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Microeconomics

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LECTURE#4

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CHAPTER#4
INDIFFERENCE CURVE ANALYSIS OF DEMAND

 PRICE LINE/ BUDGET LINE


 CONSUMER’S EQUILIBRIUM THROUGH
INDIFFERENCE CURVE ANALYSIS
 CONSUMER’S EQUILIBRIUM UNDER
VARIOUS SITUATIONS

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Budget line/Price line:

 Budget line is nothing but a line which sets a budget for you, it tells you that you
can not exceed this line.

 The understanding of the concept of budget line is essential for knowing the
theory of consumer’s equilibrium.

 "A budget line or price line represents the various combinations of two goods
which can be purchased with a given money income and assumed prices of
goods".

 For example, a consumer has weekly income of $60. He purchases only two
goods, packets of biscuits and packets of coffee. The price of each packet of
biscuits is $6 and the price of each packet of coffee is $12. Given the assumed
income and the price, of the two goods, the consumer can purchase various
combination of goods or market combination of goods weekly.
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Schedule:
 The various alternative market baskets (combinations of
goods) are shown in the table below
Packets of Biscuits Per Packets of Coffee Per
Market Basket
Week Week
A 10 0
B 8 1
C 6 2
D 4 3
E 2 4
F 0 5
Income $60 Per Week = Packets of Biscuits Costs $6 = Packets of Coffee is
Priced $12 Each

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Explanation

 (i) Market basket A in the table above shows that if the whole amounts of $60 is
spent on the purchase of biscuits, then the consumer buys 10 packets of
biscuits at a price of $6 each and nothing is left to purchase coffee.

 (ii) Market basket F shows the other extreme. If the consumer spends the entire
amount of $60 on the purchase of coffee, a maximum of 5 packets of coffee
can be purchased with it at a price of $12 each with nothing left over for the
purchase of biscuits.

 (iii) The intermediate market baskets B to E shows the mixes of packets of


biscuits and packets of coffee that the cost a total of $60. For example, in
combination of market basket C, the consumer can purchase 6 packets of
biscuits and 2 packets of coffee with a total cost of $60.

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Budget Line:

 The budget line is an important element analysis of consumer behavior.


The indifference map shows people’s preferences for the combination of
two goods.
 The actual choices they will make, however, depends on their income. The
budget line is drawn as a continuous line. It identifies the options from
which the consumer can choose the combination of goods.

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In the fig. 3.9 the line AF shows the various combinations of goods
the consumer can purchase. This line is called the budget line.

 It shows 6 possible combinations of packets of


biscuits and packets if coffee which a consumer
can purchase weekly. These combinations are
indicated by points A, B, C, D, E and. Point A
indicates that 10 packet of biscuits can be
purchased if the entire income of $60 is devoted
to the purchase of biscuits. Similarly, point F
shows the purchase of 5 packets of coffee for
the entire income of $60 per week.

 The budget line AF indicates all the


combinations of packets of biscuits and packets
of coffee which a consumer can buy given the
assumed prices and income. In case, a
consumer decides to purchase combination of
goods inside the budget line such as G, then it
involves a total expense that is smaller then the
amount of $60 per week. Any point outside the
budget line such as H requires an outlay larger
than the consumer’s weekly income of $60.

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Shifts in Budget line:

 The price line is determined by the income of


the consumer and the prices of goods in the
market. If there is a change in the income of
consumer or in the price of goods, the price
line shifts in response to a change in these
two factors:

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1. Income changes:

 If there is any change in the income, assuming no change in


prices of apples and bananas, then the budget line will shift.
When income increases, the consumer will be able to buy more
bundles of goods, which were previously not possible.
 It will shift the budget line to the right from ‘AB’ to ‘A1B1‘, as
seen in Fig. 2.9. The new budget line A1B1 will be parallel to the
original budget line ‘AB’.

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2. Price Changes:

 When the price of apples falls, then new budget line is represented by
a shift in budget line (see Fig. 2.10) to the right from ‘AB’ to ‘A1B’. The
new budget line meets the Y-axis at the same point ‘B’, because the
price of bananas has not changed. But it will touch the X-axis to the
right of ‘A’ at point ‘A1, because the consumer can now purchase more
apples, with the same income level.
 Similarly, a rise in the price of apples will shift the budget line towards
left from ‘AB’ to ‘A2B’.

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Consumer’s Equilibrium through
indifference curve analysis:

 Consumer equilibrium refers to the amount of goods and


services which the consumer buy in market given his income
and given prices of goods in market.
 Consumer equilibrium refers to a situation, in which a consumer
derives maximum satisfaction, with no intention to change it
and subject to given prices and his given income. The point of
maximum satisfaction is achieved by studying indifference map
and budget line together.
 On an indifference map, higher indifference curve represents a
higher level of satisfaction than any lower indifference curve.
So, a consumer always tries to remain at the highest possible
indifference curve, subject to his budget constraint.
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 Conditions of Consumer’s Equilibrium:
 The consumer’s equilibrium under the indifference curve theory must meet the
following two conditions:
 (i) MRSXY = Ratio of prices or PX/PY
 Let the two goods be X and Y. The first condition for consumer’s equilibrium is
that
 MRSXY = PX/PY
 a. If MRSXY > PX/PY, it means that the consumer is willing to pay more for X
than the price prevailing in the market. As a result, the consumer buys more of
X. As a result, MRS falls till it becomes equal to the ratio of prices and the
equilibrium is established.
 b. If MRSXY < PX/PY, it means that the consumer is willing to pay less for X than
the price prevailing in the market. It induces the consumer to buys less of X and
more of Y. As a result, MRS rises till it becomes equal to the ratio of prices and
the equilibrium is established.
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 In Fig. 2.12, IC1, IC2 and IC3 are the three indifference curves and AB is the
budget line. With the constraint of budget line, the highest indifference curve,
which a consumer can reach, is IC2. The budget line is tangent to indifference
curve IC2 at point ‘E’. This is the point of consumer equilibrium, where the
consumer purchases OM quantity of commodity ‘X’ and ON quantity of
commodity ‘Y.

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(i) MRSXY = Ratio of prices or PX/PY

 At tangency point E, the absolute value of the slope


of the indifference curve (MRS between X and Y)
and that of the budget line (price ratio) are same.
Equilibrium cannot be established at any other point
as MRSXY > PX/PY at all points to the left of point E
and MRSXY < PX/PY at all points to the right of point
E. So, equilibrium is established at point E, when
MRSXY = PX/PY.

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 (ii) MRS continuously falls:
 The second condition is also satisfied at point E as MRS is
diminishing at point E, i.e. IC2 is convex to the origin at point E.

 The second condition for consumer’s equilibrium is that MRS


must be diminishing at the point of equilibrium, i.e. the
indifference curve must be convex to the origin at the point of
equilibrium. Unless MRS continuously falls, the equilibrium
cannot be established.
 Thus, both the conditions need to be fulfilled for a consumer to
be in equilibrium.

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Consumer’s Equilibrium under various situations:

1. Income Effect on Consumer's Equilibrium

2. Price Effect on Consumer's Equilibrium

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1. Income Effect on Consumer's
Equilibrium:

 Income effect attributes 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 is able to
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 consumer’s income on his purchases while prices of
commodities remaining the same.
 Figure 1 explains the effect of change in the consumer’s income on his
equilibrium level.

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 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.

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Income Consumption Curve:

 You can obtain 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
consumer’s purchases of the two commodities
increases as his income increases. At the same
time, this may not be applicable in all cases.

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Substitution Effect on Consumer's Equilibrium:

 Substitution: the action of replacing


someone or something with another person
or thing.
 Suppose there are two commodities, namely apple and orange. Your money
income is $100, which does not change. You need to purchase 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 less apples since oranges are
cheaper than apples.
 What exactly you are doing is that you are substituting oranges for apples. This
is known as substitution effect.

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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.

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Explanation of substitution effect:

 In figure 2, AB represents the original budget line. The 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

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 Figure 2 is helpful to understand the concept
of substitution effect in a simple manner.

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2. Price Effect on Consumer's
Equilibrium:

 For simplicity, let us consider two-commodity model. In


substitution effect, prices of both the commodities change (price
of commodity Y increases and price of commodity X
decreases). However, in price effect, price of any one of the
commodities changes. Thus, price effect is the change in the
quantity 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. Price of
commodity Y and consumer’s income are constant.

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Graphical Representation of Price
Effect:
 Suppose price of commodity X decreases. In figure 3, the decline in the price of commodity X is
represented by the corresponding shifts of budget line from AB 1 to AB2, AB2 to AB3 and AB3 to AB4. The
points C1, C2, C3 and C4 denote respective equilibrium combinations. According to figure 3, consumer’s
real income increases as the price of commodity X reduces. Due to an increase in the consumer’s real
income, he is able to purchase more of both commodities X and Y.

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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 price of commodity X
falls, the consumer’s real income increases.

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Price-Demand Relationship:

 Effect of arise in income on demand for


the Inferior goods:
 Inferior goods: An inferior good is a product
for which demand goes down as income
goes up.
 Examples: wheat vs rice
 An increase or decrease in income affects
the demand inversely, if the given commodity
is an inferior good.
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Price-Demand Relationship with
Normal Good:

 The change in demand in response to change in price of


commodity, other things remaining same is called Price Effect.
 OR
 The rise in amount purchased of good X(wheat) as a result in
fall of its price is called price effect.
 The price effect on consumption of normal good is Negative.
 In order to get price consumption curve (PCC) join equilibrium
points from P to S.

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Price-Demand Relationship of
GIFFEN GOOD:

 A good where higher price causes an increase in demand (reversing the usual
law of demand). The increase in demand is due to the income effect of the
higher price outweighing the substitution effect.
 The concept of a Giffen good is limited to very poor communities with a very
limited choice of goods. Empirical evidence is hard to find, though some
economists thought it applied to the Victorian poor who had very limited diet.
 The idea is that if you are very poor and the price of your basic foodstuff (e.g
bread) increases, then you can’t afford the more expensive alternative food
(meat) therefore, you end up buying more bread because it is the only thing you
can afford.
 “

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As Mr. Giffen has pointed out:

 “A rise in the price of bread makes so large a


drain on the resources of the poorer laboring
families and raises so much the marginal
utility of money to them, that they are forced
to curtail their consumption of meat and the
more expensive farinaceous/starchy foods:
and, bread being still the cheapest food
which they can get and will take, they
consume more, and not less of it.”
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Graphical representation:
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.

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Consumer’s Equilibrium & the
Substitution Effect of price change:

 There are two methods to understand impact


of a price change on the quantity demanded:
 1. Hicks-Allen substitution effect
 2. Slusky substitution effect

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1.Hicks-Allen substitution effect:

 Let us look at J.R. Hicks’ method of bifurcating income effect and


substitution effect.
 In figure 2, the initial equilibrium of the consumer is E1, where
indifference curve IC1 is tangent to the budget line AB1. At this
equilibrium point, the consumer consumes E1X1 quantity of commodity
Y and OX1 quantity of commodity X. Assume that the price of
commodity X decreases (income and the price of other commodity
remain constant). This result in the new budget line is AB2. Hence, the
consumer moves to the new equilibrium point E3, where new budget
line AB2 is tangent to IC2. Thus, there is an increase in the quantity
demanded of commodity X from X1 to X2.

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 An increase in the quantity demanded of commodity X is caused by
both income effect and substitution effect. Now we need to separate
these two effects. In order to do so, we need to keep the real income
constant i.e., eliminating the income effect to calculate substitution
effect.
 According to Hicksian method of eliminating income effect, we just
reduce consumer’s money income (by way of taxation), so that the
consumer remains on his original indifference curve IC1, keeping in
view the fall in the price of commodity X. In figure 2, reduction in
consumer’s money income is done by drawing a price line
(A3B3)parallel to AB2. At the same time, the new parallel price line
(A3B3) is tangent to indifference curve IC1 at point E2. Hence, the
consumer’s equilibrium changes from E1 to E2. This means that an
increase in quantity demanded of commodity X from X1 to X3 is purely
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Topics for Assignment:

1. Derivation of individual and market demand


through indifference curve techniques
2. Comparison between indifference curve
analysis and marginal utility analysis
3. Consumer’s Surplus

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