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LECTURE#4
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CHAPTER#4
INDIFFERENCE CURVE ANALYSIS OF DEMAND
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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.
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Budget Line:
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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.
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Shifts in Budget line:
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1. Income changes:
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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:
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(i) MRSXY = Ratio of prices or 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.
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Consumer’s Equilibrium under various situations:
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1. Income Effect on Consumer's
Equilibrium:
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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:
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Substitution Effect on Consumer's Equilibrium:
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The substitution effect occurs because of the following
two reasons:
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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:
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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:
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Price-Demand Relationship:
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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:
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Consumer’s Equilibrium & the
Substitution Effect of price change:
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1.Hicks-Allen substitution effect:
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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:
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