Explain the income effect and how it is related to the Law of Demand.
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The income effect is one of two reasons for the shape of the demand curve. The demand curve has a negative slope. One reason for that is the income effect.
When prices rise, a person’s income essentially falls. When prices fall, a person’s income essentially rises. That is because the change in price affects the amount of goods and services that a person is able to buy with their income. The number of dollars that you make in income does not change, but that is in some ways irrelevant. What matters is your purchasing power, how much you can buy with your income. That changes when the price changes.
The income effect is the effect that this fact has on the demand for a good or service. When the price of the good goes up, people essentially have less income. When they have less income, they will not buy as much of the good. When the price goes down, people essentially have more income. Because they have more income, they are willing to buy more of the good. This is one of the reasons why the demand curve is shaped as it is.
Thus, the income effect affects demand by helping to ensure that the quantity demanded will be inversely related to the price of the good or service.
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