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Income effect

The effect which a change in the price of a good has on a consumer’s demand for the good via the change it induces in his real income. Suppose a consumer has a given money income which he spends on a range of products, one of which, product X, costs 50p per unit. Assume the consumer initially buys 10 units of X. If its price now fell to 30p, the real income of the consumer has increased, since with his money income unchanged he can consume the same quantities of goods as before and have 10(20p) = £2 left over to spend on more goods. This change in real income will have the effect of increasing the consumer’s demand for certain goods. If X is one of them, then the change in real income has contributed to the overall increase in quantity demanded of X resulting from its price fall. If no more of X is bought as a result of the real income change alone, then the change in the quantity of X is due entirely to the fact that, because X is now cheaper relative to its substitutes than it was previously, it will tend to be substituted for them (hence this is called the substitution effect of the price change). Finally, if the increase in real income would actually tend, other things being equal, to decrease the quantity of X bought (i.e. X is an inferior good), then the income effect will tend to offset the substitution effect and we may observe only a small increase in the quantity of X, or even a decrease, where the income effect outweighs the substitution effect. This latter case of a good being so strongly inferior that its income effect outweighs its substitution effect and causes a fall in quantity demanded of a good whose price has fallen is the theoretical explanation of the famous ‘Giffen good‘ case.

Reference: The Penguin Dictionary of Economics, 3rd edt.