What is Income Effect, Change in Consumer Equilibrium & Budget Line

Mon, 03/26/2012 - 09:00 -- Umar Farooq

Definition of Income Effect

Income effect is basically the effect on consumer equilibrium if the consumer income varies while price of commodity X sugar and Y oil remains unchanged. OR

Income effect is the impact on consumer equilibrium and variations in consumer income while the prices of commodities remaining the same.

What is Income Effect - Change in Consumer Equilibrium?

First it is presumed the tastes and preferences of consumer and the prices for any two commodities X and Y remains the same, if the income of the consumer changes, any effect it will have on the purchase is known as income effect.

If the income of any consumer goes up his budget line will shift upward to the right side parallel to the original budget line on the other side, if the income goes downward will affect the budget line inward to the left. The budget lines are parallel to each other because relative prices remain unchanged.

Graphical Representation of Income Effect – An Explanation

If we assume PQ the budget line, R is the equilibrium point, if it touches the indifference curve IC. In the above graph a buyer buys RA of commodity Y and OA of commodity X. If income of the consumer changes and goes upward, PQ will move to the right P1Q1 here a new equilibrium point will be S it touches the indifference curve IC2, at this level buyer goes for SB of commodity Y oil  and OB of commodity X sugar. As the consumer income goes up the budget line will change to P2Q2 with equilibrium point T. Here the consumer has the capability to buy two goods i.e. TC of product Y oil and OC of product X.  If we consider the three equilibrium points R, S and T draw a curve known as the income consumption curve (ICC).

The income consumption curve (ICC) represents the income effect, it enables consumer to buy more quantity of commodity X sugar and Y oil. Here at equilibrium point T (Indifference Curve IC3) consumer has more the buy as compared to S and R IC2 and IC1 respectively. We get the income consumption curve (ICC) by passing all the equilibrium points R, S having a positive slope.