Can anyone explain to me how the income effect works, in relation to budget and indifference curves?
Suppose that you have two goods: bananas and coconuts. Given the price of bananas, the price of coconuts, your indifference curves, and your budget, there is an optimal mix of bananas and coconuts that you can afford: the mix that gives you the highest utility (at the point where an indifference curve is tangent to the budget constraint line).
Suppose now that the price of bananas decreases. This increases the number of bananas you can buy for a given number of coconuts; that’s the income effect. (Not exactly, but it’s the perfect visualization.)
Technically, there is a substitution effect, and an income effect. The substitution effect is always – _ always! _ – in the direction of the relatively less expensive good. Here, the price of bananas dropped, so the substitution effect would be to buy more bananas and fewer coconuts. (If the price of bananas had risen, then coconuts would be relatively less expensive, so the substitution effect would be to buy more coconuts and fewer bananas.)
To implement the substitution, you move along the original indifference curve until the slope is the same as the slope of the _ new _ budget constraint line. In this case, because the price of bananas decreased, this point on the original indifference curve will be below the new budget constraint line.
To implement the income effect, you then move from that point on the original indifference curve to the optimal point on the new budget constraint line. Depending on the types of goods (inferior or normal), this point may have more bananas or fewer bananas, and it may have more coconuts or fewer coconuts. Because the price of bananas dropped, it will have more of something, but it may have more or less of the other thing.