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The income effect in economics describes how consumer spending changes based on the price of goods. Lower prices increase demand, while higher prices decrease it. Other factors that can affect consumer spending include changes in income and world events that threaten financial security.
The income effect is a term used in economics to describe how consumer spending changes, usually based on the price of consumer goods. Given the same income, spending habits and the number of items desired tend to be affected by the price of those items. A person earning a given salary tends to have lower purchasing power and can buy less when prices are high. When they are lower, purchasing power increases and a person may feel correspondingly “richer” since the same amount of money will buy more in quantity.
There are several things that can result in a 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 income effect are only one factor. In economies where future media seem threatened, people might not spend as much, even if purchasing power is higher or incomes are rising. They may choose to save money for lean times if they feel there is an imminent risk of economic downturn in the future.
A real change in salary is also sometimes related to the income effect. When the wage changes, up or down, given stable prices, purchasing power still changes. To mitigate the reduction in wages, goods and services would have to be offered at lower prices. This could keep purchasing power stable and make the consumer feel like they have the same amount of money. However, as is often the case in economies where wages and demand fall at the same time, prices actually rise, further reducing purchasing power and creating even less demand for goods.
Something else can mitigate the income effect to some degree. This is when income remains stable, but a consumer resorts to buying lower quality goods to keep purchasing power more constant. Instead of purchasing the $30 US dollar (USD) T-shirt at a department store, the consumer opts for a cheaper, lower quality T-shirt at a Big Box store. In this way, the consumer regulates his own effect on income by reducing spending while continuing to buy almost the same quantity. However, reduced demand for higher quality goods may partly change the way people perceive income or perceive their own ‘spending power’. Prices of quality goods could rise to meet lower demand, making more people feel “poorer.”
What the income effect tends to reveal is that lower prices given stable income will generally increase demand. Higher prices tend to decrease demand, which can ultimately be more detrimental to an overall economy. Consumer spending is generally highly influenced by price, but it can also be influenced by changes in income or by world events that would threaten future financial security.
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