Indifference Curve Analysis

The equilibrium position of the consumer will be found out on the

assumption that income of the consumer will remain constant.
Now if there is any change either in the income of the consumer or
prices of commodities, there will be a change in the equilibrium
position.


This can be explained under three heads.


1. Income Effect

2. Price Effect

3. Substitution Effect


Indifference Curve Analysis - Income Effect


Income effect: - Where there is a change in the
income of the consumer, but the prices of the
commodities remain constant, there will be a
change in consumption made by the consumer.
This change in consumption is called the Income
Effect.









Indifference Curve Analysis Income Effect

Equilibrium: Under the income effect there will be a
change in the equilibrium position of the consumer and
that can be shown in the following diagram.

In the diagram AB is the original price line. T1 is the
original equilibrium position. As there is increase in
income the new price line or the budget line is CD. T2 is
the new equilibrium position. When there is further
increase in income, EF becomes the new budget or
price line. T3 becomes the new equilibrium position. If
we now join T1, T2 and T3, it forms a curve known as
income-consumption curve(ICC). The ICC shows the
new equilibrium position of the consumer, where there
is a change in income, with prices remaining constant.

Indifference Curve Analysis-Income Effect
Types of Income Effect

1. Positive income effect: When with the increase in income, there is
increase in consumption that is known as Positive Income Effect.


2. Negative Income Effect: when with the increase in income there is
decrease in consumption that is known as Negative Income Effect. The
negative income effect is applicable in case of inferior goods. Inferior goods
are those goods, which are purchased less as one's income rises.



Indifference Curve Analysis-Income Effect
When the consumer purchases less of commodity X as a result of
increase in income, X is the inferior commodity.


Indifference Curve Analysis-Income Effect
When the consumer purchases less of commodity Y, as a result of
increase in income, Y is the inferior commodity.




Indifference Curve Analysis - Price Effect

Price Effect: When there is no change in the income of the consumer, no
change in the price of one commodity, and there is a change in the price
of another commodity, there will be a change in the consumption made
by the consumer. This change in consumption is known as the Price
Effect.




Indifference Curve Analysis - Price Effect
Equilibrium position: Under the Price Effect, there will be a change in the equilibrium
position of the consumer. This can be shown in the following diagram.

In this diagram PCC is the Price Consumption Curve. It is sloping downwards to the right.
Any point on the Price Consumption Curve will indicate the equilibrium position of the
consumer under the Price Effect. In this diagram when the price of X falls, the consumer
purchases more of X and less of Y.




Shapes of Price Consumption Curve




























In the above diagram PCC is the price consumption curve. It is a
horizontal straight line. It indicates that with a fall in the price of X,
the consumer purchases more of X and the same quantity of Y.




Shapes of Price Consumption Curve































In this diagram the price consumption curve is sloping upwards to
the left. This indicates that with a fall in the price of X, the
consumer purchases less of X. This is applicable in case of Giffen
goods.




Indifference Curve Analysis - Substitution Effect


Meaning: When there is a change in the price of one commodity,
and when the price of another commodity remains unchanged or
constant, the income of the consumer must be changed in such a
way that the consumer is neither better off nor worse off. He
remains at the same old position. Under that circumstance, if
there is a change in the consumption, that would be due to the
Substitution Effect.



Indifference Curve Analysis - Substitution Effect
In the diagram AB is the original price or budget line. T is the original equilibrium
position. There is a fall in the price of X. So the new budget line is AC. To put the
consumer at the same old position we draw another budget or price line DE, which
will meet the indifference curve at the point T1. So the movement from T to T1 on
the indifference curve IC shows the substitution effect. Here the consumer
substitutes n->n1 of Y to get m->m1 more of X because the price of X is now
comparatively cheaper than the price of Y.