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MENTAL MODEL · M4357

The Income Effect

The Income Effect
BusinessHigh supportMicroeconomics
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Updated 2026-08-01

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INTRODUCTION

English translation pending.

CORE DEFINITION

A core concept in microeconomics, analyzed alongside the substitution effect. When the price of a good falls, the consumer's real purchasing power rises even if nominal income is unchanged, which changes how much of each good they buy. For normal goods the income effect is positive; for inferior goods it can be negative, since higher real income shifts purchases toward better alternatives. Together the two effects give the total demand response.

SCAFFOLDING EFFECT

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- Trace the windfall: ask what people do with the resources a price fall releases, not only how much more they buy - Predict upgrades: expect released purchasing power to be spent on better substitutes - Separate the effects: distinguish the relative-price shift from the real-income shift when forecasting demand

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A price change alters the budget constraint in two ways at once. The relative price change makes the good more or less attractive compared with others, which is the substitution effect. The same change also moves the purchasing power of the whole budget, which is the income effect, and that shift operates on every good the consumer buys, including ones whose prices never moved.

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Source support: Explicit

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