Income effect
In economics and particularly in consumer choice theory, the income-consumption curve is a curve in a graph in which the quantities of two goods are plotted on the two axes; the curve is the locus of points showing the consumption bundles chosen at each of various levels of income.
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.
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 him 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.
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.
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