Price Effect

Dr. Aruna Kumar Dash

IBS Hyderabad
 Price Consumption Curve
The Price Consumption Curve (PCC) is the locus of all the equilibrium points due
to change in price of one commodity. Let’s assume, consumer is dealing only
two goods (X and Y). The reason for considering 2 goods is for simplicity though
the consumer deals many goods in their day today life. Here, the assumption is
price of X Changes(falls) and price of Y remains constant. PL is the budget line.
With given income(Rs 20) and the prices of two goods(Price of Y =Rs. 2 and price
of X =Rs. 2), the consumer is in equilibrium at point A where the indifference
curve IC1 is tangent to the budget line PL. At point A consumer purchase 6 units
of commodity Y and 4 units of commodity X. If price of X falls from Rs. 2 to Rs. 1
and Price of Y remains same(Rs.2), the budget line will becomes flatter. The
budget line will shift from PL to PL1 and equilibrium point changes from A to B.
At point B, consumer purchase more units of X(12 units of X now vs. 4 units of X
before) and less units of Y(4 units of Y now vs 6 units of Y before). Further, if the
price of X falls(from Rs. 1 to 50 Paisa), the budget line becomes more flatter and
consumer subsequently move to the new equilibrium point to C. By joining all
the equilibrium points A, B and C, we will get the price consumption curve.
Price Consumption Curve
Y Assumption
Consumer income = Rs. 20
P Price of Y =Rs. 2
Price of X =Rs. 2 initially then falls to
Rs. 1 then Rs. .50

6 A

B C
4 IC1
3
IC3
IC2

o 4 L 12 L1 28 L2 X
 Price Consumption Curve continues…
Previous
The price-consumption
diagram Y curve traces out the
and this utility maximizing
diagram P
market basket for the
is same . various prices for food.
Only
here I 6 A PCC is Down ward Slopping
join 3 in case of Normal good
equilibriu B
m points 4 C
to get
IC1 PCC
3
PCC
IC3
IC2

0 4 L 12 L1 28 L2 X
Derivation of Demand Curve Through PCC

Price
of X Individual Demand relates
D the quantity of a good that
Rs 2.00 a consumer will buy to the
price of that good.

Remember point A,B and C

corresponds to the point D,E and F on
E the demand curve. Here, we have taken
Rs 1.00 effects of commodity X due to change
in Price of X only.

Rs .50 F Demand Curve

4 12 28 Quantity /Units of X
 Income Consumption Curve(ICC)
Assume: Px = $1 Py = $2 Y= $10, $20, $30

How consumers demand for a good changes as his income

changes(increases or decreases).Let’s take two goods X and Y for
An simplicity assume that initially consumer income is $10, price of X is
ncrease
$1 and price of Y is $2.The budget line is PL. The consumer is
in
income, equilibrium at point A where indifference curve(IC1) is tangent to the
with the budget line. With 10$ income and price of X is $1 and price of Y is $2
prices consumer can able to buy (4*1)=4 units of X and (3*2)=6 units of Y.
fixed,
Here, the consumer spends all the income between two goods. What
causes
consum happens if the consumer income increases to $20. The budget line will
ers to shift (right) parallel to the original budget line. The new budget line is
alter P1 and L1 and the equilibrium points changes from A to B with
their
choice
increase his income. The consumer is equilibrium at point B where IC2
of tangent to the budget line P1L1. At point B consumer
market purchases(10*1)=10 units of commodity X and 5 units of commodity Y
basket. (5*2)=10. If his income will increase to $30, BL shift parallelly
equilibrium position changes too.
 Income Effect
Assume: Px = $1
Y
Py = $2 An increase in income,
P2
Y= $10, $20, $30 with the prices fixed,
causes consumers to alter
their choice of
market basket.

P1 Income-Consumption
Curve(ICC)
C
7 Connecting all the
B IC3 equilibrium points such
5 as A, B and C resulting
P IC2 from increase in income
A we will get ICC
3
IC1

L 10 L2 X
0
4 16 L1
Normal
Normal Good
Good vs.
vs. Inferior
Inferior Good
Good

For normal Goods

 The income-consumption curve has a positive slope
 The quantity demanded increases with increase in income.
 The income elasticity of demand is positive.
For Inferior Goods
 When the income-consumption curve has a negative slope:
The quantity demanded decreases with increase in
income.
 The income elasticity of demand is negative.
Income Effect: An Inferior Good
15
Steak Income-Consumption
(units per Curve
Both hamburger
month)
and steak behave
C as a normal good,
10 between A and B...

IC3

…but hamburger
becomes an inferior
B good when the income
5 consumption curve
bends backward
between B and C.
IC2
A
IC1
Hamburger
0 10 20 30 (units per month)
 Price Effect is the combination of Income and
substitution Effect
A fall in price of a good has two effects: Income and substitution
effect
Substitution Effect
 The substitution effect is the change in a good’s consumption
associated with a change in the relative price of the good,
with the level of utility held constant.
Consumer will tend to buy more of the good that has become
cheaper and less of those goods which are relatively more
expensive. When the price of an item declines, the substitution
effect always leads to an increase in the quantity of the item
demanded.
 Substitution Effect

 Substitution Effect
 The substitution effect is the change in a
good’s consumption associated with a
change in the relative price of the good,
with the level of utility held constant.
 When the price of an item declines, the
substitution effect always leads to an
increase in the quantity of the item
demanded.

Lecture 4 Slide 11
 Income effect
Due to fall in price of a good, that goods is now cheaper. Hence,
consumer purchasing power increases. Consumer is now better off
because they can buy the same amount of goods for less money,
and thus, have money left over for additional purchase. The
change in demand resulting from change in real purchasing power
is called income effect.
Price, Income and Substitution
Effects: Normal Good
Clothing
When the price of food falls,
(units per consumption increases by F1F2
month) R as the consumer moves from A
to B.
The substitution effect,F1E,
(from point A to D), changes the
C1 A relative prices but keeps real income
(satisfaction) constant.

The income effect, EF2,

( from D to B) keeps relative
D B prices constant but
C2 increases purchasing power.

Substitution IC2
Effect IC1
Food (units
O F1 Total Effect E S F2 T per month)
Income Effect
 Let’s assume that the initial budget line is RS and there are two goods (food and
clothing). The consumer is equilibrium at point A where IC1 is tangent to the
budget line (RS)and consumer buys OC1 units of clothing and OF1 units of food.
Let’s see what happens if price of food falls and price of clothing remaining same.
Due to fall in price of food, the budget line will become flatter and the new
budget line is RT. The consumer is equilibrium at point B on the indifference
curve IC2. Now IC2 is preferred to IC1 due to more satisfaction. Why the
consumer is moving from A to B i.e. from IC1 to IC2. The movement is because
of price effects . You know price effect is the combination (sum) of substitution
and income effect. First, we will see substitution effect. If price of food falls and
price of clothing remaining same, then food will be relatively cheaper compared to
clothing. Hence, consumer will substitute clothing with food. In order to see the
substitution effect, we have to draw one budget line which will tangent to
IC1(note: though the consumer is substituting one good for another, the consumer
is in same indifference curve and satisfaction is remaining same. Now new budget
line tangent to IC1 at point D. The movement from A to D is substitution effect.
 Since the price of food is relatively cheaper, the consumer will substitute
clothing for food and consumer real income increases. Consumer purchasing
power increases due to fall in price of food. Due to fall in price, the consumer
real income increases. You know with increase in consumer income, the budget
line will shift parallelly that is RT. The equilibrium point changes from D to B.
The consumer is equilibrium at point B on IC2. You know with increase in
income consumer can able to buy more of goods. The movement from D to B is
is known as income effect.
Thank you