Consumer Surplus:  Price, Income and Substitution Effect-

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Income Effect Consumer Equilibrium

• Income effect explains how a change in a consumer’s income affects his total
  satisfaction. Assume that the prices of the goods consumers purchase remain constant. Now, he is able to experience more or less satisfaction depending on the change in his income. Thus, we can define income effect as the effect caused by change in the income of the consumer on his purchases while the prices of goods remain the same.
• Figure 1 shows the effect of change in consumer’s income on his equilibrium level.

• In Figure 1, point E is the initial equilibrium position of the consumer. At point E, the indifference curve IC₁ is tangent to the price line MN. Suppose consumer’s income increases. This causes the budget line to shift from MN to MIN₁ and then to M2N2. As a result, the equilibrium point shifts from E to E and then to E2.

Income Consumption Curve

• As shown in Figure 1, you can get the income consumption curve (ICC) by connecting all the equilibrium points E, E1 and E2. Normal goods generally have a positively sloped income consumption curve, meaning that a consumer’s purchase of two goods increases his or her income. At the same time, it may not be applicable in all cases.

Replacement Effect On Consumer balance

• Assume that there are two objects called apple and orange. Your money income is $100, which does not change. You have to buy apple and oranges using the entire income, i.e. $100, suppose the price of apples rises and the price of oranges decreases. What do you do is the case? You buy more oranges and less apples because oranges are cheaper than apples. Exactly what you are doing is that you are using oranges in place of apples. This is known as the substitution effect.
• Substitution effect occurs due to the following two reasons

1. Relative prices of goods keep changing. Due to this, one thing becomes cheaper and another thing becomes expensive.
2. The consumer’s understanding the concept of substitution effect in a simple way.

• Figure 2 is helpful to understand the concept of substitution effect in a simple manner.

• In figure 2, AB represents the original budget line. Point Q represents the original equilibrium point, where the budget line is tangent to the indifference curve. At point Q, the consumer buys OM quantity of good X and ON quantity of food Y. Suppose the price of good Y increases and the price of good X falls. As a result, the new budget line will be B1A1. The new budget line is tangent to the indifference curve at point Q1. This is the new equilibrium position of the consumer after the change in relative prices.
• At the new equilibrium point, the consumer has reduced his purchase of good Y from ON to ON, and increased hid purchase of good X from OM to Om1. However, the consumer remains on the same indifference curve. This movement along the indifference curve from Q to Q1 is known as the substitution effect. In simple terms, the consumer replaces one good (that has a lower price) for another good (that has a higher price); this is known as the ‘ substitution effect’.

Effect on Price on consumer

• For simplicity, let’s consider a two-us commodity model. In the substitution effect, the prices of both goods change (the price of good Y increases and the price of good X decreases). However, in price effect, the price of a single good changes. Thus, price effect is the change in the quantity of goods or services purchased due to a change in the price of a single good.
• Let us consider two objects, namely object X and object Y. There is a change in the price of good X. The price of good Y and consumer’s income are constant.

Figure 3

• Suppose the price of good X decreases. In Figure 3, object points C1, C2, C3 and C4 represent the corresponding equilibrium combinations. According to Figure 3, consumer’s real income increases when the price of good X decreases. Due to increase in real income of the consumer, he is able to buy more of both goods X and Y.

price consumption curve

• You can get the price consumption curve (PCC) by connecting all the equilibrium points (in the above example, C1, C2, C3 and C4). In the above figure, the slope of PCC is positive. This means that as the price of good X falls, the consumer’s real income increases.
  

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Derivation of demand price curve to consumption curve.

• The price consumption curve (PCC) tells us what happens to the quantity demanded when the price changes. Consumer demand curve also explains the relationship between the price of a good and the quantity demanded. Therefore, the price consumption curve is useful to obtain the demand curve of an individual consumer. Although a consumer’s demand curve and his price consumption curve give us the same information, what the demand curve tries to tell is more straightforward.

• Figure 4 shows the process of deriving the demand curve of an individual consumer from his price consumption curve.
• In Figure 4, the horizontal axis measures good A, and the vertical axis represents the consumer’s money income. IC₁, IC2, and IC3 represent indifference curves. Suppose the price of good A keeps on decreasing. As a result, LN, LQ and LR are the next budget lines of the consumer. Initially, P₁ is the consumer’s equilibrium. At this equilibrium point, the consumer purchases quantity OM of good A.
• Price of one unit of good A = total money income/number of units that can be purchased with that money.
• Therefore, at P₁ (equilibrium point – the budget line is tangent to the indifference curve IC₁), the price per unit of good A is OL/ON. At OL/ON price, consumer OM, quantity demanded of good A.
• Similarly, at OL/OQ price, the consumer can buy OM2 quantity of commodity A and at OL/OR price, he can buy OM3 quantity of commodity A.
• If you connect all the equilibrium points (P1, P2 and P3), you will be able to get the price consumption curve.
• As mentioned above, the demand curve shows the prices and associated quantities of a good purchased by the consumer. ·
• For example, suppose consumer income is $40, ON = 8 units, OQ = 10 units, and OR = 20 units. With the help of this information, you can create demand schedule as follows:
  

  Table 1: Price-demand schedule for Commodity A

• Obtain the demand curve of an individual consumer as shown in Figure 5.

• Figure 5 shows the consumer’s demand curve. If you need to construct a market demand curve, this will be possible by horizontal summation of individual demand curves.