Consumption
2. LAW OF EQUI-MARGINAL UTILITY
2.6. CONSUMER'S EQUILIBRIUM
The consumer attains equilibrium position when he obtains maxi- mum satisfaction. When he reaches that point he would not be
willing to reallocate his purchases as it would reduce his satis- faction.
Under the indifference curve approach the equilibrium position of the consumer is traced under the certain assumptions. They are:
● The consumer has a fixed amount of money to spend.
● He intends to buy a combination of two goods.
● All goods are homogenous and divisible.
● The consumer's scale of preference remains fixed throughout the analysis.
● The consumer has definite tastes and preferences. So he has a given scale of preference expressed through an indifference map.
● The consumer is expected to be a rational person, who seeks to maximize his satisfaction.
In order to find out the consumer equilibrium, the scale of preference i.e., the indifference map and the budget line should be considered simultaneously. The price line represents the budgetary constraint relating to combining the two goods, based on the consumer income and the prices of the two goods. The indifference map on the other hand represents the consumer scale of preference depending on his tastes.
In the figure, commodity Y is measured on the Y axis, and commodity X is measured on the x axis. The price line PB shows the various combinations which are possible to be obtained by the
consumer with his income and the prices of the two goods. By the bringing the price and the indifference map, we discover the combination of the two commodities, which is suitable for the consumer. The point of tangency represents the equilibrium position of the consumer. The maximum position he can reach is on the IC3. The price line is tangential to IC3 and tangency point E is the equilibrium position of the consumer. Any other combination of the two goods would lie on the a lower indifference curve and would obtain less satisfaction for the consumer. For the price line passes through the points MNCD. Point M lies on IC1, N on IC2, C on IC2 and D on IC1, all these points yield less satisfaction to the consumer. So point E is the maximum point of satisfaction the consumer could reach within the price-line PB. Points IC4 and IC5 are unattainable with the given resources. So the consumer will prefer remaining at point E getting OA units of commodity y and OB units of commodity x. This is the equilibrium position where the consumer gets maximum satisfaction.
At the equilibrium point, E is on the IC3 and the price line PB are tangent to each other. Hence at the equilibrium point the marginal rate of substitution between two goods is equal to the ratio of their price.
that is: MRS P
xy Px y
=
CHANGES IN THE CONSUMER'S EQUILIBRIUM AND ITS EFFECT ON DEMAND
In analysing the concept of consumer's equilibrium, we assumed that the consumer's income, price of the commodity, and substitutes to remain constant. In the foregoing analysis we would be considering the change in the prices of commodities, the income of the consumer, change in prices of the substitutes and its effect on the equilibrium of the consumer demand.
1. Income Effect: When the income of the consumer increases he is in a better off position to buy more commodities and obtain greater satisfaction. Alternatively if his income decreases he reduces his purchases to lesser quantities. Thus the income effect may be defined as the effect of changes in the money income on
a consumer's equilibrium position in the purchases of a single good or a combination of goods, assuming that prices of goods and taste remaining constant. The income effect also refers to the change in the demand for a commodity resulting from a change in the income of the consumer and prices of goods being constant.
In the figure the income-consumption curve shows how equilibrium positions and combinations of two goods (x and y) changes as income changes under conditions of a given scale of preferences and fixed relative prices of goods. With the price of two goods x and y and the income of the consumer, we have drawn the price line P1L1 as shown in the above figure. The consumer is in a equilibrium position point Q1 on the indifference curve IC1. when the income of the consumer increases he will be in a position to buy OP2 of commodity y and OL1 of commodity x. And his new budget line will be P2L2, and the new equilibrium position will be Q2. Suppose his income further increases, his price line shift to a still higher position indicated by P3L3. The consumer is in a equilibirium point Q3 on the indifference curve IC3.
When the various equilibrium points are connected together, we obtain what is called the Income Consumption Curve. Thus the income consumption curve is the locus of equilibrium points at various levels of consumer's income. It traces the income effect on the quantities purchased.
Commodity x
Commodity y
The income effect may be positive or negative. Income effect is said to be positive when the purchase or consumption of a commodity increase with increase in income. Income effect can be negative when the consumer purchases less of goods with the increases in his income. Such goods are inferior goods. When the income of the consumer increases, the tendency on his part would to spend the increased income on superior goods and he will reduce his expenditure on inferior goods as they will be substituted by superior goods.
If one of the two commodities happens to be an inferior good.
For instance, if commodity 'X' is considered to be an inferior good.
As shown in the figure above the income-consumption curve would move toward the y axis indicating a high preference for commodity y.
Alternatively if commodity y is an inferior as shown in the figure below the consumer may not demand that commodity, instead he would demand more of commodity x. Hence income consumption curve would move towards the x axis indicating the consumers higher preference for commodity x, as shown in the figure below.
2. Price Effect: The consumer reaction to a change in the price of a commodity , other things like income, tastes of the consumer remaining constant is called price effect. The price effect can also be referred to the change in quantity demanded of a commodity
Icc
Commodity 'y'
Commodity x
Commodity 'x'
Commodity 'y'
resulting from a change in its price, the consumer's income being held constant. The price-consumption curve traces the price effect.
To understand the price effect we study the relative prices of the goods in question and also other factors like income, tastes etc.
In the figure below commodity y is measured on the y axis and on the x axis commodity x is measured. It is assumed here that there is a successive fall in the price of commodity x, the price of y remaining constant. When the consumer is on the indifference curve IC1 he purchases ON1 and OM1 respectively. Since the price of x has fallen, the price line PL shifts to the new PL1 position.
Here the consumer reaches a higher indifference level that is IC2. His new equilibrium position is Q2 and he purchases ON2 of commodity y and OM2 of commodity x which is a little than commodity y. Thus the consumer prefers more of x and less of commodity y. Suppose of commodity x falls still further, the income and the price of y remaining constant, the price line shift to the new position PL2. The consumers equilibrium remains at Q3, where he more of commodity x than commodity y.
When the equilibrium points Q1, Q2, and Q3 are joined together we obtain what is called the price-consumption curve. The course of this curve shows the price effect on the consumption of the commodities.
3. Substitution Effect When the consumer is demanding a substitutable commodity, he would compare the price of the two in consideration and demand a commodity whose price is less. Such
effect of demand of the consumer is known as substitution effect.
The substitution effect is the change in the quantity demanded of a commodity resulting from a change in its price relative to the prices of other commodities, the consumer's real income or satisfaction level being held constant.
Substitution effect is measured by rearranging the purchases made by the consumer as a result of change in the relative price of goods, his real income remaining constant, in such way that his level of satisfaction will remain as before. To measure the substitution effect, the consumers* real income is held constant. With a fall in the price of x there is a rise in his real income, with which he would be able to buy more goods. This surplus money of the consumer is taken away, hence he would be neither be better off nor worse off. This is called 'compensating variation in income'.
Thus it defined as an appropriate change in the consumer's income would compensate for a change in the relative prices of goods so that the consumer is neither better nor worse off. Thus the substitution effect can be defined as the change in the combination of goods bought due to a change in their relative prices, despite the compensating variation in income.
In the figure the price of commodity x falls but that of y remains constant. The point S denotes that the consumer buys ON1 of X and OM1 of Y. He has substituted NN1 of X for MM1 of Y. The initial equilibrium of the consumer is at point X. Where the price line AB is tangent to IC1. He buys OM of Y and ON of X. When the price of x falls while that of Y remains unchanged, the price line will shift to AB1. To measure the pure substitution effect, a hypothetical income line HL is drawn, which is parallel to the new price line AB1 and tangential to the original IC2, so that the consumer is placed in maintaining the same real income as before.
Though the consumer is brought back to the same indifference curve IC21, his equilibrium position has changed from P to S. Thus the movement from one point to another point on the same indifference curve measures the substitution effect.
PRACTICAL USES AND IMPORTANCE OF THE INDIFFERENCE CURVE ANALYSIS
1. Consumption: This technique has replaced the marginal utility analysis in explaining consumer behaviour, the equilibrium and demand analysis.
* real income the money income which is the income earned, divided by the general price level is referred to as real income.
2. Scientific: The indifference curve analysis is based on the principle of marginal rate of substitution. This concept is more superior to the law of marginal utility, because it considers two goods together and expresses it as ratio of physical units.
3. Production: The indifference technique is made use of in finding out the producers equilibrium. Just as the indifference curve is for the consumer, the equal product curve is for the producer.
4. Exchange: In the field of exchange, indifference curves can be used to determine the position of equilibrium when two individuals are entering into a market. The technique has shown the manner in which exchange can take place between two parties where their preferences of the goods are given.
5. Taxation: The principle of indifference curve technique is applied in the field of taxation in public finance. Which is used to judge the welfare effects of a direct and indirect tax on the individual.
6. Savings: This technique can also be utilized in the field of savings. The indifference curves shows that the preference of an individual between present and future goods. His decision to save depends on desire on present goods over future goods. It is also used in the field of index numbers to show the standard of living of the consumer in two different periods with different levels.