The income effect is the change in what a consumer chooses when their purchasing power changes. When a price rises or falls, purchasing power changes even if money income stays the same. The effect on a particular good depends on whether it is normal or inferior, and it works alongside the substitution effect.
How the income effect works
A price change affects consumer choices through two mechanisms. The substitution effect reflects a change in relative prices: consumers tend to shift toward goods that have become relatively cheaper. The income effect reflects the change in what their existing income can buy. A higher price reduces that purchasing power; a lower price increases it.
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As OpenStax explains in Principles of Economics 2e, section 6.2, a higher price effectively reduces income’s buying power, even when actual income has not changed. For a normal good, that loss of purchasing power contributes to buying less of it.
Does the income effect mean your income changed?
Not necessarily. In the price-change explanation, “income” refers to real purchasing power, not necessarily the amount of money received. If your pay stays fixed but the price of something you buy rises, your budget can buy less overall. A price decrease has the opposite effect.
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The term is also used for the way a change in actual income affects a consumer’s choices. OpenStax discusses both uses in its appendix on indifference curves. Keeping them distinct helps: an actual income increase changes money income, while a price change can change purchasing power without changing money income.
Why the effect differs for normal and inferior goods
The income effect does not move every good in the same direction. Its direction depends on how a consumer’s demand for that good responds to purchasing power.
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Normal goods
A normal good is one a consumer tends to buy more of as income rises. When a price increase reduces purchasing power, the income effect tends to reduce consumption of a normal good; when purchasing power rises, it tends to increase consumption.
Inferior goods
An inferior good is one a consumer tends to buy less of as income rises. For that good, the income effect tends to run opposite to the change in purchasing power: more purchasing power can mean less consumption, and less purchasing power can mean more.
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These are consumer-specific classifications, not permanent labels for a product. OpenStax gives examples such as a higher-income household buying fewer hamburgers or being less likely to buy a used car, perhaps choosing steak or a new car instead. The examples illustrate how preferences and circumstances can affect a good’s classification; they do not establish that those goods are inferior for everyone.
Income effect versus substitution effect
| Question | Income effect | Substitution effect |
|---|---|---|
| What changes? | Effective purchasing power | Relative prices |
| What does it describe? | How a changed budget’s buying power affects choices | Movement toward goods that have become relatively cheaper |
| What happens when a good’s price rises? | The direction for that good depends on whether it is normal or inferior | Consumers generally shift away from the good that has become relatively more expensive |
| How does it relate to the other effect? | It occurs alongside the substitution effect after a price change | It occurs alongside the income effect after a price change |
This is a conceptual way to separate the forces behind a choice, not a claim that consumers consciously calculate them. Preferences determine the final bundle, so the overall response to a price change is not just the income effect. OpenStax’s treatment of consumer choice and MIT OpenCourseWare’s lecture on deriving demand curves discuss the relationship between the two effects.
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A simple example: the price of baseball bats
Suppose Sergei buys baseball bats and cameras, and the price of bats rises while his money income stays the same. He can now afford less overall. If bats are a normal good for him, the resulting loss of purchasing power contributes to buying fewer bats. At the same time, bats have become relatively more expensive, so the substitution effect also encourages him to shift away from them. This example illustrates the two mechanisms; it does not predict every consumer’s response.
Independent reader supportYour contribution helps us test, update, and keep practical guides available for everyone.How income elasticity relates
Income elasticity describes how the quantity purchased responds to a change in consumer income. The USDA Economic Research Service glossary associates positive income elasticity with normal goods and negative income elasticity with inferior goods. It is a way to describe response to income, not by itself a decomposition of a price change into income and substitution effects.
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