A consumer will be able to enjoy more or less satisfaction, when he has more or less money income in the two cases respectively. The effect of change in consumer’s income on his total satisfaction or purchase of the two commodities, (as given by consumer equilibrium position), prices of the two commodities, his tastes and preferences remaining constant is referred to as the income effect. This is illustrated in Fig. 5.35.
In Fig. 5.35, the consumer is initially in equilibrium at point E1 where the original budget line A1 B1 is tangent to indifference curve IC1. At this point, the consumer purchases OX1 of commodity ‘X’ and OY of commodity ‘Y’. When the money income of the consumer increases, the budget line will shift upward and will be parallel to the original budget line A1 B1.
The budget line moves out by the proportion of change in the purchasing power. With the increased income, the consumer would be able to choose a combination of the two commodities on a higher indifference curve IC2. In Fig. 5.36, the new budget line A2B2 touches this indifference curve at point E2, where the consumer consumes OX2 of commodity ‘X’ and OY2 of commodity ‘Y’.
It is clear from the figure that with increased money income, the consumer is able to purchase larger quantities of both the commodities. Since he is on the higher indifference curve IC2, he will be better off than before, i.e., his level of satisfaction will rise. If the money income of the consumer increases further, the budget line will have a further upward parallel shift to A1BV. The consumer is now in equilibrium at point E3, where the budget line A3B3 is tangent to indifference curve IC2. Here, the consumer consumes greater quantities of both the commodities.
The curve obtained by connecting successive consumer’s equilibrium points (E1, E2 and E3 in this case) at various levels of money income of the consumer, other things remaining unchanged, is known as income consumption curve. It is, thus, locus of combinations of the two commodities, when the money income is varied and prices of the commodities, tastes, preferences, etc. are held constant.
The income consumption curve (ICC) traces out the income effect of the change in money income of the consumer. ICC invariably starts from the origin, because, if the consumer had no income, the quantities of commodities ‘X’ and ‘Y’ he could purchase must be zero.
However, ICC need not be a straight line curve. At every point on such a curve Px/Py = MRSy and since (Px/Py) is constant for all parallel budget lines (with same slope) A1B1, A2B2, A3B3, so MRSx,y is constant throughout ICC.
In Fig. 5.35, income effect is indicated by the movements from consumer equilibrium points E1 to E2 to Ev In this figure, X1X2 shows positive income effect for commodity ‘X’, while Y1 Y2, measures positive income effect for commodity ‘Y’ as with rise in money income, consumer purchases more of these commodities. Only an upward sloping income consumption curve can show rising consumption of the two commodities, as income increases.