Income changes are known to impact generally the amount and net value for goods purchased. However, when it comes to consumer patterns, there is more to it, considering the different types of goods in the eyes of consumers.
This article will heavily rely on microeconomics concepts namely the income effect, marginal and total utility, price elasticity of demand, among other concepts.
Also in this article, we will see how income changes affect consumer choices in two ways; the amount of goods and services purchased, and the type of goods purchased.
Effect of Income Changes on Number of Goods Consumed
Increase in income causes the increase in the amount of money at the consumers’ disposal. The consumers’ purchasing power is thus increased, and the demand for goods and services at both a personal and general level tends to rise. In a normal economic environment, an increase in the price of a commodity may reduce the number of goods bought at a go. This would be best explained in an example.
Nicholas has a budget constraint set at $500 for shoes in a given year. One pair of shoes goes for averagely $50 so the number of shoes to be purchased are budgeted at 10 per year. Shoes are non-primary commodities, and this level of price indicates that Nicholas spends on sub-luxurious shoes. Enters the theory of price elasticity in demand for goods and services.
Economists have desired to measure the changes in demand upon different extents of changes in price of a commodity. Goods with high elasticity (more than 1) change their demand drastically when the prices are altered with, even the slightest change.
Goods with low or infinite elasticity (inelastic goods) hardly change their demand when their price changes. Examples of inelastic goods are luxury goods and non-discretionary products like shoes. Elasticity in demand is affected by two things; availability of substitutes and urgency of products. High elasticity is associated with high availability of substitutes and low urgency. The contrary is associated with low elasticity.
Back to our example, shoes purchased at $50 fall under (i) high availability of substitutes and (ii) Low urgency. Such goods are referred to as discretionary goods which one easily do without.
Effects of income changes
In this year, contrary to norm, Nick’s salary has been cut by 40%. That means the amount of disposable income is reduced to 60%, and as a result the budget constraint for shoes in the year has been cut to $300. Therefore, Nick has two options; (i) To reduce the number of shoes purchasable to 6 ($300 ÷ $50), or (ii) Reduce the quality of shoes purchased to $30 so the number of shoes remains at 10 for the year.
Nick can also find a balance between the two, such that the quality of goods will be reduced, and the number of goods also lowers. Either way, the number of goods purchased is lower at the same price tag. This explains the effect of income changes on the number of goods purchased, and how this eventually reduces the demand for the goods in mention.
Effect of Income Changes on the Types of Goods Consumed
Income changes also impact the type of goods purchased, such that the consumer may change the combination of goods they buy. Look at the case scenario below:
Linda receives a monthly salary of $7000, based on which her weekly budget for dinner is constrained at $500. A booked table at a high-end restaurant costs $100 while making dinner at home costs her $50. At her current income level, Linda’s dinner combination is 3 restaurant dinners and 4 dinners made at home.
Linda’s salary is, however, set to be revised to $8,500 per month. Automatically, every aspect of Linda’s expenses is set to change for the better, due to an increase in the disposable income. By direct proportionality, Linda’s budget constraint for food is now set at 600. Linda is thus allowed to make up to 5 stops at the restaurant for the $100 dinner, and only has to make home dinner two times a week.
Three months down the line, Linda’s employer has gone through significant breakdowns which force a massive pay cut for employees, and Linda will now receive $5600. By direct proportionality, Linda’s disposable income earmarked for food budget comes down to $400. As expected, she abruptly changes her food consumption pattern to 1 dinner at the restaurant, and now makes 6 dinners at home.
Effects of income changes on Type of Goods
The above phenomenon is known as the income effect, where there are two types of goods/services which change in two opposite trajectories upon an increase or decrease in the consumer’s income. The two types of goods are inferior and normal goods.
Inferior goods are in Linda’s case scenario the dinner at home, which increases demand as the consumer’s income decreases, and reduces demand as the consumer income increases. The dinner at the high-end restaurant is in the income effect known as “normal” goods, which are goods and services whose demand increases as income increases, and decreases demand as income decreases. The income effect is made possible by the availability of substitutes, such as in Linda’s case whereby the “normal” high-end restaurant dinner can be substituted with the “inferior” and cheaper dinner at home.
Again, the extent of switching between types of products as a result of income changes varies with the elasticity of the goods or services in question. As from the above case scenario, dinner (at home and restaurant) appears to be very elastic, as a slight change in the income levels significantly impacts the demand for those products. Other concepts such as marginal and total utility also come into play in demand changes. Assuming that the restaurant’s menu is capped at $100, Linda may not spend more than the $100 no matter how much her income increases.
Consumer Choices, Income Changes, and Economic Conditions
When macroeconomics is considered in this case, consumer choices may be informed by prevailing economic conditions. During financial crises and similar predicaments, consumers tend to spend more on discretionary products (inferior), than on normal goods. So yes, income has an irrefutable effect on consumer choices as far as microeconomics is concerned.