Income effect

Income effect is the change in quantity demanded of a good resulting from a change in the consumer's real purchasing power caused by a price change (Varian H.R. 2014, p.142)^[1]. When gas prices drop from $4 to $3 per gallon, you don't just buy more gas because it's cheaper relative to alternatives—you also buy more because your overall budget stretches further. That second force is the income effect. Your nominal income hasn't changed. But what you can afford has.

Understanding this distinction helps explain puzzling consumer behavior. Why do some goods see demand rise when their prices rise? Why do price cuts sometimes backfire? The income effect provides answers.

The decomposition

When a price changes, two things happen simultaneously:

Substitution effect. The good becomes relatively cheaper or more expensive compared to alternatives. Consumers substitute toward the now-cheaper option. This effect always works in the intuitive direction—lower prices increase quantity demanded.

Income effect. The price change alters real purchasing power. A lower price makes consumers effectively richer; they can afford more of everything. A higher price makes them poorer.

Economists separate these effects analytically. In practice, they occur together and can't be observed independently. The decomposition is a thought experiment that illuminates underlying mechanisms^[2].

Consider coffee priced at $5 per bag. You buy 4 bags monthly, spending $20. Now suppose the price drops to $4. Your spending on the same 4 bags falls to $16—leaving $4 extra for other purchases. That's the income effect: you're effectively richer by $4 monthly.

The substitution effect? Coffee is now cheaper relative to tea, energy drinks, or sleeping more. You shift consumption toward coffee, away from substitutes.

Total effect = substitution effect + income effect.

The Slutsky equation

Eugen Slutsky formalized this decomposition in 1915. The Slutsky equation states:

\[\frac{\partial x}{\partial p} = \frac{\partial x^h}{\partial p} - x \cdot \frac{\partial x}{\partial m}\]

Where:

• ∂x/∂p = total effect of price change on demand
• ∂x^h/∂p = substitution effect (compensated demand)
• x · ∂x/∂m = income effect (quantity times income sensitivity)

The math looks intimidating, but the intuition is simple: how much you change consumption when prices change depends partly on how the price change affects your effective wealth^[3].

Normal goods

For normal goods—goods you buy more of as income rises—both effects push the same direction:

• Price falls → substitution effect increases demand (it's cheaper relative to alternatives)
• Price falls → income effect increases demand (you're effectively richer)

Result: unambiguously downward-sloping demand curve. Lower prices always mean higher quantity demanded for normal goods.

Examples: fresh produce, restaurant meals, vacation travel, electronics. When prices drop, people buy more. No surprise.

Inferior goods

Inferior goods work differently. These are goods people consume less of as they get richer—not because they're low quality, but because they're economical substitutes for preferred alternatives.

• Instant noodles (substitute for better food)
• Bus transportation (substitute for car ownership)
• Generic store brands (substitute for name brands)
• Used clothing (substitute for new)

When the price of an inferior good falls^[4]:

• Substitution effect: increases demand (cheaper than alternatives)
• Income effect: decreases demand (you're richer, so you buy less)

The effects oppose each other. Total effect depends on which dominates.

Usually, the substitution effect wins. Even though instant noodles are inferior, a big enough price drop makes people buy more—the cheapness outweighs the "I can afford better" sentiment.

Giffen goods

Robert Giffen observed something strange in 19th-century Ireland. When potato prices rose during famines, poor families actually bought more potatoes. The demand curve sloped upward—the opposite of normal behavior.

How? These families spent most of their income on potatoes, the cheapest calorie source. When potato prices rose, their real income fell so dramatically that they couldn't afford meat or bread at all. They substituted away from those expensive calories toward the only food they could still afford: more potatoes^[5].

For Giffen goods:

• Substitution effect: decreases demand (potatoes are more expensive relative to other foods)
• Income effect: increases demand (you're so much poorer that you can only afford the cheapest option)

The income effect dominates. Demand rises with price.

Giffen goods are theoretical curiosities—they require extreme conditions:

• The good must be inferior
• It must constitute a large share of the consumer's budget
• There must be no cheaper substitutes available

Modern economies rarely produce Giffen goods. But the logic illuminates how income effects can create counterintuitive outcomes.

Graphical analysis

Indifference curve analysis shows the decomposition visually.

Start with a budget constraint and optimal consumption bundle. When a price drops:

1. Draw the new budget constraint (rotates outward)
2. Find the new optimal bundle on a higher indifference curve
3. Decompose the move into two steps:
   • First, a hypothetical budget line parallel to the new one but tangent to the original indifference curve (substitution effect)
   • Second, a shift from this hypothetical point to the actual new optimum (income effect)

The Hicks method keeps utility constant while isolating the substitution effect. The Slutsky method keeps purchasing power constant for the same bundle. Both yield the same qualitative insights^[6].

Practical applications

Tax policy. When governments consider sales taxes, they should recognize that taxes don't just change relative prices—they reduce real income. The income effect can matter more than the substitution effect for necessities.

Wage analysis. Higher wages have ambiguous effects on labor supply. The substitution effect encourages more work (leisure is relatively more expensive). The income effect encourages less work (you can afford more leisure). At high income levels, the income effect often dominates—why top executives don't work 100-hour weeks despite their earning power.

Commodity pricing. Oil price shocks hit consumers through both channels. Higher gas prices redirect spending (substitution) and shrink budgets (income). The combined effect on consumer spending exceeds what either effect alone would suggest^[7].

Welfare economics. Compensating variation and equivalent variation—measures of welfare change from price movements—explicitly account for income effects. Ignoring them underestimates consumer harm from price increases.

Engel curves and income effects

Ernst Engel documented how spending patterns vary with income. His observations:

• Food's share of spending falls as income rises (Engel's Law)
• Luxury goods' share rises with income
• Necessities' share falls with income

These patterns reflect income effects directly. Food is a normal good but with declining income elasticity—as people get richer, they buy more food but not proportionally more. Eventually food becomes almost an inferior good at high incomes (you don't need more calories just because you're wealthy)^[8].

Income effects in aggregate

Individual income effects aggregate into macroeconomic phenomena:

Wealth effects. Stock market gains make consumers feel richer, increasing spending even without realized gains. The income effect operates through perceived, not just actual, purchasing power.

Commodity price shocks. When oil prices spike, real incomes fall globally. The aggregate income effect can push economies into recession.

Exchange rate movements. Currency depreciation raises import prices, reducing real income. Consumers cut back on imports and domestic goods alike—the income effect spreading beyond the directly affected goods.

Limitations of the concept

The income effect assumes rational, utility-maximizing consumers. Behavioral economics complicates this:

Mental accounting. People might not treat windfall gains (price drops) the same as equivalent income increases. A $100 savings on a TV might be spent differently than a $100 raise.

Reference dependence. Loss aversion means income losses (from price increases) hurt more than equivalent income gains feel good. The income effect might be asymmetric^[9].

Bounded rationality. Consumers might not even notice small price changes, meaning both effects are muted in practice.

The theoretical decomposition remains useful despite these limitations. It identifies the forces at work, even if human behavior doesn't track them precisely.

The income effect in policy debates

When economists argue about minimum wage effects, income effects feature prominently:

Higher minimum wages raise worker incomes → increased spending → income effects boost demand for various goods → potentially offsetting employment losses.

The debate continues, but the income effect framework helps structure the analysis^[10].

Similarly, universal basic income proposals generate discussions about income effects. If everyone gets $1,000 monthly, how do consumption patterns shift? The income effect predicts increased demand for normal goods across the board.

Income effect — recommended articles

Consumer behavior — Demand — Economic efficiency — Market equilibrium

References

• Mankiw N.G. (2020), Principles of Economics, 9th Edition, Cengage Learning, Boston.
• Mas-Colell A., Whinston M.D., Green J.R. (1995), Microeconomic Theory, Oxford University Press, New York.
• Nicholson W., Snyder C. (2017), Microeconomic Theory: Basic Principles and Extensions, 12th Edition, Cengage Learning, Boston.
• Varian H.R. (2014), Intermediate Microeconomics: A Modern Approach, 9th Edition, W.W. Norton, New York.

Footnotes

1. ↑ Varian H.R. (2014), Intermediate Microeconomics, p.142
2. ↑ Mas-Colell A. et al. (1995), Microeconomic Theory, pp.56-78
3. ↑ Nicholson W., Snyder C. (2017), Microeconomic Theory, pp.156-178
4. ↑ Mankiw N.G. (2020), Principles of Economics, pp.445-462
5. ↑ Varian H.R. (2014), Intermediate Microeconomics, pp.148-156
6. ↑ Mas-Colell A. et al. (1995), Microeconomic Theory, pp.82-95
7. ↑ Nicholson W., Snyder C. (2017), Microeconomic Theory, pp.189-205
8. ↑ Mankiw N.G. (2020), Principles of Economics, pp.478-492
9. ↑ Varian H.R. (2014), Intermediate Microeconomics, pp.167-178
10. ↑ Nicholson W., Snyder C. (2017), Microeconomic Theory, pp.234-256

Author: Sławomir Wawak