Introduction
In modern demand theory based on indifference curves, any change in the price of a commodity affects its quantity demanded through two distinct channels: substitution effect and income effect. In the previous question, we studied substitution effect. In this question, as treated in T.R. Jain & V.K. Ohri, Microeconomics (B.Com Ist Sem, Panjab University), we focus on the income effect in detail and show how it can be positive, negative or zero, with the help of suitable diagrams.
The concept of income effect is extremely important for distinguishing between normal goods, inferior goods and the special case of Giffen goods, and for understanding the full price–demand relationship.
Meaning and Definition of Income Effect
A change in the price of a commodity changes the purchasing power or real income of the consumer. Even if his money income (in rupees) remains unchanged, the consumer becomes effectively richer when price falls and poorer when price rises.
The income effect of a change in the price of a commodity is the change in quantity demanded of that commodity resulting from the change in the real income (purchasing power) of the consumer, when relative prices are held constant.
In other words, income effect measures how much extra (or less) of a commodity a consumer will buy when his real income changes, assuming that the ratio of prices of the commodities remains the same.
Illustration: Suppose the consumer spends his income on two goods, X and Y. When the price of X falls, the same money income can now buy more of both goods. The consumer’s real income increases. The portion of the resulting change in quantity of X that is due to this increase in real income (keeping relative prices fixed) is called the income effect of the price fall.
Relationship between Price Effect, Substitution Effect and Income Effect
When price of a good changes, total change in quantity demanded (price effect) can be decomposed into:
Price Effect (PE) = Substitution Effect (SE) + Income Effect (IE)
For a fall in price of X:
- SE: X becomes relatively cheaper compared to Y → consumer substitutes X for Y → demand for X rises.
- IE: Real income increases → depending on the nature of good X (normal or inferior), demand may rise, fall, or remain unchanged.
Substitution effect is always negative with respect to price (i.e. a fall in price of X always increases quantity of X demanded through SE). The sign of the income effect, however, depends on the type of good.
Income Effect: Positive, Negative and Zero
The income effect of a price change can be:
- Positive income effect — quantity demanded moves in the same direction as real income.
- Negative income effect — quantity demanded moves in the opposite direction to real income.
- Zero income effect — quantity demanded is unaffected by changes in real income.
1. Positive Income Effect (Normal Goods)
For a normal good, when the consumer’s real income increases, he buys more of the good; when real income falls, he buys less. Thus, for normal goods, income effect is positive.
Consider the case when price of X falls. Real income increases. Since X is a normal good, quantity demanded of X will rise due to the increase in real income. Therefore, for a normal good X, both substitution effect and income effect move in the same direction and reinforce each other.
In Fig. 1, both budget lines BL₁ and BL₂ have the same slope (same prices). When income rises, the budget line shifts outwards, and equilibrium moves from E₁ on IC₁ to E₂ on higher IC₂. The quantity of X increases from X₁ to X₂. Hence income effect is positive.
2. Negative Income Effect (Inferior Goods and Giffen Goods)
A commodity is said to be an inferior good if its quantity demanded falls when the consumer’s real income rises, and quantity demanded rises when real income falls. Thus, for inferior goods, income effect is negative.
When price of X falls, real income rises. If X is an inferior good, consumer may reduce consumption of X and shift towards superior substitutes. In such cases, substitution effect (which is always positive for X when its price falls) and income effect (which is negative) work in opposite directions. If negative income effect is strong enough to dominate substitution effect, we get a Giffen good, where demand falls when price falls.
In Fig. 2, when income rises (parallel shift of budget line outwards), the consumer moves from E₁ to E₂ on a higher indifference curve, but the quantity of X falls from X₁ to X₂. This shows a negative income effect. Inferior and Giffen goods are characterised by such negative income effect.
For a Giffen good, income effect is not only negative but also stronger in magnitude than the positive substitution effect. As a result, when price falls, the overall price effect becomes positive (price and quantity move in the same direction), which is contrary to the law of demand. This phenomenon is very rare and typically associated with staple goods in extremely poor communities.
3. Zero Income Effect (Income-Neutral Goods)
In some hypothetical cases, a change in real income may have no effect on the quantity demanded of a commodity. Such a good is said to have zero income effect.
For example, if a good occupies an extremely small proportion of the consumer’s budget or is strictly fixed in quantity by custom (say, a fixed number of candles for a ritual), then even when income rises or falls, the quantity demanded remains unchanged.
In Fig. 3, increase in income shifts the budget line outward from BL₁ to BL₂, and equilibrium moves from E₁ to E₂ on a higher indifference curve. However, the quantity of X remains constant at X*. This indicates zero income effect for X.
Income Effect in the Context of a Price Change
In the indifference curve framework, when the price of X falls:
- The budget line rotates outwards (X-axis intercept increases).
- We first trace the substitution effect by drawing a compensated budget line parallel to the new budget line but tangent to the original indifference curve.
- Then, the movement from the compensated equilibrium to the actual new equilibrium on a higher indifference curve measures the income effect.
For a normal good, the income effect reinforces substitution effect; for an inferior good, it works against substitution effect; and for a hypothetical zero-income-effect good, the final equilibrium lies on the same vertical line as the compensated equilibrium.
Summary: Positive, Negative and Zero Income Effects
| Type of Income Effect | Direction of Change in Quantity when Real Income Rises | Type of Good | Effect on Price–Demand Relationship (when price falls) |
|---|---|---|---|
| Positive | Quantity demanded increases | Normal goods | Reinforces substitution effect; demand definitely rises when price falls. |
| Negative | Quantity demanded decreases | Inferior and Giffen goods | Works opposite to substitution effect; in extreme Giffen case, may reverse law of demand. |
| Zero | No change in quantity demanded | Income-neutral goods (rare theoretical case) | Price–demand relationship depends only on substitution effect. |
Importance of the Concept of Income Effect
The concept of income effect is of great theoretical and practical significance:
Whether a good is normal, inferior or Giffen is decided by the nature of its income effect. Positive income effect implies normal good; negative income effect implies inferior or Giffen good.
The rare case of a Giffen good, where demand rises with price, can be explained only by combining strong negative income effect with substitution effect. Without income effect there can be no Giffen good.
Decomposing price effect into substitution and income effects enables a more refined analysis of how and why demand responds to price changes. It is a core feature of modern indifference curve analysis.
For evaluating the impact of indirect taxes, subsidies and price controls on different income groups, policy-makers need to understand how changes in real income (through price changes) affect the consumption of various goods.
In Panjab University examinations, questions on income effect frequently appear as separate long questions and also as part of the analysis of Giffen goods and decomposition of price effect. A clear diagram-based explanation of positive, negative and zero income effects is highly scoring.
Conclusion
To conclude, the income effect is that part of the impact of a price change on quantity demanded which operates through the change in the consumer’s real income or purchasing power. It may be positive (normal goods), negative (inferior and Giffen goods) or zero (income-neutral goods). In combination with the always negative substitution effect, income effect helps to explain the usual downward slope of the demand curve, the exceptional Giffen behaviour and the classification of goods in modern microeconomics, exactly as developed in the prescribed text of T.R. Jain & V.K. Ohri for B.Com Semester I.