Sunday, March 27, 2011

Indifference Curve Analysis - Income Effect

New equilibrium position under Indifference Curve Analysis

The equilibrium position of the consumer will be found out on the assumption that income of the consumer will remain constant. Now if there is any change either in the income of the consumer or prices of commodities, there will be a change in the equilibrium position.

This can be explained under three heads.

1. Income Effect
2. Price Effect
3. Substitution Effect

1. Income effect: Meaning - Where there is a change in the income of the consumer, but the prices of the commodities remain constant, there will be a change in consumption made by the consumer. This change in consumption is called the Income Effect.

Equilibrium: Under the income effect there will be a change in the equilibrium position of the consumer and that can be shown in the following diagram.

In the diagram AB is the original price line. T1 is the original equilibrium position. As there is increase in income the new price line or the budget line is CD. T2 is the new equilibrium position. When there is further increase in income, EF becomes the new budget or price line. T3 becomes the new equilibrium position. If we now join T1, T2 and T3, it forms a curve known as income-consumption curve(ICC). The ICC shows the new equilibrium position of the consumer, where there is a change in income, with prices remaining constant.

Types of Income Effect: There are two types of income effect.

1. Positive income effect: When with the increase in income, there is increase in consumption, that is known as Positive Income Effect.

2.Negative Income Effect: when with the increase in income there is decrease in consumption, that is known as Negative Income Effect. The negative income effect is applicable in case of inferior goods. Inferior goods are those goods, which are purchased less as one's income rises.

When the consumer purchases less of commodity X as a result of increase in income, X is the inferior commodity. When the consumer purchases less of commodity Y, as a result of increase in income, Y is the inferior commodity.

In both the cases the consumer moves from equilibrium position T1 to the new equilibrium position T3.

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