January 19, 2018

Consumer’s Equilibrium Income, Substitution and Price Effect

January 19, 2018

Consumer’s equilibrium refers to when consumer gets maximum satisfaction from his money income and prices of goods he is willing to buy. For instance, suppose, a consumer who is consuming good X and Y. Consider the prices of these two goods don’t change and the consumer has fixed income. Now the consumer will purchase the quantities of these two goods. When he gets maximum satisfaction from these two goods he will be at the point of equilibrium.

Graphically, consumer is said to be equilibrium at a point where his budget line touches the highest indifference curve.  The given below diagram is illustrating the concept of consumer’s equilibrium.

In the above figure 1.1, BL is the budget line of the consumer. It can be seen there is a set of three indifference curves IC1, IC2 and IC3. We can see budget line is touching the highest indifference curve IC3 at point E.  Point E is the consumer’s equilibrium, because at this point consumer is getting maximum satisfaction by consuming OQ quantity of good X and OM quantity of good Y.

Consumer’s equilibrium is based on the assumption that income of the consumer and prices of goods remain constant. However, the level of consumer’s equilibrium can be changed or moved due to the following effects

• Income effect
• Substitution effect
• Price effect

Consumer’s Equilibrium Under Income Effect

Income is one of the most influential factors affecting purchase of goods significantly. If the prices of goods remain unchanged while there is a change in money-income, it will affect consumer’s demand.  This effect on consumer’s demand due to change in income is referred to income effect.

A rise in income of the consumer enables him to buy more both goods (X and Y). His budget line shifts upward to the right and his level of satisfaction moves to higher point of equilibrium.  Inversely, when income of the consumer decreases, his budget line shifts to inward to the left. The budget lines are parallel to each other as prices of the goods are assumed to remain constant.  The given below diagram is illustrating income effect.

In the above graph 1.2 there are three equilibrium points E1, E2 and E3 located on three indifference curves IC1, IC2 and IC3. AB is the initial budget line which yields consumer E1 which is initial equilibrium point. When his income increases while prices of goods remain constant, his budget line shift from AB to CD and his equilibrium point also moves from point E1 to point E2. We can see when the income of consumer further increases, his budget line shifts from CD to FG and his equilibrium point also moves from point E2 to point E3. If these equilibrium points are joined together, we get income consumption curve ICC. This ICC curve represents income effect.

Consumer’s Equilibrium Under Substitution Effect

When the price of one commodity falls out of two commodities, it becomes comparatively cheaper than another commodity which price increases, the consumer substitutes the cheaper commodity for another commodity which is now relatively costly.

Suppose, a consumer who has fixed income. He purchases X and Y commodity. Now assume the price of X commodity falls and the price of Y commodity increases. What will he do in this situation? He will tend to buy more quantity of X commodity and less quantity of Y commodity in order to maintain same level of satisfaction. What is he actually doing? He is substituting X commodity for Y commodity. This behavior of consumer representing substitution effect.   The given below figure is illustrating the concept of substitution effect.

In the above figure 1.3, AB is the initial budget line of the consumer. Point R is the initial equilibrium point located at indifference curve IC. At point R consumer is obtaining ON quantity of commodity X and OF quantity commodity Y.  When the price of commodity X falls and the price of commodity Y rises, the budget line of the consumer shifts from AB to AD and consumer moves to new equilibrium point S which is located at the same indifference curve IC. This movement of equilibrium points from R to S at same indifference curve is representing the substitution effect. At point S, the consumer increased quantity of X commodity from ON to OM and decreased quantity of Y commodity from OF to OK in order to maintain same level of satisfaction.

Consumer’s Equilibrium Under Price Effect

Price effect is the quantity demanded changes due to change in price of one commodity while income of the consumer and price of other commodity remain constant. Suppose, there are two commodities X and Y. The price of X falls while income of the consumer and the price of Y remain constant. In this case, the consumer will buy more quantity of X as it is relatively cheaper than Y.  Given below graph is explaining price effect.

In the above diagram 1.4, E1 is the initial equilibrium point of the consumer located indifference IC1.  When the price of commodity X falls, the consumer increases quantity of X commodity from Q1 to Q2 while maintain the quantity of Y commodity.  By increasing quantity of X commodity, the consumer’s budget line shifts from AB to AC and his equilibrium point moves from E1 to E2 located IC2. When the price of X commodity further decreases, the consumer’s budget line shifts from AC to AD and his equilibrium point moves from E2 to E3 located IC3. If we join the equilibrium points from E1 to E3, we will get PCC curve. The PCC curve is showing price effect.
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