Application of Indifference
describe in brief as to how indifference curves and
budget lines can be used to
analysis the effects on consumption due to (a) changes in the income of a
consumer (b) changes in the price of a commodity.
(1) Changes in Consumer's
Equilibrium (Income Effect):
Definition and Explanation:
consumer’s equilibrium analysis, it is primarily assumed that the price of the
goods X and Y and the income of the consumer remains constant. We now examine as
to how the consumer reacts as regards to his purchases of good when his income
changes within the indifference curve frameworks. Income is one of the most
important factors affecting the purchase of commodities.
If the prices of goods,
tastes and preferences of the consumer remains constant and there a change in
his income, it will directly affect consumer’s demand. This effect on the
purchase due to change in income is called the income effect.
A rise in
consumer’s income will shift the price line or budget line upward to the right
and he goes on to higher point of equilibrium. A fall in the income, will shift
the price line downward to the left and the consumer attains lower (tangency)
points of equilibrium. The shift of the price line is parallel as the prices of
the goods are assumed to remain the same. The income effect is explained with
the help of following diagram.
diagram (3.12) wheat is measured along OX and rise along OY. When the price line
or budget line is BB/ , the consumer gets maximum satisfaction or is
in equilibrium position at point K where it touches the indifference curve IC1.
The consumer buys OS quantity of wheat and ON quantity of rice. We suppose now
that the income of the consumer has increased and the price line is now CC1.
Which shifts in a parallel fashion to the right.
The consumer is in equilibrium
at a level at point L which is its equilibrium point. If there is further
increase in income: shift of the price line now will be DD1, and the
consumer is in equilibrium at point T and will be purchasing OZ quantity of
wheat and OE quantity of rice. If these, equilibrium points K, L, T are joined
together by a dotted line passing through the origin, we get income consumption
This shows that with the rise in income, the consumer generally
buys more quantities of the two commodities rice and wheat. The income
consumer is now better off at T on indifference curve IC3 as compared
to L at a lower indifference curve IC2 . The income effect is
positive in case of both the goods rice and wheat as these are normal goods.
The income consumption curve ICC which is derived by joining the successive
equilibrium positions has a positive slope.
Income Effect When Wheat is
an Inferior Good:
also happens that with the rise in income, the consumer buys more of one
commodity and less of another. For instance, he may buy less of wheat and more
of rice as is, illustrated in figures 3.13.
3.13, the income consumption curve bends back on itself. With the rise in
income, the consumer buys more of rice and less of wheat. The price effect for
rice is positive and for wheat is negative. The good which is purchased less
with the increase in income is called inferior good.
Income Effect When Rice is
an Inferior Good:
In the figure
3.14, it is shown that with the rise in money income, the purchase of wheat has
increased from M1 to M4 indicating positive income effect
on the purchase of normal good wheat. The income effect on inferior good is
negative. The income consumption curve ICC is starts bending towards the
horizontal axis which shows that wheat is a normal good and rice is inferior
(2) Changes in Consumer’s
Equilibrium (Price Effect):
Effect on the Consumption of a Normal Good:
discuss the reaction of the consumer to the changes in the price of a good
while his money income, tastes, preferences and prices of other goods remain
unchanged. When there is change in the price of a good shown on the two axes of
an indifference map, there takes place a change in demand in response to a
change in price of a commodity, other things remaining the same, is called
in fig. 3.15, AB is the initial budget line. It is assumed that the price of
wheat has fallen and the price of rice and the income of the consumer remains
unchanged. The price line takes a new position AC and the equilibrium point
shifts from P to U.
buys now OT quantity of wheat (the amount demanded rises from OE to OT and OZ
quantity of rice. With further fall in the price of wheat, the consumer is in
equilibrium at point S, where the budget line AD is tangent to a higher
indifference curve AC3. He buys now OF quantity of wheat and OR quantity of
The rise in amount purchased of wheat (OE to OF) as a result of a fall in
its price is called price effect. The price effect on the consumption of a
normal good is negative. If we join the equilibrium points PUS, we get price
consumption curve (PCC) of the consumer for the commodity wheat.
Price Effect When Commodity
X is a Giffen Good:
is a particular type of inferior good. When there is a decrease in the quantity
demanded of a good with a fall in its price, the good is called Giffen good
after the name of Robert Giffen.
A British Economist Robert Giffen (1837-1910),
observed that sometimes it so happens that a decrease in the price of a
particular good causes its quantity demanded to fall. The consumer spends the
money he saves (by curtailing the demand) on the purchase of increased quantity
of the other good. The decease in the price of Giffen good has an effect similar
to an an increase in the income of a buyer. This particular type of behavior of
the consumer to decrease demanded of good when its price falls is called
effect on the consumption of the Giffen good X is now explained with the help of
In fig. 3.16, the consumer is in equilibrium at point E where the budget line AB is
tangent to the indifference curve IC1. The consumer purchases OX1
quantity of Giffen good X and OY1 quantity of good Y.
When there is
a reduction in the price of good X but no change in the price of good Y, the
budget line AB/ will showing upward. The consumer is in equilibrium
at point E/ where the budget line AB/ is a tangent to the
indifference curve IC2. In the new equilibrium position, the consumer
purchases only OX2 units of Giffen good X and OY2 units of
We find that the decrease in the price of Giffen good X, its quantity
purchased has fallen from OX1 to OX2 and the quantity
demanded of Y commodity goes up from OY1 to OY2. The price
effect on the consumption of Giffen good is positive. If is indicated by the
backward bending PCC in the case of X as a Giffen good.
(3) Consumer’s Equilibrium and
the Substitution (Effect of Price Change):
economic literature, there are two slightly different methods for explaining the
impact of a price change on the quantity demanded of the two the two goods by
the consumer. The first method is attributed to Hicks and Allen and is named as
Hicks-Allen Substitution Effect.
The second put forward by S. Slutsky, a
Russian Economist, is known as Slutsky Substitution Effect.
The two concept
differ in the way in which real income of the consumer is to be maintained
constant when the substitution effect is to be observed. We explain the
Hicks-Allen Method of tracing the substitution effect.
Hicksian method, price changes is accompanied by so much change in money income
that the consumer is neither better off nor worse off than before. The money
income is changed by an amount which keeps the consumer on the same indifference
For instance, the price of good say X falls, and that of good Y remains
unchanged. With this fall in the price of good X, then the real income of the
consumer would increase. This increase in the real income of the consumer is so
withdrawn that he is neither better off nor worse off than above. The amount by
which the money income is reduced is called compensating variation in income.
Substitution effect thus means the change in its relative price alone, real
income of the consumer remaining constant. The Hicksian substitution effect in
now explained with the help of diagram below.
diagram 3.17 the consumer with given money income and given prices of two goods
represented by price line PL is in equilibrium at point Q on the indifference
curve IC. He buys ON quantity of good Y and OM of good X.
now that the price of good X has fallen and the price of good Y remains the
same. With the fall in the price line shifts from PL to PL/.
Consumer’s real income is raised because commodity X is cheaper now. This
increase in the real income of the consumer is to be wiped out for finding out
the substitution effect. The reduction in the money income of the consumer is to
be made by so much amount which keeps him on the same indifference curve IC.
case, consumer’s income is reduced by PA (interims of Y) or LB (in terms of X),
the consumer will remain on the same indifference curve IC. PA or L/B
is the compensating variation in income. At the new price line AB, the consume
is in equilibrium at point T. He now buys OM/ of good X and ON/
of good Y.
in the purchase of good X by MM/ and decrease in the purchase of good
Y by NN/ is due to the fall in the price of good X. The consumer has
rearranged his purchase of good X and good Y as good X is now relatively cheaper
and good Y is relatively dearer than before.
has moved on the same indifference curve IC from Q to point T substituting the
commodity that has become relatively cheaper for the one that has relatively
become more expensive because of price change. The type of movement from point Q
to T on the same indifference represents the substitution effect.