Income Effect

Income Effect and Derivation of Income Consumption Curve and Engel Curve

The income effect is the total effect on demand for a commodity due to a change in income of the consumer other things remaining the same or constant. The income effect varies from commodity to commodity. It depends upon the nature of the consumer. Some commodities are normal and some commodities are inferior.

 

1. Income Effect in the Case Normal Goods:

In the case of the normal commodity, there is a positive income effect, which means as the income increases, demand for the normal commodity also increases and vice-versa. That’s why Income Consumption Curve slopes upward to the right as shown in the below figure:

In the above in panel-A, initially, the consumer is in equilibrium at the point E1 where the budget line AB is tangent to the indifference curve IC1 at the point E1 where the consumer consumes OX1 units of X and OY1 units of Y. When the income of the consumer increases other things remaining constant, the budget line shifts rightward parallel to A’B’ which is tangent to the higher indifference curve IC2 at the point E2, where the consumer consumes OX2 units of X and OY2 units of Y. As the commodity under consideration are normal one, the consumer has increased the consumption of both commodities at a time when there is a further rise in the income other things remaining constant, the equilibrium point shifts from E2 to E3. By joining equilibrium points E1, E2, and E3 by a smooth line, we get an upward sloping Income Consumption Curve (ICC).

In panel-B, on the basis of the three equilibrium points E1, E2, and E3, three points A, B, and C respectively are plotted. A point represent OX1 units of X demanded at the income level OI1. B point represents OX2 units of X demanded at the OI2 income level, and C point represents OX3 units of X demanded at the income level OI3. Here, as income increases from OI1 to OI2 to OI3. By joining these three points by a smooth line, we get an upward sloping Engel curve for god X.

 

2. Income Effect in the case of Inferior Goods:

In the case of inferior goods, there is a negative or inverse relationship between demand and the income of the consumer. When the income of the consumer increases, the quantity demanded of the commodity decreases and vice-versa. In this case, there is a negative income effect. So, the income consumption curve bent backward which is shown in the following figure:

In the above figure in panel-A, initially, the consumer is at equilibrium at point E1 where the budget line AB is tangent to the indifference curve IC1 where the consumer consumes OX1 units of X and OY1 units of Y. When the income of the consumer increases, the entire budget line shifts toward the right. The budget line A1B1 is tangent to the indifference curve E2 where the consumer consumes OX2 units of X and OY2 units of Y. At this point, due to an increase in income, the consumer decreases the consumption of inferior commodity X from OX1 to OX2, and the consumer increases the consumption of the normal commodity Y from OY1 to OY2. Further, if there is an increase in income of the consumer, the budget line shifts toward the right. Here the budget line is tangent to the higher indifference E3, where the consumer consumes OX3 units of X and OY3 units of Y respectively. At this point, the consumer decreases the consumption of inferior good X from OX2 to OX3 and increases the consumption of normal good Y from OY2 to OY3. By joining all three equilibrium points E1, E2, to E3 by a smooth line, we get upward sloping backward bending income consumption curve.

In panel-B, on the basis of three equilibrium points, E1, E2, and E3 three points A, B, and C respectively are plotted. A point represents OX1 units of X demanded at the income level OY1. B point represents OX2 units of X demanded at the income level OY2. C point represents OX3 units of X demanded at the income level OY3. By joining all these three points A, B, and C by a smooth line, we get a downward sloping Engel curve for good X.