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The income effect is a term used in economics to describe how consumer spending changes, typically based on price of consumer goods. Given the same income, consumer habits and quantity of items desired tends to be affected by price of those items. A person making a given salary tends to have lower purchasing power and may purchase a smaller quantity when prices are high. When they are lower, purchasing power goes up and a person may feel correspondingly “wealthier” since the same amount of money will buy more in quantity.
There are several things that may result in decrease in consumer spending or what is called the marginal propensity to consume (MPC). The MPC is the degree to which a person is likely to spend their income. Price and the income effect are only one factor. In economies where future means seem threatened, people might still not spend as much even if purchasing power is greater or income increases. They may choose to save money for lean times if they feel there is imminent risk of economic downturn in the future.
An actual change in salary is also sometimes related to the income effect. When salary changes, moving higher or lower, given stable prices, purchasing power still changes. In order to mitigate lowering salaries, goods and services would have to be offered at lower prices. This might keep purchasing power stable and make the consumer feel as though he or she has the same amount of money. However, as often occurs in economies where wages and demand drop at the same time, prices actually go up, further lowering purchasing power and creating even less demand for goods.
Another thing can mitigate the income effect to a degree. This is when income remains stable, but a consumer turns to buying lower quality goods in order to keep purchasing power more constant. Instead of buying the $30 US Dollars (USD) t-shirt at a department store, the consumer opts for one that is cheaper and of lower quality at a Big Box store instead. In this way the consumer regulates their own income effect by reducing spending while still purchasing about the same in quantity. However reducing demand in higher quality goods may in part change the way people perceive income or perceive their own “spending ability.” Prices on quality goods could rise to accommodate lower demand, making more people feel “poorer.”
What the income effect tends to reveal is that lower prices given a stable income will usually increase demand. Higher prices tend to lower demand, which may ultimately be more detrimental to a total economy. Consumer spending is usually greatly influenced by price, but it can also influenced by shifts in income or by world events that would threaten future financial security.
@Bhutan- I think that the Giffen effect is also interesting. With the Giffen effect the typical laws of economics are not followed with this principle.
For example, if a person living in poverty buys a gallon of milk for $4 he or she will still buy the gallon of milk even if it is $5 or $6 a gallon because it is a critical food staple.
This can be said for many critical items. Usually the demand for these types of items remains high even when the price of these items is also high. Family income with regards to these products does not matter.
@Comfyshoes- I wanted to add that the reduced consumption actually caused the gas prices to fall. I also think that this is why discount retailers like Wal Mart do so well because people perceive this store as providing value and lower prices.
In fact during times of economic uncertainty when people perceive their incomes as threatened more people tend to shop at these stores which reveals the very definition of the income effect.
The use of warehouse and big bulk retailers like BJ’s and Sam’s Club also goes up because buying in bulk is seen as more cost effective than buying a single item at a time.
People see these clubs as bargain havens and continue to shop there especially when times get tough.
The income effect indicates that the higher one’s income is the more they tend to spend. This is why people with high salaries tend to buy more luxury goods.
However, the substitution effect comes into play when the person’s income may be threatened or if they perceive a negative outlook regarding their job or economy as a whole.
Many people will seek less expensive brands and make substitutions in order to balance the psychological negative effects they feel regarding their income and the potential loss of a job.
A great example involves buying gasoline. When gasoline prices reached an all time high of $4 a gallon, many Americans began to car pool, bike to work, or
even purchase more fuel efficient cars in order to save on gas.
This is really an example of the Slutsky effect. The income remained constant but as the price of gasoline rose,consumers chose less costly options. In fact many cut down on road trip vacations in order to spend less and conserve more of their income.