Income influences demand. As our income changes, our willingness and ability to buy a product changes. When you were working for the minimum wage, you may have been willing and able to pay only 75¢ for a donut. But after your wage was doubled, your willingness and ability changed. Now you are willing and able to pay $1.25 and maybe $1.50 for a donut. And if for some reason income levels rise or fall more generally—say during a depression—the entire demand curve will shift. During good times the demand curve for donuts might look like this.
But suppose the bottom fell out of the stock market, the unemployment rate shot up, and the national average income dropped 15%. Our demand curve would shift to the left and look like this.
Why It Matters Today
Want a good indicator of the income effect? How about yacht sales. Yachts are nice, of course. But they're not exactly necessities (for most of us, anyway).
Yacht sales are thus highly sensitive to the income effect.
In the first half of 2008, before the bottom fell out of the economy, 4,157 sailboats were sold in America.
In the first half of 2009, with the economy a mess and incomes falling, sales were 28% lower.
And a hint that things might be getting better again in the American economy: sales in 2010 are up 32% compared to 2009.
When Johnny Mathis' income changes, he'll buy you anything, including a star.
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