the income effect, you need to subtract the price effect from the total effect.
What is the difference between the income effect and the substitution effect?
The income effect measures the change in quantity demanded due to a change in real income, assuming that relative prices remain constant. The substitution effect measures the change in quantity demanded due to the change in relative prices, assuming that real income remains constant.
How can you graphically represent the income effect?
The income effect can be represented graphically using an indifference curve and a budget constraint. The change in real income shifts the budget constraint outward or inward, leading to a new optimal consumption point on the indifference curve. The difference between the initial and new consumption points represents the income effect.
What is the relationship between the income effect and the law of demand?
The income effect is consistent with the law of demand for normal goods. For normal goods, an increase in income leads to an increase in quantity demanded.
What is the relationship between the income effect and inferior goods?
For inferior goods, an increase in income leads to a decrease in quantity demanded. This is known as the negative income effect.
Can the income effect be positive or negative?
The income effect can be positive or negative, depending on whether the good is normal or inferior.
What are some examples of income effects?
Examples of income effects include:
– An increase in income leading to an increase in demand for luxury goods (positive income effect)
– An increase in income leading to a decrease in demand for basic necessities (negative income effect)