Explain the income effect and how it is related to the law of demand.
The income effect is the factor that causes the demand curve to slope downward. It is called the income effect because a change in the price of goods changes the purchasing power of a person’s income.
When the price of a good changes, the value of our income changes. Let us think about this through an illustration. Let us imagine that I am making $10 per hour at my job. Up to this point, a movie had cost $7. In other words, my hourly income was worth more than one movie. Now, let us imagine that the cost of a movie jumps to $10. Now, the value of my hourly income (when expressed in movies) has dropped. My hourly income is no longer worth more than a movie. I will feel less wealthy because of this.
This causes the demand curve to slope downwards. Put differently, it means that I will buy fewer movies when their price rises. This is part of the law of demand. The income effect causes us to buy less when the price goes up because it makes our income be worth less in terms of goods and services.
When the consumer's income changes, assuming that all prices remain constant, the consumer faces a change in his equilibrium position which is called the income effect. In other words we can say that when a person's money income changes (increase/decrease) it effects the quantity demanded of a particular commodity, assuming that all related prices are constant.
I can further explain with the help of an example. Let us take the following assumptions:
- consumer is rational in his behaviors.
- there is 1 commodity x and it is a normal good.
- price of x is given and constant.
- Consumer's income changes.
- consumer's taste and preference remain same.
- other things remain constant.
Suppose that a person has an income of y1 and he consumes x1 goods, then if we increase the said person's income to y2 he will consume more of good x which will increase his consumption to x2. In the same way way if his income decreases he will consume less of the said good. This is how the Income effect is related to demand.
Given below is a graph showing income effect with the help of indifference curves.