# AN INDIFFERENCE CURVE IS FORMED BY SUBSTITUTING ONE GOOD FOR ANOTHER.

THE MRS IS THE RATE AT WHICH ONE COMMODITY CAN BE SUBSTITUTED FOR ANOTHER THE LEVEL OF SATISFACTION REMAINING THE SAME

MRS BETWEEN 2 COMMODITITES X AND Y, MAY BE DEFINED AS THE QUANTITY OF X WHICH IS REQUIRED TO REPLACE ONE UNIT OF Y IN THE COMBINATION OF THE 2 GOODS SO THAT THE TOTAL UTILITY REMAINS THE SAME. IT IMPLIES THAT UTILITY OF X GIVEN UP IS EQUAL TO THE UTILITY OF ADDITIONAL UNITS OF Y MRS = Y X

DIMINISHING MRS IT MEANS THAT THE QUANTITY OF A COMMODITY THAT A CONSUMER IS WILLING TO SACRIFICE FOR AN ADDITIONAL UNIT OF ANOTHER GOES ON DECREASING WHEN HE GOES ON SUBSTITUTING ONE COMMODITY FOR ANOTHER. .

X ( Y/ X) - b 15 + 7 -10 2 -5.Indifference Combinations Change in Y Points Y + X (.5 e 4 + 30 -2 10 -0.0 d 6 + 20 -4 8 -0.0 c 10 + 12 -5 5 -1.2 .Y) a 25 + 5 - Change in X ( X) - MRSY.

MRSy.Y = -10 = -5 X 2 .x = .

BUDGETARY CONSTRAINT/BUDGET LINE A utility maximising consumer would like the reach the highest possible indifference curve.e he would like be on IC3 But consumer has limited income and this sets a limit to which a consumer can maximise his utility. . (as shown on the OHP) i.

This budgetary constraint may be expressed as a budget equation.The limitedness of income acts as a constraint. PxQx+ Py Qy = M (Px & Py are respective prices Qx & Qy are quantities M = income) . This is called the budgetary constraint.

Qx = M + Py Qy Px Px Qx = M/ Px Qy = M + Px Qx Py Py Suppose entire income is spent for buying commodity x only ie Qy = 0 Similarly Qy = M/ Py when QX = 0 .

BUDGET LINE/PRICE LINE When the values of Qx and Qy are plotted on X and Y axis. M/Py N QC T H Y I C K OE F N NM IS THE CONSUMERS BUDGET LINE M QUANTITY OF X MUTTON M/Px . it gives line with a negative slope which is called budget line or price line.

Qy = 300/50 = 6 If Qy = 0 then Qx = 300/75 = 4 . i. Suppose price of Chicken is Rs 50 per Kg Mutton is Rs 75 per Kg Suppose Qx = 0.Suppose consumer has Rs 300 to spend on Non-Vegetarian items Chicken. Fish and Mutton a week.e all income is spend on chicken alone.

C 6 C H I C K E N 5 4 3 2 1 N M Mutton 4 3 2 1 Chicken 0 1½ 3 4½ 6 N 0 Consumer s budget line M 0 1 2 3 4 5 6 F MUTTON .

everytime a consumer gives up 3 units of chicken.e. The slope of NM is 3/2 which is the ratio of the mutton price to chicken price. i.The straight budget line NM shows all the possible combinations of the 2 goods that would just exhaust the consumers income. he can gain 2 units of mutton .

which is at a tangent to the budget line with the highest indifference curve. (As shown on OHP) The consumer reaches the highest indifference curve attainable with fixed income at point B.CONSUMERS EQUILIBRIUM Now we can combine the budget line and the indifference curves on one diagram. At Point B or at the point of equilibrium substitution ratio equals price ratio .

MUM = Substitution = Price of Mutton (x) MUc Ratio Price of chicken (y) CONSUMER EQUILIBRIUM IS ATTAINED AT THE POINT WHERE THE BUDGET LINE IS TANGENT TO THE HIGHEST INDIFFERENCE CURVE .

If consumers income increases. .SHIFTS IN BUDGET LINE Budget line changes its position following the change in consumers income and price of the commodities. 1. budget line shifts upwards parallel to the original budget line. prices remaining the same.

C CD IS THE NEW BUDGET LINE A Q t y Y D O B Qty X If income decreases. budget line will shift downwards .

IF PX REMAIN CONSTANT & PY INCREASES. A C Q t y AB CB ORIGINAL NEW BUDGET LINE Y O B Qty X . IF INCOME REMAINS SAME AND PRICE CHANGES.2.

IF PY REMAIN CONSTANT & PX DECREASES. A AB AC ORIGINAL NEW BUDGET LINE Q t y Y O B C Qty X . IF INCOME REMAINS SAME AND PRICE CHANGES.3.

ALL THE OTHER THINGS REMAINING SAME CONSUMER INCOME CHANGES IT SHOWS A PARALLEL UPWARD OR DOWNWARD SHIFT IN THE CONSUMERS BUDGET LINE .EFFECTS OF CHANGE IN INCOME ON CONSUMER DEMAND HIS CAPACITY TO BUY GOODS AND SERVICES CHANGES.

THE INDIFFERENCE CURVES IC1. IC3. . CL AND DM REPRESENT BUDGET LINES AT 4 DIFFERENT LEVELS OF HIS INCOME. IC4 REPRESENT CONSUMERS INDIFFERENCE MAP AND LINES AJ. IC2. BK.AS SHOWN ON THE OHP THE EFFECT OF CHANGE IN INCOME IS ILLUSTRATED HERE.

THE CONSUMER REACHES A NEW EQUILIBRIUM POINT E2 ON IC2. LET THE CONSUMERS INCOME INCREASE NOW. IT GIVES THE PATH OF INCREASE IN CONSUMPTION RESULTING FROM INCREASE IN INCOME. THE SUCCESSIVE EQUILIBRIUM COMBINATION OF GOODS AT 4 DIFFERENT LEVELS OF INCOME ARE INDICATED BY POINTS E1. E2. E3 AND E4. .BUDGET LINE SHIFT FROM AJ TO BK.SUPPOSE INITIALLY HE S AT EQUILIBRIUM AT E1 ON IC1. IF THESE POINTS OF EQUILIBRIUM ARE JOINED BY A CURVE. THIS CURVE IS CALLED INCOME CONSUMPTION CURVE.

THE MOVEMENT FROM POINT E1 TOWARDS POINT E4 INDICATES INCREASE IN THE CONSUMPTION OF THE NORMAL GOODS. THIS IS CALLED INCOME EFFECT.THE ICC IS DEFINED AS THE LOCUS OF POINTS REPRESENTING VARIOUS EQUILIBRIUM QUANTITITES OF 2 COMMODITIES CONSUMED BY A CONSUMER AT DIFFERENT LEVELS OF INCOME ALL OTHER THINGS REMAINING CONSTANT. X + Y. .

INCOME EFFECT .MAY BE POSITIVE OR NEGATIVE NORMAL GOODS INFERIOR GOODS Income effect is +ve Income effect is ve An inferior good is one whose consumption decreases when income increases. .

WHICH DISTURBS THE CONSUMERS EQUILIBRIUM. A RATIONAL CONSUMER ADJUSTS HIS CONSUMPTION WITH A VIEW TO MAXIMISE HIS SATISFACTION UNDER THE NEW PRICE SITUATIONS. . THE SLOPE OF THE BUDGET LINE CHANGES.EFFECTS OF CHANGES IN PRICES WHEN PRICE OF A COMMODITY CHANGES.

PRICE EFFECT MAY BE DEFINED AS THE TOTAL CHANGE IN THE QUANTITY OF CONSUMED GOODS AND SERVICES DUE TO CHANGE IN THEIR RELATIVE PRICES. .

L Q t y E1 E2 E3 E4 PCC IC4 Y O u Mr IC1 s Nt Qty X IC3 IC2 P Q .

Here the consumption of x increases by UR. Let price of x fall. The consumer now reach a higher indifference curve IC2 and his view equilibrium point is E2. CETRIUS PARIBUS.Suppose Consumer is initially in equilibrium at point E1. . so that Consumers Budget Line shift from its initial position LM to position LN. This is the price effect on the consumption of commodity X.

E2.Due to successive fall in price of X. consumers equilibrium shifts from E2 to E3 and from E3 to E4. By joining the points of equilibrium E1. resulting from the change in price of a commodity. E3 AND E4 we have a curve called PRICE CONSUMPTION CURVE PCC is a locus of points of equilibrium on indifference curves. .

Income-effect is similar to the movement along the income consumption curve which has a positive slope .INCOME & SUBSITITUTION EFFECT OF A PRICE CHANGE. INCOME-EFFECT results from the increase in real income due to decrease in the price of a commodity. Price-effect combines both income-effect and substitution effect.

SE causes movement along the priceconsumption curve which generally has a negative slope. .SUBSTITUTION-EFFECT arises due to consumers tendency to substitute cheaper goods for the relatively expensive ones.

There are 2 methods of decomposing the Total Price-effect into income & substitution effects (1) (2) HICKSIAN APPROACH SCUTSKYS APPROACH .

THE END .