Sunday, July 28, 2013

Microeconomics (2066Q3): How is consumer's equilibrium achieved under indifference curve condition? Illustrate the price effect on the consumer's equilibrium, separating it into the income effect and substitution effect.

Consumer's equilibrium achieved under indifference curve condition

Consumers choose a combination of goods which maximize their satisfaction under the limited available budget. A consumer is said to be achieved equilibrium at a point where the price line (budget line) is touching the highest attainable indifference curve from below.

The are two conditions to achieve consumer's equilibrium:
1. Budget line should be tangent to the indifference curve
2. Indifference curve must be convex to the origin

Assumptions to determine consumer's equilibrium condition are as follows:-
  1. Rationality: Consumer is rational so he wants to obtain maximum satisfaction by choosing available goods under his budget.
  2. Utility is ordinal: Consumer can rank his preference according to his satisfaction on each combination of goods.
  3. Consistency of choice: Consumer assumed to consistent on his decision of choosing goods.
  4. Perfect competition: There should be perfect competition in market for that purchased goods.
  5. Total utility: It depends on quantities of goods consumed by consumer.

Here, IC2 is tangent on budget line T and is also attainable (ie. affordable by consumer) but IC1 is attainable but consumer has more capacity to buy other more goods. So, IC1 can't match the highest attainable capacity of consumer. Similarly,  IC3 can't afford by consumer due to his budget constraint.

For the second condition, ICs should be convex to origin that means MRS (Marginal Rate of Satisfaction) should be diminishing at the equililibrium point.

Price effect on the consumer's equilibrium

Consumer's choice of consuming any goods depend on the prices of those goods as well as the income of that consumer. So, if price changes, the consumer's equilibrium choice will also change. The price effect can be defined as the change in the consumption of goods when the price of either of two goods changes while the price of other good and income of the consumer remain constant. The effect of a price change on consumer's equilibrium choice can be divided into two effects: income effect and substitution effect.

1. Income effect: It is an effect on the consumer equilibrium caused by change in his income if relative prices remain constant. This effect is due to the change in real income. For eg. when the price goes up the consumer is not able to buy as much as that he could purchase before. This effect is measured as the difference between the "intermediate consumption" at G and the final consumption of q1 and q2 at E. Unlike substitution effect, the income effect can be both positive and negative depending on whether the product is a normal or inferior good. 
2. Substitution effect: It refers to change in the amount of goods purchased due to change in their relative prices alone, while real income of the consumer remains constant. The effect due to replacement of relatively expensive goods by relatively cheaper goods is called substitution effect. There are two methods to measure substitution effect:
  • Slutsky's measure: According to Slutskian approach, consumer's real income is so reduced that he is able to purchase the original combination of two goods at new price ratio.
  • Hicks measure: According to Hicks approach, constant real income means that consumer will remain on same indifference curve as before the change in price.

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