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TANSTAAFL: A rather cumbersome and usually hard to remember acronym for the expression "There ain't no such thing as a free lunch. This is a favorite saving of many economists because it highlights, albeit in a grammatically questionable manner, the fundamental problem of scarcity. The phrase serves to emphasize that seemingly "free" lunches are not really free. While they might be free to the customer, someone must pay, that is, incur an opportunity cost of foregone production. The lunch eaten by one person cannot be eaten by another.

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INCOME EFFECT:

The change in quantity demanded that results because a change in the demand price of a good affects real income (that is, the purchasing power of income) even though nominal income remains the same. This is one of two reasons, or effects, underlying the law of demand and the negative slope of the market demand curve. The other is the substitution effect.
The income effect offers part of an explanation for the law of demand and the negative slope of the demand curve. It rests on the observation that a change in price affects the purchasing power of a given amount of income. If the price rises, then the purchasing power of income falls. If the price falls, then the purchasing power of income rises.

How It Works?

Purchasing power, in general, is the quantity of goods and services that can be purchased with a given amount of income. To illustrate purchasing power, consider the morning consumption habit of Duncan Thurly. Duncan buys two glazed donuts from his local bakery, Donuts Dough-Lites, for 50 cents each on his way to work every morning. To satisfy this somewhat unhealthy practice, Duncan always enters the bakery with a single dollar.

However, consider what happens if Duncan enters the Donuts Dough-Lites bakery one morning to discover that the price of glazed donuts has fallen to 25 cents each? Duncan's dollar has greater purchasing power at the lower price. He can now purchase four glazed donuts if he desires, which he probably will.

If Duncan gives in to the greater purchasing power of his dollar and purchases four tasty glazed donuts, then he has fallen victim to the income effect.

Up and Down

Consider the income effect from both sides of a price change.
  • Higher Price: An increase in price causes a decrease in the purchasing power of income. This restricts the ability to purchase a good and the quantity demanded decreases.

  • Lower Price: A decrease in price causes an increase in the purchasing power of income. This enhances the ability to purchase a good and the quantity demanded increases.

Not A Determinant

The income effect is triggered by a change in demand price, given that buyers' income is constant. This effect needs to be distinguished from a seemingly similar notion, the buyers' income demand determinant.
  • Income Effect: The income effect results from a change in demand price, which affects the purchasing power of a given amount of income. The change in purchasing power then causes a change in quantity demanded and a movement along the demand curve. With the income effect, price changes and income is fixed.

  • Buyers' Income Demand Determinant: Buyers' income is a demand determinant that affects the ability to purchase a good, given no change in the price of the good. The change in buyers' income causes a change in demand and a shift of the demand curve. With the buyers' income demand determinant, price is fixed and income changes.

The Substitution Effect

The income effect is one of two effects underlying the law of demand and negative slope of the demand curve. The other is the substitution effect, which results because a change in price changes the relative prices of other goods and induces buyers to substitute the purchase of one good for another. While both effects are important, for most goods, the substitution effects tends to play the biggest role in a change in quantity demanded.

<= INCOME EARNED BUT NOT RECEIVEDINCOME ELASTICITY OF DEMAND =>


Recommended Citation:

INCOME EFFECT, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2018. [Accessed: January 24, 2018].


Check Out These Related Terms...

     | substitution effect | law of demand | demand schedule | demand curve | demand space | demand determinants | consumer surplus | change in demand | change in quantity demanded |


Or For A Little Background...

     | demand | demand price | quantity demanded | market | quantity | price | unlimited wants and needs | economic analysis | exchange | scarcity | good | service | cause and effect | satisfaction |


And For Further Study...

     | market demand | competition | consumer sovereignty | competitive market | efficiency | exchange | buyers' income, demand determinant |


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