Derivation of the Demand Curve - Indifference Curve Analysis

Income and Substitution Effect of a price Change

Example: Devon has an income of $80 00 to be can spent on TWO goods; sodas and fish
Burgers. The price of a soda is $5.00, and the price of a fish burger is $4.00
Using a diagram/graph show How many sodas and fish burgers must Devon consume to achieve
consumers Equilibrium/Maximization/Optimization.
Step 1: Determine/Calculate the absolute value of the Y and X axis in order to DRAW
the BUDGET LINE.
Step 2: Prepare a schedule to show all possible combinations of both goods that can be
attained with the GIVEN income.
Step 3: Determine Consumers Equilibrium i.e. the combination that indicates
maximization. Px/Py = Y/ X

Step 4: Draw graph to show and explain all three steps above

Solution:
Step one: To determine the Absolute value of the axis Divide consumers Income by the
Price of the good.
Thus, the Absolute Value of:
Y Axis (SODA): $80.00/5.00 per soda =16 sodas.
Assuming Devon spends the entire $80.00 to purchase soda a total of 16 sodas
can be bought.
X Axis (fish burgers): $80.00/4.00 per fish burger = 20 fish burge6s
Assuming Devon spends the entire $80.00 to purchase fish burgers a total of 20
can be bought.
Absolute Value of Y axis = 1 sodas
Absolute Value of X axis = 15 fish burgers
 Step 2: Preparation of schedule showing all possible combinations that can be
bought of both goods with given income $80.00
Sodas ($5.00) Fish burgers ($4.00)
16 0
12 5
8 10
4 15
0 20

Step 3: Determine: Consumers Equilibrium:

This is Where:
Px/Py = Y/ X = the slope of the curve = 16/20 =0.8
The objective is to determine which combination satisfies the consumer Equilibrium
requirement;
Observing from the schedule above Px($4.00)/Py($5.00) = 8 sodas/10 Fish Burgers = 0.8

Step 4: Draw a Diagram of BUDGET LINE and the INDIFFERENCE CURVE to illustrate all three
steps above
:
16
sodas
8 CE Indifference curve (MRS)
CE: consumers Equilibrium
Budget Line
Fish Burgers 10 20
Devon will maximize satisfaction when he consumes 8 sodas and 10 fish burgers
Derivation of the Dem – indifference curve Analysis
Analysing the Demand for Good X using the indifference curve
Assuming the Price of good X Fish Burgers has fallen to $2.00 each, show the income Effect
and the Substitution Effect of this Change and find the NEW CONSUMERS EQUILIBTIUM point

16
Sodas (units)
8 CE Indifference curve (MRS)
CE: consumers Equilibrium
Budget Line
Fish Burgers 10 20 (units)

Price ($) 4

2
Dx
10 Fish Burgers 40 (units)

Income and substitution Effect of a Price Change:

Assuming the Price of good X Fish Burgers has fallen to $2.00 each, show the income Effect
and the Substitution Effect of this Change and find the NEW CONSUMERS EQUILIBTIUM point

Substitution Effect of a price change:

This occurs when the price of one good changes, causing one to become relatively more
expensive, and other relative cheaper. This would trigger the consumer to Substitute (give
up) some the more expensive good to buy more of the cheaper good. This is Known as Rhe
SUBSTITUTION EFFECT of a price change.
Income Effect of a price Change
Although the consumer can now buy more of the cheaper good there may still be excess
income left so that the consumer can now buy a little more of both goods this is known as the
INCOME EFFECT of a price change.
Graphical illustration:
BL1(16)

SODAS Fall in the Price of X

(units) Causes an ANTI-CLOCKWISE ROTATION
Along the Y axis

Fish Burger s BL1 (20) BL2 (40)

Because the fall in the price of X (fish burgers):
- the BUDGET LINE makes an anti-clockwise rotation along the Y axis,
- A new absolute value for X (fish Burgers) must now be established
Income /New price ($80.00/$2.00 = 40 fish burgers as shown in the diagram above
- this means a NEW CONSUMERS EQUILIBRIUM point must be determined;
- Return to step 2: Determine all possible combinations of the two goods
- On the graph show the:
(a) New Equilibrium point on the New Budget Line BL2
(b) Income Effect
(c) Substitution Effect
 New Combination
SODAS ($5.00) FISH BURGERS ($2.00)
16 0
14 5
12 10
10 15
8 20
6 25
4 30
2 35
0 40
Px/Py = Y/ X = $2.00/$5.00 = 8/20
Therefore, the New Consumers Equilibrium Point occurs when Devon consumes 8 sodas and
20 fish burgers.

8 B ID2
2 SE 2 IE
6 E ID1
SE IE
4 6 Parallel line New Budget
line
Fish Burgers 10 14 20
Due to change in the price of X (fish Burgers):

 the consumer increased consumption of the same by 4 units (10 – 14) Sub. Effect.
 and decreased the consumption of Y (sodas) by 2 units (8 – 6) Substitution Effect
 . At this point, 6 units of sodas and 14 units of Fish burger, the income spent would be
$58.00.
6 sodas x $5.00 = $30.00
14 Fish burgers x $2.00 = $28.00
$58.00*

 Obviously. there will be an excess amount of income, $22.00, still to be spent.

($80.00 -$58.00)
 Because of the Excess Devon now buys:
2 more units of Y (sodas) 6 to 8 returning to his original consumption of sodas.
INCOME EFFECT
 6 more units of X (fish burgers) increase consumption of the cheaper good. INCOME
EFFECT
2 burgers x $5.00 = $10.00
6 fish burgers X $2.00 = $12.00
$22.00

Steps to follow when drawing a diagram to illustrate Income and Substitution Effect of
a price change:

(1) Determine the New Absolute Value of the good which has changed price;
(2) Determine the rotational direction of the Budget Line;
(3) Draw the New Budget Line;
(4) Prepare a schedule of all the possible combinations that can be bought with the
given income;
(5) Determine Consumers Equilibrium
(6) Draw an indifference curve tangent to the point on the New Budget Line;
(7) Draw a Line parallel to the New Budget Line, but Tangent to The Old Indifference
curve;
(8) Draw a line to connect the Tangent point on the parallel Line/Old Indifference
Curve to the New Tangent point (consumers equilibrium) on the New Budget Line;
(9) Draw lines from the vertical axis to connect to both points mentioned in 8 above
The Line B connected to the New Consumption Equilibrium/ New indifference
Curve shows the Income Effect
The Line E, Connected, to the Parallel Line/ Old Indifference curve shows the
Substitution Effect. (The Rotation is opposite for a price increase, however, the
process remains the same)
 Using Indifference Curve Analysis to determine different types of goods:
- Normal goods
- Inferior goods
BL4 (A) Assuming the price of both goods have decreased,
BL3 draw a Demand curve For Good X and Good Y.
Good Y BL2 . What type of good is:
BL - Good X?
- Good Y?
BL1 BL2 BL3 BL4
Good X
BL3 (b) Assuming the price of both goods have decreased
(i) Draw a Demand curve for:
Good Y BL2 - Good X
- Good Y
BL1

BL1 BL2 BL#

What type of good is X?
What type of Good is Y