The income effect measures the impact of changes in purchasing power on demand. It can be positive or negative.
We measure the purchasing power of consumers from real income, namely nominal income, after adjusting for the price of the goods. It is a measure of income in terms of quantity of goods.
For example, your income does not change, it stays at Rp1,000. However, at the time, the stock price of a product rose from Rp100 to Rp200. In this case, your real income falls. With a salary of Rp. 1,000, you only get five units (Rp1,000 / Rp200) of the product, lower than the previous 10 units (Rp1,000 / Rp100).
In summary, when prices rise and assuming constant nominal income, the quantity of demand will fall because real income falls. Conversely, when prices drop, demand increases because you can buy more with the same nominal income.
Consumer choice theory: substitution effect vs. income effect
In the theory of consumer choice, the income effect is another factor besides the substitution effect, which consumes goods and services. The theory states that changes in market prices and income have an impact on consumption patterns.
The income effect explains how purchasing power affects consumption patterns. While the substitution effect explains the relative price changes between goods affecting consumption.
Consumer purchasing power changes due to changes in nominal income and changes in prices. Assuming fixed nominal income, when prices fall, purchasing power increases because the consumer’s real income rises. The increase allows consumers to buy better or more products. Likewise, when the price of fixed goods and nominal income rises, purchasing power increases.
However, income effects vary between types of goods. Normal goods have a positive relationship with a real income, and vice versa, inferior goods have an inverse relationship. An increase in real income increases the demand for normal goods. However, it decreases the demand for inferior goods.
Furthermore, the substitution effect explains the effect of the price of other goods on the consumption of an item. When the price of an item rises, demand for the item falls as consumers will look for alternatives to cheaper goods to maintain the current lifestyle. The opposite effect also applies when the price of the item declines.
Changes in consumer income can shift the product demand curve to the right (positive) or left (negative). For most goods, demand increases when income increases (referred to as normal goods). In a few cases, demand for goods decreases even though income rises (known as inferior goods).
Normal goods have a positive income elasticity. Economists distinguish normal goods into two: necessities and luxury goods. Necessities have an income elasticity of higher than zero but less than one. Meanwhile, luxury goods have a coefficient of more than one.
However, some people often refer that normal goods are necessities. In fact, it is wrong.
When consumers’ real incomes rise, they usually consider inferior goods unnecessary. They feel rich and able to reach a variety of normal goods.
However, what counts as inferior goods or normal goods will vary between individuals. It depends on each income level. For example, high-income consumers might consider rice as an inferior good for the rich, but it is normal for low-income individuals.
Marginal propensity to consume
The income effect explains how consumers respond if their income rises. But that doesn’t answer another aspect of consumer choice behavior, namely how consumers spend their extra income?
We answer this question with another economic concept, namely marginal propensity, to consume (MPC). MPC explains how much consumers spend their extra income. We calculate it by dividing the change in consumption from the change in income. The higher the additional income consumed, the higher the MPC value.
MPC is important not only in microeconomics but also in macroeconomics. Keynesian multipliers rely on the MPC to calculate the effect of changes in consumption on aggregate output and high growth. The higher the MPC, the greater the multiplier, and its impact on the economy.