In consumer decision theory and especially in economic analysis, the income effect is a chart in a graph that shows the lines that connect the points on the axis of two products; these lines represent the income packages selected at every of different levels of economic status. The income effect is a way to express the relative preferences of people who purchase the goods and services that they desire to buy. This theory was first used in the 1950s by economists Kenneth Arrow and Edward Prescott.
Kenneth Arrow was a pioneer in the study of economic decision making and was the founder of statistical methodology. Edward Prescott was also an important pioneer in the study of consumer behavior. According to one theory of economics, individuals make a number of choices, each of which is taken into account when making a decision. These choices include the product that will be purchased most efficiently, the most convenient way of purchasing it, and the least expensive way of purchasing it.
According to the Arrow and Prescott model, individuals make decisions that fit their desires and then combine those with the products that have the highest degree of satisfaction from their satisfactions. In this model, there are three variables which affect the preference of the consumer; these are the quantity of the good, the quantity of money spent on purchasing it, and the satisfaction level of the product or service that is being purchased. If there is any change in any one of these factors, then the consumer’s decision to purchase the good or service will be affected.
In his work, Arrow showed that there are four different kinds of preferences; these are the “cost-effectiveness” preferences, the “opportunity cost,” the “lifestyle” preferences, and the “income effect” preferences. The “cost-effectiveness” preference is the one which is considered to be the most significant among all the other preferences because it directly affects the level of income that the buyer earns. The “opportunity cost” preference affects the level of income by affecting the price level of a product or service which may not necessarily be of low quality.
The second preference is the “lifestyle” preference, which is influenced by the high level of disposable income that a person has because of the comfort level of the products or services which he or she uses in his or her daily life. The third preference is the “income effect” preference, which is influenced by the high level of economic activities which are involved in earning the disposable income of a person; it mainly concerns the level of production and sales which people engaged in such activities use for the purpose of earning such disposable income.
The fourth preference is the “income effect” which can be studied directly by looking at the income level which is earned from different activities which are involved in earning the disposable income of a person. The arrow and Prescott theory shows that in a society, people choose the products and services which are of high importance to them and use the products and services of lower importance to them; these products and services are the ones that are purchased by them as the result of the arrow and Prescott theory.
According to the theory, the Arrow and Prescott theory is correct because it shows the influence of the income level in people’s decision making process when a preference is formed for buying a particular product and in purchasing goods and services. People do not need to consider the quality of the product or service which they are using to purchase. Instead, they simply choose the products and services that they know that they prefer. For instance, if they know that their neighbors prefer a certain product and they also prefer it, they will buy it even if they think that the price of it is too high.
According to this theory, it is true that the arrow and Prescott theory works for certain categories of people. According to this theory, it does not work for those people who do not want to rely on their friends or neighbors to guide them. It also does not work for those people who do not think in terms of purchasing products and services. However, this theory can still be applied in many ways to increase the level of income of people.