Income Effect
The change in a consumer's purchasing power — and thus quantity demanded — caused by a change in the price of a good they buy.
What is Income Effect?
The income effect describes how a change in a good's price alters a consumer's real purchasing power, leading to a change in the quantity demanded. When a price falls, the consumer's real income effectively rises (the same nominal income buys more), generally leading to increased consumption — this is a positive income effect for normal goods. Conversely, for inferior goods (such as cheap processed foods), a rise in real income causes consumers to buy less, not more, as they switch to higher-quality alternatives. The total effect of a price change is decomposed into the income effect and the substitution effect: the substitution effect reflects consumers switching to the cheaper good, while the income effect reflects the purchasing power change. Together, these effects explain the downward slope of the demand curve and the anomalous behavior of Giffen goods (where rising prices increase quantity demanded due to a dominant income effect).
Example
When gasoline prices dropped from $4.00 to $2.50 per gallon in 2015, U.S. consumers saved roughly $700 per household annually — effectively a real income increase. In response, many households drove more miles (income effect on gasoline itself) and also spent more on restaurants, travel, and electronics (income effect on other goods). This spending ripple contributed to consumer spending growth in 2015–2016.
Source: U.S. Bureau of Economic Analysis — Personal Consumption Expenditures