Income effect

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In economics, the consumer's preferences, money income and prices play an important role in solving the consumer's optimization problem (maximization of the utility subject to a budget constraint). The income effect in economics can be defined as the change in consumption resulting from a change in real income. For more information regarding businesses, please refer to this guide Import Business Guide.


The comparative statics of consumer behavior investigates the effects of changes in the exogenous or independent variables i.e. prices and money incomes of the consumers on the equilibrium values of the endogenous or dependent variables i.e. the consumer's demand for 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 optimal points of intersection of the points of tangency of the sets of budget constraint lines and indifference curves as income varies, with prices held constanthe figure 3 on the right, shows the consumption patterns of the consumer of two goods X1 and X2, the prices of which are p1 and p2 respectively, where B1 and B2 are the budget lines and I1 and I2 are the indifference curves. 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). This essentially means that, good X2 is a normal good as the demand for X2 rose with an increase 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). This implies that, good X1 is an inferior good as the demand for X1 fell with an increase in the income of the consumer.


References:

1. http://en.wikipedia.org/wiki/Income_effect



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