Sunday, July 1, 2012

The income effect doesn't make sense. Can someone explain it?How,when a price increases occurs, I will feel poorer? It doesn't make sense. Who said...

You're right, this doesn't make as much intuitive sense as the substitution effect.  But here goes:


For most things, when their price goes up, you don't feel particularly poorer.  That's true because most things don't really take up much (a very high percentage) of your income.  For those types of things, the income effect really doesn't exist.


However, there are some things that are really expensive relative to your income (for most people).  Housing is one of them.  If your rent goes up 10%, you are likely to feel poorer because it's actually a lot of money compared to if the price of a Coke goes up 10%.


So that much makes sense to me.  My mortgage is about $800 a month and if it went up to $880 a month I'd notice and probably feel poorer.


As far as who said it's true... I don't know that one.  Just googling it, I've found a couple papers already that argue that it doesn't actually exist... at least not separate from the substitution effect.

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