An increase in the income, with the prices of all goods fixed, causes consumers to alter their

choice of market basket.

The income effect is a phenomenon observed through changes in purchasing power. It reveals
the change in quantity demanded brought by a change in real income (utility). 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. The initial bundle X*, is the bundle which is chosen by the
consumer on the budget line B1. An increase in the money income of the consumer, with p1 and
p2 constant, will shift the budget line outward parallel to itself.

This means that the change in the money income of the consumer will shift the budget line B1
outward parallel to itself to B2 where the bundle X' bundle will be chosen. Again, an increase in
the money income of the consumer will push the budget line B2 outward parallel to itself to B3
where the bundle X" will be the bundle which will be chosen. 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.

Substitution and Income Effects for an Inferior Good:

If X is an inferior good, the income effect of a fall in the price of X will be positive because as
the real income of the consumer increases, less quantity of X will be demanded. This is so
because price and quantity demanded move in the same direction On the other hand, the negative
substitution effect will increase the quantity demanded of X.

The negative substitution effect is stronger than the positive income effect in the case of inferior
goods so that the total price effect is negative. It means that when the price of the inferior good
falls, the consumer purchases more of it due to compensating variation in income. The case of X
as an inferior good is illustrated Figure 15.20. Initially, the consumer is in equilibrium at point R
where the budget line PQ is tangent to the curve I1. With the fall in the price of X, he moves to
point T on the budget line PQ1, at the higher indifference curve His movement from R to Tor
from В to E on the horizontal axis is the price effect. By compensating variation in income, he is
in equilibrium at point H on the new budget line MN along the original curve I1.
The movements from R to H on the I1 curve are the substitution effect measured horizontally by
BD of X. To isolate the income effect, return the increased real income to the consumer which
was taken from him so that he is again at point T of the tangency of PQ; line and the curve l2. The
movement from H to T is the income effect of the fall in the price of X and is measured by DE.

This income effect is positive because the fall in the price of the inferior good X leads, via
compensating variation in income, to the decrease in its quantity demanded by DE. When the
relation between price and quantity demanded is direct via compensating variation in income, the
income effect is always positive.

In the case of an inferior good, the negative substitution effect is greater than the positive income
effect so that the total price effect is negative. Thus the price effect (-) BE = (-) BD (substitution
effect) + DE (income effect). In other words, the overall price move from R to T which
comprises both the income and substitution effects has led to the increase in the quantity
demanded by BE after the fall in the price of X. This establishes the downward sloping demand
curve even in the case of an inferior good.

Substitution and Income Effects for a Giffen Good:

A strongly inferior good is a Giffen good, after Sir Robert Giffen who found that potatoes were
an indispensable food item for the poor peasants of Ireland. He observed that in the famine of
1848, a rise in the price of potatoes led to an increase in their quantity demanded. Thereafter, a
fall in the price led to a reduction in their quantity demanded.

This direct relation between price an quantity demanded in relation to essential food items is
called the Giffen paradox. The reason for such a paradoxical tendency is that when the price of
some food articles like bread of mass consumption rises, this is tantamount to a fall in the real
income of the consumers who reduce their expenses on more expensive food items, as a result
the demand for the bread increases. Similarly, a fall in the price of bread raises the real income of
consumers who substitute expensive food item for bread thereby reducing the demand of bread.

In the case of a Giffen good, the positive income effect is stronger than the negative substitution
effect so that the consumer buys less of it when its price falls. This is illustrated in Figure 12.21.
Suppose X is a Giffen good and the initial equilibrium point is R where the budget line PQ is
tangent to the indifference curve l1. Now the price of X falls and the consumer moves to point T
of the tangency between the budget line PQ: and the curve I2. His movement from point R to T is
the price effect whereby he reduces his consumption of X by BE.
To isolate the substitution effect, the increased real income due the fall in the price of X is
withdrawn from the consumer by drawling the budget line MN parallel PQ1 and tangent to the
original curve I1 at point H. As a result, he moves from point R to H along the l1 curve. This is the
negative substitution effect which leads him to buy BD more of X with the fall in its price, real
income being constant. To isolate the income effect, when the income that was taken away from
the consumer is returned to him, he moves from point H to T so that he reduces the consumption
of X by a very large quantity DE. This is the positive income effect because with the fall in the
price of the Giffen good X, its quantity demanded is reduced by DE via compensating variation
in income. In other words, it is positive with respect to price change, that is, the fall in the price
of good X leads, via the income effect, to a decrease to the quantity demanded.

Thus in the case of a Giffen good, the positive income effect is stronger than the negative
substitution effect so that the total price effect is positive. That is why, the demand curve for a
Giffen good has positive slope from left to right upwards. Thus the price effect BE= DE (income
effect) + (-) BD (substitution effect).

According to Hicks, a giffen good must satisfy the following conditions: (i) the consumer must
spend a large part of his income on it; (ii) it must be an inferior good with strong income effect;
and (iii) the substitution effect must be weak. But Giffen goods are very rare which may satisfy
these conditions

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