Concepts of Consumer Equilibrium, Price Elasticity of Demand and Income Consumption Curve - Example

Concepts Essay Introduction This paper discusses concepts of consumer equilibrium, price elasticity of demand and income consumption curve. Consumer equilibrium refers to the optimal combination of two goods or services that a consumer will choose so as to attain the greatest utility or satisfaction. Price elasticity of demand means the change in the quantity of a good or service demanded, with respect to change in the price of the good or service. Finally, income consumption curve is a curve that shows the different point of equilibrium due to changes in the consumer’s level of income. Consumer Equilibrium Consumer equilibrium refers to the point where the budget line just touches, or is tangent to, an indifference curve. Putting the budget line on the indifference map allows us to decide the one combination of services and goods that the consumer is both willing and able buy. Any combination of goods or services that lies below or on the budget line is within the consumer’s budget. Consumer equilibrium therefore refers to the combination that the consumer will choose in order to yield the greatest satisfaction or utility (Boyes & Melvin, 2010, p. 142). Essentially, a consumer will maximise the satisfaction that will be derived from consuming a combination of services or goods, given the prices of such goods or services and the income by selecting that combination that must completely exhaust the budget and at which the amount of a good or service that the consumer is willing to give up is equal to the amount of the same good or service that will be required by the market (Arnold, 2010, p. 150). As highlighted above, this point must touch or be in tangent with the budget line as shown in the figure below. Figure 1: Illustration of the consumer equilibrium In the figure above, the bold diagonal line is the budget line. Lines l1, l2 and l3 are the indifference curves. These curves show all the possible combinations of two goods or services that give the consumer the same degree of satisfaction or total utility (Boyes & Melvin, 2010, p. 143). The points below the budget line indicate the attainable combinations of the consumer while the points above the line represent the unattainable combinations with respect to the consumer. The budget line in the figure indicates that most of the combinations on the indifference curve l1 as well as point C on the indifference curve l2 are attainable. In addition, combinations on the indifference curve l1 are preferred to combinations on the indifference curve l2, but the consumer is not able to purchase the combinations on the indifference curve l3 because these combinations cost more than the consumer’s budget. Hence, point C in figure 1 represents the maximum level of utility or satisfaction that is available to the consumer. Point C is the level where the budget line is tangent to (that is, just touches) the indifference curve. This point is the chosen combination and is thus the point of equilibrium (Boyes & Melvin, 2010, p. 142). According to Arnold (2010, p. 151), a person in consumer equilibrium is regarded to have maximised total utility or satisfaction from a combination of goods or services. This implies that by spending the amount of money one has on goods or services to give the greatest marginal utility and in the process bringing about the consumer equilibrium state, the consumer is adding as much to total utility or satisfaction as possible. Price Elasticity of Demand Price elasticity of demand refers to the percentage change in the quantity of a good or service demanded, which results from a one percent change in price. That is, it is a measure of the responsiveness of the quantity demanded of a good or service to changes in its price (Frank & Bernanke, 2004, p. 92). For instance, if the price of fish declines by once percent and as a result the quantity of fish demanded increases by two percent, then the price elasticity of demand for fish has a value of -2. The change in demand of a good or service due to a change in its price is however not uniform for all products or services. For instance, a change in the price of salt would not necessarily lead to a change in the quantity of salt consumed by consumers; however, a change in the price of a given model of a car would greatly affect the quantity of the same car that is demanded by consumers. The price elasticity of demand is calculated as the percentage change in quantity of a good or service demanded divided by the corresponding percentage change in price (Frank & Bernanke, 2004, p. 92). For example, if a two percent reduction in the price of fish results into a six percent rise in the quantity of fish demanded, the price elasticity of demand for fish would be calculated as Percent change in quantity demanded = 6 percent = -3 Percentage change in price -2 percent The demand of a good or service is said to be elastic if the quantity demanded of the good or service responds substantially to changes in the price. Conversely, the demand for a good or service is said to be inelastic if the quantity demanded responds only to some extent to changes in the price (Mankiw, 2011, p. 90). The price elasticity of demand for any good or service measures the willingness of consumers to purchase less of the good or service as its price rises. However, because the demand curve reflects the numerous economic, psychological and social factors that affect the preferences of consumers, there is a not simple, universal rule for what establishes the demand curve’s elasticity (Mankiw, 2011, p. 90). As a matter of fact, the price elasticity of demand is always negative or zero because changes in price are always in the opposite direction from changes in demand. Thus for convenience, the negative sign is dropped and price elasticity is referred to in the absolute value. The demand for a good or service is said to be elastic with regard to price if the absolute value of its price elasticity is more than 1, and it is deemed inelastic if the absolute value of its price elasticity if smaller than 1. Finally, the demand is said to be unit elastic if the absolute value of its price elasticity is equal to 1 (Frank & Bernanke, 2004, p. 93). These variations in price elasticity of demand are illustrated in figure 2. Figure 2: Illustration of the price elasticity of demand Income Consumption Curve An income consumption curve is a curve that shows the points of equilibrium which result from various levels of money income and constant prices. This implies that the income consumption curve points to the direct effect of change in income on the equilibrium of the consumer (Salvatore, 1992, p. 69). If the prices of two goods or services consumed by a consumer remain the same, a positive change in the consumer’s income shifts the budget line upwards parallel to itself. Conversely, prices of the two goods or services consumed by a consumer remain the same and there is a decrease in the consumer’s level of income, the budget line shifts downwards parallel to itself (Chauhan, 2009, p. 164). This means that the equilibrium position changes accordingly, that is, it moves upwards in response an increase in the consumer’s income and downwards in response to a reduction in the level of income (see figure 3 for an illustration). Hence, when the equilibrium position shifts as a result if changes in income (that is budget lines B1, B2 and B3), the locus that is traced by the various equilibrium points (that is e1, e2 and e3), which indicates the expansion path, whether downwards or upwards, is referred to as the income consumption curve. The income consumption curve is shown by a dotted line in figure 3. Figure 3: Illustration of the path traced by the income consumption curve With reference to normal goods, the income consumption curve slopes upwards as shown in figure 3. With the consumer’s level of income (budget) remaining the same, an exactly identical effect is noted on the pattern of consumption when prices of the two goods in question fall in the same proportion. This occurs because the consumer’s budget line shifts upwards, parallel to itself when income alone increases or when prices alone decline by the same proportion for the same two goods or services (Chauhan, 2009, p. 164). The points of income consumption created by budget lines which are tangent to the indifference curves l1, l2 and l3 (thus forming the equilibrium points e1, e2 and e3) signify the changing pattern of consumption of the two goods with respect to changes in the consumer’s income (Chauhan, 2009, p. 164). Conclusion Consumer equilibrium shows the combination of two goods or service that a consumer can choose in order to attain the greatest utility. The price elasticity of demand for any service or good determines the willingness of buyers to purchase a smaller amount of a good or service as its price increases. Finally, income consumption curve shows the changes in combination of two or goods or services that a consumer will choose as his or her income increases of decreases. References Arnold, RA 2010, Microeconomics, 10th edn, Cengage Learning, New York. Boyes, W & Melvin, M 2010, Microeconomics, 8th edn, Cengage Learning, New York. Chauhan, S P S 2009, Microeconomics: An Advanced Treatise, PHI Learning Pvt. Ltd., New Delhi. Frank, R H & Bernanke, B S 2004, Principles of Microeconomics, 2nd edn, The McGraw-Hill Group of Companies, New York. Mankiw, N G 2011, Principles of Economics, 6th edn, Cengage Learning, New York. Salvatore, D 1992, Schaum's Outline of Theory and Problems of Microeconomic Theory, 3rd edn, McGraw-Hill Professional, New York. Read More