Income–consumption curve

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In economics and particularly in consumer choice theory, the income-consumption curve (also called income expansion path and income offer curve) is a curve in a graph in which the quantities of two goods are plotted on the two axes; the curve is the locus of points showing the consumption bundles chosen at each of various levels of income.

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The income effect in economics can be defined as the change in consumption resulting from a change in real income. [1] This income change can come from one of two sources: from external sources, or from income being freed up (or soaked up) by a decrease (or increase) in the price of a good that money is being spent on. The effect of the former type of change in available income is depicted by the income-consumption curve discussed in the remainder of this article, while the effect of the freeing-up of existing income by a price drop is discussed along with its companion effect, the substitution effect, in the article on the latter. For example, if a consumer spends one-half of his or her income on bread alone, a fifty-percent decrease in the price of bread will increase the free money available to him or her by the same amount which he or she can spend in buying more bread or something else.

The consumer's preferences, monetary income and prices play an important role in solving the consumer's optimization problem (choosing how much of various goods to consume so as to maximize their utility subject to a budget constraint). The comparative statics of consumer behavior investigates the effects of changes in the exogenous or independent variables (especially prices and money incomes of the consumers) on the chosen values of the endogenous or dependent variables (the consumer's demands for the goods). When the income of the consumer rises with the prices held constant, the optimal bundle chosen by the consumer changes as the feasible set available to them changes. The income–consumption curve is the set of tangency points of indifference curves with the various budget constraint lines, with prices held constant, as income increases shifting the budget constraint out.

Consumer theory

Figure 1: An increase in the income, with the prices of all goods fixed, causes consumers to alter their choice of market basket. The extreme left and right indifference curves belong to different individuals with different preferences, while the three central indifference curves belong to one individual for whom the income-consumption curve is shown. Each blue line represents one level of total consumption expenditure common to all its points; its slope depends on the two goods' relative prices. Income consumption curve graph.svg
Figure 1: An increase in the income, with the prices of all goods fixed, causes consumers to alter their choice of market basket. The extreme left and right indifference curves belong to different individuals with different preferences, while the three central indifference curves belong to one individual for whom the income-consumption curve is shown. Each blue line represents one level of total consumption expenditure common to all its points; its slope depends on the two goods' relative prices.

The income effect is a phenomenon observed through changes in purchasing power. It reveals the change in quantity demanded brought by a change in real income. The figure 1 on the left shows the consumption patterns of the consumer of two goods X1 and X2, the prices of which are p1 and p2 respectively. The initial bundle X*, is the bundle which is chosen by the consumer on the budget line B1. An increase in the money income of the consumer, with p1 and p2 constant, will shift the budget line outward parallel to itself.

In the figure, this means that the change in the money income of the consumer will shift the budget line B1 outward parallel to itself to B2 where the bundle X' bundle will be chosen. Again, an increase in the money income of the consumer will push the budget line B2 outward parallel to itself to B3 where the bundle X" will be the bundle which will be chosen. Thus, it can be said that, with variations in income of the consumers and with the prices held constant the income–consumption curve can be traced out as the set of optimal points.

For different types of goods

In the case illustrated with the help of Figure 1 both X1 and X2 are normal goods in which case, the demand for the good increases as money income rises. However, if the consumer has different preferences, he has the option to choose X0 or X+ on budget line B2. As the income of the consumer rises, and the consumer chooses X0 instead of X' i.e. if the consumer's indifference curve is I4 and not I2, then the demand for X1 would fall . In that case, X1 would be called an inferior good i.e. demand for good X1 decreases with a rise in income of the consumer. Thus, a rise in income of the consumer may lead his demand for a good to rise, fall or not change at all. It is important to note here that, the knowledge of preferences of the consumer is essential to predict whether a particular good is inferior or normal.

Normal goods

Figure 2: Income-consumption curve for normal goods Income consumption curve graph - upward sloping (normal goods).svg
Figure 2: Income-consumption curve for normal goods

In the figure 2 to the left, B1, B2 and B3 are the different budget lines and I1, I2 and I3 are the indifference curves that are available to the consumer. As shown earlier, as the income of the consumer rises, the budget line moves outwards parallel to itself. In this case, from initial bundle X*, with an increase in the income of the consumer the budget line moves from B1 to B2 and the consumer would choose X' bundle and subsequently, with a further rise in consumer's income the budget line moves from B2 to B3 and the consumer would choose X" bundle and so on. The consumer would thus maximize his utility at the points X*, X' and X", and by joining these points, the income-consumption curve can be obtained.

Inferior goods

Figure 3: with an increase of income, demand for normal good X rises while, demand for inferior good X falls. Income consumption curve graph - downward sloping (inferior goods).svg
Figure 3: with an increase of income, demand for normal good X rises while, demand for inferior good X falls.

The figure on the right (figure 3), shows the consumption patterns of the consumer of two goods X1 and X2, the prices of which are p1 and p2 respectively, where B1 and B2 are the budget lines and I1 and I2 are the indifference curves. Figure 3 clearly shows that, with a rise in the income of the consumer, the initial budget line B1 moves outward parallel to itself to B2 and the consumer now chooses X' bundle to the initial bundle X*. The figure shows that, the demand for X2 has risen from X21 to X22 with an outward shift of the budget line from B1 to B2 (caused due to rise in the income of the consumer). This essentially means that, good X2 is a normal good as the demand for X2 rose with an increase in the income of the consumer.

In contrast, it is to be noted from the figure, that the demand for X1 has fallen from X11 to X12 with an outward shift of the budget line from B1 to B2 (caused due to rise in the income of the consumer). This implies that, good X1 is an inferior good as the demand for X1 fell with an increase in the income of the consumer.

The consumer maximizes his utility at points X* and X' and by joining these points, the income–consumption curve can be obtained. [2] In figure 3, the income–consumption curve bends back on itself as with an increase income, the consumer demands more of X2 and less of X1. [3] The income–consumption curve in this case is negatively sloped and the income elasticity of demand will be negative. [4] Also the price effect for X2 is positive, while it is negative for X1. [3]

is the change in the demand for good 1 when we change income from to , holding the price of good 1 fixed at :

Engel curves

See also

Related Research Articles

As a topic of economics, utility is used to model worth or value. Its usage has evolved significantly over time. The term was introduced initially as a measure of pleasure or happiness as part of the theory of utilitarianism by moral philosophers such as Jeremy Bentham and John Stuart Mill. The term has been adapted and reapplied within neoclassical economics, which dominates modern economic theory, as a utility function that represents a single consumer's preference ordering over a choice set but is not comparable across consumers. This concept of utility is personal and based on choice rather than on pleasure received, and so is specified more rigorously than the original concept but makes it less useful for ethical decisions.

<span class="mw-page-title-main">Indifference curve</span> Concept in economics

In economics, an indifference curve connects points on a graph representing different quantities of two goods, points between which a consumer is indifferent. That is, any combinations of two products indicated by the curve will provide the consumer with equal levels of utility, and the consumer has no preference for one combination or bundle of goods over a different combination on the same curve. One can also refer to each point on the indifference curve as rendering the same level of utility (satisfaction) for the consumer. In other words, an indifference curve is the locus of various points showing different combinations of two goods providing equal utility to the consumer. Utility is then a device to represent preferences rather than something from which preferences come. The main use of indifference curves is in the representation of potentially observable demand patterns for individual consumers over commodity bundles.

In economics, elasticity measures the percentage change of one economic variable in response to a percentage change in another. If the price elasticity of the demand of something is -2, a 10% increase in price causes the demand quantity to fall by 20%.

The theory of consumer choice is the branch of microeconomics that relates preferences to consumption expenditures and to consumer demand curves. It analyzes how consumers maximize the desirability of their consumption as measured by their preferences subject to limitations on their expenditures, by maximizing utility subject to a consumer budget constraint. Factors influencing consumers' evaluation of the utility of goods: income level, cultural factors, product information and physio-psychological factors.

<span class="mw-page-title-main">Budget constraint</span> All available goods and services a customer can purchase with respect to their income

In economics, a budget constraint represents all the combinations of goods and services that a consumer may purchase given current prices within his or her given income. Consumer theory uses the concepts of a budget constraint and a preference map as tools to examine the parameters of consumer choices. Both concepts have a ready graphical representation in the two-good case. The consumer can only purchase as much as their income will allow, hence they are constrained by their budget. The equation of a budget constraint is where P_x is the price of good X, and P_y is the price of good Y, and m = income.

<span class="mw-page-title-main">Inferior good</span> Concept in economics

In economics, an inferior good is a good whose demand decreases when consumer income rises, unlike normal goods, for which the opposite is observed. Normal goods are those goods for which the demand rises as consumer income rises.

In microeconomics, two goods are substitutes if the products could be used for the same purpose by the consumers. That is, a consumer perceives both goods as similar or comparable, so that having more of one good causes the consumer to desire less of the other good. Contrary to complementary goods and independent goods, substitute goods may replace each other in use due to changing economic conditions. An example of substitute goods is Coca-Cola and Pepsi; the interchangeable aspect of these goods is due to the similarity of the purpose they serve, i.e fulfilling customers' desire for a soft drink. These types of substitutes can be referred to as close substitutes.

In economics and particularly in consumer choice theory, the substitution effect is one component of the effect of a change in the price of a good upon the amount of that good demanded by a consumer, the other being the income effect.

<span class="mw-page-title-main">Law of demand</span> Fundamental principle in microeconomics

In microeconomics, the law of demand is a fundamental principle which states that there is an inverse relationship between price and quantity demanded. In other words, "conditional on all else being equal, as the price of a good increases (↑), quantity demanded will decrease (↓); conversely, as the price of a good decreases (↓), quantity demanded will increase (↑)". Alfred Marshall worded this as: "When we say that a person's demand for anything increases, we mean that he will buy more of it than he would before at the same price, and that he will buy as much of it as before at a higher price". The law of demand, however, only makes a qualitative statement in the sense that it describes the direction of change in the amount of quantity demanded but not the magnitude of change.

<span class="mw-page-title-main">Complementary good</span>

In economics, a complementary good is a good whose appeal increases with the popularity of its complement. Technically, it displays a negative cross elasticity of demand and that demand for it increases when the price of another good decreases. If is a complement to , an increase in the price of will result in a negative movement along the demand curve of and cause the demand curve for to shift inward; less of each good will be demanded. Conversely, a decrease in the price of will result in a positive movement along the demand curve of and cause the demand curve of to shift outward; more of each good will be demanded. This is in contrast to a substitute good, whose demand decreases when its substitute's price decreases.

<span class="mw-page-title-main">Demand curve</span> Graph of how much of something a consumer would buy at a certain price

In economics, a demand curve is a graph depicting the relationship between the price of a certain commodity and the quantity of that commodity that is demanded at that price. Demand curves can be used either for the price-quantity relationship for an individual consumer, or for all consumers in a particular market.

Utility maximization was first developed by utilitarian philosophers Jeremy Bentham and John Stuart Mill. In microeconomics, the utility maximization problem is the problem consumers face: "How should I spend my money in order to maximize my utility?" It is a type of optimal decision problem. It consists of choosing how much of each available good or service to consume, taking into account a constraint on total spending (income), the prices of the goods and their preferences.

In microeconomics, a consumer's Marshallian demand function is the quantity they demand of a particular good as a function of its price, their income, and the prices of other goods, a more technical exposition of the standard demand function. It is a solution to the utility maximization problem of how the consumer can maximize their utility for given income and prices. A synonymous term is uncompensated demand function, because when the price rises the consumer is not compensated with higher nominal income for the fall in their real income, unlike in the Hicksian demand function. Thus the change in quantity demanded is a combination of a substitution effect and a wealth effect. Although Marshallian demand is in the context of partial equilibrium theory, it is sometimes called Walrasian demand as used in general equilibrium theory.

The Slutsky equation in economics, named after Eugen Slutsky, relates changes in Marshallian (uncompensated) demand to changes in Hicksian (compensated) demand, which is known as such since it compensates to maintain a fixed level of utility.

Revealed preference theory, pioneered by economist Paul Anthony Samuelson in 1938, is a method of analyzing choices made by individuals, mostly used for comparing the influence of policies on consumer behavior. Revealed preference models assume that the preferences of consumers can be revealed by their purchasing habits.

In microeconomics, a consumer's Hicksian demand function or compensated demand function for a good is his quantity demanded as part of the solution to minimizing his expenditure on all goods while delivering a fixed level of utility. Essentially, a Hicksian demand function shows how an economic agent would react to the change in the price of a good, if the agent's income was compensated to guarantee the agent the same utility previous to the change in the price of the good—the agent will remain on the same indifference curve before and after the change in the price of the good. The function is named after John Hicks.

A relative price is the price of a commodity such as a good or service in terms of another; i.e., the ratio of two prices. A relative price may be expressed in terms of a ratio between the prices of any two goods or the ratio between the price of one good and the price of a market basket of goods. Microeconomics can be seen as the study of how economic agents react to changes in relative prices, and of how relative prices are affected by the behavior of those agents. The difference and change of relative prices can also reflect the development of productivity.

<span class="mw-page-title-main">Local nonsatiation</span> Consumer preferences property

In microeconomics, the property of local nonsatiation (LNS) of consumer preferences states that for any bundle of goods there is always another bundle of goods arbitrarily close that is strictly preferred to it.

In economics and consumer theory, quasilinear utility functions are linear in one argument, generally the numeraire. Quasilinear preferences can be represented by the utility function where is strictly concave. A useful property of the quasilinear utility function is that the Marshallian/Walrasian demand for does not depend on wealth and is thus not subject to a wealth effect; The absence of a wealth effect simplifies analysis and makes quasilinear utility functions a common choice for modelling. Furthermore, when utility is quasilinear, compensating variation (CV), equivalent variation (EV), and consumer surplus are algebraically equivalent. In mechanism design, quasilinear utility ensures that agents can compensate each other with side payments.

In economics and other social sciences, preference is the order that an agent gives to alternatives based on their relative utility. A process which results in an "optimal choice". Preferences are evaluations and concern matters of value, typically in relation to practical reasoning. The character of the preferences is determined purely by a person's tastes instead of the good's prices, personal income, and the availability of goods. However, people are still expected to act in their best (rational) interest. Rationality, in this context, means that when individuals are faced with a choice, they would select the option that maximizes self-interest. Moreover, in every set of alternatives, preferences arise.

References

  1. ↑ O'Sullivan, Arthur; Sheffrin, Steven M. (2003). Economics: Principles in Action . Upper Saddle River: Pearson Prentice Hall. p.  80. ISBN   0-13-063085-3.
  2. ↑ Salvatore, Dominick. Microeconomics (PDF). Archived from the original (PDF) on October 20, 2012.
  3. 1 2 Application of Indifference Curve Analysis Archived December 27, 2019, at the Wayback Machine , EconomicsConcepts.com, retrieved April 25, 2017.
  4. ↑ Rubinfeld, Daniel; Pindyck, Robert (1995). Microeconomics. Mainland China: Tsinghua University Press/Prentice-Hall. p. 98. ISBN   7-302-02494-4.
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