Income effect – definition

The income effect is the effect on real income when price changes – it can be positive or negative. In the diagram below, as price falls, and assuming nominal income is constant, the same nominal income can buy more of the good – hence demand for this (and other goods) is likely to rise.

income effect diagram

The income effect is considered one ‘proof’ of why the relationship between price and demand is inverse, and consequently the demand curve is typically downward shoping.

Read how the income effect can be illustrated through indifference curves