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ADJUSTMENT, LONG-RUN AGGREGATE MARKET: Disequilibrium in the long-run aggregate market induces changes in the price level that restore equilibrium. If the price level is above the long-run equilibrium price level, economy-wide product market surpluses cause the price level to fall. If the price level is below the long-run equilibrium price level, economy-wide product market shortages cause the price level to rise. In both cases long-run equilibrium is restored. Price level changes induce changes in aggregate expenditures but NOT changes in real production. The reason is that long-run aggregate supply is full-employment real production, which is unaffected by the price level.
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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 DownConsider 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 DeterminantThe 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 EffectThe 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.
Recommended Citation:INCOME EFFECT, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2024. [Accessed: April 25, 2024].
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