The Income effect refers to a situation where the price of a good changes leading to a change in the purchasing power of a given income. For example, if the price of a good falls, those consumers who consume that good will only have to pay a reduced fee.
In other words, a change in the price of a good will either increase or decrease the purchasing power of their incomes. In simple terms, this is the income effect.
However, complications arise when we try to calculate how consumers will react to the new purchasing power of their incomes. This is because, when the price of one good changes relative to other goods, the income effect operates in unison with the 'substitution effect'.
The substitution effect comes into play because, other things being equal, when the price of one good falls relative to other goods, consumers will tend to disproportionately increase their consumption of that cheaper good. The simple income effect alone would merely predict an increase in consumption of all goods due to increased purchasing power.
I will illustrate these two effects in a graph below, but first I should point out that this model assumes that we are talking about normal goods i.e., goods that consumers wish to consume more of when the price falls or when their income increases. This is not true of all goods, and for details on that you should refer to my article about types of economic goods.
The graph below illustrates both the income effect and the substitution effect of a fall in the price of one good relative to another.
If you are unfamiliar with the budget line or the indifference curve, then a little background reading will be helpful. Have a look at my articles about:
In the graph, we start with budget line BL and indifference curve U. The budget line shows all combinations of goods x and y that the consumer can afford given his/her income. Points on the line will exhaust that income, points below it will mean that some income is left unspent.
For simplicity, we assume the consumer will always wish to maximize utility by spending all of his/her income, so only points on the line are relevant.
The indifference curve plots all combinations of goods that are equally desirable i.e., that offer the same 'utility', even though some of those combinations are more expensive than others.
The most utility that the consumer can afford is illustrated by the highest indifference curve that touches the budget line, and this occurs with x amount of good X and y amount of Good Y.
Now, after a reduction in the price of good X the budget line pivots outwards to BL' as illustrated. The new preferred combination of goods is x' and y' respectively. Consumption of the cheaper good X has increased dramatically, but consumption of good Y has fallen even though the new purchasing power of the customers income has increased, meaning that more of both goods could have been chosen.
In this example, even though consumption of good Y fell, there was still both an income effect and a substitution effect at play.
We can illustrate the two effects by adding a new budget that is parallel to BL' and that touches the original indifference curve U. This shows us what the preferred consumption of goods X and Y would be if the original amount of utility is held constant but with the new lower price of Good X implemented.
This eliminates the income effect, because the movement down the original indifference curve represents a pure substitution of one good for the other. For good X this is illustrated by the first green arrow. As can be seen, consumption of good X increases, but by less than the full x to x'. The income effect accounts for the remainder, as illustrated by the second green arrow.
Note how the substitution effect led to an increase in consumption of good X at the cost of decreased consumption of good Y, this is reasonable since good X became cheaper. However, the income effect led to a further increase in good X AND and increase in good Y. The overall effect on good Y was a reduction because the substitution effect dominated the income effect, but the income effect on good Y partially offset the substitution effect.
Both the income effect and the substitution effect is simple to understand conceptually, and with a little practice you should soon be able to illustrate your own examples with graphs of your own. The case illustrated here is for normal goods, but similar graphs can be drawn for other types of economic goods.