The Income Effect in Economics: Definition & Example

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  • 0:00 What Is Income Effect?
  • 0:42 Income Effect and Price
  • 1:33 Real-Life Examples
  • 2:43 Lesson Summary
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Lesson Transcript
Instructor: Brianna Whiting

Brianna has a masters of education in educational leadership, a DBA business management, and a BS in animal science.

In this lesson, you'll learn about income effect, or how changes in wages and prices affect your purchasing decisions. You'll also explore some real-life examples of income effect and their impact on our everyday lives.

What Is Income Effect?

Like most of us, you go to work, do your job, and collect your paycheck. However, one Friday, you notice that your paycheck is significantly bigger than usual; you've been given a raise! Now that your income has increased, are you going to buy more goods or services? This is what we call income effect, or how changes in income affect the amount of goods or services consumers will demand or purchase.

According to the principle of income effect, if an individual gets a raise in income, he will also demand an increased amount of goods and services. However, if an individual's income decreases, then so will his demand for goods and services.

Income Effect and Price

Income is not the only factor to consider when discussing income effect; price also plays a role. For example, as the price of goods and services increases, there will be a lower demand for the goods and services. When the price decreases, there will be a higher demand.

So, how are changes in prices related to income? Well, let's say the price of milk goes down $1.00. The decrease in the price of milk increases the amount of money left from your paycheck, also known as free money, so you can buy more milk, or something else. While higher prices don't actually affect your paycheck, they can make you feel like you have less money, and therefore, cause you to buy less. Consequently, lower prices make you feel a little richer and able to buy more than you did before.

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