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.
