Economists calculate the income effect separately from the price effect by keeping real income constant in the calculation. Normally, one formula is used to calculate the price effect using the income and substitution effects. There are two methods of separating the income and substitution effects.
Changes in price often have a dramatic impact on consumption. Consumer spending and demand rise or fall based on what goods consumers are able to purchase at what prices. Increases in consumer income and reductions in price allow higher levels of consumption of goods and services. How much demand and consumption of a consumer good or service increase may be estimated using complex mathematical calculations. The price effect is comprised of both the income and substitution effect.
- The income effect and the price effect are components of the total effect of a price change on quantity demanded.
- The price effect measures the change in quantity demanded due to the price change, assuming income remains constant.
- The income effect measures the impact of the price change on real income and, consequently, on purchasing power and welfare.
- Economists use a variety of methods to calculate each.
- The total effect is the sum of the price effect and income effect.
Calculating Income Effect and Price Effect
The income effect and the price effect are two components of the total effect that a change in the price of a good or service has on the quantity demanded by consumers. They are used in the context of the price elasticity of demand, which measures the responsiveness of quantity demanded to changes in price.
There’s a couple of steps to take when calculating the effect of each; be mindful that other analysis methods are discussed below and may slightly vary from these steps.
- Step 1: Determine the Initial Quantity and Price. Start with the original quantity demanded (Q1) and the initial price (P1) of the good or service.
- Step 2: Determine the New Quantity and Price. Identify the new quantity demanded (Q2) and the new price (P2) after the price change occurs.
- Step 3: Calculate the Total Effect. The total effect is the change in quantity demanded due to both the income effect and the price effect. In other words, subtract Q1 from Q2 from the first two bullets above.
- Step 4a: Isolate the Price Effect. To calculate the price effect, we need to hold the consumer’s real income constant. This means adjusting the consumer’s purchasing power by considering the impact of the price change on their real income. You can do this by subtracting the Income Effect from Step 3, or you can subtract both Q1 and the Income Effect from Q2.
- Step 4b: Isolate the Income Effect. To calculate the income effect, we need to adjust for the impact of the change in real income caused by the price change. The income effect is given by subtracting the price effect from the total effect.
By analyzing the price and income effects, economists can predict how consumers respond to changes in market conditions. This helps in forecasting changes in demand patterns, assessing the impact of price fluctuations, and understanding consumer preferences.
Other Calculation Methods
Compensating Variation Method
The compensating variation approach is used to analyze how price changes affect consumers’ welfare and satisfaction. The approach involves considering the consumer’s initial utility level when the price of a good or service is at its original level and the quantity consumed is at its original level. Then, imagine a scenario where the price changes to a new level, resulting in a new quantity consumed. The compensating variation represents the additional income needed to restore the consumer’s well-being to its original level after the price change.
This approach is valuable in understanding how consumers respond to price changes, accounting for adjustments in purchasing power and measuring the impact of price changes on their overall welfare.
The Hicksian Method
The Hicksian method, developed by British economist John R. Hicks, reduces hypothetical consumer income in the calculation to determine the impact of the substitution and income effects. In the economy, taxation could be an arbitrary means of reducing consumer income. The impact of the reduction in income alone could be readily seen using this modification.
Both the price effect and income effect can be positive. This occurs when the price of a normal good decreases, leading to an increase in quantity demanded due to both the substitution effect prompting higher consumption and the income effect from increased real income.
The Slutskian Method
Also, the substitution effect could be singled out using the Slutskian method. This method reduces the price of the commodity in the calculation, resulting in the price effect. Consumers’ incomes allow for the purchase of additional goods after a decrease in price. Then, consumer income is decreased until the purchase of goods falls back to where it was before the price decrease. Now, only the substitution effect remains.
The Equivalent Variation Method
The equivalent variation approach also helps understand how price changes affect consumers’ real income and well-being. The equivalent variation approach involves considering the consumer’s initial utility level when the price of a good or service is at its original level and the quantity consumed is at its original level. It then calculates the equivalent variation, which is the amount of income required to maintain the same level of satisfaction experienced at the new situation.
The equivalent variation approach is conceptually equivalent to the compensating variation approach, but it is based on different theoretical assumptions. The compensating variation approach starts with a budget constraint and determines the income required to maintain utility levels, while the equivalent variation approach starts with utility levels and calculates the income needed to achieve the same utility levels under different price and quantity combinations.
How Does the Price Effect Influence Consumer Behavior?
The price effect results in consumers buying more of a good or service when its price decreases and less when the price increases, assuming no change in their income. This inverse relationship between price and quantity demanded is central to the law of demand.
Can the Income Effect Be Negative?
Yes, the income effect can be negative. If the price of an inferior good decreases, the consumer’s real income increases, leading to a decrease in the quantity demanded. Inferior goods have a negative income elasticity of demand.
How Does the Price Effect Differ for Normal and Inferior Goods?
For normal goods, a decrease in price leads to an increase in the quantity demanded due to both the income and substitution effects. In contrast, for inferior goods, a price decrease increases the quantity demanded primarily due to the substitution effect, while the income effect is negative.
What Factors Affect the Magnitude of the Income Effect?
The magnitude of the income effect depends on the income elasticity of demand for the good. If a good is income elastic, the income effect is more significant, and consumers’ quantity demanded responds substantially to changes in income.
The Bottom Line
To calculate the income effect distinctly from the price effect, economists use methods like the ones discussed above. These approaches involve assessing changes in consumer welfare resulting from price fluctuations while keeping income constant or examining changes in consumer expenditure. By isolating the income effect, analysts gain insights into how consumers respond to price changes and adjust their purchasing decisions.