How Do Income Effect, Substitution Effect and Price Effect Influence Consumer's Equilibrium?
Income Effect on Consumer's Equilibrium
Income effect attributes how a change in the consumer’s income influences his total satisfaction. Assume that the prices of commodities that the consumer purchases remain constant. Now, he is able to experience more or less satisfaction depending upon the change in his income. Thus, we can define income effect as the effect caused by changes in consumer’s income on his purchases while prices of commodities remaining the same.
Figure 1 explains the effect of change in the consumer’s income on his equilibrium level.
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.
Income Consumption Curve
You can obtain income consumption curve (ICC) by joining all equilibrium points E, E1 and E2 as shown in figure 1. Normal goods generally have positively sloped income consumption curves, which implies that consumer’s purchases of the two commodities increases as his income increases. At the same time, this may not be applicable in all cases.
Substitution Effect on Consumer's Equilibrium
Suppose there are two commodities, namely apple and orange. Your money income is $100, which does not change. You need to purchase apple and orange using the entire money income, i.e. $100. Assume that the price of apple increases and the price of orange decreases. What do you do in this case? You tend to buy more oranges and less apples since oranges are cheaper than apples. What exactly you are doing is that you are substituting oranges for apples. This is known as substitution effect.
The substitution effect occurs because of the following two reasons:
(a) The relative prices of commodities change. This makes one commodity cheaper and the other commodity costlier.
(b) Money income of the consumer does not change.
Figure 2 is helpful to understand the concept of substitution effect in a simple manner.
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.’
Price Effect on Consumer's Equilibrium
For simplicity, let us consider two-commodity model. In substitution effect, prices of both the commodities change (price of commodity Y increases and price of commodity X decreases). However, in price effect, price of any one of the commodities changes. Thus, price effect is the change in the quantity of commodities or services purchased due to a change in the price of any one of the commodities.
Let us consider two commodities, namely commodity X and commodity Y. Price of commodity X changes. Price of commodity Y and consumer’s income are constant.
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 AB1 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.
Price Consumption Curve
You can derive the Price Consumption Curve (PCC) by joining all equilibrium points (in the above example, C1, C2, C3 and C4). In the above figure, the PCC has a positive slope. This means that as price of commodity X falls, the consumer’s real income increases.
Derivation of Demand Curve from Price Consumption Curve
The price consumption curve (PCC) tells us what happens to the quantity demanded when there is a change in price. A consumer’s demand curve also explains the relationship between the price and quantity demanded of a commodity. Therefore, price consumption curve is useful to derive an individual consumer’s demand curve. Though a consumer’s demand curve and his price consumption curve give us same information, the demand curve is more straightforward in what it tries to convey.
Figure 4 illustrates the process of deriving the individual consumer‘s demand curve from his price consumption curve.
In figure 4, horizontal axis measures commodity A, and vertical axis represents consumer’s money income. IC1, IC2, and IC3 denote indifference curves. Suppose the price of commodity A continuously decreases. As a result, LN, LQ and LR are the subsequent budget lines of the consumer. Initially, P1 is consumer’s equilibrium. At this equilibrium point, the consumer buys OM1 quantity of commodity A.
Price of a unit of commodity A = total money income/number of the units that can be bought with that money.
Hence, at P1 (equilibrium point – budget line is tangent to the indifference curve IC1), the price per unit of commodity A is OL/ON. At OL/ON price, the consumer demands OM1 quantity of commodity A.
Likewise, at OL/OQ price, the consumer is able to buy OM2 quantity of commodity A and at OL/OR price, he buys OM3 quantity of commodity A.
If you connect all equilibrium points (P1, P2 and P3), you will be able to get the price consumption curve.
The demand curve, as mentioned above, depicts the prices and corresponding quantities of commodity purchased by the consumer.
For illustration purpose, suppose the consumer’s income is $40, ON = 8 units, OQ = 10 units and OR = 20 units. With the help of this information, you can construct a demand schedule as follows:
Table 1: Price-Demand Schedule for Commodity A
Price of A (in $) = Total Money Income/No. of Units of A
Quantity of A Demanded
OL/ON (40/8 = 5)
OM1 = 8 units
OL/OQ (40/10 = 4)
OM2 = 10 units
OL/OR (40/20 = 2)
OM3 = 20 units
Once you have the demand schedule, you can derive an individual consumer’s demand curve as shown in figure 5.
Figure 5 illustrates a consumer’s demand curve. If you need to construct a market demand curve, it will be possible by a horizontal summation of individual demand curves.
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