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BUSINESS

PAPER NO. 1: MICRO ECONOMICS ANALYSIS

Subject Business Economics

Paper No and Title 1- Micro Economics Analysis

Module No and Title 8- Consumer Equilibrium- Part II

Module Tag BSE_P1_M

BUSINESS

PAPER NO. 1: MICRO ECONOMICS ANALYSIS

1. Learning Outcomes

2. Introduction

3. Change in Income and the Engel Curve

3 Income Consumption Curve

3 Engel Curve

3 Income consumption curve and Engel curve for an Inferior good

4. Change in Price and the Individual Demand Curve

4 Price Consumption Curve

4 Individual Demand Curve

5. Substitution Effect and Income Effect

5 Substitution Effect and Income Effect for Normal Goods

5 Substitution Effect and Income Effect for Inferior Goods

5 Compensated Demand Curve

6. Summary

BUSINESS

PAPER NO. 1: MICRO ECONOMICS ANALYSIS

increases further to M 3 so that the budget line shifts to EF, the consumer reaches the indifference curve IC 3 at point R and purchases greater quantities of both the commodities.

If the successive consumer equilibrium points (like P, Q and R) corresponding to various level of income are connected together, we obtain the Income Consumption Curve (ICC). The Income Consumption Curve is thus the locus of the consumer’s equilibrium points corresponding to different levels of consumer’s income.

[Figure 1: Income consumption curve and Engel curve for a normal good]

3 Engel Curve

The income consumption curve can be used to derive the relationship between a consumer’s income and the quantity of goods purchased. The Engel curve shows the relationship between the consumer’s level of income and quantity purchased of a commodity, other factors remaining constant. To derive the Engel curve from income consumption curve let us measure income levels

BUSINESS

PAPER NO. 1: MICRO ECONOMICS ANALYSIS

on the vertical axis and quantity of a good purchased on the horizontal axis as in the lower panel of Figure 1.

The Income Consumption Curve in the top panel of Figure 1 shows the equilibrium quantity of X and Y purchased as the income level changes. The parallel budget lines AB, CD and EF corresponds to M1, M2 and M3 level of income respectively, prices remaining constant. Each point of the ICC corresponds to a particular level of income and to a particular quantity of X (and Y). The various combinations of the income level and the quantity purchased of good X i. (M 1 , OX 1 ), (M 2 , OX 2 ) and (M 3 , OX 3 ) are plotted in the lower panel to obtain the Engel curve for good X. The income-quantity combinations (M 1 , OX 1 ), (M 2 , OX 2 ) and (M 3 , OX 3 ) shown by point P’, Q’ and R’ in the lower panel of Figure 1 correspond to the consumer’s equilibrium points P, Q and R respectively in the top panel of Figure 1.

3 Income consumption curve and Engel curve for an inferior good

In case of a normal good the consumer purchases more of it when his income increases. But an inferior good is a type of good which the consumer purchases less of when his income increases. Figure 1 above shows the income consumption curve and Engel curve when X is a normal good. We get a positively sloped Engel curve and income consumption curve for a normal good because the consumer purchases more of X when his income increases.

Now, let us assume X is an inferior good (Figure 2 below). In this case, consumption of the commodity decreases as income increases. So the ICC is backward bending and the Engel curve is negatively sloped, indicating a fall in quantity purchased with an increase in income.

BUSINESS

PAPER NO. 1: MICRO ECONOMICS ANALYSIS

equilibrium when the price of a good changes, but his income, tastes and prices of other goods remain unchanged. The price consumption curve for good X is the locus of consumer equilibrium points resulting only from changes in the price of a single good, say good X.

In Figure 3, PQ indicates the budget line for a given income level (M 1 ) and given prices of commodities X and Y. The consumer is in equilibrium at point A when the indifference curve IC 1 is tangent to the budget line PQ. At A, the consumer purchases OX 1 of commodity X and OY 1 of commodity Y. Now, suppose the price of good X falls, ceteris paribus, i., income and price of the other commodity remaining constant. As a result the budget line swivels from PQ to PR. The consumer moves to a new equilibrium B on a higher indifference curve IC 2. Ceteris paribus, if the price of X falls further, the budget line rotates further to PS and the consumer reaches a new equilibrium C on indifference curve IC3. Joining all the successive consumer equilibrium points (like A, B and C) at various price levels of good X, we get what is called Price Consumption Curve (PCC) for good X. Price consumption curve for good X is thus the locus of consumer’s equilibrium points resulting from changes in the price of good X.

BUSINESS

PAPER NO. 1: MICRO ECONOMICS ANALYSIS

[Figure 3: Price consumption curve and the individual demand curve]

4 Individual Demand Curve

The demand curve for a good shows the quantity demanded of that good at various prices of the good, with income, tastes and preferences and prices of other goods being held constant. The price consumption curve gives us the change in quantity demanded when price of a good changes but it does not directly relate the goods’ price with quantity demanded. The demand curve of an individual shows that the relationship between price and quantity demanded can be easily derived from the price consumption curve as shown in the lower panel of Figure 3. The horizontal axis in the lower panel measures quantity of good X, as in the top panel, but the vertical axis measures the price of commodity X.

BUSINESS

PAPER NO. 1: MICRO ECONOMICS ANALYSIS

[Figure 4: Substitution effect and the Income effect for a normal good]

The substitution and income effect of a price change is illustrated in Figure 4. With the given money income and prices the consumer’s equilibrium is shown at point A where the indifference curve IC 1 is tangent to the budget line PQ. With a fall in the price of commodity X, ceteris paribus, the budget line swivels to PR and the new equilibrium is achieved at point B. This decrease in price of X results in an increase in the real income or purchasing power of the consumer. To isolate the substitution effect, the individual’s money income should be reduced sufficiently, so as to keep him on the initial indifference curve IC 1. To show this, an imaginary budget line P’R’ is drawn, that is parallel to the budget line PR and lies below it (as it represents a reduction in income), such that it touches the original indifference curve IC 1. PP’ represents the compensating variation in income due to a fall in price of X – it is the amount by which income is reduced to offset the gain due to the increase in real income (owing to the fall in price), so that the consumer remains on the same indifference curve as before.

In this case, the consumer’s satisfaction is maximized at point C where the indifference curve IC 1 is tangent to our imaginary budget line P’R’. The imaginary budget line P’R’ reflects the new relative prices of commodities X and Y since it is parallel to the new budget line PR which was obtained after the fall in price of commodity X. At the point C the consumer increases the consumption of good X and decreases the consumption of good Y due to the change in relative price of commodities X and Y (the fall in price of X makes it relatively cheaper compared to Y whose price is unchanged). Thus, point C shows the new consumer’s equilibrium when only the relative price of the commodities has changed. So the movement from point A to point C along the indifference curve IC 1 measures the substitution effect. The convexity of the indifference ensures that the decline in relative price of a good always leads to an increase in its quantity demanded due to substitution effect. In Figure 4, LM represents the substitution effect.

BUSINESS

PAPER NO. 1: MICRO ECONOMICS ANALYSIS

Let us now consider the income effect of the price change. The move from point C on IC 1 to point B on a higher indifference curve IC 2 measures the income effect. The movement from point C to point B does not involve any change in relative price because the imaginary budget line P’R’ and actual budget line PR are parallel. Thus, this change in consumer equilibrium from C to B is only due to the change in purchasing power of the consumer, owing to increase in real income (due to fall in price of X) and therefore measures the income effect. If X is a normal good, an increase in purchasing power leads to an increase in the quantity demanded of X. In Figure 4, MN shows the income effect for a normal good X.

5 Substitution Effect and Income Effect for Inferior Goods

For a normal good, the quantity purchased increases when the price falls both due to the income effect and substitution effect. But in case of inferior goods the income effect works in opposite direction to the substitution effect. That is, when the price of an inferior good falls, the income effect leads the consumer to reduce the quantity purchased, while the substitution effect leads the consumer to purchase more. Since the substitution effect is generally larger than the income effect, a fall in price leads to an increase in quantity demanded. This results in a downward sloping demand curve in most cases, even for inferior goods.

[Figure 5: Substitution effect and the Income effect for an inferior good]

The income effect and substitution effect for an inferior good are shown in Figure 5. As before, we consider the case of a fall in price of good X, ceteris paribus. It is assumed that X is an inferior good. As discussed above, the movement from A to C along the indifference curve IC 1 shows the substitution effect and the movement from C to B, on a higher indifference curve IC 2 , shows the income effect of a fall in price of X. In this case, the substitution effect LM is opposite

BUSINESS

PAPER NO. 1: MICRO ECONOMICS ANALYSIS

demanded is reduced by MN; but LM < MN. Therefore the total price effect shows a reduction in quantity consumed with a fall in price of the good, ceteris paribus. Thus, when the price of a Giffen good decreases the quantity demanded also decreases representing an exception to the law of demand.

5 Compensated Demand Curve

In Section 4, we discussed the derivation of ordinary demand curve for an individual consumer, from the price consumption curve. We saw that the individual’s demand curve includes both the income effect and substitution effect of the price change. As the consumer moves downward along the ordinary demand curve his purchasing power increases and he moves to a higher indifference curves attaining higher level of satisfaction. The increase in real income or purchasing power of the consumer results from the fall in price of the commodity since the money income is kept constant. But sometimes we are more interested in studying the change in quantity demanded when real income is held constant rather than money income being held constant. Such a demand curve which shows the effect of a price change on quantity demanded, holding real income constant is called a compensated demand curve. For derivation of compensated demand curve only the substitution effect of the price change is considered.

Thus, whereas the ordinary demand curve includes both the income effect and the substitution effect of a change in price of the good, the compensated demand curve shows only the substitution effect. It follows that, for a normal good, the compensated demand curve will be steeper than the ordinary demand curve.

BUSINESS

PAPER NO. 1: MICRO ECONOMICS ANALYSIS

6. Summary

 The income consumption curve is the locus of consumer equilibrium points resulting only

due to changes in the consumer’s income, ceteris paribus.

 The Engel curve shows the relationship between level of income and the quantity purchased

of a commodity, other factors (e., prices, tastes and preferences etc.) remaining constant.

 Inferior good is a type of good of which the consumer purchases less when income increases.

 The price consumption curve for good X is the locus of consumer equilibrium points

resulting only from changes in the price of good X, ceteris paribus.

 The total effect of a price change on quantity demanded can be separated into two

components called the substitution effect and the income effect.

 Substitution effect measures the change in consumption of a good as a result of change in

relative prices alone, real income remaining constant.

 The income effect measures the change in quantity demanded of a good as a result of change

in his real income only, holding relative prices unchanged.  The amount by which the money income is changed to bring the consumer back to the original indifference curve after change in price of a good is called Compensating Variation.

 In case of inferior goods the income effect works in opposite direction to the substitution

effect.

 In case of Giffen good the quantity demanded of the good decreases when its price decreases

and the quantity demanded increases when its price increases.

 The demand curve is positively sloped for a Giffen good.

 All Giffen goods are inferior good, but not all inferior goods are Giffen Goods.

 Compensated demand curve shows the effect of a price change on quantity demanded,

holding real income constant.

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