The Income Effect
To examine the substitution effect, we reduced Tristan’s money income
following the price reduction so that we could see the effect of the relative
price change, holding purchasing power constant. Now we want to see
the effect of the change in purchasing power, holding relative prices
constant at their new value. To do this, suppose that after Tristan has
adjusted his purchases to the new price and his reduced money income,
he convinces his uncle to increase his allowance by $15 to restore it to its
original amount. If we assume that ice cream is a normal good, Tristan
will say to himself “I now have a higher income, so I’m going to buy more
ice cream!” and he will increase his consumption of ice cream (even
beyond the increase we have already seen as a result of the substitution
effect). The change in the quantity of ice cream demanded as a result of
Tristan’s reaction to increased real income is called the income effect
The income effect leads consumers to buy more of a product whose price has fallen, provided
that the product is a normal good.Notice that the size of the income effect depends on the amount of
income spent on the product whose price changes and on the amount by
which the price changes. In our example, if Tristan were initially spending
half of his income on ice cream, a reduction in the price of ice cream from
$5 to $4 would be equivalent to a 10 percent increase in real income (20
percent of 50 percent). Now consider a different case: The price of