Presentation on theme: "Income effect is the effect on the quantity demanded of the commodity due to the change in the income of the consumer while the prices of the other commodities."— Presentation transcript:
Income effect is the effect on the quantity demanded of the commodity due to the change in the income of the consumer while the prices of the other commodities remain same. Thus, the income effect reflects the change on the consumer equilibrium due to change in money income. Other things being equal, increase in income increases the satisfaction of the consumer. As a result, equilibrium shifts upward to the right. On the other hand, decrease in income leads to a decrease in satisfaction and consumer equilibrium shifts to downward to the left.
FOLLOWING ARE THE ASSUMPTIONS THAT MUST BE KEPT IN MIND... 1.The prices of the two commodities remains unaltered. 2.Scale of preferences is given. 3.Income of the consumer changes.
Given fig. illustrates shows that initially with price line AB, the consumer is in equilibrium at point T1,and he buys OB quantity of X commodity and OA quantity of Y commodity. Now, we assume that consumer income get increased. As a result the price or budget line shifts to CD from AB. T2 is the new equilibrium point on higher indifference curve. At this point, he buys OD quantity of commodity X and OC quantity of commodity Here he is better as he moves to higher indifference curve, and get higher level of satisfaction. Thus, as a result, budget line shifts from CD to EF and T3 is new equilibrium point. If we join the T1,T2 and T3 point we will get a curve known as INCOME CONSUMPTION CURVE(ICC).Therefore, income consumption curve is the locus of points showing the equilibrium of the consumer at different levels of income, when prices of two goods are given and constant.
Normally, in case of superior goods ( normal goods ), as level of income increases, the demand for such goods also increases and vice versa. On the contrary, in case of inferior goods, as the level of income increases, the demand for such goods falls and vice versa. It means that when the level of income of any individual is low, he prefers only inferior goods,i e he affords only cheap goods. But as his level of income increases, he likes to purchase superior goods. This will raise the demand of superior goods and reduce the demand for inferior goods.
The diagrammatic presentation can be shown below.. a) X good as an inferior and Y good as a superior:- Considering X good inferior and Y good superior, as the level of income increases, consumer will purchase more of Y good and less of X good. On the other hand if the level of income falls, consumer will prefer more of X good as inferior.so as a result, ICC slopes backwards towards Y good..(in fig.1) b)Y good as an inferior and X good as a superior:-In this case, consumer buy more of X good and less of Y good. The equilibrium is E1.Therefore, at different budget lines like AA, BB, and CC, the consumer gets E1,E2 and E3 where IC curve touches. By joining these points we get a slope of ICC moves downward to the right bends towards x axis.
It shows a tendency on the part of consumer to substitute a cheaper commodity in place of an expensive commodity. In simple terms, substitution effect refers to the change in amount demanded of a commodity resulting from a change in its relative price alone while real income of consumer remains constant. Thus, when price of X good falls, real income of the consumer will naturally increase. The substitution effect can be explained as under: a).Relative prices of two goods change in such way that one commodity becomes dearer and the other cheaper. b).Monetary income of the consumer changes in such a way that he gets equal satisfaction in new stage also.
In fig.,suppose AB is the initial price line touches at T.It is the equilibrium point of the consumer. Here, the consumer buys Om quantity of commodity X and On quantity of commodity Now suppose price of Y commodity increases and that of commodity X decreases. The difference between the relative price of two goods occurs in such a way that the loss due to the increase in the price of one commodity can be compensated by decrease in the price of other commodity, Now, the consumer changes his purchasing power in such a way that he remains on the same indifference curve. In other words, there is no change in his level of satisfaction.New equilibrium point is T1.and he buys Om1 quantity of X commodity and On1 quantity of commodity of Now, the consumer buys more of cheaper goods than before and less of dearer good.
In simple words, price effect explains how a consumer reacts to changes in the price of good when his money income, tastes, habits and prices of other goods remain the same. It depends whether price falls or rises. However, in case of fall in price, the equilibrium of consumer will be at higher indifference curve while in case of rise in price, the equilibrium will be on the lower indifference curve. According to prof. Lipsey,” the price effect shows how much satisfaction of the consumer varies due to change in consumption of two goods as the changes in the price of other goods and money income remains constant.”
In the given fig. with given prices of X and Y good and money is represented by price line AB. The consumer gets equilibrium at T3 on the indifference curve IC1.let us suppose, price of X good falls ( price of Y good remains constant ).As a result, price line shifts from AB to AC.The consumer is in equilibrium at T2 and T3 points on higher indifference curve IC2 and IC3. When all the equilibrium points such as T3, T2 and T1 get joined,we get PRICE CONSUMPTION CURVE(PCC).This downward sloping of PCC indicates that as price of X good falls, the consumer purchases more of X good and lesser of Y good.
Given fig. depicts the upward sloping of price consumption curve. Good X has been measured on the X axis ( which is inferior ) and commodity Y ( which is superior ) measured on the Y axis.AB is price line and consumer is in equilibrium at T1.Now, when the prices of good X falls while the price of commodity Y and income of the consumer remains same. As a result, price line shifts to AC ON WHICH THE EQUILIBRIUM POINT IS T2.It means fall in the price of one commodity will increase the satisfaction of the consumer. In other words, the demand for X will increase and demand for Y will decrease.
PRICE EFFECT = INCOME EFFECT + SUBSTITUTION EFFECT According to the law of demand, price and demand are inversely related. If there is fall in price, demand increases because 1. real income or purchasing power increases. 2.consumer substitutes relatively cheaper good for costlier one.
Let us assume that price of commodity X falls. It will lead to increase in demand due to price effect. Consumer will get more satisfaction because his purchasing power or real income will increase.If additional real income is taken away in such a,manner that he gets same satisfaction as he was getting before the fall in price, it means that income effect get neutralized. Even after neutralizing income effect, if consumer purchase more of X good it will be due to substitution effect. Once we know substitution effect income effect can be measured by subtracting substitution effect from price effect.