The indifference curve

 

INTRODUCTION

 

The indifference curve is a geometrical device that has been used to replace the neo-classical cardinal utility concept. Prof. Hicks presented its comprehensive version in his Value and Capital in 1939 and its major revision in his A Revision of Demand Theory in 1956.

 

  INDIFFERENCE CURVES

a curve that shows combinations of goods among which an individual is indifferent.

 

The slope of the indifference curve is the ratio of marginal utilities of the two goods say X and Y. An indifferent curve is drawn from the indifference schedule of the consumer. The latter shows the various combinations of the two commodities such that the consumer is indifferent to those combinations. "An indifference schedule is a list of combinations of two commodities the list being so arranged that a consumer is indifferent to the combinations, preferring none of any other

 

ASSUMPTIONS OF INDIFFERENCE CURVE ANALYSIS

The indifference curve analysis retains some of the assumptions of the cardinal theory, rejects others and formulates its own. The assumptions of the ordinal theory are the following:

1)The consumer acts rationally so as to maximize satisfaction.

 

2) There are two goods X and Y.

 

3) The consumer possesses complete information about the prices of the goods in the market.

 

4)The prices of the two goods are given.

 

5)The consumer's tastes, habits and income remain the same throughout the analysis

 

6)He prefers more of X to less of Y or more of Y to less of X. If indifference curves crossed, it would violate the “prefer-more-to-less” principle.

 

7)An Indifference curve is negatively inclined sloping downward and bowed inward

 

8) An indifference curve is always convex to the origin.

 

(9) An indifference curve is smooth and continuous which means that the two goods are highly divisible and that levels of satisfaction also change in a continuous manner.

 

(10) The consumer arranges the two goods in a scale of preference which means that he has both `preference' and `indifference' for the goods.

 

(11 ) Both preference and indifference are transitive.        It means that if combination A is preferable to B, and B to C; then A is preferable to C. Similarly, if the consumer is indifferent between combinations A and B, and B and C, then he is indifferent between A and C. This is an important assumption for making consistent choices among a large number of combinations.

 

12) The best combination is the point where the indifference curve and the budget line are tangent.

 

(13)  Indifference curves can neither touch nor intersect each other so that one indifference curve passes through only one point on an indifference map

 

PROPERTIES OF INDIFFERENCE CURVES

 

 From the assumptions described above the following properties of indifference curves can be deduced.

 

(I) A higher indifference curve to the right of another represents a higher level of satisfaction and preferable combination of the two goods.

 

In Figure 15.3, consider the indifference curves I1, and I2, and combinations N and A respectively on them. Since A is on a higher indifference curve and to the right of N, the consumer will be having more of both the goods X and Y. Even if the two points on these curves are on the same plane as M and A, the consumer will prefer the latter combination, because he will be having more of goods X though the quantity of goods Y is the same.

 

 (2) In between two indifference curves there can be a number of other indifference curves, one for every point in the space on the diagram.

 

(3) The numbers I1, I2„ 13, I4,....etc. given to indifference curves are absolutely arbitrary. Any numbers can be given to indifference curves. The numbers can be in the ascending order of 1, 2, 4, 6 or 1, 2, 3, 4, etc. Numbers have no importance  in the indifference curve analysis.

 

(4) The slope of an indifference curve is negative, downward sloping, and from left to right- It means that the consumer to be indifferent to all the combinations on an indifference curve must leave less units of good Y in order to have more of good X. To prove this property, let us take indifference curves contrary to this assumption.

 

In above Figure (A) combination B is preferable to combination A which has a smaller mount of the two goods. Therefore an indifference Curve cannot slope upward from left to right.

 

Similarly, in Figure (B& C) combination B is preferable  to combination A so indifference curve cannot be horizontal or vertical.

 

(5) Indifference curves can neither touch nor intersect each other so that one indifference curve passes through only one point on an indifference map.

 

What absurdity follows from such a situation can be shown with the help of Figure 15.5(A) where the two curves I1 and I2 cut each other. Point A on the I1 curve indicates a higher level of satisfaction than point Bon the I2, curve, as  it lies farther away from the origin But point C which lies on both the curves yields the same level of satisfaction as point A and B. Thus

 

On the curve   I1: A = C ,and

 

on the curve   I2: B = C   So A= B

 

 

This is absurd because A is preferred to B, being on a higher indifference curve I1. Since each indifference curve represents a different level of satisfaction, indifference curves can never intersect at any point. The same reasoning applies if two indifference curves touch each other at point C in Panel (B) of the figure.

 

(6) An indifference curve cannot touch either axis. If it touches X-axis as I1, in Figure 15.6 at M, the consumer will be having OM quantity of good X and none of Y'. Similarly  if an indifference curve I2, touches the Y-axis at L, the consumer will have only OL of Y  good and no amount of X.  Such curves are in contradiction to the assumption that the consumer buys two goods in combinations.

 

(7) An important property of  indifference curves is that they are convex to the origin.

 

 The convexity rule implies that as the consumer substitutes X' for Y, the marginal rate of substitution diminishes. To prove this, let us take a concave curve where the marginal rate of Substitution of X for Y increases instead of diminishing i.e., more of Y is given up to have additional units of X. As in Figure 15.7 (A), the consumer is giving up ab< cd<ef  units of Y for bc= de=fg units of x. But an indifference curve cannot be concave to the origin.

 

 

 

If we take a straight line indifference curve at an angle of 45° with either axis, the marginal rate of substitution between the two goods will be constant, as in Panel (B) where ab of Y= bc of X and cd of Y= de of X. Thus an indifference curve cannot be a straight line.

 

 

 

Figure 15.7(C) shows the indifference curve as convex to the origin. Here the consumer is giving up less and less units of Y in order to have equal additional units of X i.e., ab> cd> ef of Y for bc= de=fg= of X. Thus an indifference curve is always convex to the origin because the marginal rate of substitution between the goods declines.

 

 (8) Indifference curves are not necessarily parallel to each other.

 

Though they are falling  negatively inclined to the right, yet the rate of fall will not be the same for all indifference curves. In other words, the diminishing marginal rate of substitution between the two goods  is essentially not the same in the case of all  indifference schedules. The two curves I1,and I2,shown in figure 15.8 are not parallel to each other.

 

(9) In reality, indifference curves are like bangles. But as a matter of principle, their effective region  in the form of segments is shown in figure 15.9. This is so because indifference curves are assumed to be negatively sloping and convex to the origin.

 

ELASTICITIES OF DEMAND

 

ELASTICITIES OF DEMAND

There are as many elasticities of demand as its determinants. The most important of these elasticities are (a) the price elasticity, (b) the income elasticity, (c) the cross-elasticity of demand.

 

The price elasticity of demand

 

 The price elasticity is a measure of the responsiveness of demand to changes in the commodity's own price. If the changes in price are very small we use as a measure of the responsiveness of demand the point elasticity of demand. If the changes in price are not small we use the arc elasticity of demand as the relevant measure.

The point elasticity of demand is defined as the proportionate change in the quantity demanded resulting from a very small proportionate change in price. Symbolically we may write

 

 

which implies that the elasticity changes at the various points of the linear-demand curve. Graphically the point elasticity of a linear-demand curve is shown by the ratio of the segments of the line to the right and to the left of the particular point. In figure 2.33 the elasticity of the linear-demand curve at point F is the ratio

 

 

Figure 2.33

 

The basic determinants of the elasticity of demand of a commodity with respect to its own price are:

 

(I) The availability of substitutes; the demand for a commodity is more elastic if there are close substitutes for it.

 

(2) The nature of the need that the commodity satisfies. In general, luxury goods are price elastic, while necessities are price inelastic.

 

(3) The time period. Demand is more elastic in the long run.

 

(4) The number of uses to which a commodity can be put. The more the possible uses of a commodity the greater its price elasticity will be.

 

(5) The proportion of income spent on the particular commodity.

The above formula for the price elasticity is applicable only for infinitesimal changes in the price. If the price changes appreciably we use the following formula, which measures the arc elasticity of demand:

 

The arc elasticity is a measure of the average elasticity, that is, the elasticity at the mid­point of the chord that connects the two points (A and B) on the demand curve defined by the initial and the new price levels (figure 2.38). It should be clear that the measure of the arc elasticity is an approximation of the true elasticity of the section AB of the de­mand curve, which is used when we know only the two points A and B from the demand curve, but not the intermediate ones. Clearly the more convex to the origin the demand curve is, the poorer the linear approximation attained by the arc elasticity formula.

 

The income elasticity of demand

 

The income elasticity is defined as the proportionate change in the quantity demanded resulting from a proportionate change in income. Symbolically we may write

 

The income elasticity is positive for normal goods. Some writers have used income elasticity in order to classify goods into `luxuries' and `necessities'. A commodity is considered to be a `luxury' if its income elasticity is greater than unity. A commodity is a `necessity' if its income elasticity is small (less than unity, usually).

The main determinants of income elasticity are:

 

          1.The nature of the need that the commodity covers: the percentage of income spent on food declines as income increases (this is known as Engels Law and has some­times been used as a measure of welfare and of the development stage of an economy).

 

          2.The initial level of income of a country. For example, a TV set is a luxury in an underdeveloped, poor country while it is a `necessity' in a country with high per capita income.

 

3.The time period, because consumption patterns adjust with a time-lag to changes in income. Over the long-run, the consumption patterns of the people may change with changes in income with the result that a luxury today may become a necessity after the lapse of a few years.

 

4.Again, the demonstration effect also plays an important role in changing the tastes, preferences and choices of the people and hence the income elasticity of demand for different types of goods.

 

5.Last but not the least, it is the frequency of increase in income which determines income elasticity of demand for goods. If the frequency is greater, income elasticity will be high because there will be a general tendency to buy comforts and luxuries.

 

The cross-elasticity of demand

 

The cross-elasticity of demand is defined as the proportionate change in the quantity demanded of x resulting from a proportionate change in the price of y. Symbolically we have

 

The sign of the cross-elasticity is negative if x and y are complementary goods, and positive if x and y are substitutes. The higher the value of the cross-elasticity the stronger will be the degree of substitutability or complementarity of x and y.

 

The main determinant of the cross-elasticity is the nature of the commodities relative to their uses. If two commodities can satisfy equally well the same need, the cross­ elasticity is high, and vice versa.

Division of Labor

Division of Labor

 

By division of labor we mean an arrangement whereby people perform different functions at the same time. Though the term, 'Division of labor' is applied in the field of economics, yet in fact division of labor in modern society is not limited simply to labor but applies to all the factors of production and exists beyond the purely economic field. For instance, in a large scale readymade garment factory, a man does cutting of cloth, the second man stitches clothes with machines, the third buttons, the fourth makes folding and packing etc. This way of doing the work is called division of labor. Division of labor is based on the principle of co-operation or interdependence. The different persons among whom the work is divided co-operate in the production of a thing for example, to make a chair, one group is engaged in making backs another seats and still another joining them and finally there is group of workers polishing the chairs. All of them co-operate and through their cooperation, a chair is made. Division of labor is both a divisional and integrating social principle. There may be four forms of division of labor.

 

l. Simple Division of Labor:.

 

 When the production is split up into different parts and many workers come together to complete the work, but the contribution of each worker cannot be known, it is called simple division of labor. For example when many persons carry a huge log of wood, it is difficult to assign how much labor has been contributed by an individual worker. It is simple division of labor

 

2. Complex Division of Labor:

 

This means the division of labor within a particular enterprise. Thus within a factory there are weavers, spinners, designers, accountants, managers and engineers. The work may be divided into complete tasks like spinning, weaving, bleaching, designing, finishing etc. or it may be divided into incomplete processes. It is said that work in a modern spinning factory is divided into 18 processes. Technical division of labor is marked feature of modern machine age.

 

3. Occupational Division of Labor.

 

 When the production of a commodity becomes the occupation of the worker, it is called occupational division of labor This means division into occupation. Thus, there are farmers, weavers, teachers, priests, laborers etc.

 

4. Geographical or Territorial Division of Labo:

 

 This is also known as localization of industries. Certain places or regions come to specialize in the making of certain articles; Hosiery at Ludhiana, Cotton textiles at Ahmadabad and Bombay, Jute industry at Calcutta, Leather industry at Agra and Kanpur etc.

 

Division of labor is an inevitable feature of the modern industrial system. It is advantageous in the following ways.

 

Merits of Division of Labor

 

l. Increase in Production. With the adoption of division of labor, the total production increases. Adam Smith has explained the advantage of division of labor with the help of an example that a worker can produce only 20 pins daily. If the making of pins in a modern factory is divided into 18 processes, then 18 workers can produce 48,000 pins in a single day

 

2. Goods of Superior Quality. Division of labor is beneficial in making goods of superior quality. When the worker is entrusted with the work for which he is best suited, he will produce superior quality goods.

 

 3. Increase in Employment Opportunities. Division of labor leads to the diversity of occupations which further leads to the employment opportunities. On the other hand, the scale of production being large, the number of employment opportunities also increases.

 

4. Development of International Trade. Division of labor increases the tendency of specialization not only in the workers or industries, but in different countries also. On the basis of specialization, every country produces only those goods in which it has a comparative advantage and imports such goods from those countries which have also greater comparative advantage. Therefore, division of labor is beneficial for the development of international trade also.

 

5. Reduction in the Cost of Production. If a shoe-maker makes himself two pairs of shoes daily, then four shoe-makers can make more than eighth pairs of shoe, if they work in cooperation with each other. In this way, division of labor increase production which reduces the average cost of production. Saving of capital, tools and machinery, etc. also help in the reduction of cost of production.

 

(6)The right man in the right place:  Under division of labor, the chance is that each man will get the job for which he is best fitted. There will be no round pegs in square holes. The work will be better done.

 

(7) The worker becomes an expert:  Practice makes a man perfect; under division of labor, the worker repeats his task. By constant repetition, he is bound to become expert in his task. He will be able to turn our better goods. There is an increase in the skill and craftsmanship.

 

(8) Heavy work taken over by machinery:  Division of labor makes it possible for heavy work to be passed on to machinery. Only light work is done by workers so that there is less strain on them.

 

(9) Less training required:  As the worker has to do only a part of the job, he needs to learn only that much. Long and costly training is rendered unnecessary. It will take long time for a man to learn how to make a complete chair but it will take him less time to learn how to polish it.

 

(10) Invention:  When a man is doing the same work over and over again some new ideas are bound to occur. This leads to many inventions. These inventions make for economic progress.

 

(11) Cheaper things:  On account of mass production make possible by division and the use of machinery, cheaper things are turned out. Even poor persons can buy them. Standard of living improves.

 

(12) Economic in the use of tools:  Division of labor helps in the saving of capital and tools. It is not essential to provide a complete set of tools to every worker. He needs a few tools only for the job he has to do. Thus there is the saving of tools as well as capital. For instance, if a tailor stitches the shirt, he requires a sewing machine, scissors, etc. But on the basis of division of labor, one can do the cutting and the other can stitch the clothes. In this way, two tailors can work with the help of one pair of scissors and one machine only.

 

 (13) Saving in time:   The worker has no longer to move from one process to another. He is employed on the same process. He therefore goes on working without loss of time.

 

Demerits of Division of Labor

 

The demerits of division of labors are the following:

 

(i)Monotony:Doing the same work over and again without any change produced mental fatigue. Work becomes joyless and monotonous. There is no pleasure in the job. The worker cannot be expected to take any interest. The quality of work suffers.

 

(ii) Kills the creative instinct:  Since many men contribute to the making of an article, none can say that he has made it. His creative instinct is not satisfied. The work gives him no pride and no pleasure, since no worker can claim the product as his own creation.

 

(iii) Loss of skill:   The worker deteriorates in the technical skill. Instead the making of whole article, he is required just .to repeat a few simple movements. The skill gradually dies out.

 

(iv) Check mobility:   The worker is doing only a part of the job. He knows only that much and no more. It may not be easy for him to find exactly the job elsewhere, if he desires a change. (In this way, the workers losses his mobility)

 

(v) Risk of unemployment:   If the worker is dismissed from one factory, he may have to search far and wide before he secures a job in which he has specialized. He may be making only the legs of a chair. It is doubtful if he can get the complete chair. His chance of getting a job elsewhere would be brighter.

 

(vi) Check development of personality:  If a man has been making an eighteenth part of a pin, he becomes an eighteenth part of a man. A narrow sphere of work checks proper physical and mental development of the worker,

 

(vii) Loss of sense or responsibility:  None can be held responsible for bad production because none makes the complete article. When the thing is bad, everybody tries to shift the responsibility to somebody else.

 

(viii) Evils of factory system:  Division of labor gives rise to factory system, which is full of evils. It spoils the beauty of the place all round, leads to exploitation of women and children and removes the personal factor in the production and management.

 

(ix) Problem of distribution: Under division of labor, many persons contribute to the production of an article. They must receive a due share of the product and it is not easy to determine this share. Thus, the problem  of distribution is made difficult. If the worker makes the article, independently he gets its value and there is no trouble. But division of labor had divided the community into two conflicting groups, i.e. capital and labor. The gap between them is daily growing wider strikes and lockout have become a common occurrence in the present day.

 

(x) Dependence:  The dependence of one country upon another which is necessary consequence of division of labor, proves dangerous in times of war.

 

Conclusion

 

To sum up, we can say it that division of labor is beneficial to the workers, to the producers and to the society as a whole. Its merit outweigh its demerits

CONSUMER'S EQUILIBRIUM: MAXIMISING SATISFACTION

CONSUMER'S EQUILIBRIUM: MAXIMISING SATISFACTION

 

 A consumer is said to be in equilibrium when he is buying such a combination of goods as leaves him with no tendency to rearrange his purchases of goods. He is then in a position of balance in regard to the allocation of his money expenditure among various goods. In the indifference curve analysis it is assumed that the consumer tries to maximize his satisfaction.

 

We shall make the following assumptions to explain the equilibrium of the consumer:

 

(1) The consumer has a given indifference map exhibiting his scale of preferences for various combinations of two goods, X and Y

 

(2) He has a fixed amount of money to spend on the two goods. He has to spend whole of his given money on the two goods.

 

(3) Prices of the goods are given and constant for him. He cannot influence the prices of the goods by buying more or less of them.

 

(4) Goods are homogeneous and divisible.

 

(5) the consumer is assumed to be rational in the sense that he aims at maximizing his satisfaction.

 

It will be seen from Fig. below that the various combinations of the two goods lying on the budget line BL and which therefore he can afford to buy do not lie on the same indifference curve; they lie on different indifference curves. The consumer will choose that combination an the budget line BL which lies on the highest possible indifference curve. The highest indifference curve to which the consumer can reach is the indifference, curve to which the budget line BL is tangent. Any other possible combination of the two goods either would lie on a lower indifference curve and thus yield less satisfaction or would be unattainable.

 

Fig: 5 Consumer’s Equilibrium

 

 In Fig. 5 budget line BL is tangent to indifference curve IC3 at point Q. Since indif­ference curves are convex to the origin, all other points on the budget line BL, above or below the point Q, would lie on the lower indiffer­ence curves. Take point R which also lies on the budget line BL and which the consumer can afford to buy. Combination of goods represented by R costs him the same as the combination Q. But, as is evident, R lies on the lower indifference curve IC1, and will therefore yield less satisfaction than Q.

 

Likewise, point S also lies on the budget line BL but will be rejected in favor of y since S lies on the indifference curve IC2, which is also lower than IC3, on which Q lies. Similarly, Q will be preferred to all other points on the budget line BL which lies to the right of Q on the budget line, such as T and H. It is thus clear that of all possible combinations lying on BL, combination Q lies on the highest possible indifference curve and yields maximum possible satisfaction.

 

 Of course, combinations lying on indifference curves IC4, and IC5 will give greater satisfaction to the consumer than Q, but they are unattainable with the given money income and the given prices of the goods as represented by the budget line BL.

 

 It is therefore concluded that with the given money expenditure and the given prices of the goods as shown by BL the consumer will obtain maximum possible satisfaction and will therefore be in equilibrium position at point Q at which the budget line BL is tangent to the indifference curve IC3. In this equilibrium position at Q the consumer will buy OM amount of good X and ON amount of good Y.

 

Second Order Condition for Consumer Equilibrium

 

The tangency between the given budget and an indifference curve  is a necessary but not a sufficient condition for consumer's equilibrium. The second order condition must also be fulfilled. The second order condition is that at the point of equilibrium indiffer­ence curve must be convex to the origin., or to put it in another way, the marginal rate of substitution of X for Y must be falling at the point of equilibrium.

 

 It will be noticed from Fig. 5 above that the indifference curve IC3, is convex to the origin at Q. Thus at point Q both conditions of equilibrium are satisfied. Point Q in Fig.5 is the optimum or best choice for the consumer and he will therefore be in stable equilibrium at Q.

 

  But it may happen that while budget line is tangent to an indif­ference curve at a point but the indifference curve may be concave at that point. Take for instance, Fig. 6 where indifference curve IC1, is concave to the origin around the point J. Budget line BL is tangent to the indifference curve IC1, at point J But J cannot be a position of equilibrium because satisfaction would not be maximum there. Thus the consumer by moving along the given budget line BL can go to points such as U and obtain greater satisfaction than at J.

 

 

Fig:6 Second Order condition for Consumer’s Equilibrium

 

We therefore conclude that for the consumer to be in equilibrium, two conditions are required :

1. A given budget line must be tangent to an indifference curve, or marginal rate of substi­tution of X for Y (MRSxy.,) must be equal to the price ratio of the two goods .

 

2. Indifference curve must be convex to the origin at the point of tangency.

 

BUDGET LINE

 

BUDGET LINE

The budget line can be defined as a set of combinations of two commodities that can be purchased if whole of income is ,spent on them and its slope is equal to the negative of the price ratio. The budget line shows all those combinations of two goods which the consumer can buy spending his given money income on the two goods at their given prices.

Suppose our consumer has got income of Rs. 50 to spend on goods X and Y. Let the price of the good X in the market be Rs. 10 per unit and that of Y Rs. 5 per unit. If the consumer spends his whole income of Rs. 50 on good X, he would buy 5 units of X; if he spends his whole income of Rs. 50 on good Y he would buy 10 units    of Y. If a straight line joining 5X and l0Y is drawn, we will get what is called the price line or the budget line. A look at Fig. 1 shows that with Rs. 50 and the prices of X and Y being Rs. 10 and Rs. 5 respectively the consumer can buy l0Y and OX; or 8 Y and 1X; or 6Y and 2X, or 4 Y and 3X etc.

 

 

FIG:1 The Budget Line

 

 In other words, he can buy any combination that lies on the budget line with his given money income and given prices of the goods. It should be carefully noted that any combination of goods as H (5Y and 4X) which lies above and outside the given budget line will be beyond the reach of the-consumer. But any combination lying within the budget line such as K (2X and 21) will be well within the reach of the consumer, but if he buys any such combination he will not be spending all his income of Rs. 50. Thus, with the assumption that whole of the given income is spent on the given goods and at given prices of them, the consumer has to choose from all those combinations which lie on the budget line.

 

 

It is clear from above that budget line graphically shows the budget constraint. The combi­nations of commodities lying to the right of the budget line are unattainable because income of the consumer is not sufficient to be able to buy those combinations. Given his income and the prices of goods, the combinations of goods lying to the left of the budget line are attainable, that is, the consumer can buy any one of them. 

 

The budget line can be written algebraically as follows :

 

Px.X + Py.Y = M

 

 Where Px and Py denote prices of goods X and Y respectively and

 

 M stands for money income

 

Solving the equation  for Y we have the following alternative form of the budget equation.

 

Y=  ─  . X

 

The first term on the right side of the budget equation , that is, M/Py, shows the amount of commodity Y that can bought if quantity purchased of X is zero. In Figure:1, this is represented by the distance OB on the Y-axis. Thus M/Px is the vertical intercept of the budget line equation. The second term on the right hand side of the equation  has the coefficient  which equals the slope of the budget line.

Budget Space

 

A budget space shows a set of all commodity combinations that can be purchased by spending the whole or a part of the given income. In other words, budget space represents all those combinations of the commodities which the consumer can afford to buy, given the budget constraint. Thus, the budget space implies the set of all combinations of two goods for which income spent on good X (i.e Px.X) and income spent on good Y(i.e Py.Y) must not exceed the given money income. Therefore, we can algebraically express the budget space in the following form of inequality.

 

 

PxX + Py.Y≤ M, or M ≥ Px. X + PY.Y

 

The budget space has been graphically shown in Figure 6.22 as the shaded area. The budget space is the entire area enclosed by the budget line BL and the two axes.

Fig. 2. Budget space

 

Changes in Price and Shift in Budget Line

 

Now, what happens to the price line if either the prices of goods change or the income changes. Let is first take the case of the changes in prices of the goods. This is illustrated in Fig. 3. Suppose the budget line in the beginning is BL, given certain prices of the goods X and Y and a certain income.

 

 

Fig.3 Changes in budget line as a result of

 

         Changes in price of good X

 

Suppose the price of X falls, the price of Y and income remaining unchanged. Now, with a lower price of X the consumer will be able to purchase more quantity of X than before with his given income. Let at the lower price of X, the given income purchases OL' of X which is greater than OL. Since the price of Y remains the same, there can be no change in the quantity purchased of good Y with the same given income and as a result there will be no shift in the point B. Thus, with the fall in the price of good X, the consumer's money income and the price of Y remaining constant, the price line will take the new position BL'.

 

Now, what will happen to the budget line (initial budget line BL) if the price of good X rises, the price of good Y and income remaining unaltered. With higher price of good X, the consumer can purchase smaller quantity of X, say OL", than before. Thus, with the rise in price of X the price line will assume the new position BL".

 

Fig.4 Changes in budget line as a result of

 

         Changes in price of good Y

 

Fig. 4 shows the changes in the price line when the price of good Y falls or rises, with the price of X and income remaining the same. In this the initial budget line is BL. With the fall in price of good Y, other things remaining unchanged, the consumer could buy more of Y with the given money income and therefore budget line will shift to LB'. Similarly, with the rise in price Y, other things being constant, the budget line will shift to LB".

 

Changes in Income and Shifts in Budget Line

Now, the question is what happens to the budget line if the income changes, while the prices of goods remain the same. The effect of changes in income on the budget line is shown in Fig. 5. Let BL be the initial budget line, given certain prices of goods and income. If the consumer's income increases while the prices of both goods X and Y remain unaltered, the price line shifts upward (say, to B'L') and is parallel to the original budget line BL. This is because with the increased income the consumer is able to purchase proportionately larger quantity of good X than before if whole of the income is spent on X, and proportionately greater quantity of good Y than before if whole of the income is spent on Y. On the other hand, if the income of the consumer decreases, the prices of both goods X and Y remaining unchanged, the budget line shifts downward (say, to B"L") but remains parallel to the original price line BL. This is because a lower income will purchase a proportionately smaller quantity of good X if whole of the income is spent on X and proportionately smaller quantity of good Y if whole of the income is spent on Y.

 

 

 

Fig. 5. Shifts in Budget Line as a result of Changes in income