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Application of Indifference Curve Analysis:

We now 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:

In the 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/Figure:

In the 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 curve ICC.

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.

Example:

Income Effect When Wheat is an Inferior Good:

Sometimes it 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.

In diagram 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 good.

(2) Changes in Consumer’s Equilibrium (Price Effect):

Price Effect on the Consumption of a Normal Good:

We now 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 price effect.

For example 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.

The consumer 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 rice.

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:

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 Giffen Paradox.

The price effect on the consumption of the Giffen good X is now explained with the help of diagram below:

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 good Y.

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):

In the 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.

Hicks-Allen Substitution Effect:

In the 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 curve.

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.

In this 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.

We suppose 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.

In 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.

The increase 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.

The consumer 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.