Indifference Curve Analysis

The equilibrium position of the consumer will be found out on the assumption that income of the consumer will remain constant. Now if there is any change either in the income of the consumer or prices of commodities, there will be a change in the equilibrium position.

This can be explained under three heads.

1. Income Effect

2. Price Effect

3. Substitution Effect

Indifference Curve Analysis - Income Effect

Income effect: - Where there is a change in the income of the consumer, but the prices of the commodities remain constant, there will be a change in consumption made by the consumer. This change in consumption is called the Income Effect.

Indifference Curve Analysis – Income Effect

Equilibrium: Under the income effect there will be a change in the equilibrium position of the consumer and that can be shown in the following diagram.

In the diagram AB is the original price line. T1 is the original equilibrium position. As there is increase in income the new price line or the budget line is CD. T2 is the new equilibrium position. When there is further increase in income, EF becomes the new budget or

price line. T3 becomes the new equilibrium position. If we now join T1, T2 and T3, it forms a curve known as

income-consumption curve(ICC). The ICC shows the new equilibrium position of the consumer,

where there is a change in income, with prices remaining constant.

Indifference Curve Analysis-Income Effect

Types of Income Effect

1. Positive income effect: When with the increase in income, there is increase in

consumption that is known as Positive Income Effect.

2. Negative Income Effect: when with the increase in income there is decrease in

consumption that is known as Negative Income Effect. The negative income effect is

applicable in case of inferior goods. Inferior goods are those goods, which are

purchased less as one's income rises.

Indifference Curve Analysis-Income Effect

When the consumer purchases less of commodity X as a result of increase in income, X is the inferior commodity.

Indifference Curve Analysis-Income Effect

When the consumer purchases less of commodity Y, as a result of increase in

income, Y is the inferior commodity.

Indifference Curve Analysis - Price Effect

Price Effect: When there is no change in the income of the consumer, no change in the price of one commodity, and there is a change in the price of another commodity, there will be a change in the consumption made by the consumer. This change in consumption is known as the Price Effect.

Indifference Curve Analysis - Price Effect

Equilibrium position: Under the Price Effect, there will be a change in the equilibrium position of the consumer. This can be shown in the following diagram.

In this diagram PCC is the Price Consumption Curve. It is sloping downwards to the right. Any point on the Price Consumption Curve will indicate the equilibrium position of the consumer under the Price Effect. In this diagram when the price of X falls, the consumer purchases more of X and less of Y.

Shapes of Price Consumption Curve

In the above diagram PCC is the price consumption curve. It is a horizontal straight line. It indicates that with a fall in the price of X, the consumer purchases more of X and the same quantity of Y.

Shapes of Price Consumption Curve

In this diagram the price consumption curve is sloping upwards to the left. This indicates that with a fall in the price of X, the consumer purchases less of X. This is applicable in case of Giffen goods.

Indifference Curve Analysis - Substitution Effect

Meaning: When there is a change in the price of one commodity, and when the price of another commodity remains unchanged or constant, the income of the consumer must be changed in such a way that the consumer is neither better off nor worse off. He remains at the same old position. Under that circumstance, if there is a change in the consumption, that would be due to the Substitution Effect.

Indifference Curve Analysis - Substitution Effect

In the diagram AB is the original price or budget line. T is the original equilibrium position. There

is a fall in the price of X. So the new budget line is AC. To put the consumer at the same old

position we draw another budget or price line DE, which will meet the indifference curve at the

point T1. So the movement from T to T1 on the indifference curve IC shows the substitution

effect. Here the consumer substitutes n->n1 of Y to get m->m1 more of X because the price of X

is now comparatively cheaper than the price of Y.