The income effect is a major concept in microeconomics and is used alongside the substitution effect to explain how consumer behaviour is affected by changes in price and income. It refers to a situation in which an increase in income causes an increase in the demand for a given good or service. This can occur even if the price of the good or service remains constant, creating an upward shift in the demand curve.

The classic example of the income effect is the normal good, which is a good or service whose demand rises when income rises. Examples of normal goods include holidays, gym memberships, and luxury cars. This happens because higher-income individuals have more money to spend and can afford to buy more of a good or service. Consequently, when their income increases, demand for these normal goods increase, even if the price remains the same.

In contrast, an inferior good is a good or service whose demand falls when income rises. Examples of inferior goods include fast food, generic clothing brands, and the like. This happens because higher-income individuals will substitute these goods for more expensive, higher-quality items. Consequently, when their income increases, demand for these inferior goods decreases, even if the price remains the same. This is the opposite of the income effect for normal goods.

The income effect can also depend on the elasticity of demand of the good or service in question. If demand is relatively elastic, then consumers are sensitive to changes in prices, so an increase in income will not necessarily lead to a proportionate increase in demand. On the other hand, if demand is relatively inelastic, then consumers are less sensitive to changes in prices, so an increase in income can lead to a proportionate increase in demand.

Finally, the income effect is influenced by the availability of substitutes for a given good or service. If there are many substitutes available, then an increase in income is more likely to lead to consumers substituting more expensive goods for cheaper alternatives. For example, if air travel becomes more expensive relative to other forms of transportation (such as car rentals or train travel), then consumers may switch to these alternatives, even if their income rises.

Overall, the income effect is a powerful economic concept that helps explain how consumer demand is affected by changes in income. It applies to both normal and inferior goods, and can be influenced by the elasticity of demand and the availability of substitutes. In most cases, an increase in income will lead to an increase in the demand for normal goods, and a decrease in the demand for inferior goods.