What Are the Consequences of Income Effect?

The income effect may have positive or negative consequences on a small business, depending on many factors. The income effect relates to how a consumer spends money based on an increase or decrease in his income. An increase in income results in demanding more services and goods, thus spending more money. A decrease in income results in the exact opposite. In general, when incomes are lower, less spending occurs, and businesses are hurt by the effect. But this is not always the case.

If a small business specializes in goods or services that are bought when incomes have decreased, it may see a boom in profits. Examples of these types of businesses include discount stores, stores that sell items in bulk or other inexpensive retailers. More than likely, for most businesses, when the income effect shows a decrease in income, there will be less spending, and business will be affected negatively. Two factors, the marginal propensity to spend and the marginal propensity to save, are looked at when determining the influences of the income effect.

An additional factor to consider when exploring income and business bottom line is the substitution effect. This occurs when consumers spend money on lower-priced items versus higher-priced ones. While this, too, is generally negative for businesses, if the business specializes in some of the above-mentioned niches, such as discount stores, it may see an increase in its bottom line. A business may be able to make adjustments for the income effect by offering its customers incentives to continue patronizing it.