8.5 Change of income

In the previous sections we have derived how a household makes its consumption decision. In the following sections, we will observe what happens when the household’s income or the prices of goods change. Let us first look at a change in income. If, for example, income increases, the household can afford more of both goods, i.e. the quantity of consumable combinations of goods increases. We can see this when we move the controller for income upwards. The resulting green area shows the quantity of all bundles of goods that can be acquired additionally after the increase in income. Since the increase in income does not change the prices given by the market, the budget line maintains its slope. The new budget constraint is thus created by a parallel shift of the original budget constraint. Now the consumer can reach higher indifference curves and again chooses an optimum on the highest reachable indifference curve. In the graph, this can be seen by shifting the new optimum outwards, away from the original optimum. In our example, the household chooses an optimum where it consumes both more of Good 1 and more of Good 2 (orange arrows). This is not mandatory, because an increase in income does not necessarily lead to increased consumption of both goods. However, goods for which an increase in income leads to increased consumption are called normal goods and are the usual case. In our example, we assume that Good 2 and Good 1 are normal goods, due to the course of the indifference curves. The situation is analogous in the case of a decline in income: The budget constraint is shifted downward, the amount of consumable goods decreases. The loss of possible consumption bundles is represented by the red area. All in all, for normal goods a decline in income leads to less consumption of both goods.