Lecture 09

Unit No.2- Demand Analysis Lesson No.-9 Consumer equilibrium and demand curve

Learning Outcomes

After reading this lesson you shouldDerive demand curve based on Ordinal Utility Approach. Understand the relationship between the IE, SE and PE. Understand the chief characteristics of the Ordinal Utility Approach Analyze the concept of Consumer’s Surplus.

IntroductionBefore going to the derivation of demand curve we need to understand the income effect, substitutions effect and price effect: 1) Income effect – The increase or decrease in the income can be shown by the parallel shift of the budget line. Diagram

Qty of Y A1 A A2

B2

B

B1

According to the diagram: AB – original budget line A1B1 – increase in the income A2B2 – decrease in the income The budget line shifts parallel because with increase in income a consumer can buy more amount of goods and vice versa. Thus with the higher level of income he can go to the higher level of IC. Diagram

Qty of Y A2 ICC

A1 A

B

B1

B2

Qty of X

ICC is the Income Consumption Curve which shows the impact of changes in the income on the level of consumption. 2) Substitution effect – It is defined as the change in the equilibrium consumption of good in response to the change in the relative prices of goods when the utility level of the consumer remains the same. It is measured through the movement of the consumer equilibrium along the same indifference curve.

Diagram

Qty of Y A

E1 A1 E

B

IC 1 B1

The substitution effect thus measures the effect of a good becoming relatively cheaper or costlier on the basis of the quantity added of it without making the consumer better or worse off. It always increases the demand for relatively cheaper good and reduces the demand fro relatively costlier one. For e.g. – In our earlier example, if the price of mangoes increase then I may prefer to buy more of oranges and less of mangoes. In the diagram equilibrium shifts E to E1 along the same of utility (IC1). 3) Price effect – It is the change in consumption of a good because of the changes in the price of the good. Diagram

(P.T.O)

Qty of Y A

A1

E E2 E1

IC2 IC 1

M

M1

B M2

B1

B2

According to the diagram initial point of equilibrium is point E which is the point of tangency between AB and IC1. Suppose, the price of x declines it results into shift of budget line from AB to AB2 and new equilibrium is E2. This total change of MM2 is called a price effect. This total change can be broken up into 2 components: i) Substitution effect which results into the movement of the consumer along the same IC from E to E1. ii) Income effect – It takes place because of the decline in the Px results into more purchasing power in the hands of the consumer. This results into parallel shift of the budget line from A1B1 to A2B2 and shift of equilibrium from E1 to E2. Thus, PE = SE + IE i.e. MM2 = MM1 + M1M2 This is very important result yielded from ordinal approach. Such a neat division of PE into IE and SE is possible only through the ordinal approach.

(P.T.O)

Derivation of Demand curve – Diagram 1

QY A

B

B1

B2 Q X

D Price

D QX

According to the diagram, the upper panel shows the price effect and shift in the equilibrium from E1 to E2 to E3 because of the decline in the price of x. In the lower panel the demand curve is drawn by considering the respective quantities of commodities from the upper panel. Thus the downward sloping demand curve of the lower panel gives the inverse relation between the price and the quantity demanded. Consumer Surplus – The dd curve can be used to estimate the amount a consumer is willing to spend for a given level of the consumption of a commodity rather than go without it. The excess of such an amount over what he actually pays for the good is a surplus that accrues to the consumer for consuming the given quantity of the good. This surplus is known as a “consumer surplus.” For e.g. – Suppose, I am extremely thirsty and want water very desperately. At that time I am ready to pay even Rs. 20/- for a small Bislery bottle which costs Rs. 5/-. Here, the excess of money Rs. 15/- which I am ready to pay

rather that going without it is the consumer’s surplus. This consumer’s surplus declines with consumption of hjgher quantity of the same commodity. Diagram

PX 6 5 4 3 D 1

2

3

Qty

According to the diagram at price Rs. 6/- or more, the individual does not demand any amount of x. The consumer would be willing to pay Rs. 5/- for the first unit of x rather than go without it. Similarly, he would be willing to pay Rs. 4/- for second unit and so on. Thus the total amount the consumer is willing to pay for two units is Rs. 9/(= 5+4). However, he actually only Rs. 8/- (= price Rs. 4 x 2 units). Thus his notional gain is Rs. 1/- when he consumes 2 units. “What is the policy implication of the “consumer’s surplus” to the manager?” Consumer’s surplus shows the potential revenue a seller or a government can raise from the consumers of a good under very special conditions. Activity: Analyze the situation in which “artificial scarcity is created to increase the profit” in terms of consumer’s surplus.

ExercisesQ.1 Analyze the diagram given below and answer the question : 1. State the case of giffen goods. [Hint : MM2 = MM1 + (-M2M1)] 2. From commodity x and y, which is a giffen goods? Diagrams

Qty of Y A

A1

E2 IC2 E E1 IC 1 M2 M B M1

Q.2 Distinguish between IE, SE and PE

B1

B2