Income effect

As income effect the change of the demand for a good is referred to in microeconomics, which arises due to a change of the (real) income. More precisely, one speaks of an income effect, if due to a price change in a market changes the real income of an actor; this change in real income losses then turn the said change in demand.

From the income effect, a distinction is occurring a second effect, the so-called substitution effect when considering the effects of a price change. Depending on the scenario, the effects reinforce each other or are contrary to each other.

For the isolated consideration of the income and substitution effect one often uses the so-called Slutsky decomposition; in particular in the photographic analysis, bib often resorted to ( analytically but less rich ) Hicks decomposition.

Formal definition

The income effect results directly from the Slutsky equation (for proof and explanation of the various functions and variables referenced in the article Slutsky decomposition )

It is handled different in the literature as to whether the income effect is now defined as protruding or we except the minus sign of the expression, which for the income effect then only remain standing. This is of course essential for the application, because the sign of the effect are reversed in this case (so that, for example, the income effect for normal goods would always be positive, see below). We will use throughout the former definition.

For the term is the right of the equal sign corresponding to the effect of the price change of a property on the demand for the same good at ( own-price case).

Properties

Ambiguity of the sign

It refers to the income effect of a price change as positive if the sign of the income and the change in demand are different. Otherwise, one speaks of a negative income effect. (Note that in contrast, the substitution effect is called positive if the sign of the price and the [ compensated ] change in demand are identical. )

Consider a situation in which there are only two goods: good 1 and good 2 to investigate, as the demand for these two goods changes when the price of good 1 increases. The price increase has two effects:

Overall effect: In this example, both the substitution effect for good 1 ( price increase → ​​decrease in demand ) as well as the income effect for good 1 are negative ( price increase → ​​decrease in income → decline in demand ). Both effects add up to a negative overall effect - the demand for good 1 is reduced in consequence so. In terms of good 2, however, affect the substitution effect (positive) and the income effect (negative) against each other. A clear statement of the overall effect is not possible here. If the substitution effect outweighs the income effect in terms of magnitude, the consumption of good 2 increases; However outweighs the income effect, it sinks.

The idea is reversed in part, if one considers instead of a price increase a price reduction of good 1. Such a dual effect:

Overall effect: In this example, both the substitution effect and the income effect for good 1 are negative ( price reduction → increase in demand or increase in income → increase in demand ). Both effects add up to a negative overall effect - the demand for good 1 increases as a consequence so. In terms of good 2, however, affect the substitution effect (positive) and the income effect (negative) against each other. A clear statement of the overall effect is not possible here. If the substitution effect outweighs the income effect in terms of magnitude, the consumption of good 2 decreases; However outweighs the income effect, it rises.

In fact, it is about a general insight. While the substitution effect due to the price change of a property with convex indifference curves always negative for the demand for this good is (a higher relative price of good 2 leads to an output- minimizing consumers always a reduction in the demand for that good), the sign of the income effect opens up (and thus the overall effect ) only other assumptions. Often, the question of which outweighs the effects, even at a given equipment of players of which depends on what area of the respective budget line you are.

Income effect for different types of goods

The descriptions of goods as inferior and normal to refer to the direction of the overall effect with respect to the demand for a change in income ( under constant prices ) in each case. This is the term (after a common classification) an estate as inferior, if income growth attracts a reduction in demand for the good by themselves and to be normal when an increase in income to an increase in demand leads. It appears, therefore, that the income effect is always negative in normal goods, inferior in contrast, positive. This comes directly from the formal definition out, because by definition is at normal goods and inferior goods.