Wealth effect

From Market
Jump to: navigation, search

Template:Market failure

Definition

Wealth effect refers to a situation where the wealth or purchasing power of a party to an economic transaction significantly distorts that person's reservation price compared to that person's private cost (in case of a seller) or that person's private benefit (in case of a buyer).

Under the idealized assumption of efficient capital markets, the role of wealth effects is reduced. In an efficient capital market, people are able to borrow money at zero cost if they are clearly capable of paying back the money.

Examples

Poor buyer

The classic example of this is a person with very little money who is unable to purchase a basic amount of food even though the private benefit the person receives from the food is high.

Poor seller

The example is a person desperate for food to survive who is willing to sell labor at a lower price than the private cost to the person of performing that labor.