Useful Notes on the Concept of Income Consumption Curve and Income Effect

The concept of an Engel curve is similar to that of the demand curve derived from the price consumption curve in the previous section. The Engel curve relates quantity demanded with different levels of income, other things remaining constant.

Since Engel curve can be derived from the income consumption curve, we first explain the concept of income consumption curve and income effect.

Income Effect and Income Consumption Curve:

With given money income and the prices of the two commodities, the consumer is in equilib­rium at the point of contact of budget line and the highest possible indifference curve. Now, we shall analyse the consumer behaviour, when only his money changes.

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 A₁B_V. 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 P_x/P_y ⁼ MRS_y and since (P_x/P_y) is constant for all parallel budget lines (with same slope) A₁B₁, A₂B₂, A₃B₃, so MRS_x,y is constant throughout ICC.

In Fig. 5.35, income effect is indicated by the movements from consumer equilibrium points E₁ to E₂ to E_v 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.