income effect

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income effect

the change in CONSUMERS’ real INCOME resulting from a change in product PRICES. A fall in the price of a good normally results in more of it being demanded (see THEORY OF DEMAND). A part of this increase is due to the real income effect (i.e. income adjusted for changes in prices to reflect current purchasing power). If a consumer has a money income of, say, £10 and the price of good X is £1, he can buy 10 units of the product; if the price of good X now falls to 50 pence, he can buy the same 10 units for only £5. The consumer now has an ‘extra’ £5 to spend on buying more of good X and other goods. The income effect, together with the SUBSTITUTION EFFECT, provides an explanation of why DEMAND CURVES are usually downward sloping. See CONSUMER EQUILIBRIUM, REVEALED PREFERENCE, PRICE EFFECT.

See INCOME-ELASTICITY OF DEMAND.