The income effect explains consumer demand in terms of elasticity, i.e., how it responds to changes in income. The income effect is part of economic theory that relates consumer choices to individual income elasticity and demand curves which express how changes in income and real market prices affect consumer demand for particular consumer goods and services, over time. It can be used to examine how the elasticity of income effects consumption decisions across the income range. The income effect also indicates the degree to which changes in income level affect income of low earners, the effect being stronger for low earners than for middle or higher earners.
The elasticity of the income effect implies that changes in income level are stimulative to demand. If income level increases then people spend more and so increases in disposable income occur. But if income level decreases then people spend less and so income decreases. The elasticity of the income effect can be examined in many different ways.
Diets are a good example of using elasticity concept to examine the income effect on consumer spending. The substitution effect of changing the quantity of one commodity by another is called substitution. The substitution effect between raising the price of vegetables and reducing the price of meat is called the substitution effect. Let us assume that income has increased and let us assume that the quantity of vegetables has decreased. We can calculate by using the substitution relationship that the increase in the price of vegetables will have the same effect as the reduction in the price of meat.
The substitution relationship exists because the quantity of something decreased is the same as the value of the item that has been increased. We can observe the indifference curve by plotting the horizontal trend of changes in prices against the increase in the income group. A straight line on the horizontal graph would indicate a decreasing tendency on the y-axis and an increasing tendency on the x-axis. Therefore, when the x increases linearly with y the slope of the curve of a price decrease is zero on the y-axis and that for the x decreases linearly with y. In this example the elasticity of demand is the same for the two price changes.
Let us assume that income has increased and let us also assume that the quantity of consumption goods sold has also increased. We can calculate the elasticity of demand by plotting the horizontal trend of changes in the volume of consumption goods against the increase in income group. Again, a straight line on the x-axis would indicate that the slope of the curve of change in price increases at the same time as the change in income group increases linearly. The price elasticity is zero on the y axis when consumption is constant and increases monotonously as income does so. When the elasticity of demand is positive (and consumption increases) then the curve of price decrease slopes directly opposite to the initial trend.
Using the concept of substitution effect, we can solve the problem of market income effects by calculating the change in elasticity of demand between rich and poor households when their total income is changed. Let us suppose that the income of poorer households have been increased by some amount above their expenditure so that they have enough income to reduce consumption and allow for saving. Then their total income elasticity will have changed from high to lower elasticity band; consequently, the quantity of consumption goods sold will fall below their cost in the long run.
By means of a logarithmic regression we can calculate the change in elasticity of demand as the product of personal preferences i.e., how much of the income is saved or spent between income groups. If this saving or spending is not equal across income bands then the substitution effect disappears. For instance, if two households with the same saving and spending habits to save and spend the same amount at the same time their income effect will be zero as their saving and spending will be the same.
The price changes can also affect the income effect as prices of products tend to increase in line with increases in nominal income. This means that if there are price increases in certain goods the real income increases but not the nominal ones and vice versa. Let us suppose that by the end of one period of rising prices the real income increases but not the nominal one and then price increases equal to the marginal product of increases in both income bands. We get the situation where prices are decreasing in the low band but increasing in the high band; this implies that income decreases but not vice versa.