Transcript Indifference Curve

Income effect is the effect on the quantity demanded of
the commodity due to the change in the income of the
consumer while the prices of the other commodities
remain same. Thus, the income effect reflects the change
on the consumer equilibrium due to change in money
income. Other things being equal, increase in income
increases the satisfaction of the consumer. As a result ,
equilibrium shifts upward to the right. On the other hand,
decrease in income leads to a decrease in satisfaction and
consumer equilibrium shifts to downward to the left.
FOLLOWING ARE THE
ASSUMPTIONS THAT MUST BE
KEPT IN MIND...
1.The prices of the two
commodities remains unaltered.
2.Scale of preferences is given.
3.Income of the consumer
changes.
Given fig. illustrates shows that initially with price line AB , the
consumer is in equilibrium at point T1,and he buys OB quantity
of X commodity and OA quantity of Y commodity. Now, we
assume that consumer income get increased. As a result the
price or budget line shifts to CD from AB. T2 is the new
equilibrium point on higher indifference curve. At this point , he
buys OD quantity of commodity X and OC quantity of
commodity Here he is better as he moves to higher indifference
curve, and get higher level of satisfaction. Thus, as a result ,
budget line shifts from CD to EF and T3 is new equilibrium
point. If we join the T1,T2 and T3 point we will get a curve
known as INCOME CONSUMPTION CURVE(ICC).Therefore,
income consumption curve is the locus of points showing the
equilibrium of the consumer at different levels of income, when
prices of two goods are given and constant.

Normally, in case of superior goods ( normal goods ) , as
level of income increases, the demand for such goods also
increases and vice versa. On the contrary, in case of inferior
goods, as the level of income increases , the demand for
such goods falls and vice versa. It means that when the
level of income of any individual is low, he prefers only
inferior goods ,i e he affords only cheap goods. But as his
level of income increases , he likes to purchase superior
goods. This will raise the demand of superior goods and
reduce the demand for inferior goods.



The diagrammatic presentation can be shown below..
a) X good as an inferior and Y good as a superior:Considering X good inferior and Y good superior, as the
level of income increases , consumer will purchase more of
Y good and less of X good. On the other hand if the level of
income falls, consumer will prefer more of X good as
inferior.so as a result , ICC slopes backwards towards Y
good..(in fig.1)
b)Y good as an inferior and X good as a superior:-In this
case, consumer buy more of X good and less of Y good. The
equilibrium is E1.Therefore, at different budget lines like
AA, BB, and CC, the consumer gets E1,E2 and E3 where IC
curve touches. By joining these points we get a slope of ICC
moves downward to the right bends towards x axis.




It shows a tendency on the part of consumer to substitute a
cheaper commodity in place of an expensive commodity. In
simple terms, substitution effect refers to the change in
amount demanded of a commodity resulting from a change
in its relative price alone while real income of consumer
remains constant. Thus, when price of X good falls, real
income of the consumer will naturally increase.
The substitution effect can be explained as under:
a).Relative prices of two goods change in such way that one
commodity becomes dearer and the other cheaper.
b).Monetary income of the consumer changes in such a
way that he gets equal satisfaction in new stage also.

In fig.,suppose AB is the initial price line touches at T.It is
the equilibrium point of the consumer . Here, the consumer
buys Om quantity of commodity X and On quantity of
commodity Now suppose price of Y commodity increases
and that of commodity X decreases. The difference
between the relative price of two goods occurs in such a
way that the loss due to the increase in the price of one
commodity can be compensated by decrease in the price of
other commodity, Now, the consumer changes his
purchasing power in such a way that he remains on the
same indifference curve. In other words, there is no change
in his level of satisfaction .New equilibrium point is T1.and
he buys Om1 quantity of X commodity and On1 quantity of
commodity of Now, the consumer buys more of cheaper
goods than before and less of dearer good.

In simple words, price effect explains how a
consumer reacts to changes in the price of good
when his money income , tastes, habits and prices
of other goods remain the same. It depends
whether price falls or rises. However, in case of fall
in price , the equilibrium of consumer will be at
higher indifference curve while in case of rise in
price , the equilibrium will be on the lower
indifference curve. According to prof. Lipsey ,” the
price effect shows how much satisfaction of the
consumer varies due to change in consumption of
two goods as the changes in the price of other
goods and money income remains constant.”

In the given fig. with given prices of X and Y
good and money is represented by price line
AB. The consumer gets equilibrium at T3 on
the indifference curve IC1.let us suppose ,
price of X good falls ( price of Y good remains
constant ).As a result , price line shifts from
AB to AC .The consumer is in equilibrium at
T2 and T3 points on higher indifference curve
IC2 and IC3. When all the equilibrium points
such as T3, T2 and T1 get joined ,we get
PRICE CONSUMPTION CURVE(PCC).This
downward sloping of PCC indicates that as
price of X good falls, the consumer purchases
more of X good and lesser of Y good.

Given fig. depicts the upward sloping of price
consumption curve. Good X has been
measured on the X axis ( which is inferior )
and commodity Y ( which is superior )
measured on the Y axis.AB is price line and
consumer is in equilibrium at T1 .Now, when
the prices of good X falls while the price of
commodity Y and income of the consumer
remains same. As a result , price line shifts to
AC ON WHICH THE EQUILIBRIUM POINT IS
T2.It means fall in the price of one
commodity will increase the satisfaction of
the consumer. In other words, the demand
for X will increase and demand for Y will
decrease.




PRICE EFFECT = INCOME EFFECT +
SUBSTITUTION EFFECT
According to the law of demand , price
and demand are inversely related. If
there is fall in price , demand
increases because
1. real income or purchasing power
increases.
2.consumer substitutes relatively
cheaper good for costlier one.

Let us assume that price of commodity X falls. It
will lead to increase in demand due to price
effect. Consumer will get more satisfaction
because his purchasing power or real income will
increase .If additional real income is taken away
in such a ,manner that he gets same satisfaction
as he was getting before the fall in price, it
means that income effect get neutralized . Even
after neutralizing income effect, if consumer
purchase more of X good it will be due to
substitution effect. Once we know substitution
effect income effect can be measured by
subtracting substitution effect from price effect.