The price effect is the impact on the market based on how the consumer is spending money as a result of the income effect. The income effect is the manner in which a consumer spends money or demands services and goods based on an increase or decrease in his income. The price effect is composed of the income effect and another economic factor, the substitution effect. The substitution effect occurs when a consumer spends money on services and goods that are less expensive, based on the fact there is a reduction in income available to spend.

Income and Price Effect

Both the income effect and the price effect are two important factors in the economy, and they must be taken into account when starting a small business. Businesses may alter the pricing on goods or services based on the income effect. If consumers are spending more or less, a business can modify what it charges in an attempt to create more profits, maintain current profits or attract more customers to gain even more profits. A business must carefully watch income trends in order to thrive in the market. For example, it is not advisable to raise prices when the market indicates consumers aren't willing to pay for them. This is especially true if there are cheaper products that are similar on the market. Consumers are more likely to purchase these cheaper versions, exhibiting what is known as the substitution effect. Businesses, both small and large, have more freedom to modify prices when the consumer has the ability to spend more money.