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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So, let's apply this concept to some real-life scenarios; we'll call our hypothetical wage earner Sally. Sally works as a cashier for a small clothing store. Due to her limited income and the cost of groceries, Sally can only buy coffee once a month. A year later, Sally gets a significant raise. Sally now has the income to buy coffee twice a month, and she doesn't have to worry about making it last. Unfortunately, her excitement is short-lived because the price of coffee has gone up. Despite her increase in pay, Sally reverts to buying coffee on a monthly basis. The increase in the price of coffee made Sally feel poorer than she did before because less of her free money was available after buying coffee twice a month.
Now, let's assume that after Sally receives her raise, the price of coffee drops. Now, Sally feels like she has more free money because she's spent less on coffee. She decides to purchase coffee once a week. The drop in prices made Sally feel richer, so she decides to use her extra free money and purchase more coffee.
Let's review. Income effect is a change in income that affects the amount of goods or services individuals will demand or purchase. While income is a primary factor, price is also a consideration. If prices go up, individuals tend to purchase less, regardless of their income. If prices go down, then individuals might purchase more because they have more money to spare.
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