The Income Effect

For the vast majority of goods, the substitution effect is pretty much the entire story behind the slopes of the individual and market demand curves. There are, however, some goods, like food or housing, that account for a substantial share of many consumers’ spending. In such cases another effect, called the income effect, also comes into play.

Consider the case of a family that spends half its income on rental housing. Now suppose that the price of housing increases everywhere. This will have a substitution effect on the family’s demand: other things equal, the family will have an incentive to consume less housing—say, by moving to a smaller apartment—and more of other goods. But the family will also, in a real sense, be made poorer by that higher housing price—its income will buy less housing than before.

The amount of income adjusted to reflect its true purchasing power is often termed “real income,” in contrast to “money income” or “nominal income,” which has not been adjusted. And this reduction in a consumer’s real income will have an additional effect, beyond the substitution effect, on the family’s consumption bundle, including its consumption of housing.

The income effect of a change in the price of a good is the change in the quantity of that good consumed that results from a change in the consumer’s purchasing power due to the change in the price of the good.

The change in the quantity of a good consumed that results from a change in the overall purchasing power of the consumer due to a change in the price of that good is known as the income effect of the price change. In this case, a change in the price of a good effectively changes a consumer’s income because it alters the consumer’s purchasing power. Along with the substitution effect, the income effect is another means by which changes in prices alter consumption choices.

It’s possible to give more precise definitions of the substitution effect and the income effect of a price change, and we do this in the appendix to this chapter. For most purposes, however, there are only two things you need to know about the distinction between these two effects.

First, for the great majority of goods and services, the income effect is not important and has no significant effect on individual consumption. So most market demand curves slope downward solely because of the substitution effect—end of story.

Second, when it matters at all, the income effect usually reinforces the substitution effect. That is, when the price of a good that absorbs a substantial share of income rises, consumers of that good become a bit poorer because their purchasing power falls. As we learned in Chapter 3, the vast majority of goods are normal goods, goods for which demand decreases when income falls. So this effective reduction in income leads to a reduction in the quantity demanded and reinforces the substitution effect.

However, in the case of an inferior good, a good for which demand increases when income falls, the income and substitution effects work in opposite directions. Although the substitution effect tends to produce a decrease in the quantity of any good demanded as its price increases, in the case of an inferior good the income effect of a price increase tends to produce an increase in the quantity demanded.

A Giften good is a hypothetical inferior good for which the income effect outweighs the substitution effect and the demand curve slopes upward.

As a result, there are hypothetical cases involving inferior goods in which the distinction between income and substitution effects is important. The most extreme example of this distinction is a Giffen good, a good that has an upward-sloping demand curve.

The classic story used to describe a Giffen good harks back to nineteenth-century Ireland, when it was a desperately poor country and a large portion of a typical household’s diet consisted of potatoes. Other things equal, an increase in the price of potatoes would have led people to reduce their demand for potatoes. But other things were not equal: for the nineteenth-century Irish, a higher price of potatoes would have left them poorer and increased their demand for potatoes because potatoes were an inferior good.

If the income effect of a price increase outweighs the substitution effect—as was conjectured for potatoes in nineteenth-century Ireland—a rise in price leads to an increase in the quantity demanded. As a result, the demand curve slopes upward and the law of demand does not hold.

In theory, Giffen goods can exist; but they have never been validated in any real situation, nineteenth-century Ireland included. So as a practical matter, it’s not a subject we need to worry about when discussing the demand for most goods. Typically, income effects are important only for a very limited number of goods.

ECONOMICS in Action: Mortgage Rates and Consumer Demand

Mortgage Rates and Consumer Demand

Most people buy houses with mortgages—loans backed by the value of the house. The interest rates on such mortgages change over time; for example, from 2000 through 2003 interest rates fell by 3.3% and remained at record low levels through 2008. The decline in interest rates was a primary factor in the housing bubble that occurred over the same time period. When mortgage rates fall, the cost of housing falls for millions of people—even people who have mortgages at high interest rates are often able to “refinance” them at lower rates. The large fall in interest rates corresponded with a large increase in homeownership rates through the United States. The percentage of American households who owned their home increased from 67.1% in 2000 to a historical high of 69.2% in 2004. Homeownership rates remained well above 68% until the housing market collapsed in 2007.

Demand for housing goes up when mortgage rates go down. But so does the demand for exotic vacations.
Martin Valiqursky/Shutterstock

It’s not surprising that the demand for housing goes up when mortgage rates go down. Economists have noticed, however, that the demand for many other goods also rises when mortgage rates fall. Some of these goods are items connected with new or bigger houses, such as furniture. But people also buy new cars, eat more meals in restaurants, and take more vacations. Why?

The answer illustrates the distinction between substitution and income effects. When housing becomes cheaper, there is a substitution effect: people have an incentive to substitute housing or other goods in their consumption bundle. But housing also happens to be a good that absorbs a large part of consumer spending, with many families spending a quarter or more of their income on mortgage payments. So when the price of housing falls, people are in effect richer—there is a significant income effect.

The increase in the quantity of housing demanded when mortgage rates fall is the result of both effects: housing becomes a better buy compared with other consumer goods, and people also buy more and bigger houses because they feel richer. From 2000 through 2007 the average size of a new American home grew by nearly 250 square feet. And because they feel richer, people also buy more of all other normal goods, such as cars, restaurant meals, and vacations. Over the same time period there was a 20% increase in airplane departures, and Americans spent an additional 35% on eating out and entertainment.

Quick Review

  • Most goods absorb only a small fraction of a consumer’s spending. For such goods, the substitution effect of a price change is the only important effect of the price change on consumption. It causes individual demand curves and the market demand curve to slope downward.

  • When a good absorbs a large fraction of a consumer’s spending, the income effect of a price change is present in addition to the substitution effect.

  • For normal goods, demand rises when a consumer is richer and falls when a consumer is poorer, so that the income effect reinforces the substitution effect. For inferior goods, demand rises when a consumer is poorer and falls when a consumer is richer, so that the income and substitution effects move in opposite directions.

10-4

  1. Question 10.7

    In each of the following cases, state whether the income effect, the substitution effect, or both are significant. In which cases do they move in the same direction? In opposite directions? Why?

    1. Orange juice represents a small share of Clare’s spending. She buys more lemonade and less orange juice when the price of orange juice goes up. She does not change her spending on other goods.

    2. Apartment rents have risen dramatically this year. Since rent absorbs a major part of her income, Delia moves to a smaller apartment. Assume that rental housing is a normal good.

    3. The cost of a semester-long meal ticket at the student cafeteria rises, representing a significant increase in living costs. Assume that cafeteria meals are an inferior good.

  2. Question 10.8

    In the example described in Question 1c, how would you determine whether or not cafeteria meals are a Giffen good?

Solutions appear at back of book.

Having a Happy Meal at McDonald’s

In 2013, McDonald’s agreed to stop featuring and promoting soda as a beverage option for its Happy Meals. It was the latest step in McDonald’s efforts to make its standard child’s Happy Meal more healthful. For example, in 2011 McDonald’s changed its standard Happy Meal to include a quarter cup of apple slices and fewer french fries, and removed its caramel sauce, thereby lowering the salt, sugar, fat, and calorie content. To be sure, healthier options had always been available: a parent could ask for fruit or milk instead of fries or soda. But most people opted for the standard meal by default. According to restaurant analyst Peter Saleh, “This is good publicity, and if you sell more Happy Meals, you’re selling more Big Macs to the parents.”

The changes are meant to help offset long-standing criticism of the company for the lack of nutritional balance in its menu and address concerns over the growing epidemic of childhood obesity. Critics contend that at around 600 calories, Happy Meals are still too calorie rich for small children. Long-time observers say that more than just countering its critics, McDonald’s is trying to hold onto a loyal customer base: Happy Meals accounted for an estimated 10% of its annual sales, or close to $9 billion in 2013. And although its rivals, such as Burger King and Wendy’s, followed McDonald’s lead by offering healthier kids’ meals, McDonald’s consistently sells more kids’ meals than the competition.

Michael Neelon/Alamy

McDonald’s has, in fact, been amazingly successful at keeping its customers happy even in a tough environment. In 2009, at the lowest point of the recession that began in 2007, sales at full-service restaurants fell more than 6% but stayed about the same at fast-food outlets. These restaurants kept their sales up by offering discounts and promotions as well as $1 menus and cheap combination meals. Same-store sales at McDonald’s have stayed approximately level during the downturn.

However, many fast-food chains, such as Burger King, Jack in the Box, and Carl Jr.’s, saw their sales fall during the recession years. They cut back their advertising spending as the much larger McDonald’s increased its spending and its market share. McDonald’s has also aggressively expanded its menus—from the healthier Happy Meals to the “McCafé” line of espresso drinks, smoothies, and exotically flavored wraps.

Observers are divided as to whether McDonald’s is earnestly attempting to get its customers to eat healthier food or is just engaging in advertising spin. One unknown is how customers will react: as one commenter said, “Salt may be bad for you, but it tastes great…. You can’t demand that McDonald’s or Burger King stop selling hamburgers and fries.” In the same vein, one franchise owner noted, “Expect customers to try the apples and then revert to asking for fries.”

QUESTIONS FOR THOUGHT

  1. Question 10.9

    Y3SuL+o4cMcTM9G1Ay0cJuT3l9AFEb3GFPOsKH82UsRPcFAf/eWaXpzlf7OeODrJECQXDy/VVJh+oJojkQCgwVHvA20HXVs4RxlwqeQVxs01+PM4UEBLNtFhM+YvRNUe+PBPVN9edsT82JxLh/w7PZ+eqq2WdYPPRKqZ0hGYvaaEsoXuVdcnemOlAoqRIVN1tbm0nFD4P286YaXF
    Give an example of a normal good and an inferior good mentioned in this case. Cite examples of substitution effects and income effects from the case.

  2. Question 10.10

    C577IB+hvfZVJsWAXU30+ikiPMciU0pyr81hQlrmraF3fbi/ABREpmQ/mv2RX88slzI7f8TnxIdMo4x+KZHYppZ9O/Cc4f583p/Dv4TrJ7U2Rzh2bfVVRWwrHAbXYrqC1VvKJ/d1zFh2usQmFec7Ntz+XdDMO0Wuh+Xbk+P5VTkfYtGyuonjE3J/kNXAzucR7u4j1Ke6bTbY+CvLXA20oHPr4frRDHHw1BodJxAIcOPgfUe65GxqjsPcMJTG9SZSSVItmP835BodgvPFy+OUIQ==
    To induce fast-food customers to eat more healthful meals, what alternatives are there to bans? Do you think these alternatives would work? Why or why not?

  3. Question 10.11

    CBM4aaUE8CccysiBkBNeIQABi6svFaf8uLR4x/bKD6iVYYoxbblJsRUbqjO767tGhA46llxy+2mlDYvY/rh3yqpdO99c8e4VgO6mxnakSEqkSFQenhM3nXI4ylP63KQg4np+RYpFIbjZebTD
    What do you think accounts for McDonald’s success? Relate this to concepts discussed in the chapter.