Income effect or demand effect is used to calculate the amount of profit or loss. The law of demand says that the amount of desired demand shows an inverse correlation with the price of an item when other economic factors are also held constant (demand/supply). It thus means that when the cost increases, profit also decreases. The concept of income effect was introduced by Keynes to measure the relationship between investment and savings. By measuring demand and supply, he was able to make his economic theory more precise.
Let us see how does the income effect plays in the matter of investment. As the prices of commodities rises, saving rate decreases. The capital investments also increases but the rate at which goods are produced remains the same or goes down. And since the amount saved is equal to the income created from investment, the saving will always remain unchanged.
But what happens when the prices fall? When the prices fall, saving starts decreasing and investment starts increasing again but at a slower pace. Hence, the equilibrium stands at the lowest price and income effect turns out to be negative. We can say that in this situation, the demand for the different goods rises while production increases and so on.
On the contrary, if we consider consumption expenditure less than the income effect then substitution effect plays a major role. As the prices fall, more of the available commodities are purchased by the people. So, they enjoy increased incomes. They start using all the newly acquired commodities in place of the old ones.
Following are some of the key takeaways to understand the relationship between economic concepts such as substitution and income effect. As the prices fall, the producers increase the supply of commodities. The consumers, on the other hand, buy fewer commodities because of the high prices. This leads to an increase in the unemployment rate and inflation rates. The central bank then steps in and tries to normalize the economy by raising interest rates and changing the national debt. The end result is the growth of the economy at a moderate pace.
However, let us now analyze the relationship between substitution and income effect using another example. Say that there are two markets, A and B, with prices varying on the market shares. Let us assume that each market has its own unique set of goods available at particular prices. Now if we use the concept of consumer demand, it would lead to the following key takeaways.
When the prices are high, people tend to save more because they believe that they will receive a bigger pay day when they purchase the goods from A and when they purchase the goods from B, they will receive a lesser pay day. Thus, this leads to excess savings and income effects on the demand for goods. On the other hand, when the prices are low, people tend to increase their saving and income effect by using the services offered by A. The service cost associated with the services offered by B is also passed on to customers. This leads to excess saving and income effect in the form of increased consumption of B and lower consumption of A. This leads to a reduction in the income effect of A and B together with the increase in the productivity effect of A and B.
The process is repeated when the relative prices of goods decrease. The process is further concluded when the prices of goods increase. According to the theory, the changes in relative prices leads to changes in income effect. The theory further assumes that when prices rise, purchasing power increases for some time until the prices fall again. Thus, the analysis is that when prices rise relative to income, people start saving more so that they can afford to purchase higher quantities of goods at lower prices.