Income effect describes the alteration in the demand for something when its price rises. The law of demand explains that the amount demanded of an item normally increases with time when other variables are held constant (e.g. the cost of living). It then follows that when other variables are held constant, demand usually increases.
There are two main ways to understand the concept of the income effect on budgets. One way is to view it as a decrease in purchasing power. In theory, there would be a tendency for expenses to increase at a faster rate than income. Another way of viewing the income effect on budgets is to see it as an increase in income only, with nothing to do with savings or expenditures. Both ways have their merits and drawbacks.
In order to understand the income effect on budgets, it makes sense to first define what the concept of substitution effect means. Substitution means that something is substituted for another thing. Let us use the classic example of the jackfruit.
Jackfruit contains more calories and hence more calories are needed to eat it than table sugar. Hence, a jackfruit contains twice the number of calories as a piece of bread (a point 1 ration). Thus, there is an income effect on costs, but not on income. Thus, spending the same amount on a Jackfruit as on a loaf of bread does not produce any increase in consumption.
The best example to describe this phenomenon in the context of budgets is food prices. As food is a high priced good, the elasticity of supply increases over time as demand increases relative to supply. There is therefore a price increase relative to demand.
In the market for commodities, we observe that when the demand for some commodity falls relative to others, prices fall to reflect the new elasticity of supply. The elasticity of supply is referred to as the relative price deflationary effect. If we observe in detail how prices affect as a result of changes in relative prices, we can identify an income effect on prices. As the prices fall, people find it cheaper to buy goods whereas people find it expensive to buy the same goods at higher prices.
This is just one example among many where the income effect on market prices is identified. The consumption behavior of the consumers is characterized by what they regard as optimal utility function. The consumption of money and the consumption of other goods are deemed to be elements of their utility function. We refer to this form of consumer preference as consumer demand curves.
Another example of the income effect on market prices is found in the foreign exchange market. There, the prices of currencies are affected by the variation in relative foreign exchange rates between the various countries. On the supply side, there is a substitution effect whereby a country with lower export tariffs can purchase more foreign goods from other countries at lower costs than otherwise. On the demand side, there is a deflation effect whereby the quantity of domestically produced goods is lower than the demand for imported products.
The elasticity of the demand and supply of money is also considered in economics. One of the key economic concepts in macroeconomics is the Phillips Curve. This concept relates changes in output relative to changes in investment, which are known as changes in potential savings and investment. The lower the investment, the lower the output and vice versa. It is thus implied that if the government spending is lower than the saving of households, there will be a reduction in consumption. In short, the Phillips Curve identifies the relationship between changes in the level of investment and changes in the level of consumption.
Changes in the income effect on the price of a good is called the substitution effect. If a rise in output causes a fall in the price of a good, then a decrease in expenditure and a rise in output will cause the price to rise. Thus the equilibrium lies between increases in the quantity demanded (falling employment and rising prices) and decreases in the quantity supplied (increased output and falling employment). It is possible to analyse this concept in more detail using theoretical models.
An example of an income effect on the price of a good is illustrated by the substitution curve shown below. Here, an increase in income causes a reduction in the average time preference of an individual towards goods and services A and he shifts from his preference of A to goods and services B. The elasticity of demand and supply can be analysed using a graph representing the change in income effects on the price of a commodity. The dashed green line shows the theoretical expectation of the elasticity of the demand curve, which is based on the assumption that the income of the individual is constant.
Analysis of the income effect on the price of a commodity is sometimes complicated due to changes in production capacity, changes in the rate of profitability and other factors. One way of dealing with these issues is to regress the response of changes in the production capacity and profitability on changes in the unemployment rate. If the elasticity of substitution is high, then changes in output elasticities imply lower prices for most goods and services. Conversely, if the substitution effect is low then increases in income may lead to higher prices for goods and services. These effects are often estimated using aggregate data, which involves averaging different estimates across firms over time, or using imperfect comparables to identify changes in income effects on output and prices.