Income Effect vs. Price Effect: An Overview

The income effect and the price effect are both economic concepts that help analysts, economists, and business professionals understand economic trends. Both the income effect and the price effect can be used by companies in monitoring and establishing price levels for their goods based on demand theories and trends. The income effect and price effect use two different isolated variables to understand changes in demand.

Income Effect

The income effect is a concept that analyzes the change in consumers’ demand for goods and services based on their income. It can be looked at broadly across the economy or directly against demand.

When broadly studying and analyzing the income effect there are two key statistical metrics that can be helpful. The monthly Personal Income and Outlays report details the personal income and personal expenditure levels of Americans on a monthly basis. The Bureau of Labor Statistics’ monthly Employment Situation report is also an important report for following hourly wages. While the headline for the Employment Situation focuses on the number of payrolls added and the monthly unemployment rate, analysts also look closely at the hourly wage data as well.

Generally, consumers are expected to spend more when their income rises and less when their income falls. Income and spending correlations can also trend with economic cycles which are known to heavily affect the consumer discretionary and consumer staples sectors. Overall, higher income levels can lead to higher prices because consumers spend more and demand rises allowing businesses to charge more.

Income Effect Calculations

There can be several ways to mathematically analyze the income effect. One of the most basic ways is to look at marginal propensity to consume (MPC). In the monthly Personal Income and Outlays report, data is provided on income and expenditures. The MPC can use this data to understand how much consumers are spending with income changes. MPC is calculated by dividing change in consumption by change in income.

A demand curve can also be used to understand the income effect. With income on the y-axis and demand on the x-axis, the income-demand curve is typically upward sloping and income elasticity of demand defines the marginal change in quantity demand per income increase.

Price Effect

The price effect is a concept that looks at the effect of market prices on consumer demand. The price effect can be an important analysis for businesses in setting the offering price of their goods and services.

In general, when prices rise, buyers will typically buy less and vice versa when prices fall. This is demonstrated by a standard price to demand curve.

Price Effect Calculations

A demand curve plots price on the y-axis and demand quantity on the x-axis. The shape is typically downward sloping.

Price elasticity of demand describes the expected change in demand per price change. The demand curve can be important for businesses in understanding the potential affects of a price increase or decrease in their offerings.

Special Considerations: Understanding the Economy

Income and prices are two variables followed by economists at large. Income can rise for a variety of reasons. Companies may pay more annually due to standard of living adjustments. When economies are expanding or peaking, income usually rises with these economic cycles as companies report higher profits.

Prices across the economy can be influenced by several factors. When an economy is expanding it usually comes with rising inflation due to increased demand. In expansions, demand for all types of goods and services is higher and therefore businesses charge more. Prices can also be influenced by other factors influencing costs such as tariffs, shortages, or surpluses. These idiosyncratic factors can affect the demand curve by potentially changing the marginal decrease in demand for each $1 increase in price.

Comprehensively the income effect looks at how rising or falling income effects demand for goods and services in the economy. The price effect looks at how demand is affected by prices. Both effects have demand as the central component but the difference is the isolated indirect variable affecting the direct variable which is demand.

Holistically, to understand the combined effects of price and income together on demand an analyst would need to do a multi-factor regression. A multi-factor regression could most accurately chart the graphical changes in a demand curve with the combined influences of both changing consumer income and changing prices.

Key Takeaways

  • Income and price both have an effect on demand.
  • The income effect looks at how changing consumer incomes influence demand.
  • The price effect analyzes how changes in price effect demand.