Income–consumption curve

For example, if a consumer spends one-half of his or her income on bread alone, a fifty-percent decrease in the price of bread will increase the free money available to him or her by the same amount which he or she can spend in buying more bread or something else 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 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.

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.

An increase in the money income of the consumer, with p1 and p2 constant, will shift the budget line outward parallel to itself.

Thus, it can be said that, with variations in income of the consumers and with the prices held constant the income–consumption curve can be traced out as the set of optimal points.

It is important to note here that, the knowledge of preferences of the consumer is essential to predict whether a particular good is inferior or normal.

In the figure 2 to the left, B1, B2 and B3 are the different budget lines and I1, I2 and I3 are the indifference curves that are available to the consumer.

As shown earlier, as the income of the consumer rises, the budget line moves outwards parallel to itself.

Figure 3 clearly shows that, with a rise in the income of the consumer, the initial budget line B1 moves outward parallel to itself to B2 and the consumer now chooses X' bundle to the initial bundle X*.

The figure shows that, the demand for X2 has risen from X21 to X22 with an outward shift of the budget line from B1 to B2 (caused due to rise in the income of the consumer).

In contrast, it is to be noted from the figure, that the demand for X1 has fallen from X11 to X12 with an outward shift of the budget line from B1 to B2 (caused due to rise in the income of the consumer).

[2] In figure 3, the income–consumption curve bends back on itself as with an increase income, the consumer demands more of X2 and less of X1.

Figure 1: An increase in the income, with the prices of all goods fixed, causes consumers to alter their choice of market basket. The extreme left and right indifference curves belong to different individuals with different preferences, while the three central indifference curves belong to one individual for whom the income-consumption curve is shown. Each blue line represents one level of total consumption expenditure common to all its points; its slope depends on the two goods' relative prices.
Figure 2: Income-consumption curve for normal goods
Figure 3: with an increase of income, demand for normal good X 2 rises while, demand for inferior good X 1 falls.