Unit 1 DEMAND AND SUPPLY ANALYSIS 1
LESSON 1 ELASTICITY OF DEMAND AND APPLICATIONS 1. STRUCTURE 1.1. Objective 1.2. Introduction 1.3. Meaning of Elasticity of Demand 1.4. Types of Elasticity of Demand 1.4.1. Price Elasticity of Demand 1.4.2. Income Elasticity of Demand 1.4.3. Cross Price Elasticity of Demand 1.5. Methods of Calculating Price Elasticity of Demand 1.5.1. Percentage Method 1.5.2. Point Method 1.5.3. Total Expenditure Method 1.5.4. Geometric Method 1.6. Derivations based on elasticity of Demand 1.7. Summary 1.8. Self Assessment Questions 1.9. Suggested Readings 1.1 OBJECTIVE After reading this lesson, you should be able to a) Understand the concept of Elasticity b) Differentiate between different kinds of elasticity c) Calculate different types of elasticity d) Comprehend relationship between revenue and elasticity e) Explain and analyze the relation between slope of the demand curves and their elasticities. 1.2 INTRODUCTION Law of demand states that when price of a commodity decreases/increases the quantity demanded of the commodity increases/decreases respectively ceteris paribus. But the law is silent about the quantum of change, the answer to that is provided by the concept of Elasticity. Elasticity in a layman s term is the responsiveness of a dependent factor to a change in the independent factor. Understanding of how elastic or inelastic is a variable in response to some other variable helps in the decision making, policy formulations, deciding about the closeness (substitutes or complementary status) of the commodities involved. It is one of the most important factors that firms take into consideration for deciding whether to change the price of their commodity or bring changes in some other variables. 2
1.3 MEANING OF ELASTICITY OF DEMAND Elasticity measures the responsiveness of the quantity demanded due to change in the price of the commodity itself (Price Elasticity), income of the consumer (Income Elasticity) or change in the price of the related commodity that can be substitute or complementary good (Cross Price Elasticity). Therefore we have three kinds of elasticity of demand 1. Price elasticity of demand 2. Cross elasticity of demand 3. Income elasticity of demand It is simply calculated as: Ed = If there is a small change in the quantity demanded of a commodity because of change in any one of the underlying factor that is price of commodity, income or price of related commodity (substitute or complement commodity) then it is said to be having relatively inelastic demand. The converse that is if there is large change in the quantity demanded in response to change in any of the above mentioned variables then there is said to be existence of relatively elastic demand. Different types of elasticity and their measurements is explained under the next topic: 1.4 TYPES OF ELASTICITY OF DEMAND As mentioned above the change in the quantity demanded can be effected by any of the following three variables namely: 1) Price of the commodity itself whose quantity has changed 2) Income of the consumer or 3) Price of the related commodity that can be either a substitute or a complementary good. Accordingly the elasticity can be defined as either of the following: 1) Price elasticity denoted by Ed or Ep or simply E. 2) Income Elasticity of Demand denoted by Ey or EI 3) Cross Price Elasticity of Demand denoted by Exy 1.4.1 Price Elasticity of Demand This is the most commonly studied form of elasticity that measures how much change is there in the quantity demanded of a commodity because of change in the price of the commodity itself other things remaining constant. It is calculated as: Ed = 3
On calculation, price elasticity of demand comes out to be a negative number because it indicates the inverse relationship between price and quantity demanded. However there is a negative sign in the formula to convert it to positive and hence price elasticity varies from 0 to +. Example: If the quantity demanded for a good increases by 20% because of a 10% decrease in price, the price elasticity of demand would be 20% / 10% = 2. Price Elasticity is impacted by a number of factors like availability of close substitutes (where existence of close substitutes would make the demand of the commodity elastic and absence of the substitutes would make it inelastic), categorization of the commodity as necessity, luxury or comfort goods (as necessities usually have relatively inelastic demand as compared to luxuries that tend to have more elastic demand). Calculation of price elasticity would be studied in detail in the next heading. 1.4.2 Income Elasticity of Demand It shows how responsive is the quantity demanded of a commodity to change in the income of the consumer ceteris paribus. Here we talk about nominal income of the consumer that is change in the money income and not the real income which changes because of change in the prices of the commodities. It is calculated as: Ey = Ey = Income elasticity to a great extent depends on the type of goods under study that is whether the good is normal or inferior as in case of normal goods income elasticity is positive there being direct relation between Income of the consumer and the quantity demanded and it comes out to be negative in case of inferior goods there being inverse relation between income and quantity demanded. There can be a further division of the income elasticity where it can be categorized as follows: Different values of income elasticity of Types of goods demand E y > 1 Luxury goods E y = 1 Comfort goods 0 < E y < 1 Necessity E y < 0 Inferior goods If income of a consumer increases by 10% and the quantity demanded of a commodity increases by 20% then the commodity would have elastic income demand as Ey comes out to be 20%/10% = 2 showing that commodity is a luxury good. 4
Figure 1 Figure 2 As can be seen from the figures above that in case of inferior good there is inverse relation between income of the consumer and the quantity demanded, when income of the consumer increases his purchasing power increases and he moves on to the consumption of superior commodity reducing the quantity consumed of the inferior good. While in case of normal good there is a direct relation between income and quantity consumed as with an increase in the income consumer consumes more of the commodity if it s a normal good and by how much the consumption of the normal good would increase depends upon whether the commodity being talked about is necessity, luxury or comfort. 1.4.3 Cross Price Elasticity of Demand It shows how responsive is the quantity demanded to change in the price of a related commodity ceteris paribus. The related commodity can be a substitute or a complement. It is calculated as: Exy = Ey = Different Values of Cross Price Elasticity Type of Good E xy = + Perfect Substitutes 0 < E xy < + Substitute goods E xy = 0 Unrelated E xy = - Perfect Complements - < E xy < 0 Complementary goods Example 1: There are 2 commodities X and Y and there before and after prices and quantity are given as follows: 5
Commodity Y Commodity X Price (Rs./unit) 20 40 Before Quantity (unit/month) 40 80 Price (Rs./unit) 40 40 After Quantity (unit/month) 30 70 Here cross price elasticity comes out to be E y = E y = = = -0.125 (Goods are Complementary as there is inverse relation between price of commodity Y and quantity of commodity X) Example 2: Calculate cross price elasticity of demand between coffee(x) and tea(y) from the following data and comment on the relationship between the two goods. lemon(x) Tea(Y) Before Price (Rs./unit) 10 20 Quantity (unit/month) 20 40 After Price (Rs./unit) 20 20 Quantity (unit/month) 15 35 Here cross price elasticity comes out to be E y = E y = = = -0.125 (Goods are Complementary as there is inverse relation between price of commodity X and quantity of commodity Y) Cross price elasticity is positive in case of substitute goods as in the example of Tea and Coffee if price of Tea increases then people reduce its demand and switch to coffee that is its substitute and has unchanged price which brings an increase in the quantity demanded of coffee, thereby having a positive relation between price of tea and quantity demanded of its substitute coffee. Similarly if two goods are complementary like say petrol and car, then increase in price of petrol would reduce the demand of petrol cars in the market, the cross price elasticity would hence come out to be negative showing inverse relation between price of one commodity and its complement. Cross Price elasticity thus helps in establishing the relation between two commodities, whether two goods are substitutes or complementary to each other or are totally unrelated, as if goods are related then change in the price of one would have an impact on the other. 1.5 METHODS OF CALCULATING PRICE ELASTICITY OF DEMAND Price elasticity is one of the most important factors that determine various policy measures undertaken by firms as well as the government. For example if government imposes tax on a commodity who is relatively price inelastic then quantity demanded would not reduce by a greater extent as compared to a commodity which is price elastic. As price of a commodity is the most important determinant of the quantity demanded so is the price elasticity the most important elasticity, hence it is also sometimes called elasticity only instead of 6
specifying price elasticity. Now the question is how to calculate price elasticity or simply elasticity. There are various methods give by different economists for its classification out of which three are given below: 1.5.1 Percentage Method According to this method, price elasticity of demand is measured as the ratio of percentage change in quantity demanded of a commodity to percentage change in its price. This method was devised by Marshall. Ed = Ed = Where = Change in quantity demanded, final quantity-initial quantity, Q2 Q1 Example 3: = Change in the price of the commodity itself, final price initial price, P2 P1 Price Quantity 10 100 20 80 Here Elasticity is E d = = E d = = 0.2 Using Percentage method following five types of elasticity can be identified: 1) Perfectly Elastic Demand: here demand curve is a horizontal straight line parallel to X axis as at the same price any amount of the quantity can be demanded. For example in case of demand curve for a firm under perfect competition, demand is perfectly elastic as if price changes by even a small proportion, quantity demanded shrinks to 0. Here E d = + 2) Relatively Elastic Demand: When percentage change in quantity demanded is more than percentage in price, there is relatively elastic demand. For example: if Price of a commodity decreases by 10% and its quantity increases by say 20%, there is said to be relatively elastic demand. Demand curve here is flatter showing % change in Q is greater than % change in P. Here 1 < E d < + 3) Unitary Elastic Demand: When Percentage change in quantity demanded is equal to percentage change in price, there is said to be a unitary elastic demand. For example: if Price of a commodity decreases by 10% and its quantity increases 10%, there is said to be unitary elastic demand. Demand curve here is a Rectangular Hyperbola as % change in Q is equal to % change in Price so area below the demand curve remains constant. Here E d = 1 7
4) Relatively Inelastic Demand: When Percentage change in quantity demanded is less than percentage change in price, there is said to be relatively inelastic demand. For example: if Price of a commodity decreases by 10% and its quantity increases 5%, there is said to be relatively inelastic demand. Demand curve here is steeper as % change in Q is less than % change in Price. Here 0 < E d < 1 5) Perfectly Inelastic Demand: When change in price has no impact on the quantity and demand curve is vertical, there is said to perfectly inelastic demand. This takes place in case of absolute necessities. Here E d = 0. From the above it can be seen that using percentage method, elasticity varies from Zero to Infinity as is shown in the Figure below: 1.5.2 Arc Method Figure 3 The method is also called Arc or average method as it gives the elasticity mid way between two price changes on a demand curve. To calculate elasticity using Arc method following formula is used: Ed = = Point elasticity vs. arc elasticity Point elasticity of demand It refers the proportionate change in quantity demanded in response to very small proportionate change in price. If the changes in the price are very small,then we use the point elasticity of demand Arc elasticity of demand It is the price elasticity of demand between two points on a demand curve. In other words it measures price elasticity midway between two points. If the changes in the price are not small, then we use the arc elasticity of demand. 8
1.5.3 Total Expenditure Method This method calculates elasticity by finding out the relation between Price and Total Expenditure. Here elasticity can be classified into three categories: a) Elastic Demand: When price and Total Expenditure moves in the opposite direction i.e. if price decreases quantity increases more than proportionately thereby increasing the total outlay on the consumption of the commodity and vice versa. It can be illustrated with the following example: Price(Rs) Quantity (Units) Total expenditure (P*Q) 10 20 Rs 200 8 30 Rs 240 b) Unitary Elastic Demand: When irrespective of the change in the price total expenditure remains constant, demand is said to be Unitary Elastic. It can be illustrated with the following example: Price(Rs) Quantity (Units) Total expenditure (P*Q) 10 20 Rs 200 8 25 Rs 200 c) Inelastic Demand: When price and Total Expenditure moves in the same direction i.e. if price decreases quantity increases less than proportionately thereby decreasing the total outlay on the consumption of the commodity and vice versa. It can be illustrated with the following example: Price(Rs) Quantity (Units) Total expenditure (P*Q) 10 20 Rs 200 8 22 Rs 176 Example 4: From the data given below calculate Elasticity of Demand using Total Expenditure method Price Quantity of Commodity X Quantity of Commodity Y 1 320 1200 2 200 500 3 150 325 4 120 225 5 110 160 Solution: To calculate elasticity we have to find out whether total expenditure moves in the same direction as the price or in the opposite direction which has been explained below: 9
Price Total Expenditure on Commodity X Total Expenditure on Commodity Y 1 320 1200 2 400 1000 3 450 975 4 480 900 5 550 800 The calculation above shows that commodity X is relatively inelastic as price and total expenditure on X moves in the same direction whereas commodity Y is relatively elastic as price and total expenditure on Y moves in the opposite direction. 1.5.4 Geometric Method This method is used to calculate elasticity at a point on the demand curve by using the following formula: Ed = It is used to measure the elasticity at different points on the straight line or linear demand curve as can be shown using the following where it is shown that elasticity varies 0 to on a straight line demand curve. Figure 4 (a) As is seen in the figure above Elasticity can be calculated at different points on the linear demand curve using Geometric method as is shown below: Ed at Point D = DD /0 = Ed at Point S = SD /SD > 1 Ed at Point R = RD /RD = 1 Ed at Point L = LD /LD < 1 Ed at Point D = 0/DD = 0 10
Proof of Geometric method: Figure 4(b) When Price falls from OA to OC, quantity demanded increases from OB to OD. Thus we get P = AC = PQ, Initial price = p = OA = PB Q = BD = QM, Initial Quantity = q = OB Using percentage method of Elasticity and substituting above values we get following: Ed = = QM/PQ * PB/OB Now PQM and PBS are similar triangles BS/PB * PB/OB = BS/OB Also PBS and ROS are similar triangles, so BS/OB = OA/AR = PS/PR = Lower segment/upper segment Geometric method can also be used to calculate elasticity on a non linear demand curve where elasticity is measured by drawing a tangent at the point where elasticity is to be calculated and extending it to touch the X and Y axis and then using the above formula for calculation of elasticity. 11
1.6 DERIVATIONS BASED ON ELASTICITY OF DEMAND Derivation1: Relation between Average Revenue, Marginal Revenue and Elasticity of Demand Total Revenue, TR = Price *Quantity = P*Q Average Revenue, AR = TR/Q = P*Q)/Q = P Marginal Revenue, MR = ΔTR/ΔQ = Δ (P*Q)/ΔQ = P (ΔQ/ ΔQ) + Q (ΔP/ ΔQ) MR = P + Q (ΔP/ ΔQ) Multiplying and dividing above by P we get following MR = P + Q/P (ΔP/ ΔQ)*P............................(1) Also, E d =, (-) 1/ E d = Substituting the value of Ed in equation (1) we get MR = P + P*[(-) 1/ E d], MR = P [1 1/ E d ], MR = AR [1 1/ E d ] Above result shows relation between MR, AR and Elasticity of demand in the below given results: a) If demand curve has unit elasticity i.e. E d = 1, MR = 0 b) If demand curve is relatively elastic i.e. E d > 1, MR = Positive c) If demand curve is relatively inelastic i.e. E d < 1, MR = Negative It can be presented diagrammatically as follows: Figure 5 12
Derivation 2: Two Linear Parallel Demand Curves have unequal elasticity at a given price Two Parallel Demand curves have same slope and slope of the demand curve is given by ΔP/ ΔQ Using percentage method, we calculate elasticity using the following formula: E d = or E d = E d of demand curve D 1 = Figure 6 E d of demand curve D 2 = In above Figure D1 is parallel to D2, so Slope of demand curve D1 = Slope of demand curve D2 Also initial price P* is same in both the demand curves so in the above two equations we are left with E d of demand curve D 1 = E d of demand curve D 2 = As can be seen from figure 6, Q1 < Q2 or Hence proved that E d of demand curve D 1 > E d of demand curve D 2 13
Derivation 3: Two Linear Parallel Demand Curves have unequal elasticity at a given quantity Two Parallel Demand curves have same slope and slope of the demand curve is given by ΔP/ ΔQ Using percentage method, we calculate elasticity using the following formula: E d = or E d = E d of demand curve D 1 = Figure 7 E d of demand curve D 2 = In above Figure D1 is parallel to D2, so Slope of demand curve D1 = Slope of demand curve D2 Also initial quantity Q* is same in both the demand curves so in the above two equations we are left with E d of demand curve D 1 = P 1 E d of demand curve D 2 = P 2 As can be seen from figure 7, P1 < P2 Hence proved that E d of demand curve D 1 < E d of demand curve D 2 14
Derivation 4: A straight line from the origin that intersects two parallel demand curves has equal elasticity at the point of intersection It can be explained with the following figure: Figure 8 Elasticity of the two demand curves using percentage method: E d = or E d = E d of demand curve D 1 = E d of demand curve D 2 = In above Figure D1 is parallel to D2, so Slope of demand curve D1 = Slope of demand curve D2 So in the above two equations we are left with the following E d of demand curve D 1 = E d of demand curve D 2 = Now ΔOAB ~ ΔODC So, AB/OA = DC/OD Thus proving that the demand curves have equal elasticity at the point of intersection 15
Derivation 5: Two intersecting demand curves have unequal elasticity at the point of intersection It is explained with the following figure: Figure 9 Using percentage method we calculate elasticity using following formula: E d = E d of demand curve D 1 is:......................(1) Change in quantity = Q1 to Q Change in price = P1 to P2 E d of demand curve D 1 is:...................... (2) Change in quantity = Q1 to Q2 Change in price = P1 to P2 Initial price and initial quantity is same in both the above cases i.e ratio is same. So we are left with the change in quantity/change in price. Now in case of demand curve D1, change in quantity is Q1 to Q or AC Change in quantity in case of demand curve D2 is Q1 to Q2 or AB Change in price is same in both the demand curves i.e. P1 to P2. 16
So for the comparison we are left with only comparing change in quantity. As can be seen from the figure above AC < AB or we can say that Ed of D1 < Ed of D2. Derivation 6: Relationship between Average Revenue and Marginal Revenue Let Demand function is given by the following equation: P = a bq Where P = Price, Q = Quantity, a = Intercept and b = Slope Total Revenue, TR = P*Q = (a-bq)*q = aq-bq 2 Average Revenue = TR/Q = (aq-bq 2 )/Q = a bq = Price................... (1) Marginal Revenue = ΔTR/ΔQ = Δ(aQ-bQ 2 )/ ΔQ = a 2bQ................... (2) Thus comparing equation (1) and (2) we get the following results: 1) Intercept of both Average Revenue and Marginal Revenue is same = a, that is both start from the same point 2) Both AR and MR are downward sloping that is have a negative slope. 3) Slope of MR is 2b and AR is b that is slope of MR is twice the slope of AR, so MR falls twice as fast as AR and is steeper than the AR. The above three results can be shown in the following figure: Figure 10 17
1.7 SUMMARY Law of demand stated that there is inverse relation between price and quantity demanded but impact of change in price is different in different commodities. Some are impacted more while some are impacted less. The answer to this is not provided by the demand curve itself and hence we have to understand the concept of elasticity. The chapter thus talked about the concept of elasticity that can be further classified into price, income and cross price elasticity. It is the price elasticity however that is commonly talked about and has various methods to calculate to show how responsive is the quantity demanded to change in the price. We have percentage method, arc method, geometric method and total expenditure method. All of these are used under specific conditions. Then there is income elasticity that shows the impact of change in income on the quantity demanded by the consumer. On the basis of income elasticity of demand commodities can be classified as necessities, comfort, luxury or inferior goods. There is also the concept of cross price elasticity that helps in measuring how related two commodities are and whether the goods in the question are substitutes or complements. All these measures of elasticity are helpful in policy formulation by the business firms as well as competitors. The chapter has talked about various derivations showing how the concept of elasticity can be utilized in deriving certain mathematical proofs. Elasticity of demand is important to understand as it can be used for the following decision making: 1) Pricing Decisions: Elasticity of demand of a commodity helps in determining how much price a commodity can command in the market under different market structures. 2) Price discrimination: Elasticity of demand also helps in setting up differential prices as a producer can charge a higher price in a market segment having relatively inelastic demand whereas a lower price has to be charged in the market segment having relatively elastic demand. 3) Government Policy Formulation: Government also takes into consideration the elasticity of demand while determining the quantum of tax to be imposed as commodities having relatively inelastic demand can take the burden of tax whereas a commodity having relatively elastic demand would be unable to take the burden of tax. 1.8 SELF ASSESSMENT QUESTIONS Check your progress Exercise 1: True and False (a) If the cross price elasticity between good X and good Y comes out to be negative the goods are substitutes. (b) Arc elasticity gives the elasticity mid way between two points on the demand curve. (c) If Price increases by 10% and total expenditure on the commodity decreases by 15% then there is unitary elasticity (d) Two parallel straight line demand curves having same slope also have same elasticity at a given price (e) When Marginal revenue becomes negative, Total Revenue also decreases and becomes negative Ans. 1(F), 2(T), 3(F), 4(F), 5(F) Exercise 2: Fill in the Blanks (a) When Price decreases and total expenditure increases, demand must be _ (b) When changes in price is very small we use method of calculating price elasticity 18
(c) When Marginal revenue is positive, elasticity of the demand curve is (d) If demand curve has unitary elasticity, the shape of the demand curve is known as (e) A demand curve is perfectly elastic. (f) When demand is elastic, an increase in price causes quantity demanded to _ and total revenue to _. Ans 1. Elastic 2. Percentage method 3. More than one 4. Rectangular Hyperbola 5. Horizontal 6. Decrease more than proportionately, increase. Exercise 3: Questions 1. Explain the concept of different types of elasticity of demand along with suitable examples. 2. Derive the relation between Marginal Revenue, Average Revenue and Elasticity of Demand 3. What is the difference between percentage method and Arc method of calculation of Price Elasticity of Demand 4. Show that two parallel linear demand curves have unequal elasticity at a given quantity 5. Show that a line that passes through the origin intersecting two parallel demand curves have unequal elasticity at the point of intersection. 1.9 SUGGESTED READINGS Salvatore Dominick, Micro Economics Theory and Applications, Oxford University Press. Browning K. Edgar, Micro Economics Theory and Applications, Wiley Publishing House Pindyk Robert, Microeconomics, Prentice Hall 19
LESSON 2 ELASTICITY OF SUPPLY AND APPLICATIONS 1. STRUCTURE 2.1 Objective 2.2 Introduction 2.3 Law of Supply 2.4 Meaning of Elasticity of Supply 2.5 Types of Elasticity of Supply 2.6 Derivations based on elasticity of Demand 2.7 Summary 2.8 Self Assessment Questions 2.9 Suggested Readings 1.1 OBJECTIVE After reading this lesson you should be able to a) Explain the concept of Elasticity of Supply b) Calculate Elasticity of Supply c) Prove various mathematical derivations using the concept of Elasticity of Supply 1.2 INTRODUCTION Law of supply is in contrast to law of demand which states that there is direct relation between price of a commodity and its quantity supplied. It is from the perspective of the producers as if price increases than only producers have the incentive to supply more as that would cover increased cost of production and desire for more profits. However Law of supply provides nothing about how sensitive is the quantity supplied to change in the price of a commodity which we need to understand to know how the supply is going to react to changes in the price of a commodity as it helps in various policy decisions making. The solution lies in the concept of elasticity of supply. This chapter explains the concept of elasticity of supply and the methods to calculate the elasticity. The various mathematical derivations and proofs used in determining the elasticity of supply are also explained. 1.3 LAW OF SUPPLY Law of supply states the quantity of a commodity which a firm or producer is willing and able to offer for sale at a particular or given price during a given period of time. 20
There are various factors that have an impact on the supply the most important of them being the price of the commodity at which consumers are willing to buy it. Supply function is thus a multivariate function as shown below: QSx = F (Px, Pr, T, Pf, O) Where QSx is the quantity being supplied of a commodity Px is the price of the commodity itself Pr is the price of the related commodities T is the technology being used in the production Pf is the price of factors of production/ raw material being used O is the objectives/goals of the producer. 1) Price of the commodity: There is direct relation between price of the commodity and supply, as when a producer produces more because of law of diminishing marginal returns, more output comes with employment of larger units of factors of production, thereby more and more factors are needed for producing each additional unit that increases the cost and hence more supply would come from the producer only if he gets a higher price to cover the increased cost and get profits. 2) Price of Related commodities: When the price of related commodity increases, then it is beneficial for the producer to stop the production of the existing commodity and go into the production of related commodity to earn higher profits as it is no longer profitable to produce the existing commodity. 3) Technology: When firm uses a superior technology, more output comes with lesser usage of factors of production thereby reducing the cost per unit and hence more can be supplied by the producer because of increase in the productivity. Whereas if an outdated technology is used then more factors of production are required for production of output which increases the cost of production and producer is no more willing to supply it at the same price. 4) Price of Factors of Production: If the price of factors of production that go into the production of a commodity increases, it becomes costly for the producer to produce more as it reduces the profit margin, therefore more supply would come only at increased price. 5) Objectives of the firm: If the objective of the firm is to capture maximum market share rather than profit maximization then such a firm would produce and supply more. Law of supply thus states that there is direct relation between price of a commodity and its supply ceteris paribus. It can be depicted with the help of a supply schedule and supply curve shown in the figure below. Supply schedule is the tabular representation showing relation between price of a commodity and its supply whereas supply curve is the graphical representation between the price and the supply. When price is P1 producers are willing to sell Q1 of the commodity. However if price increases to P2 then consumer would be supplying higher quantity that is Q2 as there is incentive to earn higher profits. 21
Price (Rs) Quantity (Units) 1 10 2 12 3 14 4 16 Figure 1 It is graphical representation of relation between price of a commodity and the quantity being supplied, other things remaining constant. There can be two types of changes in the supply curve, one is movement on the same supply curve and other is shift in the supply curve. There is a movement along the supply curve whenever price changes and shift in the supply curve due to change in any other factor keeping the price of the commodity constant as is shown below in Figure 2: Figure 2 Difference between Movement along supply curve and shift in the supply curve 22
Movement on the Supply Curve When price of a commodity changes other things remaining constant quantity supplied changes which is known as movement on the supply curve. It happens due to of Law of Supply There are two types of movement in the supply curve: Expansion and contraction There is one single supply curve Shift of the Supply Curve When factor other than price of a commodity changes there is change in the quantity supplied known as shift in the supply curve. It does not happen due to of Law of Supply There can be increase (rightward) or decrease (leftward) shift of the supply curve. There are parallel supply curves. Important facts about law of supply Law of supply indicates the positive relationship between price of commodity and quantity supplied, other things remaining constant. Law of supply is one sided as it indicates the effect of change in price on quantity supplied only but does not explain the effect of change in quantity supplied on price of commodity It is the qualitative statement as it explains the direction of change in quantity supplied but does not indicate the magnitude of change. It does not explain any proportional relationship between change in price and the resultant change in quantity supplied. For this we need elasticity of supply which is the next topic to be done. 1.4 MEANING OF ELASTICITY OF SUPPLY Elasticity of supply measures the responsiveness of the quantity supplied to the change in the price of the commodity other things remaining constant. Elasticity thus shows the proportionate change in the quantity supplied due to proportionate change in the price of a commodity. There are various factors that have an impact on the elasticity of supply which are given below: 1) Raw Materials: If raw materials used for the production are available in plenty and are available at less cost then supply can be increased thereby making it elastic whereas if raw materials are scarce or expensive or both then supply would be inelastic as raw materials cannot be obtained easily and production cannot increase by a greater quantity in spite of increase in the prices. 2) Nature of the commodity produced: If goods are perishable in nature and cannot be stored then supply would be inelastic as stock of the good that producer keeps with himself to be brought to the market as supply with increase in the price would be less but for goods that can be easily stored supply can increase with increase in price as more stock can be kept of such type of commodities by the producer rendering the supply elastic. 3) Time to Produce: If producers have enough time with them to respond to changes in price then supply would be elastic otherwise it would be inelastic. This is because of the fact that when the goods are not to be provided quickly then producers have enough time to procure the raw material and produce the commodity and bring it to the market as supply therefore supply would be relatively elastic and vice versa. 23
4) Number of Producers: If there are many producers in the market, then supply can be increased easily thereby supply being elastic and vice versa. This is because when price increases all the producers would increase the production and therefore supply would increase by a proportionately greater amount making the supply elastic and opposite would be the case if there are only few sellers of a particular commodity. 1.5 TYPES OF ELASTICITY OF SUPPLY When Price of a commodity increases/decreases its quantity supplied also increases/decreases ceteris paribus Law of Supply. But by how much the quantity would change is given by elasticity of supply. Elasticity of supply can be measured using the following methods: 1) Percentage Method 2) Arc Method 3) Geometric Method Percentage Method Percentage method is the most commonly used method for calculation of elasticity of Supply. This method is used to calculate elasticity at a particular point on the supply curve. It is calculated as follows using Percentage Method: Es = or Es = Where Change in quantity supplied Change in Price Initial Price Initial Quantity Supplied There is a positive sign in the above formula indicating direct relation between price and quantity supplied showing the incentive of the producer to produce more at higher price. Using Percentage method Elasticity of supply can be classified in the following five categories: 1. Perfectly Elastic Supply: When supply curve is horizontal, parallel to X axis, supply is said to be perfectly elastic. It shows that even minutest of the change in the price would shrink the quantity supplied to zero. There is no such example found in real life as it is just an imaginary situation. Es =. It can be represented using the figure number 3 Price (Rs) Quantity Supplied (units) 10 100 10 120 10 150 : 24
Figure 3 Above figure shows a perfectly elastic supply curve as any number of units of the commodity can be supplied at the existing price. Relatively Elastic Supply: When because of 10% change in the price, quantity supplied changes by more than 10%, supply is said to be relatively elastic. Supply curve here is relatively flatter showing that proportionate change in quantity supplied is more than proportionate change in the price. Es > 1. It is represented in Figure 4 Price (Rs) Quantity (units) 10 100 12 140 15 200 Figure 4 25
Above figure shows when price increases from P2 to P1 then supply increases from Q1 to Q2 but change in quantity is more than change in the price. Supply could be elastic for the following reasons: 1) If there is spare capacity in the factory. 2) If there are stocks available. 3) In the long run supply will be more elastic because capital can be varied. 4) If it is easy to employ more factors of production. 1) Unitary Elastic: When because of 10% change in the price, quantity supplied also changes by 10%, supply is said to be unitary elastic. Supply curve here is a straight line from the origin showing that proportionate change in quantity supplied is equal to proportionate change in the price. Price (Rs) Quantity (units) 10 100 12 120 14 140 Es = 1. It is represented in Figure 5 Figure 5 Here when price increases from P1 to P2 quantity supplied also increases from Q1 to Q2 and change in quantity supplied is equal to change in price. 2) Relatively Inelastic Supply: When because of 10% change in the price, quantity supplied changes by less than 10%, supply is said to be relatively inelastic. Supply curve here is relatively steeper showing that proportionate change in quantity supplied is less than proportionate change in the price. Price (Rs) Quantity (units) 10 100 12 110 15 135 26
Es < 1. It is represented in Figure 6 Figure 6 In figure above when Price increases from P1 to P2, quantity supplied increases from Q1 to Q2 but change in quantity is less than change in price. Supply can be inelastic due to the following reasons: 1) Firms operating close to full capacity. 2) Firms have low levels of stocks, therefore there are no surplus goods to sell 3) In the short term, capital is fixed in the short run e.g. firms do not have time to build a bigger factory. 4) If it is difficult to employ factors of production, e.g. if highly skilled labour is needed 5) With agricultural products supply is inelastic in the short run, because it takes time to grow crops. 3) Perfectly Inelastic Supply: When there is no change in the quantity supplied irrespective of how much change is there in the price, supply is said to be perfectly inelastic. Here supply curve is vertical parallel to Y axis. Price (Rs) Quantity (units) 10 100 12 100 15 100 27
Figure 7 Here figure above shows that there is no change in the quantity supplied irrespective of the change in the price. It happens when supply cannot increase that is it is fixed irrespective of how much change there has been in its price. For example: Painting of Mona Lisa or any Antique piece whose supply is fixed and cannot be increased however price it commands in the market, its supply would be always perfectly inelastic (fixed) at all levels of prices. Example 1: From the following calculate Elasticity of supply and comment on the relation between price and quantity supplied Price Quantity 10 100 8 50 Using percentage method elasticity can be calculated as follows: Es = Es = = = 2.5 As Elasticity is greater than one so it is relatively elastic showing that the proportionate change in quantity demanded is more than the proportionate change in price that is supply is sensitive to the change in price. Example 2: From the following calculate Elasticity of supply and comment on the relation between price and quantity supplied Price Quantity 5 100 10 200 28
Es = Es= = = 1 As Elasticity is equal to one so it is unitary elastic showing that the proportionate change in quantity demanded is equal to proportionate change in price. Example 3: From the following calculate Elasticity of supply and comment on the relation between price and quantity supplied Price Quantity 2 50 8 80 Using percentage method elasticity can be calculated as follows: Es = Es = = = 0.2 As Elasticity is less than one so it is relatively inelastic showing that the proportionate change in quantity demanded is less than the proportionate change in price that is supply is less sensitive to the change in price. Arc Method A limitation of the percentage method is that it gives elasticity at a particular point on the supply curve and if it is measured for price increase answer is different from when elasticity is calculated for price decrease. To overcome this problem Arc method is used. This method measures the elasticity mid way between two points. It is used when there is very small change in the price of the commodity. It can be explained with the following example Example 4: Price Quantity 10 100 8 60 Using Arc method elasticity can be calculated as: Es = = = 2.25 Here instead of using initial price and initial quantity in the formula as is used in the percentage method, we use average price and average quantity which is calculated by taking the average of initial and final price and initial and final quantity respectively. It is giving elasticity between the price 10 and 8 in the above example that is elasticity is 2.25 neither at price of Rs10 or Rs8 but midway. 29
Example 5: Point Price Quantity A 2 10 B 4 40 Calculate Elasticity for the following cases: 1) From Point A to B 2) From Point B to A and 3) Midway between A and B Solution: To calculate Elasticity from point A to B and from B to A we would be using Percentage method and for third case that is midway between A and B Arc method would be used. A to B Es = Es = = = 3 B to A Es = Es = = = 1.5 Mid Way between A and B using Arc Method Es = = = 0.018 Thus the result above shows that elasticity is different when we use different methods as in percentage method we use initial price and initial quantity as one of the component, so when we calculate for price increase and for price decrease the initial price and quantity changes thereby giving different results and in case of Arc method we use average price and average quantity instead of initial price and quantity getting elasticity mid way between the two points. Geometric Method This method calculates elasticity of supply at a point on the linear demand curve by using the formula given below 30
Es = = Intercept on X-axis/Quantity supplied at that price According to Geometric method Elasticity of Supply can be classified under three heads: 1) If Supply curve passes through X axis then it is relatively Inelastic 2) If Supply curve passes through Y axis then it is relatively Elastic 3) If Supply curve passes through Origin it is unitary Elastic This would be explained using the derivations in the next segment (2.6). Example 6: Explain how Time factor has an impact on the elasticity of supply Solution: Time has an important role to play in the production of the commodities as in the long run production can be easily expanded by increasing even fixed factors of production while in the short run production can be expanded to a certain extent. Thus elasticity is usually relatively inelastic in the short run and becomes elastic in the long run. 1.6 DERIVATIONS BASED ON ELASTICITY OF DEMAND Derivation 1: If a supply curve passes through the Price Axis (Y axis), it is relatively elastic i.e. Es > 1. Using Percentage method to calculate Elasticity of supply, we get Es as: E s = E s =............................(1) If Price increases from P1 to P2 then: = Q1Q2 or AC = P1P2 or BC P or Initial Price = OP1 = AQ1 Q or Initial Quantity = OQ1 Putting above in Equation 1 we get the following: E s =............................(2) Now AC/BC = DQ1/AQ1, Putting this in Equation 2, we get E s as follows: 31
DQ1/OQ1 = DQ1 > OQ1 Thus the above proves that Es > 1 if Supply curve passes through the Y axis or supply curve is flatter. Figure 8 Derivation 2: If a supply curve passes through the Quantity Axis (X axis), it is relatively inelastic (Es < 1). Using Percentage method to calculate Elasticity of supply, we get Es as: E s = E s =............................(3) If Price increases from P1 to P2 then: = Q1Q2 or AC = P1P2 or BC P or Initial Price = OP1 = AQ1 Q or Initial Quantity = OQ1 Putting above in Equation 3 we get the following: 32
E s =............................(4) Now AC/BC = DQ1/AQ1, Putting this in Equation 4, we get E s as follows: DQ1/OQ1 = DQ1 < OQ1 Thus the above proves that Es < 1 if Supply curve passes through the X axis or Quantity Axis, supply curve is Steeper. Figure 9 Derivation 3: If a supply curve passes through the Origin, it is Unitary elastic i.e. Es = 1. Using Percentage method to calculate Elasticity of supply, we get Es as: E s = E s =......................(5) If Price increases from P1 to P2 then: = Q1Q2 or AC 33
= P1P2 or BC P or Initial Price = OP1 = AQ1 Q or Initial Quantity = OQ1 Putting above in Equation 5 we get the following: E s =...................... (6) Now AC/BC = OQ1/AQ1, Putting this in Equation 6, we get E s as follows: = 1 Thus the above proves that Es = 1 if Supply curve passes through the origin. 1.7 SUMMARY Figure 10 As elasticity of demand, elasticity of supply measures responsiveness of quantity supplied to a change in its price. It varies from zero to infinity. There are three methods that can be used for calculation of Elasticity of Supply Percentage method, Arc method and Geometric method. Percentage method is usually used for measuring elasticity that can classify it in five types namely- Perfectly inelastic, relatively inelastic, unitary elastic, relatively elastic and perfectly elastic. Arc method gives elasticity in between (midway) changes in price and quantity. It is indifferent whether elasticity is being calculated for price or price decrease as it uses average price and average quantity. Geometric method classifies elasticity into three types relatively elastic, unitary elastic and relatively inelastic. When supply curve passes through the Y axis it is more than unitary elastic. When it passes through the origin there is unitary elastic supply curve and if it passes through X axis then it is 34
less than unitary elastic. Elasticity of supply is taken into consideration by government, policy makers and business firms to determine various measures to be undertaken with respect to various decisions that are taken by them. 1.8 SELF ASSESSMENT QUESTIONS Check your progress Exercise 1: True and False (a) If the supply curve passes through the origin, it is perfectly elastic. (b) There is no difference between Elasticity of supply and slope of supply curve (c) When Elasticity of supply is zero, it is called perfectly inelastic supply (d) Elasticity of supply is unaffected by the expectations about future price (e) When supply curve is a horizontal straight line parallel to X axis, Es = infinity (f) Elasticity of a commodity that is perishable in nature has inelastic supply (g) Elasticity for a rare thing like Kohinoor is Elastic in supply (h) If supply curve passes through origin it is relatively inelastic (i) Arc elasticity method of elasticity of supply calculates elasticity midway between two points Ans. 1(F), 2(F) 3(T), 4(F), 5(T), 6(T), 7(F), 8(F), 9(T) Exercise 2: Fill in the Blanks (a) When Es > 1, supply curve is _ (b) Longer the time period, _ is the supply. (c) Supply curve that is vertical, parallel to Y axis has _ supply (d) If factors of production used in the production of a commodity are scarce, supply is _ (e) Supply Curve passing through origin has _ Elasticity of supply. (f) A supply curve that passes through the quantity axis has relatively _ supply Ans 1. Flatter 2.Relatively Elastic 3. Perfectly Inelastic 4. Relatively Inealstic 5.Unitary 6. Elastic Exercise 3: Questions 1. Explain the concept of different types of elasticity of supply along with suitable examples. 2. Using mathematical derivation, prove that a demand curve that passes through the Price Axis has relatively elastic supply curve 3. Explain the importance of elasticity of supply 35
4. How Elasticity of supply is measured, explain using percentage method 5. Differentiate between Elasticity of demand and elasticity of supply 6. Prove that a supply curve that passes through origin has unitary elasticity 7. How elasticity of supply can be measured using Geometric method. Also show how it varies from zero to infinity on a straight line supply curve 8. Explain the difference between percentage method and Arc method of calculating Elasticity of Supply 1.9 SUGGESTED READINGS Samuelson Nordhaus, Microeconomics, McGraw Hill. Salvatore Dominick, Micro Economics Theory and Applications, Oxford University Press. Browning K. Edgar, Micro Economics Theory and Applications, Wiley Publishing House 36
Unit 2 CONSUMER BEHAVIOR 37
LESSON 1 CONCEPT OF INDIFFERENCE CURVE AND BUDGET LINE 1. STRUCTURE 1.1 Objective 1.2 Introduction 1.3 Concept of Indifference Curve 1.4 Concept of Budget Line 1.5 Consumer s Equilibrium 1.6 Summary 1.7 Self Assessment Questions 1.8 Suggested Readings 1.1 OBJECTIVE After reading this lesson, you should be able to a) Understand the concept of Indifference Curve and Budget Line b) Understand the slope of Indifference Curve and Budget Line c) Differentiate between the slope of Indifference Curve and Budget Line d) Establish and derive the Consumer s Equilibrium 1.2 INTRODUCTION Law of demand stated that there is inverse relationship between price of a commodity and its quantity demanded, theory of consumer behavior helps in providing the reason behind the negative slope of demand curve. Different economists have explained the concept of Utility in different manners like Marshall said that utility is Cardinal that can be quantified (measured) using an imaginary unit Util or by the Price that the consumer is willing to spend on the commodity. Hicks and Allen on the other hand using Indifference Curve Analysis said that utility is Ordinal that can be only ranked and not measured. Utility is in fact the want satisfying power of a commodity which is ethically neutral. This chapter deals with the ordinal concept of utility explaining the concept of Indifference curve and budget line thereby moving to the Consumer s Equilibrium. 38
1.3 CONCEPT OF INDIFFERENCE CURVE Concept of Indifference Curve is based on the following assumptions: 1) Rational Consumer: Consumer is rational that is he would like to maximize his satisfaction given the money income and price of the commodities 2) Ordinal Utility: Utility is Ordinal that is it can be ranked. Consumer can rank various commodities in terms of satisfaction derived from it. Utility cannot be measured or quantified. 3) Consistency: Consumer is consistent in his choice. If a consumer has revealed his preference for a particular combination then a consumer would always prefer the same if the conditions are same. 4) Transitivity: If a consumer has preferred A > B and B > C, then by notion of transitivity A > C. 5) Non Satiety: Saturation point has not been reached that is consumer wants more and more of a commodity. Based on these assumptions we can now move on to the concept of Indifference Schedule. It would be explained with the help of the following example: Table 1 Combinations Units of Tea Units Of Biscuits A 1 18 B 2 13 C 3 9 D 4 6 E 5 4 Out of the above combinations all having the same price if consumer is indifferent between the five combinations then he is said to have satisfaction from each of the five combinations. A = B = C = D = E Thus tabular representation of different combinations of two commodities that gives the consumer equal satisfaction is known as Indifference Schedule. It can be plotted in the form of a graph as follows: Figure 1 39
Indifference Curve is thus the Graphical representation of different combinations of two commodities that gives the consumer equal satisfaction. Indifference curve has the following properties: 1) Indifference curves are downward sloping: It can be explained with the concept of absurdity that is upward sloping, vertical and horizontal indifference curves are not possible, thus the only possible shape being downward sloping. It can be explained with the following diagram. Figure below shows that if we increase one of the commodity or both the commodities without reducing the other still we are on the same indifference curve except the last diagram. The rest figures show that marginal utility of the commodity that has been increased is zero but it is not possible because of the assumption of non satiety. Hence the first three shapes are not possible and the only shape possible of the indifference curve is downward sloping where consumer is reducing one commodity and increasing the other thereby having the same satisfaction. As in first diagram of the figure below we are increasing both X and Y and still are on the same Indifference Curve (IC), showing that the impact of increasing X and Y is nil or MUx = 0 and MUy = 0 which goes against our basic assumption of more is better. Similarly in second diagram IC is horizontal showing that keeping Y constant and increasing X has no impact on the satisfaction as consumer is on the same IC showing MUx = 0 which is again not feasible. Similarly in vertical IC there would be zero MUy which is not feasible. Figure 2 40
2) Indifference Curve is Convex to the origin: Convexity implies that the slope of the indifference curve reduces as one goes down the indifference curve. The reason for convexity lies in the Diminishing MRSxy or Marginal rate of substitution which is explained with the concept of slope of indifference curve. 3) Two Indifference curves can never intersect: This would be explained with the concept of Transitivity using Figure 3: As can be seen two points on IC1 that gives equal satisfaction are B = E. Similarly two points on IC2 that gives equal satisfaction are A = E. By the notion of Transitivity A = B but these two points are on two different Indifference curves hence A B showing that two IC s can never intersect. Figure 3 4) Higher Indifference curve represents higher satisfaction: It would be explained with the concept of Indifference Map which is as follows: Figure 4 41
Indifference curve map is the combination of different Indifference Curves on the same axis such that higher Indifference Curve represents higher satisfaction. As can be seen from figure 4 initially consumer is at A where he is having a combination of X and Y, now if the consumer keeps one of the commodities constant and increases the other he moves to either B or C whereby his satisfaction increases as he has not reduced the other commodity. Another possibility is to move to point D where consumer increases the consumption of both the commodities. This shows that points B,C or D gives the consumer higher satisfaction and he has moved to a higher Indifference Curve showing that an Indifference Curve which is farther from the origin gives higher satisfaction. Slope of Indifference Curve Marginal Rate of Substitution (MRS) gives the slope of Indifference Curve. It shows how many units of commodity Y the consumer is willing to forego for one additional unit of commodity X such that the satisfaction of the consumer remains same. It would be explained using the following example and figure: Table 2 Combinations Units of Tea Units Of MRS Biscuits A 1 18 - B 2 13 5:1 C 3 9 4:1 D 4 6 3:1 E 5 4 2:1 The table above shows that when we move from point A to point B, consumption of commodity Y reduces by 5 units and consumption of X increases by 1 unit and consumer is having the same satisfaction as he is on the same Indifference Curve. Thus it shows that consumer is willing to forego 5 units of Y for one additional unit of X if he wants to keep his satisfaction same. Similarly on moving from point B to point C, he is willing to forego only 4 units of Y for one extra unit of X and this sacrifice of Y for each additional unit of X keeps on diminishing as we come down the Indifference Curve. The reason being that when Y reduces and X increases consumer has relatively more of X and less of Y thereby marginal utility of Y increases and X decreases and he has to give less and less of Y for each additional unit of X and also because the relative capacity to sacrifice of the consumer reduces as he comes down the Indifference Curve. At point A he has plenty of biscuits and less of tea thus he is willing to give 5 units of biscuits for one additional cup of tea. But at point D he has only 6 units of biscuits left thus he cannot sacrifice the same amount of biscuit for each additional cup of tea. The same thing can be explained graphically by showing that MRS is the slope of the indifference curve and it reduces as we come down the Indifference Curve. Therefore IC is steeper at the top and flatter at the bottom - the reason for the convex shape of Indifference curve. As we know mathematically the slope is change in quantity of Y divided by change in quantity of X. So here slope is calculated as follows: From point A to B = -ΔY/ΔX = -5 Biscuits/+1Tea as consumer is reducing biscuits by 5 units so we have a negative sign and increasing tea by 1 unit will lead to a positive sign. 42
From B to C = -4 Biscuits/+1Tea = -4/1 From C to D = -3 Biscuits/+1Tea = -3/1 From D to E = -2 Biscuits/+1Tea = -2/1 The above slopes are represented by the shaded portion in the Figure 5: Figure 5 Thus we get the measurement of slope as MRSxy =. It can also be written as: Reduction in Satisfaction because of decreasing Y = Increase in satisfaction due to increasing X - (MUy)(ΔY) = (MUx)( ΔX), - (ΔY)/( ΔX) = (MUx) / (MUy) Thus slope of IC = MRSxy = Reasons for diminishing MRSxy is: Relative capacity to sacrifice commodity Y diminishes as one come down the Indifference curve. Change in marginal utility of the commodity as consumption of commodity X increases and commodity Y decreases, thereby less and less of Y is to be given for an additional unit of X keeping the utility constant. Relative importance attached by the consumer to the goods- if commodity Y is more important than consumer would be willing to give less of units Y for additional unit of good X and vice versa. 43
Indifference curve map depicted what a consumer would like to possess but what a consumer can possess depends upon the money income of the consumer and prices of the commodities that consumer can consume. This takes us to the next topic which is Budget Line that would be taken up next: 1.4 CONCEPT OF BUDGET LINE Budget line shows different combinations of two commodities that consumer can actually possess given his money income and prices of the two commodities ceteris paribus. This can be explained with the help of an example: Let Money Income M = Rs 100 Price of commodity X, Px = Rs 10 per unit Price of commodity Y, Py = Rs 5 per unit Now given the above information and assuming that consumer spends his entire money income on either X or Y or both, we can have following combinations: Spending his entire money income on consumption of X he can get 100/10 = 10 units of commodity X. Here consumer would be at point A in the figure 6. Spending his entire money income on consumption of Y he can get 100/5 = 20 units of commodity Y. Here consumer would be at point B in the figure 6. Spending the entire money income on combination of X and combination Y. here consumer can lie anywhere between points A and B. Figure 6 A consumer cannot lie above the budget line as he does not have the money income to support that level of consumption, it being unattainable. Similarly any point below the budget line is though feasible but 44
inefficient as consumer is not spending his entire money income. So points lying on the budget line represent the feasible and attainable combinations where the consumer would be. Slope of Budget Line Slope of any line is given by the mathematical formula of (Y2-Y1)/(X2-X1). Using the same concept slope of the budget line can be calculated as: Slope = = = Thus slope of the budget line is given by the ratio of two prices and negative sign depicts a downward sloping budget line. Equation of the Budget Line Aggregate money income that is M in above case is spent either on commodity X or commodity Y or both. Thus equation of budget line can be written as: Money Income = Total expenditure on X + Total Expenditure on Y M = TEx + TEy M = PxQx + PyQy Changes in the Budget Line There are two types of changes in the Budget Line: 1. Parallel Shift This happens when the slope of the budget line is same. It takes place when either the Money Income of the consumer changes keeping constant the prices of the commodities or when the money income is constant but prices of the commodities change in the same proportion thereby keeping the slope that is given by Px/Py unchanged. There can be parallel rightward shift or parallel leftward shift as is explained with following Example and Diagram Example 1: Taking the original example and comparing it with two cases one where money income changes ceteris paribus and other where prices change in the same proportion keeping constant the money income Original Case: M = Rs 100 Px = Rs 10 per unit Py = Rs 5 per unit New Case 1: M = Rs 200 (it has doubled) Px = Rs 10 per unit Py = Rs 5 per unit The above two are represented in the figure below: 45
Figure 7 Above case represents that when money income changes there is parallel shift in the budget line as slope that is ratio of the prices is same. In above case when money income increased there is a parallel rightward shift. The reason being that with the prices being unchanged consumer can now consume more of the commodities. Similarly there would be parallel leftward shift if money income decreases. Other situation when there is parallel shift in the budget line is given below: New Case 2: M = Rs 100 Px = Rs 5 per unit Py = Rs 2.5 per unit Here both prices are reduced to half showing that there is a parallel rightward shift in the budget line as slope is still the same and at reduced prices consumer can buy more of the commodities with increased purchasing power (real income) though his nominal money income is the same. It is represented with the figure 8. Similarly if prices increase in the same proportion there would be a leftward parallel shift showing decrease in the purchasing power and hence reduced consumption of the commodities. 46
Figure 8 1) Pivot or rotation or non parallel change movement of the budget line If there is a change in any of the three variables i.e. money income, price of commodity X or price of commodity Y in such a manner that the slope changes then there is a rotation of the budget line. Following are the few cases that can take place. We have compared them with the original case. New Case 3: M = Rs100 Px = Rs5 per unit (it has halved) Py = Rs5 per unit New Case 4: M = Rs100 Px = Rs10 per unit Py = Rs10 per unit (it has doubled) New Case 5: M = Rs100 Px = 20 per unit Py = 2.5 per unit. All the above explained cases are shown in the figure 9 and 10: 47
Figure 9 Figure 10 Above two figures show how the budget line rotates along X axis and Y axis because of the change in the slope. In figure 9 because of reduction in price of commodity X without any change in money income and price of commodity Y consumer can buy more of commodity X if he spends his entire income on X. The slope of the budget line reduces to -1 (-5/5) (taking only the absolute value ignoring the negative sign) compared to -2 (- 10/5) the slope of original case making the budget line pivot out and becomes flatter. If however price of X would have increased there would have been an increase in the slope and reduction in the purchasing power and hence inward (leftward) pivot of the budget line would have taken place. Similarly in Figure 10 price of commodity Y has doubled other things remaining constant thereby reducing the purchasing power of the consumer and reducing the slope to -1, making the budget line pivot along Y axis and flatter. The opposite would have happened with reduction in the price of commodity Y. Figure 11 48
Here both Price of commodity X and Price of commodity Y have changed but neither in the same proportion nor in the same direction thereby making a non parallel movement in the budget line as shown in the figure 11. Example 2: Let us say there are two consumers A and B. while consumer A has stronger preference for commodity X. Consumer B has stronger preference for commodity Y. show this using Indifference Curve analysis and concept of Marginal Rate of Substitution. Solution: Consumer A having stronger preference for commodity X would be willing to forego more of commodity Y for an additional unit of commodity X whereas consumer B having stronger preference for commodity Y would be willing to forego less units of commodity Y for each additional unit of commodity X, thus in case of consumer A, MRSxy would be more and Indifference curve would be steeper as slope is greater whereas in case of consumer B, MRSxy would be less and Indifference curve flatter as slope is lesser. This can be shown using the following figures where figure 12 is of consumer A and figure 13 for consumer B. Figure 12 Figure 13 Example 3: Explain the concept of Composite good. Solution: In the Indifference Curve analysis we considered two commodities that is Tea and Biscuit or commodity X and Y but in reality a consumer consumes various types of products and to show it in a two dimensional diagram the solution is composite good. Under this all goods except the most important (commodity X) is plotted on X axis and all other goods clubbed together on Y axis as other goods. E.g. Weekly Income of consumer = Rs 100, Price of Food (Pf) = Rs 10 per unit 49
Figure 14 Composite Good, Slope = Y2 Y1/X2-X1 = (0 M)/ (M/Px-0) = -Px So slope of budget line in case of composite good is nothing but the price of the good on X axis. 1.5 CONSUMER S EQUILIBRIUM Equilibrium is a position of rest where there is no tendency to change. A consumer is said to be in equilibrium when he maximizes his satisfaction given the money income and the prices of two commodities. The concept of consumer equilibrium is based on the following assumptions: 1. Rational Consumer: Consumer is rational; he would like to maximize his satisfaction within the constraint of money income and prices of the commodities. 2. Ordinality: Satisfaction cannot be quantified but can be ranked on the basis of utility derived. 3. Monotonic Preferences: Consumer would choose a bundle with more of either of the commodity or both the commodities. That is more is preferred to less by the consumer. 4. Consistency: Consumer is consistent in his behavior. If the conditions are same consumer would go with the same set of bundle. 5. Transitivity: If consumer chooses A over B and B over C then A is preferred to C. For understanding the concept of consumer s equilibrium we need two things: Indifference Curve Map It is the loci of various indifference curves on the same axis where higher indifference curve represents higher satisfaction. A consumer would be finally on which indifference curve would depend on his budget line. 50
Figure 15 Budget Line It is the loci of various combinations of two commodities that consumer can possess given his money income and prices of the two commodities. Figure 16 So from the above two we can analyze that indifference curves represent what consumer desires and budget line shows what consumer can actually possess. To get the consumer equilibrium we superimpose the above two that is indifference map and budget line and get the figure 17: 51
Figure 17 From figure 17 we see that point A,B and E are within the consumer s budget set that is the commodities that consumer can possess. Point C is unattainable given the budget line. Now out of the three points mentioned above there can be only one equilibrium. Points A and B though attainable but they are not feasible as they are on a lower indifference curve that gives lesser satisfaction therefore consumer would not stop here. Point E is the highest point that is within the consumer s capacity to get. Thus E is the Equilibrium as it is on the highest Indifference curve and also within consumer s budget. Hence it can be said that a consumer is at equilibrium when he reaches the highest indifference curve that is tangent to the budget line. The two conditions of budget line that need to be attained are: First Order Condition: Budget line should be tangent to the highest possible Indifference Curve. So the slope of the indifference curve and budget line should be equal at the point of equilibrium. Following condition should be fulfilled: Slope of Indifference Curve = Slope of Budget Line MRSxy = = Second Order Condition: Indifference curve should be convex at the point of equilibrium that is the slope of Indifference curve or MRSxy should be diminishing. As if slope is increasing or Indifference curve is concave to the origin there is a corner solution as shown in Figure 18: 52
Figure 18 Here Point E is not the point of equilibrium though here Indifference curve is tangent to the budget line as in case of concave indifference curve it is possible to reach a higher indifference curve without satisfying the condition of tangency. In figure 18 Point A is the equilibrium where consumer is consuming only commodity Y and nothing of commodity X. This can be the case when if consumer buys one unit of a commodity then it being so expensive that he has to go without having anything of the other commodity. This is the case of Corner Solution as equilibrium is lying at one corner. There can be other case also where consumer is buying only commodity X and nothing of commodity Y as shown below: Figure 19 53
Example 4: Draw Indifference curves between Pepsi and beer for two individuals Shreyas and Saleem with Shreyas having stronger preference for Pepsi and Saleem having stronger preference for beer. (Delhi, SOL B.Com (H), 2011) Solution: It can be explained with the help of indifference curves and their slope. If we take Pepsi on Y axis and Beer on X axis then in the first case of Shreyas who has stronger preference for Pepsi he would be willing to give less and less units of commodity Y (here Pepsi) for each additional unit of X (here Beer) thus having flatter indifference curves whereas in the second case of Saleem who has stronger preference for commodity X or Beer he would be willing to give more and more of commodity Y or Pepsi for each additional unit of Beer thereby having steeper indifference curves. The result is shown in the figure 20: Figure 20 Example 5: Rohit s budget line relating to good X and good Y has intercepts of 72 units of good X and 60 units of Good Y. If the price of Good X is Rs. 5, what is Rohit s income? Calculate the price of good Y and slope of the budget line. Write the equation for the budget line. (Delhi, SOL B.Com (H), 2011) Solution: We know that the Budget line is given by the equation: M = PxQx + PyQy. Now if Rohit buys only commodity X then the equation reduces to: M = PxQx as Qy = 0 M = 5*72 = Rs360 = Money Income Now if Rohit buys only commodity Y then the equation reduces to: M = PyQy as Qx = 0 360 = Py*60, Py = Rs 6 Slope of the Budget Line = -Px/Py = -5/6 Equation for Budget Line: 54
360 = 5Qx + 6Qy Example 6: Vandana spends her entire monthly income of Rs 600 on two commodities X and Y. If the price of X is Rs.30 and price of Y is Rs.10 per unit If she consumes 12 units of X and 24 units of Y. Is she in equilibrium at this point on her budget line? Show the result in a diagram. (Delhi,SOL B.Com (H), 2011) Solution: For the consumer to be in equilibrium following condition should be satisfied: Slope of Indifference Curve = Slope of Budget Line MRSxy = Px/Py In above example: Coordinates of X and Y axis would be calculated as: M/Px = X coordinate = 600/30 = 20 units and M/Py = Y coordinate = 600/10 = 60 units Now if she consumes 12 units of X and 24 units Y she would be spending 12*30+10*24 = 600 Thus she is on the budget line as she is spending her entire money income but whether she is on the highest Indifference curve or not would be determined by the equilibrium condition, it is explained as: MRSxy = -30/10 = -3. So if slope of Indifference curve is -3 then she is in equilibrium otherwise not. Figure 21 55
Criticism of Indifference Curve Approach Indifference curve given by Hicks and Allen though is advancement over the cardinal approach of Marshall but still it suffers from various limitations like: 1) Assumption of consistency and transitivity my not exist in real life because there are many behavioral factors that an impact on the consumer s choice. 2) Indifference curve approach assumes that consumer has full knowledge of all the options available to him but a consumer is faced by bounded rationality wherein he does not have the time and knowledge to explore all the possibilities 3) It makes use of mostly two commodity cases and in other cases composite good is taken wherein all the goods are clubbed under one which is not feasible. 4) The foremost assumption here has been that consumer is rational but in various cases consumer behaves in an irrational manner having no justification for his choices. 5) Indifference curve analysis is based on Weak Ordering Hypothesis where consumer is indifferent between various bundles that comprise of different combinations of two commodities. However Revealed preference theory given by Samuelson is based on Strong ordering which is a step ahead of the Hicksian approach. 1.6 SUMMARY Utility or the want satisfying power of a commodity has been the topic of discussion for long. Earlier it was considered a cardinal concept where an imaginary unit Util was created to measure utility to make a decision about the commodities to be consumed by the consumer. Later the cardinal approach gave way to ordinal where utility was taken as a non quantifiable concept and it was assumed that it can be ranked that is consumer can rank the satisfaction that he gets from different commodities or different combinations but cannot quantify them. This gave way to the concept of Indifference curve that provided different combinations of two commodities that the consumer can possess and provides the consumer equal satisfaction. Then there is concept of Budget Line which provides different combination of commodities that consumer can actually possess with his money income. These two are then used to reach the equilibrium of the consumer wherein he gets maximum satisfaction within the budget constraint. However the concept of indifference curve suffers from various limitations because of the assumptions that it is based on but it does not reduce its usefulness as a step to understanding consumer behavior. 1.7 SELF ASSESSMENT QUESTIONS Check your progress Exercise 1: True and False (a) Indifference curve can be horizontal or vertical. (b) Slope of Indifference curve increases as we go down the curve. 56
(c) In case of concave Indifference curve the condition of tangency of budget line and the indifference curve is not required (d) In case of Indifference Map a higher indifference curve show higher satisfaction (e) A point above the budget line is also attainable by the consumer. Ans. 1(F), 2(F), 3(T), 4(T), 5(F) Exercise 2: Fill in the Blanks (a) For a consumer to be in equilibrium the slope of indifference curve and budget line should be _ (b) When we shown many commodities on the axis of a Indifference curve it is called (c) In case of Concave Indifference curve we have a solution called (d) Budget Line has a slope (e) Monotonic Preference means a consumer chooses a combination that has _ of either one or both the commodities. (f) Indiiefernce Curve is based on the assumption of _ utility Ans 1. Equal 2.Composite Good 3. Corner Solution 4.Negative 5. More 6. Ordinal Exercise 3: Questions 1. Explain the concept of Budget Line. What factors can bring a change in the budget Line 2. Derive the Consumer s Equilibrium using the concept of Ordinal Utility 3. What are the assumptions of Ordinal Utility Approach. 4. What do you mean by Composite Good Concept 1.8 SUGGESTED READINGS Salvatore Dominick, Micro Economics Theory and Applications, Oxford University Press. Browning K. Edgar, Micro Economics Theory and Applications, Wiley Publishing House Pindyk Robert, Microeconomics, Prentice Hall 57
LESSON 2 INCOME CONSUMPTION CURVE, PRICE CONSUMPTION CURVE 1. STRUCTURE 1.1 Objective 1.2 Introduction 1.3 Exceptions to Convex shape of Indifference curve 1.4 Concept of Income Consumption Curve 1.5 Concept of Price Consumption Curve 1.6 Summary 1.7 Self Assessment Questions 1.8 Suggested Readings 1.1 OBJECTIVE After reading this lesson, you should be able to a) Understand the exceptions to convex shape of Indifference Curve b) Comprehend the Income Consumption curve and Price Consumption curve c) Divide the price effect into substitution and income effect 1.2 INTRODUCTION After understanding the Indifference curve and its properties including the property that these curves are convex to the origin, we shall now relax this assumption and we would be explaining exceptions to convex shape of Indifference curve. After explaining the budget line and how it changes parallel shift or pivot we shall now understand its impact on the consumer s equilibrium using the concept of Income Consumption Curve and Price Consumption curve. We shall also explain how the price effect that is change in the consumption of a commodity due to a change in its price is divided into Substitution and Income effect using the Hicksian approach. 1.3 EXCEPTIONS TO CONVEX SHAPE OF INDIFFERENCE CURVE Under normal conditions indifference curves are convex to the origin because of diminishing marginal rate of substitution that is as one moves down the indifference curve its slope reduces and it subsequently becomes flatter because of the fact that now consumer is willing and able to forego less and less units of commodity Y for each additional unit of X because his relative capacity to sacrifice has reduced and also the marginal utility of commodity Y increases because it is now scarcely available as compared to commodity X which is available in plenty as compared to the situation that existed at the upper part of the indifference curve. However there are some exceptions to this convex shape of indifference curve which can be subdivided under the following heads: 1) Perfect Substitutes 2) Perfect Compliments 58
3) Economic Goods 4) Economic Bads 5) Neuters We would be explaining them one by one. Case 1: Perfect Substitutes Perfect substitutes are commodities that have infinite elasticity of substitution between them that is one commodity can be replaced by a specific number of units of the other commodity at all levels and with extreme ease. Example 1: A consumer gets equal satisfaction with 1 unit of ice cream and 2 units of cold drink and he is willing to forego 1 unit of ice cream for 2 units of cold drink and vice versa. Thus 1 cold drink = 2 ice creams. These are perfect substitutes or a consumer gets equal satisfaction from 1 unit of coca cola and 1 unit of pepsi. Thus here 1 coca cola = 1 pepsi. Here marginal rate of substitution that is how many units of commodity Y consumer is willing to forego for one additional unit of X remains constant. Earlier we had studied that Indifference curves are convex to the origin because of Diminishing MRSxy but here as MRSxy is constant so we have Linear Indifference curves where slope remains constant throughout. These have been shown in figure 1(a). Case 2: Perfect Compliments Perfect compliments are commodities that have zero elasticity of substitution between them that is one commodity cannot be replaced with the other commodity as a specific combination of the two commodities is required to get a level of satisfaction. Here just increasing one commodity without being supplemented by the other commodity has no usefulness for the consumer hence satisfaction would not increase with increase in just commodity. To increase the satisfaction both the commodities have to be increased and in a specific proportion. Example 2: A consumer would have increased satisfaction only if along with right leg shoe he also gets a left leg shoe. If we keep on increasing the quantity of right leg shoe without increasing the quantity of left leg shoe, satisfaction of the consumer would not increase as its just a waste for him. These are perfect complements. Here marginal rate of substitution that is how many units of commodity Y consumer is willing to forego for one additional unit of X is zero as goods are not substitutable at all. Here Indifference curves are L shaped. These have been shown in figure 1(b). Here it shows that X1 units of commodity X and Y1 units of commodity Y are required to provide the consumer a level of satisfaction. If we keep on increasing X that is shown by horizontal segment of IC1 satisfaction does not increase and consumer is on same indifference curve. Similarly if we increase only Y that is the vertical stretch of IC1 satisfaction of the consumer would remain same. Consumer would move on to a higher Indifference curve with increased level of satisfaction only if both X and Y are increased and that too in a specific proportion. Thus points X2 and Y2 is on IC2 and X3 and Y3 on IC3. 59
Figure 1(a): Perfect substitutes Case 3: Economic Goods Figure 1(b): Perfect Compliments Economic goods are those commodities that satisfy the following characteristics: 1) These goods provide the consumer positive utility or satisfaction 2) Here more is better that is consumer wants more and more of a commodity 3) Example: fast speed internet, dresses, bags etc. 4) Different consumers have different commodities that list under their category of Economic Good, the concept is not universal. 60
Case 4: Economic Bads Economic bads are those commodities that satisfy the following characteristics: 1) These goods provide the consumer negative utility or dissatisfaction 2) Here less is better that is consumer wants less and less of a commodity 3) Example: corruption, pollution etc. 4) Different consumers have different commodities that list under their category of Economic bad, this concept too is not universal. Economic Goods and Economic Bads and their combinations can be jointly shown with the help of figure 2: Figure 2 Point O or origin is known as bliss or saturation point and IC3 is the IC closest to bliss point in all the quadrants and having highest satisfaction in all the four quadrants. Now let us take one quadrant at a time and explain it: 61
Figure 2(A): Quadrant 1 Figure 2(B): Quadrant 2 Figure 2(C): Quadrant 3 Figure 2(D): Quadrant 4 Quadrant 1: 1) Here both commodity X and commodity are Economic Goods 2) Preference Direction (Direction the movement in which satisfaction increases) is North East 3) Indifference curve is negatively sloped 4) MRSxy is diminishing 62
Quadrant 2: Quadrant 3: Quadrant 4: 1) Commodity X is Economic Bad and commodity Y is Economic Good 2) Preference Direction is North West 3) Indifference curve is Positively sloped 4) MRSxy is Positive and increasing. 1) Both Commodity X and Y are Economic Bad 2) Preference Direction is South West 3) Indifference curve is Concave 4) MRSxy is Negative and increasing 1) Commodity X is Economic Good and Y is Economic Bad 2) Preference Direction is South East 3) Indifference curve is Positively sloped 4) MRSxy is Positive and decreasing Example 3: Draw indifference curve for a commodity which is Economic good up to a certain point and then becomes economic bad. Solution: Initially the commodity gives positive satisfaction to the consumer therefore is economic good but after the satiety point it starts giving dissatisfaction and becomes an economic bad. It can be shown in the figure 3: Figure 3 63
Case 5: Neuters 1) Commodity that gives neither positive satisfaction nor dissatisfaction. 2) They have no impact on the consumer s satisfaction therefore are called neuters. 3) Example: For a vegetarian, price of non-vegetarian food is a neuter. 4) There can be two cases for a neuter: Commodity on X axis is neuter and Commodity on Y axis is a normal good Commodity on Y axis is neuter and Commodity on X axis is a normal good Figure 4(A) Figure 4(B) As can be seen from figure 4(A) Indifference curves are horizontal parallel to X axis when commodity X is a neuter. If units of commodity X increase it has no impact on the satisfaction as consumer remains on the same curve, satisfaction would increase only if commodity Y increases and that is when the consumer would move to a higher Indifference curve. Similarly figure 4(B) shows that when commodity Y is a neuter Indifference curves are vertical parallel to Y axis. If units of commodity Y increase it has no impact on the satisfaction as consumer remains on the same indifference curve, satisfaction would increase only if commodity X increases and that is when the consumer would move to a higher Indifference curve. Thus above are few cases where indifference curve is not convex to the origin and hence these are known as exceptions to the convex shape of Indifference curve. 1.4 CONCEPT OF INCOME CONSUMPTION CURVE Consumer s equilibrium depends upon the budget that consumer has which in turn depends on the money income and prices of the two commodities. Thus if any of these three component changes there is a change in the consumer s equilibrium. This change can be depicted with the help of Income Consumption curve (ICC) which happens because of change in the money income, prices of the commodities remaining constant or with the Price Consumption Curve (PCC) which happens because of change in the price of one of the commodities 64
money income and price of other commodity remaining constant. In this segment we would be talking about ICC and PCC would be taken up in the next segment. Income Consumption Curve: ICC is the loci of equilibrium points showing successive changes in the equilibrium and consumption of two commodities when money income of the consumer changes, other things remaining constant. When nominal income of a consumer changes (say increases) ceteris paribus, he can now bring changes in his equilibrium and consumption pattern which was earlier not attainable. How much change would be there and in which direction depends upon the income elasticity of demand. So the shape of ICC is dependent on whether good is a normal commodity or inferior. Let us do all the cases one by one: 1) Normal good: A commodity that has positive relation with income and where law of demand operates is known as a normal good. Figure 5(A): X and Y are normal goods Above figure shows ICC for normal goods on both the axis. Initial budget line is AB and consumer is in equilibrium at point e1 consuming X1 units of commodity X and Y1 units of commodity Y. Now if money income increases other things remaining constant budget line makes a rightward parallel shift to A B where consumer moves to a higher IC2 and new equilibrium at e2 consuming X2 and Y2. Further increase in the money income to M3 shifts the budget line further to A B reaching a higher equilibrium at e3 with X3 and Y3 units of commodity X and Y. Joining successive equilibrium points e1, e2 and e3 we get the income consumption curve that traces the path of changed consumption pattern with change in the money income ceteris paribus. Here income elasticity of demand is positive. It can be further classified into three categories as given by Ernst Engel: Luxury Goods Goods having more than unitary elasticity of income. Ey > 1 Comfort Goods - Goods having unitary elasticity of income. Ey = 1 Necessities - Goods having less than unitary elasticity of income. Ey < 1 65
All these cases can be further explained with the help of diagrams 5(B), 5(C), 5(D) and 5(E): Figure 5 (B) : ICC and Demand Curve for Luxury on X axis and Necessity on Y axis Figure 5(B) shows how we derive Income Consumption Curve (ICC) when on X axis the good is luxury and Y axis it is necessity. Now here the difference between the goods is of sensitivity towards income. Luxury has elasticity more than one and necessity has elasticity less than one. So when money income increases there is proportionately more change in the quantity of luxury then necessity. Thereby ICC is flatter. Demand curve too has been drawn below the ICC that shows that there is a rightward parallel shift in the demand curve because of change in the income of the consumer as price of the commodity has not changed. So at the same price now more of commodity X is being demanded. 66
Figure 5 (C): ICC and Demand Curve for Comfort goods Figure 5(C) shows how we derive Income Consumption Curve (ICC) when there is comfort good on both the axis. Comfort goods have income elasticity equal to unity, so when money income increases there is a proportionate change in the quantity of comfort goods. Thereby ICC is a straight line from the origin. Demand curve too has been drawn below the ICC that shows that there is a rightward parallel shift in the demand curve because of change in the income of the consumer as price of the commodity has not changed. So at the same price now more of commodity X is being demanded. However it can be seen that shift in demand curve has been more in this case as compared to the case of necessity exhibited in Figure 5(B). 2) Inferior Good: A commodity that has inverse relation with income and where law of demand operates is known as an inferior good. Figure 5(D): ICC for Inferior goods on X axis and Normal goods on Y axis 67
Figure 5(D) shows the derivation of Income Consumption Curve (ICC) for inferior good that has inverse relation with income and also with price. Initially consumer is at point e1 consuming X1 and Y1 units of commodity X and Y respectively with M money income and Px and Py as prices of the two commodities. Now if money income of the consumer increases with prices of goods being constant consumer moves on to a higher budget line A B and higher indifference curve IC2 at equilibrium e2. Though the consumption of inferior good decreases as consumer now moves to superior commodity with increase in the nominal income. ICC is thus backward bending. Drawn below is the demand curve for the inferior good where we can see that though the demand curves are downward sloping but with increase in income there is leftward parallel shift showing decrease in the consumption of commodity X. Income Consumption curve can be used to derive Engel curve that shows the relation between Money Income and consumption of a commodity. The concept was given by Ernst Engel to classify the commodity as Luxury, comfort, necessity or inferior. Engel curves for different types of commodities are present in Figure 5(E): Figure 5 (E): Engel Curve for Luxury, Comfort, Necessity and Inferior Goods Above graph shows the derivation of Engel curve. Its information is obtained from the Income Consumption curve only. In ICC relation between money income and quantity of commodity is shown indirectly whereas in Engel curve relationship between money income and quantity is shown explicitly. In figure above the first case is that of Luxury good where income elasticity is greater than unity showing that proportionate change in the 68
quantity demanded is more than proportionate change in the price. Thus gap between M1M2 is less than X1X2. Engel curve is thus flatter. Second figure is that of comfort good which has income elasticity = 1 thus proportionate change in money income is equal to proportionate change in quantity. M1M2 = X1X2. Engel curve is a straight line from the origin. Third figure depicts Engel curve for Necessities where Income Elasticity is less than Unitary elastic. Thus proportionate change in money income is greater than proportionate change in quantity. M1M2 > X1X2. Engel curve is steeper. Last panel shows Engel curve for inferior good that has inverse relation with income. Thus when money income increases quantity demanded decreases as consumer can now consume superior goods because of increased income and with reduced consumption of inferior good. Engel curve here is therefore downward sloping. 1.5 CONCEPT OF PRICE CONSUMPTION CURVE As discussed above when there is a change in the income of the consumer prices of the commodities remaining unchanged the successive equilibriums are traced by drawing an Income consumption curve. Now in this section we would be discussing about the other part that is price consumption curve (PCC) which is the Loci of equilibrium points showing the change in the consumption pattern because of the change ij price of one of the commodity other things that is money income and price of other commodity remaining constant. The shape of the PCC is dependent on the price elasticity of demand. Hence we would be showing the following cases of PCC: 1) Normal Goods: Goods where Law of demand operates that is there is inverse relation between price and quantity demanded or Elasticity lies between zero to positive infinity. Here also we can have the following three cases: A) More than Unitary Elastic demand, Ed > 1 When Price of a commodity changes ceteris paribus the change in quantity of the commodity whose price has changed is proportionately more. Example: If price of a commodity say X changes by 10% then change in the quantity demanded of X is more than 10%. It can be shown using the figure 6(A): The diagram shows that PCC is downward sloping when elasticity of demand of a commodity is more than unitary elastic. The reason can be explained as: Initially when price of commodity X is Px1 and with a specific income and price of commodity Y consumer is at equilibrium at e1 on IC1 consuming OX1 and OY1 units of the respective commodities. Now if price of commodity X reduces to Px2 with same money income and PY, elasticity being more than unity consumer increases the consumption of X to X2 and reduces the consumption of Y to Y2. The reason behind this is given by Total Expenditure method of calculating Price Elasticity of demand. In case of Ed > 1, with reduction in price of a commodity the total expenditure on the commodity increases. So in this case it can be explained as: let s say Price of X falls by 10%, this leads to increase in purchasing power by 10% but Ed > 1 so change in quantity of X is more than 10% say 12%. Now from where did this extra 2% 69
come as purchasing power has increased only by 10%. It has come by reducing the consumption of Commodity Y to support increased expenditure on commodity X. Thus PCC here is downward sloping. PCC can also be used to draw the demand curve which has been drawn below the PCC. Initially with Px1 consumer is consuming OX1 and with fall in price of X to Px2 consumer is consuming more of the quantity of X that is OX2. Here the proportionate change in quantity demanded is more than proportionate change in price. Therefore demand curve is flatter. Figure 6(A): PCC and Demand Curve when Ed > 1 B) Unitary Elastic Demand, Ed = 1 Here when Price of a commodity changes ceteris paribus the change in quantity of the commodity whose price has changed is equal to the change in price. Example: If price of a commodity say X changes by 10% then change in the quantity demanded of X is equal to 10%. It can be shown using the figure 6(B): The diagram shows that PCC is Rectangular Hyperbola when elasticity of demand of a commodity is unitary elastic. The reason can be explained as: Initially when price of commodity X is Px1 and with a specific income 70
and price of commodity Y consumer is at equilibrium at e1 on IC1 consuming OX1 and OY1 units of the respective commodities. Now if price of commodity X reduces to Px2 with same money income and PY, elasticity being unity consumer increases the consumption of X to X2 and keeps the consumption of Y unchanged. The reason behind this is given by Total Expenditure method of calculating Price Elasticity of demand. In case of Ed = 1, with reduction in price of a commodity the total expenditure on the commodity remains unchanged. So in this case it can be explained as: let s say Price of X falls by 10%, this leads to increase in purchasing power by 10% but Ed = 1 so change in quantity of X is equal to 10%. As all the increased purchasing power is spent on commodity X itself so nothing is left to be spent on commodity Y and hence its consumption remains unchanged. Thus PCC here is Horizontal Straight Line parallel to X axis. PCC can also be used to draw the demand curve which has been drawn below the PCC. Initially with Px1 consumer is consuming OX1 and with fall in price of X to Px2 consumer is consuming more of the quantity of X that is OX2. Here the proportionate change in quantity demanded is equal to proportionate change in price. Therefore demand curve is rectangular hyperbola. Figure 6(B): PCC and Demand Curve when Ed = 1 C) Less than Unitary Elastic Demand, Ed < 1 71
Here when Price of a commodity changes ceteris paribus the change in quantity of the commodity whose price has changed is proportionately less. Example: If price of a commodity say X changes by 10% then change in the quantity demanded of X is less than 10%. It can be shown using the figure 6(C): The diagram below shows that PCC is Upward Sloping when elasticity of demand of a commodity is less than unitary elastic. The reason can be explained as: Initially when price of commodity X is Px1 and with a specific income and price of commodity Y consumer is at equilibrium at e1 on IC1 consuming OX1 and OY1 units of the respective commodities. Now if price of commodity X reduces to Px2 with same money income and PY, elasticity being less than unity consumer increases the consumption of X to X2 and also the consumption of Y to Y2. The reason behind this is given by Total Expenditure method of calculating Price Elasticity of demand. In case of Ed < 1, with reduction in price of a commodity the total expenditure on the commodity also reduces. So in this case it can be explained as: let s say Price of X falls by 10%, this leads to increase in purchasing power by 10% but Ed < 1 so change in quantity of X is less than 10% say 8%. As all the increased purchasing power is spent on commodity X as well as commodity Y so the consumption of the both the goods increases. Thus PCC here is Upward sloping. PCC can also be used to draw the demand curve which has been drawn below the PCC. Initially with PX1 consumer is consuming OX1 and with fall in price of X to Px2 consumer is consuming more of the quantity of X that is OX2. Here the proportionate change in quantity demanded is less than proportionate change in price as not all the increased purchasing power is spent only on X. Therefore demand curve is steeper. Figure 6(C): PCC and Demand curve for Ed < 1 72
2) Giffen Goods: Giffen goods are special type of Inferior goods where Law of Demand does not operate that is it has direct relation between price and quantity demanded and inverse relation with income and quantity demanded. Here elasticity of demand is negative, Ed < 0. The Price Consumption Curve (PCC) here is Backward bending as can be shown in the figure 6(D): Figure 6(D): PCC and Demand Curve for Ed < 0 The above figure gives the PCC for Giffen good and the associated demand curve. PCC in case of giffen good is backward bending because of the reason that when initially the price of commodity is Px1 consumer is at e1 on IC1 consuming OX1 units of commodity X which is a giffen good and OY1 of commodity Y. Now with fall in the price of commodity X which is a giffen good its elasticity of demand being negative consumer reduces the consumption of this commodity and all the increased purchasing power is spent only on commodity Y, thereby consumption of good X reduces with a fall in the price of X. the demand curve thus exhibits a positive relation between price and quantity demanded which is an exception to the Law of Demand. As we can see above that Price Consumption Curve is also used for deriving the demand curve, but there is a slight difference between the two. PCC shows the relation between price and quantity demanded of a commodity impliedly through the budget line as axis nowhere has the price of the commodity as the variable. 73
This implied information is directly used in the demand curve where one of the variables on the axis is price of the commodity. It thus shows the relation between price and quantity demanded explicitly 1.6 SUMMARY In the previous lesson we talked about the concept of Indifference curve, budget line and consumer equilibrium. This chapter is an extension of that where it provided for certain conditions where Indifference curve is not convex to the origin. Few cases are that of Perfect Substitutes, Perfect Complements, Economic Goods, Economic Bads and Neuters. The chapter also talked about how there can be change in the consumer equilibrium when there is a new budget line because of change in either the money income of the consumer or price of one of the commodity. How consumer shifts to new equilibrium can be shown with the help of Income Consumption Curve that traces out the successive equilibrium points showing different combinations of two commodities that consumer consumes when his money income changes ceteris paribus. ICC can be drawn in case of normal goods as well as inferior goods; first one having positive relation with nominal income while the latter has inverse relation with income. ICC has been used further to derive the Engel curves that shows the relation between money income and quantity demanded explicitly. Another is the Price consumption curve that shows the successive changes in the consumption of two commodities because of change in the price of one of the commodity other things remaining constant. There have been four cases in case of PCC depending upon elasticity of demand being equal to unity, less than unity, more than unity or negative. PCC has been used to draw the demand curve showing explicitly the relation between price of the commodity and its quantity demanded. 1.7 SELF ASSSSMENT QUESTIONS Check your progress Exercise 1: True and False (a) If the commodity is an economic bad it provides neither satisfaction nor dissatisfaction to the consumer (b) In case of elasticity of demand greater than unity Price Consumption Curve is downward sloping. (c) Income consumption curve for inferior good is backward bending (d) If there is economic bad on both the axis, indifference curve is upward sloping. (e) For a neuter on X axis the Indifference Curve is vertical parallel to Y axis. Ans. 1(F), 2(T), 3(T), 4(T), 5(F) Exercise 2: Fill in the Blanks (a) Neuters provide neither _ nor to the consumer. (b) For a Giffen good the Price Consumption curve is (c) When Marginal revenue is positive, elasticity of the demand curve is (d) If demand curve has unitary elasticity, the shape of the Price Consumption Curve is (e) An Engel curve shows relation between _ and. Ans 1. Satisfaction, Dissatisfaction 2.Backward Bending 3.Horizontal parallel to X axis 4.Money Income, Quantity demanded 5. Horizontal 74
Exercise 3: Questions 1. Explain the concept of Income consumption curve and derive Engel Curve from it 2. State the exceptions to convex shape of Indifference curve. 3. Draw the Price consumption curve when elasticity of demand is equal to unity. 4. Draw the indifference curve for two consumers one having stronger preference for commodity X and other having stronger preference for commodity Y 1.8 SUGGESTED READINGS Salvatore Dominick, Micro Economics Theory and Applications, Oxford University Press. Browning K. Edgar, Micro Economics Theory and Applications, Wiley Publishing House Pindyk Robert, Microeconomics, Prentice Hall 75
LESSON 3 APPLICATION OF INDIFFERENCE CURVE AND BUDGET LINE 1. STRUCTURE 1.1 Introduction 1.2 Objective 1.3 Hicksian approach for Division of Price Effect into Substitution and Income Effect 1.4 Application of Consumer Behaviour: Lump sum subsidy vs excise Subsidy 1.5 Concept of Consumer Surplus 1.6 Summary 1.7 Self Assessment Questions 1.8 Suggested Readings 1.1 OBJECTIVE After reading this lesson, you should be able to a) Understand the concept of Consumer Surplus b) Explain the Hicksian Approach for division of Price Effect into Substitution and Income Effect c) Learn the suitability of Lump sum subsidy and Excise subsidy d) Comprehend the Revealed Preference Theory 1.2 INTRODUCTION Price Consumption curve and Income Consumption Curve showed how change in price of a commodity or nominal income of the consumer respectively have an impact on the consumer s equilibrium. Professor Hicks however stated that the price effect or Law of Demand operates because of two forces that work behind it that is the Income effect and Substitution effect and Price effect is nothing but a cumulative of these two factors. However these effects also depend on what type of commodity it is that is whether it is a normal good, inferior good or Giffen good. All this would be studied in the chapter. Secondly Consumer surplus has been much talked about in every sphere of life where the objective of every consumer is how to maximize his consumer surplus which is an indicator of the consumer s satisfaction. Two different views have been given on this by two different economists Marshall and Hicks using two different ideologies that is cardinal utility and ordinal utility respectively. The third issue that finds a place in the chapter is how to decide between two types of subsidies that government can provide to the consumers that is how to decide which one maximizes the welfare of the consumer out of Cash (Lump sum) subsidy and Excise (food) subsidy. Lastly the chapter also talks about Samuelson s Revealed Preference Theory which is based on strong ordering concept unlike weak ordering concept of Hicks. 76
1.3 DIVISION OF PRICE EFFECT INTO SUBSTITUTION AND INCOME EFFECT: HICKSIAN APPROACH Law of Demand states that when price of a commodity reduces other things remaining constant its quantity demanded increases and vice versa and this is known as the Price effect as it shows impact of price on the quantity demanded. Professor Hicks has given that this price effect is actually a combination of substitution effect and income effect which can be segregated using the Compensating Variation Income Method. However the division depends upon whether the good is a Normal good, Inferior good or Giffen good. Thus we would be talking about these three one by one: Division of price effect into substitution and income effect using Hicksian Approach for Normal Good Normal Good: A commodity that has inverse relation with price and direct relation with income is known as a normal good. Here Law of Demand is operative that is with reduction in the price of a commodity its quantity demanded increases and with increase in income its quantity demanded increases. Price effect: When the price of a commodity reduces/increases other things remaining constant, because of Law of demand its quantity demanded increases/decreases respectively in case of normal good. This change in the quantity demanded that is shown by the Price Consumption curve also is known as the Price effect. Income effect: When price of a commodity changes say decreases other things remaining constant, the purchasing power or real income of the consumer increases whereby he can buy more of a commodity with the same nominal income in case of normal goods. This effect is known as the Income Effect that can be traced by using the Income Consumption Curve Substitution Effect: When price of a commodity changes let s say it decreases ceteris paribus then it becomes relatively cheaper as compared to other commodities and consumer purchases more of it whose price has reduced with the same money income and price of other commodity. Substitution effect remains same in case of all commodities whether it is normal good, inferior good or giffen good because of the fact that price effect is dependent on Price elasticity of demand, Income effect is dependent on Income Elasticity of demand but substitution effect is based on the concept of rationality of consumer where he would always prefer a commodity that is relatively cheaper to maximize his satisfaction. Let us now explain the concept of Hicksian division with the following diagram: 77
Figure 1: Normal Good: Division of Price effect into substitution and Income Effect Above figure shows that initially with a particular money income and prices of the two commodities consumer is on IC1 at e1 consuming OX1 units of X (X being a normal good). Now if price of commodity X reduces other things remaining constant the budget line pivots to AB and consumer reaches a higher equilibrium e2 on IC2 consuming OX2 units of commodity X. this increase in the consumption of commodity X is known as the price effect as it has happened because of change in the price of this commodity. To segregate this effect into substitution and income effect Hicks has given the concept of Compensating Variation Income line where we draw a budget line that is parallel to new budget line here AB and tangent to old indifference curve here IC1. This has been done to take the impact of the increased money income back from the consumer and see what would have been the consumption of X if it would have been initially cheaper. This line is MN which is tangent to IC1 at e3 thereby showing that consumer would have consumed OX3 units of commodity X had it been relatively cheaper. Thus X1 to X3 is the substitution effect. Now to get the income effect we give back the consumer his increased purchasing power thereby X2 to X3 shows the income effect. Below this we have drawn the demand curve which shows that initially with price of X being Px1 consumer was consuming OX1 units of commodity X and with decrease in the price to Px2 the consumption has increased to OX2. The movement thus explains why Law of Demand operates. Demand curve here is also flatter showing that the change in quantity is more because of the fact that both substitution and income effect are forcing the consumer to buy more of the commodity. 78
Division of price effect into substitution and income effect using Hicksian Approach for Inferior Good Inferior Good: A commodity that has inverse relation with price and also inverse relation with income is known as a inferior good. Here Law of Demand is operative that is with reduction in the price of a commodity its quantity demanded increases in spite of the fact that with increase in income its quantity demanded decreases. This can be explained as below: Price effect: When the price of a commodity reduces/increases other things remaining constant, because of Law of demand its quantity demanded increases/decreases respectively in case of inferior good. This change in the quantity demanded that is shown by the Price Consumption curve also is known as the Price effect. Income effect: When price of a commodity changes say decreases other things remaining constant, the purchasing power or real income of the consumer increases and it being an inferior good consumer reduces its consumption as he moves to the consumption of superior commodity. This effect is known as the Income Effect that can be traced by using the Income Consumption Curve Substitution Effect: When price of a commodity changes let s say it decreases ceteris paribus then it becomes relatively cheaper as compared to other commodities and consumer purchases more of it whose price has reduced with the same money income and price of other commodity. Substitution effect remains same in case of all commodities whether it is normal good, inferior good or giffen good because of the fact that price effect is dependent on Price elasticity of demand, Income effect is dependent on Income Elasticity of demand but substitution effect is based on the concept of rationality of consumer where he would always prefer a commodity that is relatively cheaper to maximize his satisfaction. Let us now explain the concept of Hicksian division with the following diagram: Figure 2: Inferior Good: Division of Price effect into substitution and Income Effect 79
Above figure shows that initially with a particular money income and prices of the two commodities consumer is on IC1 at e1 consuming OX1 units of X (X being a inferior good). Now if price of commodity X reduces other things remaining constant the budget line pivots to AB and consumer reaches a higher equilibrium e2 on IC2 consuming OX2 units of commodity X. this increase in the consumption of commodity X is known as the price effect as it has happened because of change in the price of this commodity. To segregate this effect into substitution and income effect Hicks has given the concept of Compensating Variation Income line where we draw a budget line that is parallel to new budget line here AB and tangent to old indifference curve here IC1. This has been done to take the impact of the increased money income back from the consumer and see what would have been the consumption of X if it would have been initially cheaper. This line is MN which is tangent to IC1 at e3 thereby showing that consumer would have consumed OX3 units of commodity X had it been relatively cheaper. Thus X1 to X3 is the substitution effect which is same as it was in case of normal good. Now to get the income effect we give back the consumer his increased purchasing power thereby X3 to X2 shows the income effect which is moving leftward because of the fact that in case of inferior good income effect forces the consumer to buy less of the commodity whose price has reduced. But still the price effect is rightward that is consumer is buying more of X as substitution effect is stronger than the income effect and hence law of demand operates in case of Inferior good. Below this we have drawn the demand curve which shows that initially with price of X being Px1 consumer was consuming OX1 units of commodity X and with decrease in the price to Px2 the consumption has increased to OX2. The movement thus explains why Law of Demand operates in case of inferior good as well. Demand curve here is although steeper as compared to normal good as the change in quantity is less because of the income effect being leftward. Division of price effect into substitution and income effect using Hicksian Approach for Giffen Good Giffen Good: A commodity that has direct relation with price and inverse relation with income is known as a Giffen good. Here Law of Demand is not operative that is with reduction in the price of a commodity its quantity demanded also decreases and thus Giffen goods is an exception to the Law of Demand. This can be explained as below: Price effect: When the price of a commodity reduces/increases other things remaining constant, because of non operative Law of demand its quantity demanded decreases/increases respectively in case of giffen good. This change in the quantity demanded that is shown by the Price Consumption curve also is known as the Price effect. Income effect: When price of a commodity changes say decreases other things remaining constant, the purchasing power or real income of the consumer increases and it being a giffen good consumer reduces its consumption as he moves to the consumption of superior commodity. This effect is known as the Income Effect that can be traced by using the Income Consumption Curve Substitution Effect: When price of a commodity changes let s say it decreases ceteris paribus then it becomes relatively cheaper as compared to other commodities and consumer purchases more of it whose price has reduced with the same money income and price of other commodity. Substitution effect remains same in case of all commodities whether it is normal good, inferior good or giffen good because of the fact that price effect is dependent on Price elasticity of demand, Income effect is dependent on Income Elasticity of demand but 80
substitution effect is based on the concept of rationality of consumer where he would always prefer a commodity that is relatively cheaper to maximize his satisfaction. Let us now explain the concept of Hicksian division with the following diagram: Figure 3: Giffen Good: Division of Price effect into substitution and Income Effect Above figure shows that initially with a particular money income and prices of the two commodities consumer is on IC1 at e1 consuming OX1 units of X (X being a Giffen good). Now if price of commodity X reduces other things remaining constant the budget line pivots to AB and consumer reaches a higher equilibrium e2 on IC2 consuming OX2 units of commodity X. this decrease in the consumption of commodity X is known as the price effect as it has happened because of change in the price of this commodity. Here Law of Demand does not operate as with reduction in price of X its quantity demanded too has reduced. To segregate this effect into substitution and income effect Hicks has given the concept of Compensating Variation Income line where we draw a budget line that is parallel to new budget line here AB and tangent to old indifference curve here IC1. This has been done to take the impact of the increased money income back from the consumer and see what would have been the consumption of X if it would have been initially cheaper. This line is MN which is tangent to IC1 at e3 thereby showing that consumer would have consumed OX3 units of commodity X had it been relatively cheaper. Thus X1 to X3 is the substitution effect which is same as it was in case of normal good. Now 81