Introductory Economics

Indifference Curve Analysis

Substitution Effect: The change in the purchases of a good as a consequence of a change in relative prices alone, real income remains constant. As the price of good changes; real income or purchasing power of the consumer also changes. To keep the real income of the consumer constant so that the effect of relative price alone may be known, price change is compensated by a simultaneous change in income. Suppose the price of good X falls, real income of the consumer would increase. In order to find out the substitution effect i. e. change in the quantity of X purchased due to the change in relative price, the consumer’s income must be reduced by an amount so as to cancel out the gain in the real income. There are two concepts of substitution effect. Hicks-Allen Substitution effect: According to this concept, price change is accompanied by so much change in money income that the consumer is neither better off nor worse off than before. This means that the money income of the consumer is changed in such a way that consumer remains on the same indifference curve on which he was before the change. The amount by which the money income of the consumer is changed so that he is neither better off nor worse off than before is called Compensating variations in income. Hicks’ Allen Substitution Effect: Say with given money income and price of the goods, consumer is in equilibrium at Q as shown in the figure. Now suppose that the price of good X falls (Price of good Y remaining the same), so price line PL shifts to PL’. With the fall in the price of X, real income of the consumer has increased. To find out the substitution effect, this gain in real income is reduced in such a way that the consumer remains at the same indifference curve as shown by the price line which is tangent at T. Now consumer rearranges his purchases by substituting X for Y which has become cheaper. So movement from Q to T depicts the substitution effect. Slustsky substitution effect: According to this concept, consumers’ income is reduced in such a way that he is still able to purchase the old combination of the two goods if he wishes to do so. That is the income is changed by the difference between the costs of the amount of good X purchased at old price and the cost of the same quantity of X at new price. Income is then said to be changed by the cost difference. Thus, in Slustky substitution effect, income is changed not by compensation variations but by the cost difference. A consumer is in equilibrium with his given money income and prices of two goods at Q by purchasing ON of Y and OM of good X. Now suppose the price of good X falls and PL’ is the new price line. According to Slustky effect GH price line parallel to Pl’ is drawn in such a way that the consumer is able to buy old combination of the goods. However this price line is tangent at a higher indifference curve at S. This movement from Q to S is Slustky substitution effect (Fig.). Price effect: Price consumption curve: Consumers’ reaction to changes in the price of a good, his money income, tastes and price of other good remain the same. When the prices of goods changes, the consumer would be either better off or worse off than before, depending upon whether prices falls or rise. In other words, as a result of change in price of good, his equilibrium position would lie at a lower indifference curve in case of rise in price and at a higher indifference curve in case of fall in price. With the given prices of goods and given money income consumer is in equilibrium at Q on IC1 with ON of Y and OM of X. As a result of price fall price line shifts to PL2 and consumer is in equilibrium at R at a higher indifference curve and so on (Fig.) When all the points such as Q, R, and S are joined together, we get a curve called Price consumption curve. Price consumption curve traces out the price effect. It shows how the changes in the price of good X affect the consumers’ purchases of X, price of Y, his tastes and money income remains unchanged. Price consumption curve can have different shapes. Upward sloping Price consumption curve for X means that when the price of X falls, the quantity of both X and Y rises. This type of curve is found when the demand for good X is less elastic. Price consumption curve can be backward sloping when the price of X falls, smaller quantity of it is demanded. This is true in case of Giffen goods. Price consumption curve can also take horizontal shape too. It means when the price of good X falls its quantity purchased rises proportionately but the quantity purchased of good Y remains the same.