An increase in income will lead a consumer to gain satisfaction either by consuming more or less of a product. In case of a normal or superior product, the consumer will gain satisfaction by consuming more of it. In contrast, consumer will gain satisfaction by consuming less of an inferior goods following an increase in income.
As the income rises, the consumer will substitute the consumption of an inferior goods with a superior goods and will maximize satisfaction. Thus, the consumption of inferior goods will fall with a rise in income.
It can be stated that an increase in income will lead a consumer to find its equilibrium on a higher indifference curve and vice versa, product prices remaining the same. This is termed as an income effect. As a result of income-effect, consumption of superior goods will rise while that of the inferior goods will fall.
Further, an increase in income will shift the budget line upward (or rightward) in a parallel fashion while a fall in income will shift it downward (or leftward). Needless to repeat, a change in income will not affect the budget line’s slope, which is a ratio of prices of the two products. In other words, any change in income of the consumer will only affect the positioning of the budget line, away or closer to the point of origin but not its slope.
With the above understanding, let us discuss the income effect in case of a normal or superior product when the income of the consumer increases. This has been shown in Figure-3.18.
Based on the figure, following discussion may be carried out:
i. The initial equilibrium of a consumer is at point R, given the budget line AB and the indifference map consisting of four indifference curves, IC1 to IC4. At equilibrium, the consumer is on IC1 consuming OX1 + OY1.
ii. When the income of the consumer increases, the budget line shifts upward in a parallel fashion to A1B1 and equilibrium is found at point S on IC2. At this point, the consumer consumes OX2 of the product X and OY2 of the product Y.
iii. A further increase in the income shifts the budget line further away from the point of origin to A2B2 and A3B3 and the respective equilibrium points are found as T and V. The consumption bundles become larger, i.e., OX3 + OY3 at point T and OX4 + OY4 at point V.
iv. Joining all the points of equilibrium, viz., R, S, T and, V, we get a curve which can be termed as Income consumption curve (ICC).
v. The ICC shows a relationship between consumption and different income levels of the consumer at equilibrium. In case of normal products, it will be an upward sloping curve which shows that consumption of the both the products will increase when the income of consumer rises.
An income consumption curve can be defined as the locus of successive equilibrium points when income of the consumer changes.
The ICC curve can also be derived if we consider a fall in income of the consumer. In this situation, in the above Figure-3.18, initial equilibrium will be at point V on IC4 and on budget line A3B3. As the income of the consumer will fall, the budget line will shift downwards (A4B4 to A3B3 to A2B2 and A1B1) and the consumer will find its equilibrium on lower indifference curve. Joining all the points of equilibrium (V, T, S and R), we can construct the ICC.
A derivation of ICC when one of the two products is inferior. For this purpose, Figure-3.19 was constructed which considers product X as an inferior product and product Y as a superior one.
To derive ICC, a method similar to that followed above is adopted.
This can be discussed as follows:
i. In the figure, an increase in income is represented by an upward shift in budget line, from AB to A1B1 and to A2B2 successively.
ii. With the rise in income, the consumer’s equilibrium will show a gain in satisfaction by way of a larger consumption of the superior product and lesser of the inferior one. As such, the consumer will move on to a higher indifference curve every time, from IC1 to IC2 and further to IC3.
iii. The ICC can be drawn by joining the respective points of equilibrium, viz., R, S and T. The ICC so constructed is tilted towards Y-axis or backward sloping.
iv. It can be observed that as the income increases successively, consumption of X declines and that of Y increases, after the point R. It implies that beyond that income level the product X has become inferior.