An income effect, also called the income effect curve, is an exponential curve that shows how the prices of goods and services change in relation to changes in income; it can be either linear (meaning increasing prices as income increases) or quadratic (meaning decreasing prices as income decreases). In economics and especially in consumer decision theory, the income curve is a plot on a graph where the values of two commodities are plotted against the respective prices; the line is the point at which the consumption packages chosen at different levels of income overlap each other.
In economic terms, when income is not growing, it does not mean that there is no growth in demand for the product; it means that incomes have not increased. If we look at the price of goods and services, we may conclude that the price rises as income increases. However, that does not mean that there is no demand. It simply means that the increase in demand for the product is not due to increasing prices. We can use the same logic to interpret the increase in the income of one person from one year to the next as the effect of an income effect.
There is no real limit to the effect of the increase in income on prices. The income effect is more often than not exponential; when income is growing linearly, as it is in the United States, for example, the income effect curve may not show any change in price for quite some time. However, when the economy is experiencing an economic slowdown, for example, income growth is expected to slow down; therefore, the change in the price is expected to accelerate. This is the reason why income growth has been slowing down for many years in the United States, and the slowdown is expected to continue in the near future.
Economic theorists suggest that we should be concerned about the effects of income on price. A good example of this is seen in food production, when the increase in food production has caused a dramatic increase in the prices of food and a drop in the availability of food.
Income is closely associated with consumption, because the prices of goods and services depend upon the amount of income a person has. As incomes increase, so do the prices of these goods and services. But as incomes decrease, so do the prices of those goods and services.
For example, in the case of the food industry, the change in the income curve would cause the prices of food to go up and down and stay at the same level. On the contrary, if you increase the income of a person by one dollar, then the price of food would go down one dollar, but if you reduce the income of that same person by one dollar, then the price of food would go up one dollar. This means that the increase in income has the opposite effect on food production.
This means that the rise in income may be good for consumers, but it is bad for producers. The rising prices of commodities causes consumers to buy fewer items, which reduces their consumption; thus reducing the quantity produced per capita. And since fewer commodities means fewer jobs, unemployment increases.
In summary, the trend toward increasing prices as the amount of income increases is called the income effect. As an illustration, suppose that the increase in the price of gasoline or food causes people to drive less miles on their cars; this results in less gasoline consumed. If people were to drive fewer miles per person, then fewer jobs would be required and employment would rise.