Changes in Consumers’ Equilibrium
BY : Arjun Paudyal
Equilibrium Equilibrium is the tendency to no change. Consumer's equilibrium is the condition in which consumer is in level of maximum satisfaction and he has no tendency to buy or give up any commodities in the combination. During equilibrium, his expenses on consumption of goods always remains in his budget line. But this tendency is broken due to some reasons and there is change in consumers’ equilibrium point.
We know that the change in money income and the change in price of commodities causes to change (shift) in budget line. When there is change in budget line, it is true that equilibrium is also changed. The major causes for change in equilibrium or the factors leading the change in consumer's equilibrium point can be can be written as:
- Price effect
- Income effect
- Substitution effect
1. Price Effect
{FIGURE HERE}
Change in the price of the any of the goods he consumes will also lead to change the equilibrium point. Price effect shows the reaction of consumer to the change in the price of a commodity, other things remaining the same. It measures the change in amount (quantity) demanded of a commodity with change in it's price when price of the other commodity with which it is being combined remains the same.
When there is increase in the price of a commodity, obviously he consumes it less (and becomes worse off). And when the price of the commodity decreases or falls, he consumes the commodity more (and becomes better off). Remaining the consumption of a commodity in the combination same, it is clear that when the price of commodity (another in combination) increases, consumer shifts to the lower indifference curve, and when price falls, consumer goes to higher indifference curve.
In the above diagram (Fig. 1.1), consumer's original budget line is PL. When the price of a commodity in X - axis (say Book) increases (remaining the price of commodity on Y axis same - say Copies), consumer will certainly reduce the consumption of commodity in X - axis (Books). Budget line shifts downward. After increase in the price of good in X - axis, his budget line becomes PL1. He gets the new equilibrium point at E1 which is at lower IC on IC1. This is in case of rise in price of a commodity.
But there may be the case of fall in price of commodity also. When there is fall in price of commodity in X-axis, budget line shifts upward and becomes PL2 (in above diagram). On his budget line PL2 , consumer gets new equilibrium point E2 which is at IC curve IC3 that is higher than IC2 and IC1.
Joining the points of Equilibrium obtained due to change in price of commodities (or Price Effect), we get Price Consumption Curve (PCC).
Price Consumption Curve may be upward sloping, downward sloping (or backward sloping). Nature of slope of PCC shows the types of goods and their cross elasticity of two goods. Slope PCC is dependent on the nature of goods whether they are inferior, superior, luxurious or whether the combination is complements or substitutes.
a) Inferior Good :
Inferior goods are such good whose consumption decrease with increase in its price. Inferior goods have positive relationship with price of its own.
{FIGURE HERE}
In figure 1.2 (a), consumers initial price line or budget line is PL. Consumer is in equilibrium point at E on his budget line. He attains the maximum satisfaction there and his satisfaction is expressed by Indifference Curve IC1.
With the fall in the price of good in X axis, consumers budget line shifts upward to the right. PL1 is the budget after change in price of good in X-axis. With further decrease in the price of commodity in X-axis, budget line shifts to PL2.
With the fall in price of commodity in X axis, consumption of commodity in X axis is also falling. So , commodity in X axis in figure 1.2 (a) is inferior. Where commodity in Y axis is normal.
With regards to figure 1.2 (b), consumption of commodity is falling with fall in its price. Consumption of commodity in X axis is increasing with increase in real income. So commodity in X axis in figure 1.2 (b) is normal and commodity in Y axis is inferior.
b) Essential Good :
Essential goods are such goods whose consumption decreases with decrease in income or rise in price. Quantity demanded of such goods increase with increase in consumers’ income only up to certain limit. Increase or decrease in price of such goods doesn’t effect the demand of them. They are so essential that consumer at any cost consumes them.
{FIGURE HERE}
In the above diagram (fig. 1.3 a) on the continuous fall in price of good in Y-axis, its consumption first has increased and then it is constant. Therefore commodity in Y-axis is Essential good. In the diagram above (fig. 1.3 b) commodity in X-axis is essential. On the continuous rise in price of good in X-axis, consumption is almost constant.
So , from above diagrams, it is clear that essential goods are such goods whose consumption does not decrease with rise or fall in price.
c) Normal Good :
{FIGURE HERE}
Normal goods are such goods whose consumption decreases with increase in price of its own and its consumption increase with increase in price of its own. They have positive relationship with the price.
In the diagram by side (Fig 1.5 a), PL is the original budge line. When there is rise in price of good in Y axis, budget line changes to P1L and consumption of good in Y axis decreases. But then there is fall in price of same good, budget line shifts to P2L from PL the consumption increases. Good in Y axis and X axis are both normal goods.
{FIGURE HERE}
In the diagram by side (Fig 1.5 b), PL1 is the original budget line. When there is fall in price of good in X axis, budget line changes to PL2 and consumption of good in X axis increases from X1 to X2. There is also rise in consumption of good in Y axis from Y1 to Y2. When there is further fall in price of good in X axis, budget line further shifts to PL3 and consumption of both X and Y increases to X3 and Y3.
Good in Y axis and X axis are both normal goods.
d) Veblen Good :
A Veblen good is a good thats quantity demanded rises when its price rises. There existence is doubtful. Veblen goods are sometimes called goods of ostentation
The hypothesis that resulted was that people buy some goods for their status value. The more expensive the goods are, the more people will desire them. Thus there will be an upward sloping demand curve.
Evidence for the existence of these goods is weak. Like Giffen goods, it is hard to prove that increasing price of the good leads to an increase in demand. It is perhaps impossible to avoid the charge that no other determinant of demand changed during the period of experimentation or observation. Thus the increase in demand may not be caused by the price change rather a change in one of the determinants for example the price change may have created some extra publicity causing the whole demand curve to shift to the right
Thornstein Veblen (1857 – 1929) described conspicuous consumption. This he said was consumption
designed to show how wealthy a person was. Outlandish dress for example rendered the wearer unfit to do jobs of work. The wearer demonstrated superiority over the working class. The elaborately dressed woman also served the purpose of demonstrating the wealth of the man she belonged to.
Slope of Price Consumption Curve
{FIGURE HERE}
PCC may be downward sloping. When price of commodity falls (assume commodity on X axis), consumer increases the consumption of good in X axis and reduces the consumption of good in Y-axis.
A downward sloping PCC curve states that the goods on X and Y axis are substitute goods. Cross Elasticity of demand between the two goods when they are substitute is positive.
Upward Sloping
{FIGURE HERE}
In the below diagram (a) , There is original budget line PL1 . When price of commodity X falls, budget line shifts to PL2 and when it further falls, it further shifts to PL3. Point E is the original equilibrium point E2 and E3 are new equilibrium points on higher Indifference Curves when there is shift in budget line to upward to the right. Price Consumption Curve PCC is obtained by joining the equilibrium points. PCC is slopping upward to the right. It is clear that when there is decrease in price of commodity X, consumer consumes both commodity X and Y more.
{FIGURE HERE}
In diagram (b), when there is fall in price of commodity Y, consumer consumes both commodities X and Y more.
In diagram (a), commodity X is inelastic. Inelastic means that when there is great change in Price of it, change in demand is relatively less. This is because when there is change in price (DECREASE), he allocates the surplus amount to purchase other commodity (Commodity Y) also. So he purchases less amount of good X.
Backward Sloping
When the Price Consumption Curve is backward slopping, whether there is change in price of commodity X or commodity Y, good in X – axis is inferior.
In diagram (a), when there is fall in price of commodity X, less or small quantity of commodity X is consumed.
{FIGURE HERE}
In diagram (b) price of good Y causes increase in real income. Even in increase in income, less of commodity
X is preferred. So, commodity x is inferior.
Figure (a) and (b) shows PCC curve is backward sloping to the Y - axis. PCC may be backward sloping to X – axis also. When PCC is backward sloping to Y axis, good in X axis is inferior and when it is backward sloping to X-axis, good in Y axis is inferior.
d) Horizontal / Vertical Sloping
{FIGURE HERE}
{FIGURE HERE}
When there is change in price of Commodity X, consumer keeps consumption of Commodity Y same and increases consumption of Y. This leads to PCC be a horizontal straight line.
But when there is change in price of commodity Y, consumer consumes commodity Y more keeping the consumption of Commodity X same or constant. This effect causes PCC be a vertical straight line.
- PCC with different slopes
PCC with different slopes is rarely found. PCC may be upward sloping, downward or backward sloping throughout its length. PCC may have different slopes at different price (range). At higher price, it slopes downward, it may be horizontal straight line at some price range. Finally it slopes upward. Backward sloping shape of PCC can be obtained when the good is griffin paradox.
{FIGURE HERE}
PCC having different slopes at different price range means that the price elasticity of demand varies at different price range is shown below.
2. Income Effect
When there is change in income of consumer, there is change in equilibrium point due to change in quantity demanded.; When there is change in income, there is shift in budget line. Generally income and quantity demanded relationship is positive. But it depends on the nature of goods whether it is inferior or normal. If good is griffin paradox or inferior, income demand relationship is negative.
A line joining equilibrium points which are set due to change in income , is income consumption curve.
Nature of ICC curve (i.e relationship between change in income and type of good or quantity demanded) is dealt below.
Nature of Income Consumption Curve : Variation of goods
Normal goods
{FIGURE HERE}
Normal goods are those goods whose quantity demand increases with increase in income and its quantity demanded decreases with decrease in income.
When there is increase in income , quantity demanded of both commodities increases. PL is the original budget line or price line. When income of consumer decreases from PL to PL1, consumer consumes both the commodities less and Equilibrium E1 is set on new budget line P1L1 and in lower Indifference Curve IC1. But when there is increase in income of consumer, his budget line shifts upward to the right from the origin (P2L2). During increase in income, consumer consumes both the commodities more and equilibrium is set at point E2 on higher IC on budget line P2L2. Both commodities in X and Y axis are normal goods so ICC is sloping upward.
Inferior goods
Inferior goods are such goods whose demand decrease with increase in income. Income and demand relationship of such goods is negative. ICC of such commodities is either downward sloping or backward sloping.
{FIGURE HERE}
{FIGURE HERE}
If commodity on Y axis is inferior, ICC is downward sloping to the X-axis
If commodity on X axis is inferior, ICC is backward sloping to the Y-axis.
Neutral goods
A neutral good is type of good which is neutral for consumption. Demand of neutral good does not change with change in income.
{FIGURE HERE}
{FIGURE HERE}
Derivation of Engel curve through Income Consumption Curve
Engel curve shows the relationship between the levels of income and quantity purchased of a particular commodity. This curve has been named after the German statistician Ernest Engel (1821 – 1896). This curve was first derived by him. Engel curve is derived from Income Consumption Curve. In other words Engel curve can be termed as the photocopy of the income consumption curve.
{FIGURE HERE}
{FIGURE HERE}
In the above fig left side represents the income consumption curve and right side represents the Engel curve derived from left side. In the left figure, as the income increases the quantity purchased of X and Y is increased with the shift in the budget line. Where as in right figure in X-axis is quantity and Y-axis is income and the activities done in the fig.1 is transferred to on it respectively. Thus, equilibrium point’s continuity the income consumption curve is consumers indifference map have been transformed in to Engel curve depicting quantity- income relationship. As seen in fig.2 Engel curve for normal goods is upward sloping which shows that as the income increases, consumer buys more of the commodity.
In case of inferior goods, consumption of the commodity declines as income increases. Engel curve as an inferior good is drawn below, which is backward bending indicating fall in quantity purchased as income increases.
An extreme case of an Engel curve is a vertical straight line as drawn in below figure. This represents the case of a neutral commodity that is quite unresponsive to increase in income. For example, the quantity of common salt purchased by a family remains same, determined as it is by food habits, with the increase in their income.
- If the income consumption curve slopes up, both goods are normal.
- If the income consumption curve slopes down, one good is inferior.
- At least one good must be normal.
- If a good is normal, its Engel curve is upward sloping.
- If a good is inferior its Engel curve is downward sloping.
3. Substitution Effect
Substitution effect is also one of the responsible factor to cause change in consumers' equilibrium. Substitution effect is the result of consumers inherent tendency to substitute cheaper goods for the relatively expensive ones. Substitution effect means the change in the purchase of a commodity as a consequence of change in relative price alone, real income remaining the constant.
When price of a good changes, the real income (or purchasing power) of the consumer is also changed. To keep real income of the consumer constant so that the effect due to change in relative price may be known, price change is compensated by simultaneous change in income.
For example when the price of good X falls, real of consumer increases. To find the substitution effect (i.e change in demand of X due to change in its relative price), we reduce the money income of consumer (to cancel the increase in real income due to fall in price of X). For further study of substitution, two slightly different theories have been developed. Theory developed by Hicks and Allen is called Hicks Substitution Effect and theory developed by E.Slutsky is known as Slutsky Substitution Effect.
Hicks Substitution Effect
In Hicks substitution effect, price change is compensated by so much change in money income that the consumer is neither better off nor worse off than before change in price. In other words, money income of consumer is changed in such a amount that consumer is in previous stage of satisfaction ie he will return to previous Indifference Curve that he was before the change in price. Thus the consumer, being on same indifference curve, demands a different quantity of goods which is substitution to the previous one before change in price.
{FIGURE HERE}
The figure below presents the price effect, income effect and substitution effect. Consumers original budget line is PL. Consumer is in equilibrium at point E in Indifference curve IC1. Suppose price of good X falls so budget line shifts to PL1. New equilibrium is set at point E1. To compensate his increase in real income, his money income is reduced in same proportion. In this condition, his budget line shifts downward to AB.
According to Hicksian approach, the consumer is in same indifference curve when he was before the change in price of X. Now AB represents the relative price of good X and Y and equilibrium at point E2. AB is drawn parallel to PL2 and is tangent to the original or previous indifference curve IC1 at point E2.
Due to fall in price of X and his money income is cut off, good X is relatively cheaper. So, he substitute Y for X. Movement from point E to E2 is substitution effect. Movement from E to E1 is price effect as it is caused by fall in price of X. And movement from E1 to E2 is income effect. Income effect is caused due to cut off of his money income.
Slutsky Substitution Effect
{FIGURE HERE}
Slutsky has a slightly different view of substitution effect. In his vision, when the price of a good changes and consumer’s real income or purchasing power increases. Money income of the consumer is changed by the equal amount of change in real income caused due to change in price. Thus in substitution effect, income increased is reduced not by compensating variation but by cost difference.
According to Slutskian method, the real income of the fall in the price of a commodity equals to only that which if taken away from the consumer, leaves with him an adequate income to buy the original combination of the two goods after the change in the price ratio. Therefore according to Slutsky’s approach of measuring of the real income effect, the imaginary budget line must pass through the original equilibrium point.
Diagram by side shows the income effect, price effect and substitution effect according to so Slutskian method of measurement. Consumer is originally at equilibrium point E when his budget line is PL. There is fall in price of X and he consumes good X more. His budget line shifts to PL1 and he is at new equilibrium point E1 on higher IC curve IC2.
Consumer’s real income is so reduced that he is able to purchase the original combinations of two goods at the new price ratio. For this, an imaginary budget line AB is drawn such a way that it is parallel to PL1 and passes from the original equilibrium point E. On new budget line, consumer is equilibrium at point E2 after income adjustment.
Movement from E to E1 is price effect. Movement from E1 to E2 is income effect and movement from E1 to E2 is substitution effect.
Practical illustration in use of indifference curve in determining subsidy Subsidies are said to be the amount paid by the government to the individual for promoting social welfare. The effect of subsidy on consumer’s welfare and money value of this subsidy to the consumer is illustrated below:
{FIGURE HERE}
Here, lets suppose the OP money income and PL the budget line with given income and market price. Since, assuming government pays half the market price the budget line of individual will shift to Pl2 from pl1 and is in equilibrium at point R on the indifference curve IC, and purchase OA quantity of food with PT amount of money (spending)
Now if no subsidy was given the budget line was PL, and quantity purchase is OA, on which individual spends PN amount of money. Since pt amount of money is paid by individual himself, the remaining amount TN or RM- paid by the government as food subsidy for the individual.
Again there arise about the money value of this food subsidy (RM or TM) to the individual. When no food subsidy is paid, individual faces the budget line PL. So in order to find the money value of subsidy of individual draw a line EF parallel to PL so that it touches the same indifference curve IC where the individual comes to be in equilibrium at point S when subsidy in paid buying OB quantity of food. This means that individual is paid PE amount of money (say as a cash grant) he reaches the same indifference curve IC (same level of welfare) at which he is given subsidy by the government. In the figure PE=MK and RM is greater than MK (TN>MK or PE) if instead of giving RM as a price subsidy on food government pays the individual cash equal to PE, the individual will reach the same level of welfare as he does with RM or PE subsidy. Thus the cost of subsidy giving to consumer is greater than money equivalent to the subjective gain to the consumer.
Practical illustration in use of indifference curve in determining tax
An important application of indifference curve is to judge the welfare effects of direct and indirect taxes on the individuals. In order to increase the revenue the government imposes the tax that reduces the welfare of individual or consumers. It shall be proved below that indirect tax causes excess burden that the lump sum tax
when equal amount of revenue is raised through them.
In the given figure, X-axis is good X and Y-axis is good Y and with the given income of the individual the price line is PL, of good X and Y good that is tangent to indifference curve IC3 at point Q3 where the individual is in equilibrium position.
Now when the government imposes indirect tax then price of good X rises as a result price line will shift to PL2 that is tangent to indifference curve IC1 at point Q. Thus it is clear that individual has shifted to lower indifference curve IC1 from higher indifference curve IC3 due to imposition of tax and has decline the welfare.
It should be further noted that at point Q1 the individual is purchasing ON quantity of good X by paying PM amount of money after the indirect tax is imposed. But before imposition of tax, ON quantity of good X can be purchased by PT amount of money. Thus, the difference TM (or KQ1) between the two is the amount of money, which the individual is paying as the excise duty (indirect tax).
But now, when government imposes the direct tax, the price line will shift parallel PL, which is AB and passes through the Q1because imposition of direct tax is equivalent in terms of revenue rising in excise duty. However, in price line AB individual not remain in same point Q1 and will shift to Q2 to higher indifference curve IC2. In other words, at point Q2 the level of satisfaction is higher than Q1. Here, the lump sum tax has reduced less welfare than the indirect tax. So, the indirect tax is excess burden than direct tax. Indirect tax is excess burden because with its imposition on goods results income effect and the price effect. When tax imposed on goods, prices of goods rise and cause the income effect that result the substitution effect and then purchase of another good. In figure, due to income effect by indirect tax consumer moves from Q3 on indifference curve IC3 to the point Q2 on lower indifference curve IC2 and as a result substitution effect he further pushed to point Q1 to lower indifference curve IC1. But the direct tax which is not levied on saleable goods, it doesn’t effect the price of those goods and the amount of indirect tax is taken away due to which he is pushed to lower indifference curve and doesn’t cause the substitution effect, but causes the income effect (Q3 toQ1).
Conclusion
As a conclusion it is concluded that consumer’s equilibrium is changed due to change in price to its own, related good, or change in income. Price effect can be broken into Income effect and Substitution effect. For study of changes in consumers equilibrium, his taste and preference and other factors are assumed to be the same.
Reference:
Ahuja, H.L Advanced Economic Theory (10 th Revised Edition 1998)
Jhingan, M.L Advanced Economic Theory (11 th Edition)
Joshi, Shyam Micro and Macro Economic Analysis
|
