The income effect refers to the change in consumers’ consumption of products as a result of an increase in income. What does this mean? Well, let’s put it this way, a person who makes $1000 per month would likely to splurge at least that much on a new plasma TV, a fancy exercise bike, or an all-inclusive vacation. Now, if that same person made just a little extra per month, she might be inclined to save that cash instead, putting some of the money towards her debt load. This is basically how the income effect works in our society.
The income effect is really more of a consumption effect. This means that consumers will tend to spend more when they experience a rise in income, and they might also spend less when their income falls. This works mainly because individuals have to face a lot of challenges when faced with changes in their consumption. These changes, most importantly inflation, have made many people suddenly pay a price for having increased their income (or, put another way, for buying goods that might otherwise not have been available).
One way to understand how the income effect works is by conceptualizing consumption in terms of money. Let’s say that one earns x amount of dollars per week. Now, assume that after taxes are taken out, she has to make use of these earnings in order to satisfy her basic needs, such as food, clothing, shelter, and other social necessities. Now, suppose that she then consumes a particular dollar amount of money per day in order to satisfy her basic needs.
Under the condition just quoted, the substitution effect may make consumers feel worse off if the price of the dollar increases as compared to before, especially if those earnings that she makes are used to meet basic needs. This is, of course, where the substitution effect comes into play. In short, consumers may feel Worse off as the price of products increases and this can have a negative impact on overall economic activity.
So, it would seem that when the price changes, the income effect hits home. However, what occurs is something somewhat different when we look at the income effect from the point of view of the quantity of money available to be spent on consumption. Let us take, for example, the following scenario. Say that Y purchases a B in the dollar store. But, when the dollar store price increases, so does Y’s consumption.
So, the income effect is, in fact, the change in Y’s net worth that he makes due to the increase in the price of B. But, when we look at the scenario just presented, we see that Y’s net worth only goes down because he no longer has access to B. This means that the increase in price only affects Y’s income from the sale of B to the point of purchase. So, when we add up the total of Y’s purchases of goods above his required level of consumption, we get the amount of income gained from Y’s purchases of B. But, when we take the total of all of Y’s purchases of other goods, including C, then we get the amount of income gained from Y’s purchases of C.
In the previous example, the equilibrium price points were determined by minimizing utility loss through investment in capital goods. This is because, when equilibrium prices are found, the utility is zero. But, in an optimal consumption combination, there must be some amount of income gained from investments in non-monetary assets. Therefore, the quantity of income produced by capital goods x will equal the sum of the relevant quantities of consumption goods.
This summary should help you see that there is an essential relationship between income and wealth, which can be called the income Wealth Consumption Gap. To draw a clear conclusion, however, it is necessary to actually calculate this relationship; and the best method is to use the concept of indifference. indifference is defined as the amount of benefit obtained per unit of expenditure in a situation where all possible externalities of consumption are taken into account, as determined by the theory of potential savings and investment, which is called the theory of optimum consumption.