Indifference Curve – Consumer

Equilibrium, Income & Price Effect

Indifference Curve Analysis – Price/Budget
Line
Given that
Budget = Rs.80
Price of Good X = Rs.20 Price of Good Y = Rs. 10

The consumer could spend all money on Y and get 8 units of commodity Y and no
commodity X
Or entire money can be spent on commodity X to get 4 units of commodity and no
commodity Y
Or a combination of X and Y can be bought for Rs.80
 Price line/Budget Line
Given Budget = Rs.80; Price of Good X = Rs.20; Price of Good Y = Rs. 10, the
combinations of X & Y are:
A = M/Py

Combination Quantity Quantity

(X) (Y)
A 0 8
Q 1 6
P 2 4
N 4 2
B = M/Px
B 0 1

Price line AB shows different combinations of two goods X & Y which a consumer can buy with a given
amount of money income and the price of the two goods. Money spent by consumer on points A, Q, P, N &
B is the same.
 Slope of Price Line
Slope of Price Line AB = OA/OB
OA is the point where the consumer buys only Y i.e. entire budget spent on Y
OA =
OB is the point where the consumer buys only X i.e. entire budget spent on X
OB =
÷ =

The slope of the price line is the ratio of the price of the two goods
Effect of a Change in Income, Px & Py are
unchanged
Budget Line AB - Money Income (M)= Rs.1500

A1 Price of movie ticket (Y) = Rs.100, Price of concert ticket (X) =Rs.
300
OA = M/Py = 1500/100 = 15; OB = M/Px = 1500/300 = 5

Slope = Px/Py = 300/100 = 3

A Budget Line A1B1 (Increase in Income) Money Income (M1) =

Rs.3000

Price of movie ticket = Rs.100, Price of concert ticket =Rs. 300

OA1 = M1/Py = 3000/100 = 30; OB1 = M1/Px = 3000/300 = 10

B B1 Slope = PX/Py = 3

Since the slope is unchanged, there is a outward parallel shift of the

budget/price line from AB to A1B1
 Effect of a Change in Price of Goods, Money Income is unchanged
Figure 1
(Money Income (M)= Rs.1500)
Price of movie ticket (Py) = Rs.100, Price of concert ticket
(Px) =Rs. 300
OA = M/Py = 1500/100 = 15; OB = M/Px = 1500/300 = 5
Slope of AB = 300/100 = 3
A1
When price of movies tickets (Py) fall to Rs. 50, M & Px
remaining unchanged
• Price line shifts to A1B
• Slope = Px/ Py1 = 300/50 = 6 A
A

Figure 2
Price of concert tickets fall (Px) from Rs. 300 to Rs.100,
M (Rs.1500) & Py (Rs.100) are unchanged
Price line shifts from AB to AB1 B B B1
Slope of AB1 = 1

Slope of price line changes when price changes

 Shifts in the Price Line
Qty of
Solve: Tea
M/Pt1
Given that the consumer has a 10

budget of Rs. 200 which she M/Pt

spends on tea and samosa, the 8
price of a cup of tea being Rs.25
and that of a plate of samosa is
Rs.40, draw the price line. If the
price of tea falls to Rs.20, does M/Ps
the slope of price line change. 5 Quantity of Samosa
(Take tea on Y axis & samosa on
X axis)
At Pt = 25, slope = Ps/Pt = 40/25 = 1.6
At Pt1 = 20, slope increases to 40/20 = 2
Consumer Equilibrium on an Indifference Curve

o Money spent by consumer

on P, E & Q are equal as all
lie on price line
o Point E on IC2 is the
equilibrium point
o E is preferred to P & Q (on
IC1)as E is on a higher IC
o IC3 is outside the budget
of consumer
Consumer Equilibrium
Necessary Condition for equilibrium
 Price line to be tangent to IC

 At point of tangency, the slope of the curve at

tangency point equals the slope of the tangent

Equilibrium at E  Slope of IC at E = Slope of Price line AB

 Slope of IC at a point = Marginal rate of
substitution at that point (MRSxy)
 Slope of price line = Price of Good X / P rice of
Good Y (Px/Py)

At Equilibrium
MRSxy = Px/Py
Consumer Equilibrium

• Price line AB, being linear, has a constant slope. If

A Px = Rs.30 & Py = 20, slope of price line AB =
Px/Py = 1.5
C • The slope of the IC = MRSxy
• MRSxy diminishes as we go down the IC
• At point E on IC2, MRSxy = PX/Py = 1.5
• D is not a point of equilibrium, as MRSxy ≠ (Px/Py)
• Slope at D less than slope of AB; MRSxy < (Px/Py)
• If the consumer is at point D, the consumer has to
D move to E to be at equilibrium
• The consumer has to rearrange purchases of X & Y
to reach equilibrium point E
B • He has to reduce quantity of X and increase Y to
reach equilibrium
 Income Effect & Income Consumption Curve (ICC)
Assumption – Price of the two goods X & Y are When both X & Y are normal goods, an
unchanged, the money income of the consumer increase in income increases the
alone changes purchase of both goods
 Original equilibrium is at point E1 – point of
tangency of IC1 & price line AB
 When income increases, Px & Py unchanged,
there is a parallel shift upward of the price line
to A1B1 (no change in slope)
 New price line A1B1 is tangent to a higher IC2
at E2
 Further increase in money income shifts price
line to A2B2 and new equilibrium to E3
 When we join E1, E2 & E3, we get Income
Consumption Curve (ICC)
 ICC tracks the effect of a change in consumer
income
 Normal Good, Inferior Good & ICC

Income Consumption Curve is obtained by joining the successive points of consumer equilibrium of a
consumer which changes with income, Px & Py remaining unchanged

 As money income rises, the

consumer moves from equilibrium
points E1 to E2
 At E2, the consumer is buying more
of X (X1 to X2), but less of Y (Y1 to Y2)
 From E2 to E3, there is a further fall
in quantity of Y to Y3
 Y is an inferior good as the
consumer buys less when income
rises
 X is a normal good as more of X is
purchased with an increase in
income
ICC for Inferior Good (X), Normal Good (Y)

X is an inferior goods as the

quantity of X bought falls
from X1 to X2 to X3 when
consumer income rises
Y is a normal good as
quantity of Y rises
with a rise in income
 Price Effect & Price Consumption Curve (PCC)

PCC measures price effect – the effect of a

fall in price of X
 Consumer is originally at equilibrium point E on IC
 When Px (price of Parle G) falls, [Py (Tiger
Biscuits)& M unchanged], price line shifts outwards
from AB to AC
 AC is tangent to IC1 at F, (new equilibrium point)
 If Parle G price falls further, price line shifts to AD
 Equilibrium moves to G on IC2

Joining points E, F & G we get Price Consumption Curve (PCC)

Since both are normal goods, quantity purchase of both goods
rise
Derivation of Demand Curve from PCC
On the top panel,
• Equilibrium point E1 corresponds to the highest
price P1 (Price line AB)
• E2 is the equilibrium when price of X falls to P2
(Price line AB1)
• Equilibrium point E3 corresponds to a still lower
price P3 (Price line AB2)

On the lower panel, we derive the negatively

sloped demand curve for Good X from the
following table

Price Quantity of
Good X
P1 X1

P2 X2

P3 X3