Income–consumption curve

The income effect in economics can be defined as the change in consumption resulting from a change in real income. This income change can come from one of two sources: from external sources, or from income being freed up (or soaked up) by a decrease (or increase) in the price of a good that money is being spent on. The effect of the former type of change in available income is depicted by the income-consumption curve discussed in the remainder of this article, while the effect of the freeing-up of existing income by a price drop is discussed along with its companion effect, the substitution effect, in the article on the latter. For example, if a consumer spends one-half of his or her income on bread alone, a fifty-percent decrease in the price of bread will increase the free money available to him or her by the same amount which he or she can spend in buying more bread or something else

The consumer's preferences, monetary income and prices play an important role in solving the consumer's optimization problem (choosing how much of various goods to consume so as to maximize their utility subject to a budget constraint). The comparative statics of consumer behavior investigates the effects of changes in the exogenous or independent variables (especially prices and money incomes of the consumers) on the chosen values of the endogenous or dependent variables (the consumer's demands for the goods). When the income of the consumer rises with the prices held constant, the optimal bundle chosen by the consumer changes as the feasible set available to them changes. The income–consumption curve is the set of tangency points of indifference curves with the various budget constraint lines, with prices held constant, as income increases shifting the budget constraint out.

Consumer theory

The income effect is a phenomenon observed through changes in purchasing power. It reveals the change in quantity demanded brought by a change in real income. The figure 1 on the left shows the consumption patterns of the consumer of two goods X¹ and X², the prices of which are p₁ and p₂ respectively. The initial bundle X^*, is the bundle which is chosen by the consumer on the budget line B₁. An increase in the money income of the consumer, with p₁ and p₂ constant, will shift the budget line outward parallel to itself.

In the figure, this means that the change in the money income of the consumer will shift the budget line B1 outward parallel to itself to B2 where the bundle X^' bundle will be chosen. Again, an increase in the money income of the consumer will push the budget line B2 outward parallel to itself to B3 where the bundle X^" will be the bundle which will be chosen. Thus, it can be said that, with variations in income of the consumers and with the prices held constant the income–consumption curve can be traced out as the set of optimal points.

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For different types of goods

In the case illustrated with the help of Figure 1 both X¹ and X² are normal goods in which case, the demand for the good increases as money income rises. However, if the consumer has different preferences, he has the option to choose X⁰ or X⁺ on budget line B2. As the income of the consumer rises, and the consumer chooses X⁰ instead of X^' i.e. if the consumer's indifference curve is I⁴ and not I², then the demand for X¹ would fall . In that case, X¹ would be called an inferior good i.e. demand for good X¹ decreases with a rise in income of the consumer. Thus, a rise in income of the consumer may lead his demand for a good to rise, fall or not change at all. It is important to note here that, the knowledge of preferences of the consumer is essential to predict whether a particular good is inferior or normal.

Normal goods

In the figure 2 to the left, B1, B2 and B3 are the different budget lines and I¹, I² and I³ are the indifference curves that are available to the consumer. As shown earlier, as the income of the consumer rises, the budget line moves outwards parallel to itself. In this case, from initial bundle X^*, with an increase in the income of the consumer the budget line moves from B1 to B2 and the consumer would choose X^' bundle and subsequently, with a further rise in consumer's income the budget line moves from B2 to B3 and the consumer would choose X^" bundle and so on. The consumer would thus maximize his utility at the points X^*, X^' and X^", and by joining these points, the income-consumption curve can be obtained.

Inferior goods

The figure on the right (figure 3), shows the consumption patterns of the consumer of two goods X¹ and X², the prices of which are p₁ and p₂ respectively, where B1 and B2 are the budget lines and I¹ and I² are the indifference curves. Figure 3 clearly shows that, with a rise in the income of the consumer, the initial budget line B1 moves outward parallel to itself to B2 and the consumer now chooses X^' bundle to the initial bundle X^*. The figure shows that, the demand for X² has risen from X²₁ to X²₂ with an outward shift of the budget line from B1 to B2 (caused due to rise in the income of the consumer). This essentially means that, good X² is a normal good as the demand for X² rose with an increase in the income of the consumer.

In contrast, it is to be noted from the figure, that the demand for X¹ has fallen from X¹₁ to X¹₂ with an outward shift of the budget line from B1 to B2 (caused due to rise in the income of the consumer). This implies that, good X¹ is an inferior good as the demand for X¹ fell with an increase in the income of the consumer.

The consumer maximizes his utility at points X^* and X^' and by joining these points, the income–consumption curve can be obtained. In figure 3, the income–consumption curve bends back on itself as with an increase income, the consumer demands more of X² and less of X¹. The income–consumption curve in this case is negatively sloped and the income elasticity of demand will be negative. Also the price effect for X² is positive, while it is negative for X¹.

$Δ X_{n}^{1}$ is the change in the demand for good 1 when we change income from $m^{'}$ to $m$ , holding the price of good 1 fixed at $p_{1}$ :

$Δ X_{n}^{1} = X^{1} (p_{1}, m) - X^{1} (p_{1}, m^{'}) .$