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The Income Effect is seen when change in demand for a product caused by the impact of a change in its price affects the spending power of the consumer.

This change in price affects the real income of the consumer. If the price rises, the consumer can no longer afford the same goods, if the price falls, the consumer can afford the same amount of the goods with more left over for additional purchases.

The income effect is the impact of this change in spending power on the demand for the product whose price has changed. It is equivalent to some change in income with all prices remaining constant.

The determining factor in the size of the income effect, is the proportion of the total money income that is spent on the commodity in question. Usually, as real income increases, demand for the commodity will rise. If the demand for the commodity increases as money income falls, that commodity is known as an inferior good. There are certain commodities which are an execption to this generalised rule, known as Giffen goods.

When combined with the substitution effect it is possible to use income effect to calculate the complete effect of a price change on the demand for a commodity.

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