Wednesday, July 31, 2013

Microeconomics (2067Q3): What is meant by "Consumer's Equilibrium"? How would the equilibrium of a consumer in respect of a particular commodity be affected if (a) the price of that commodity rise, (b) the income of the consumer falls, and (c) the price of a substitute commodity falls? Use indifference curve technique for the answer.

Consumer's Equilibrium

Consumer's equilibrium is a state of the consumer at which he will get maximum satisfaction from the purchase of different available goods and services with his limited amount of money. Hicks and Allen developed IC to demonstrate the situation of consumer's equilibrium graphically with the help of budget line.

Effects on Consumer's Equilibrium – using indifference curve technique
a. Price of commodity rise
It changes in the price of that commodity and the budget line of consumer. If income is held constant, and the price of that commodity changes then the slope of curve will change. If the price increases, the budget line will move inwards.

Here in figure, if price of Apples increases from Rs. 6 per unit to Rs. 12 per unit, then for a budget of Rs. 24, price line will shift inward to L3­­. If price of Apples decreases from Rs. 6 to Rs. 4 per unit, then for a budget of Rs. 24, price line will shift outward to L2.

b. Income of consumer falls
If consumer's income increases then he will be able to purchase higher combinations of goods. Hence an increase in consumer's income will result in a shift in the budget line. If the prices of two goods have remained same, then the increase in income will result in a parallel shift in the budget line.
As in figure below, if budget (income) of consumer increases to Rs. 36, then budget line will shift outward to L2. Similarly, if income reduces to Rs. 12, then budget line will shift inward to L3

c. Price of a substitute commodity falls

Substitution effect means if utility held constant, as the price of the good increases, consumers substitute other, relatively cheaper goods for that one. So, if the price of substitute commodity falls then consumer switches to new commodity rather than recently using one.

There are two methods to measure substitution effect:
i. Slutsky's Measure
As in figure above, if the price of a substitute commodity falls, then movement from D to F will be the substitution effect. That means, the consumers substitute the consuming commodity at point D by point F and MN is the effect shown by substitution.

ii. Hicks Measure
Same as in Slutsky's approach but here one curve is removed for analyzing substitution effect as well as price effect.