Income Effect
The income effect is the change in the quantity of a good demanded that results from a change in the consumer's real income, holding relative prices constant. When the price of a good falls, the consumer can afford to buy the same bundle as before and still have income left over, which is equivalent to an increase in real income. This increase leads the consumer to adjust purchases, and the resulting change, separate from the substitution effect, is the income effect. Together with the substitution effect, it decomposes the total response of demand to a price change, a decomposition named after the economists Hicks and Slutsky.
Decomposition of a price change
When the price of a good changes, the quantity demanded changes for two reasons. The substitution effect captures the change in relative prices: a good that becomes cheaper relative to others is substituted for the others. The income effect captures the change in real purchasing power: a fall in price raises real income and generally increases the demand for normal goods. The total change is the sum of the two effects, and the decomposition allows analysts to understand the channels through which price changes act.
The decomposition can be performed in different ways. The Hicksian approach holds utility constant, defining the income effect as the compensation needed to restore the original level of satisfaction. The Slutsky approach holds the original bundle affordable, defining the income effect as the compensation needed to purchase the initial bundle after the price change. Both procedures yield a substitution effect that is always negative, so that the demand curve slopes downward for normal goods.
Normal and inferior goods
For normal goods, both effects work in the same direction. A fall in price makes the good relatively cheaper, raising demand through substitution, and increases real income, raising demand further. The income effect reinforces the substitution effect, and the demand curve is unambiguously downward-sloping.
For inferior goods, the effects work in opposite directions. A fall in price raises real income, but because the good is inferior, higher real income reduces the quantity demanded. The income effect therefore works against the substitution effect, potentially reducing demand. If the income effect is smaller than the substitution effect, which is typical, the demand curve still slopes downward, but it is flatter than it would be otherwise.
Giffen goods and the paradox
In rare cases, the income effect can outweigh the substitution effect, producing a Giffen good whose demand rises when its price rises. For this to happen, the good must be strongly inferior, must account for a large share of the consumer's budget, and must have few close substitutes. Historical examples have been proposed, including certain staple foods in poor economies, though the empirical evidence is limited and contested.
The possibility of a Giffen good illustrates that the law of demand is not a logical necessity but a consequence of assumptions about preferences. Under standard assumptions, the substitution effect is always negative, and the income effect, while possibly positive for inferior goods, is usually small. The decomposition therefore clarifies both the generality and the limits of the law of demand, and it is a standard tool in the theory of consumer choice.
Policy and measurement
The decomposition is used in applied work to assess the effects of taxes, subsidies, and price changes. The welfare cost of a tax includes the substitution effect, which distorts choices, while the income effect represents a transfer of real income. Analysts separate the two to measure the efficiency cost of a policy, and the substitution effect is the relevant component for deadweight loss, since a lump-sum transfer of income would not distort behaviour.
Measuring income effects requires information on preferences and on the shares of goods in the budget. Empirical demand systems estimate income and substitution responses, and the estimated elasticities are used to predict the effects of price changes and to evaluate policies. The income effect is thus both a theoretical construct and an empirical object, and its measurement is integral to applied microeconomics and to policy analysis.
Compensating and equivalent variation
The income effect underlies two measures of the welfare change caused by a price change. The compensating variation is the amount of money that would restore the consumer to the original level of utility after a price change, and the equivalent variation is the amount that would have the same effect as the price change if paid before it. These measures differ from the change in consumer surplus because they account for the income effects that a large price change generates.
For small price changes and small budget shares, the three measures are close, which justifies the widespread use of consumer surplus in applied work. For large changes and for goods with large budget shares, however, the differences can be substantial, and the choice of measure matters for the evaluation of policies. Analysts therefore use the measures that correspond to the question at hand, and they report the assumptions underlying their calculations.
Income effects and labour supply
The decomposition of price and wage changes into income and substitution effects is applied to the labour supply decision as well. A rise in the wage raises the reward for working, which encourages more work through the substitution effect, but it also raises income, which encourages more leisure through the income effect. The net effect on hours worked is theoretically ambiguous, and the empirical literature finds that, for many groups, the substitution effect dominates and labour supply rises with wages, while for others the effects roughly cancel.
This ambiguity has implications for tax policy. The efficiency cost of a labour income tax depends on the substitution effect, because it is the distortion of the work-leisure choice that creates deadweight loss, while the income effect represents a transfer. The design of taxes and benefits therefore focuses on the effective marginal tax rates that workers face, since these determine the substitution effect, rather than on the average rate, which mainly reflects the income effect.
Measurement issues
Measuring income effects empirically is challenging because income changes are rarely exogenous. Analysts use windfall gains, lottery winnings, tax rebates, and policy changes to identify the response of demand to income, and they use these estimates to calibrate models. The results show considerable heterogeneity across households, with liquidity-constrained and low-income households exhibiting larger responses, and they inform the design of transfers and stimulus measures.
The decomposition also depends on the assumptions made about preferences. Different demand systems imply different relationships between income and substitution effects, and the estimated welfare measures vary accordingly. Sensitivity analysis across specifications is therefore important, and conclusions should be presented with attention to the uncertainty that arises from the modelling choices as well as from the data.