Income Effect

Y E C ICC

A G K M P Q

IC 3 IC 2 IC 1

 In the above figure, AB is the original price line or income line. Consumer is in equilibrium at point P on IC 1 .He buys ON of X and OM of Y. When income rises the price line shifts upward from AB to CD. Now, consumer is in equilibrium at point Q on IC 2.He buys OT of X and OK of Y When income further rises, the price line shifts upward from CD to EF. Now, consumer is in equilibrium at point R on IC 3.He buys OH of X and OG of Y. When we join all the equilibrium point we get ICC i.e. Income Consumption Curve

It refers to the effect of change in relative prices on consumer equilibrium position. As the price of a good falls, the consumer substitutes that good in place of other goods whose prices have not changed. For e.g. when price of x falls while price of y remaining constant, consumer will buy more of x and less of y. However, Substitution effect is such that consumer is neither better-off nor worse-off. He remains on the same level of satisfaction or on the same IC Substitution Effect can be explained with the help of the following figure.

Substitution Effect
Y

A A

P Q R IC 2 IC 1

 In the above figure, AB is the original Price Line. Consumer is in equilibrium at point P on IC 1.He buys OM of X. When price of X falls, the price line shifts from AB to AC. Now consumer is in equilibrium at point R on IC 2.He buys OK of X. However, in order to show Substitution Effect, we have to reduce the income of the consumer which has gone up due to the fall in price. This process is called Compensating Variation in Income. Thus another price line AC is drawn which is parallel to price line AC. Now consumer is in equilibrium at point Q on IC 1.He buys ON of X. Thus movement from P to Q is Substitution Effect

Price Consumption Curve (PCC) shows the price effect i.e. the effect of change in prize on consumer equilibrium position It shows quantity demanded at different prices. Therefore, it is possible to draw Demand Curve from PCC. This can be seen from the following figure.

Y A

Derivation of Demand Curve from PCC

P2 P1 P E1 E2

E3 PCC IC3 IC 2 IC 1

Q1 B

Q2

 The figure explains the Price Effect. AB is the original Price Line. Consumer is in equilibrium at point E1 at IC 1. He buys OQ of X and spends AP on X. When price of X falls, the price line shifts from AB to AC. Now consumer is in equilibrium at point E2 on IC 2. He buys OQ1 of X. When price of X further falls, the price line shifts from AC to AD. Now consumer is in equilibrium at point E3 on IC 3.He buys OQ2 of X. When we join all the equilibrium points we get PCC i.e. Price Consumption Curve