The income effect relates to consumer spending in response to an increase or decrease in the consumer's income. An increase in income (the ability to spend more money) results in a demand for more services and goods. A decrease in income results in the exact opposite. In general, when incomes are lower, less spending occurs, and businessesare hurt by the effect. But this is not always the case. The income effect may have positive or negative consequences on a small business, depending on many factors.
Key Takeaways
- The income effect seeks to understand how individuals change their spending habits due to a change in their income.
- Due to changes in spending habits, the income effect may have positive or negative consequences on a small business, depending on many factors.
- An increase in income results in an increase in the demand for goods and services, while a decrease in income results in a decrease in demand, though not always.
- The marginal propensity to spend and the marginal propensity to save are looked at when determining the influences of the income effect.
- The substitution effect also plays a role in how consumers spend their income in times of rising or declining income.
The Marginal Propensity to Spend or Save
If a small business specializes in goods or services that are bought when incomes have decreased, it may see a boom in profits. Examples of these types of businesses include discount stores, stores that sell items in bulk, or other inexpensive retailers.
The income effect is a component of microeconomics because microeconomics deals with how individuals and businesses deal with the allocation of resources and decision-making.
More than likely, for most businesses, when the income effect shows a decrease in income, there will be less spending, and business will be affected negatively. Two factors, the marginal propensity to spend and the marginal propensity to save, are looked at when determining the influences of the income effect.
The Substitution Effect
An additional factor to consider when exploring income and a business's bottom line is the substitution effect. This occurs when consumers spend money on lower-priced items versus higher-priced ones.
Products that have substitutes are price elastic, meaning that the demand for those products shift as the price of those products increase or decrease.
While this, too, is generally negative for businesses, if the business specializes in some of the above-mentioned niches, such as discount stores, it may see an increase in its bottom line. A business may be able to make adjustments for the income effect by offering its customers incentives to continue patronizing it.
What Is an Example of the Income Effect?
For example, John works in the city every day of the week. Out of the five days at work, he brings a packed lunch from home two days a week to save money. The other three days a week, John has lunch in a restaurant, which costs him $20 for each lunch, for a total cost of $60 a week. Sixty dollars is the most John will spend a week on outside lunches given his salary because he only wants to spend 12% of his monthly income on lunch. One month later, John was notified that he would receive a raise due to his hard work. The raise is high enough that he can now eat lunch at a restaurant four times a week for a total cost of $90 and still maintain the 12% budget.
What Is the Difference Between Income Effect and Price Effect?
The difference between income effect and price effect is that income effect seeks to evaluate consumer spending habits based on a change in a consumer's income. Price effect, on the other hand, seeks to evaluate consumer spending habits based on a change in the price of a good or service.
When Is Income Effect Positive for a Business?
The income effect is positive for a business based on the type of business and if a consumer's income increases or decreases. If income increased for a consumer and the business sells normal goods, the business will see an increase in business. If the income of a consumer decreases, the business will see a decrease. If the business sells inferior goods, such as a discount store, the opposite will hold true.
When Is Income Effect Negative for a Business?
Income effect is negative for a business solely based on the type of business and if the income of a consumer increased or decreased. If income increased for a consumer and the business sells normal goods, the business will see an increase in business. If the income of a consumer decreases, the business will see a decrease. If the business sells inferior goods, such as a discount store, the opposite will hold true.
What Is the Relationship Between Income Effect and Demand?
The relationship between income effect and demand can be broken down into the types of goods: normal goods and inferior goods. The relationship between income and normal goods is a direct one. When income rises, the demand for normal goods goes up. When income decreases, the demand for normal goods decreases. The relationship between income and inferior goods is an inverse one. When income rises, the demand for inferior goods decreases, whereas when income decreases, the demand for inferior goods increases.
The Bottom Line
The income effect seeks to measure the change in demand for goods and services based on the change in consumer income. The change in spending habits will also depend on the specific type of product or service. If a consumer's income increases, they are willing to spend more, particularly on items of better quality. If a consumer's income decreases, they will spend less, particularly on items of better quality. Though they may spend more on items of inferior quality.
