Explain the income effect and how it is related to the law of demand.

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The income effect is the factor that causes the demand curve to slope downward.  It is called the income effect because a change in the price of goods changes the purchasing power of a person’s income.

When the price of a good changes, the value of our income changes.  Let us think about this through an illustration.  Let us imagine that I am making $10 per hour at my job.  Up to this point, a movie had cost $7.  In other words, my hourly income was worth more than one movie.  Now, let us imagine that the cost of a movie jumps to $10.  Now, the value of my hourly income (when expressed in movies) has dropped.  My hourly income is no longer worth more than a movie.  I will feel less wealthy because of this.

This causes the demand curve to slope downwards.  Put differently, it means that I will buy fewer movies when their price rises.  This is part of the law of demand.  The income effect causes us to buy less when the price goes up because it makes our income be worth less in terms of goods and services.

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