Income Effect on Consumer’s Equilibrium
The income effect attributes to how a change in the consumer’s income influences his total satisfaction. Assume that the prices of commodities that the consumer purchases remain constant. Now, he can experience more or less satisfaction depending upon the change in his income. Thus, we can define income effect as the effect caused by changes in a consumer’s income on his purchases while prices of commodities remain the same.
Figure 1 explains the effect of change in the consumer’s income on his equilibrium level.
In figure 1, Point E is the initial equilibrium position of the consumer. At point E, the indifference curve IC1 is tangent to the price line MN. Suppose the consumer’s income increases. This causes the budget line shifts from MN to M1N1 and then to M2N2. Consequently, the equilibrium point shifts from E to E1 and then to E2.
Income Consumption Curve
You can obtain the income consumption curve (ICC) by joining all equilibrium points E, E1 and E2 as shown in figure 1. Normal goods generally have positively sloped income consumption curves, which implies that the consumer’s purchases of the two commodities increases as his income increases. At the same time, this may not be applicable in all cases.
Substitution Effect on Consumer’s Equilibrium
Suppose there are two commodities, namely apples and oranges. Your money income is $100, which does not change. You need to purchase an apple and orange using the entire money income, i.e. $100. Assume that the price of apple increases and the price of orange decreases. What do you do in this case? You tend to buy more oranges and fewer apples since oranges are cheaper than apples. What exactly you are doing is that you are substituting oranges for apples. This is known as the substitution effect.
The substitution effect occurs because of the following two reasons:
(a) The relative prices of commodities change. This makes one commodity cheaper and the other commodity costlier.
(b) Money income of the consumer does not change.
Figure 2 is helpful to understand the concept of the substitution effect simply.
In figure 2, AB represents the original budget line. Point Q represents the original equilibrium point, where the budget line is tangent to the indifference curve. At point Q, the consumer buys OM quantity of commodity X and ON quantity of commodity Y. Assume that the price of commodity Y increases and the price of commodity X decreases. As a result, the new budget line would be B1A1. The new budget line is tangent to the indifference curve at point Q1. This is the new equilibrium position of the consumer after the relative prices change.
At the new equilibrium point, the consumer has decreased the purchase of commodity Y from ON to ON1 and increased the purchase of commodity X from OM to OM1. However, the consumer stays on the same indifference curve. This movement along the indifference curve from Q to Q1 is known as the substitution effect. In simple terms, the consumer substitutes one commodity (its price is less) for the other (its price is more); it is known as the ‘substitution effect.’
Price Effect on Consumer’s Equilibrium
For simplicity, let us consider the two-commodity model. In the substitution effect, prices of both commodities change (the price of commodity Y increases and the price of commodity X decreases). However, in price effect, the price of any one of the commodities changes. Thus, the price effect is the change in the number of commodities or services purchased due to a change in the price of any one of the commodities.
Let us consider two commodities, namely commodity X and commodity Y. Price of commodity X changes. The price of commodity Y and the consumer’s income are constant.
Suppose the price of commodity X decreases. In figure 3, the decline in the price of commodity X is represented by the corresponding shifts of the budget line from AB1 to AB2, AB2 to AB3 and AB3 to AB4. The points C1, C2, C3 and C4 denote respective equilibrium combinations. According to figure 3, consumers’ real income increases as the price of commodity X reduces. Due to an increase in the consumer’s real income, he can purchase more of both commodities X and Y.
Price Consumption Curve
You can derive the Price Consumption Curve (PCC) by joining all equilibrium points (in the above example, C1, C2, C3 and C4). In the above figure, the PCC has a positive slope. This means that as the price of commodity X falls, the consumer’s real income increases.
Derivation of Demand Curve from Price Consumption Curve
The price consumption curve (PCC) tells us what happens to the quantity demanded when there is a price change. A consumer’s demand curve also explains the relationship between the price and quantity demanded of a commodity. Therefore, the price consumption curve is useful to derive an individual consumer’s demand curve. Though a consumer’s demand curve and his price consumption curve give us the same information, the demand curve is more straightforward in what it tries to convey.
Figure 4 illustrates the process of deriving the individual consumer‘s demand curve from his price consumption curve.
In figure 4, the horizontal axis measures commodity A, and the vertical axis represents the consumer’s money income. IC1, IC2, and IC3 denote indifference curves. Suppose the price of commodity A continuously decreases. As a result, LN, LQ and LR are the subsequent budget lines of the consumer. Initially, P1 is the consumer’s equilibrium. At this equilibrium point, the consumer buys OM1 quantity of commodity A.
Price of a unit of commodity A = total money income/number of the units that can be bought with that money.
Hence, at P1 (equilibrium point – budget line is tangent to the indifference curve IC1), the price per unit of commodity A is OL/ON. At OL/ON price, the consumer demands OM1 quantity of commodity A.
Likewise, at OL/OQ price, the consumer can buy OM2 quantity of commodity A and at OL/OR price, he buys OM3 quantity of commodity A.
If you connect all equilibrium points (P1, P2 and P3), you will be able to get the price consumption curve.
The demand curve, as mentioned above, depicts the prices and corresponding quantities of commodities purchased by the consumer.
For illustration purposes, suppose the consumer’s income is $40, ON = 8 units, OQ = 10 units and OR = 20 units. With the help of this information, you can construct a demanding schedule as follows:
Table 1: Price-Demand Schedule for Commodity A
Once you have the demand schedule, you can derive an individual consumer’s demand curve as shown in figure 5.
Figure 5 illustrates a consumer’s demand curve. If you need to construct a market demand curve, it will be possible by a horizontal summation of individual demand curves.
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