Consumer Equilibrium: Ordinal Approach, Income & Price Consumption Curve

Consumer Equilibrium: Ordinal Approach

A consumer attains equilibrium at a point where he maximizes his utility from the consumption of goods, given his money income and the prices of the goods. According to the ordinal utility analysis, two sets of conditions must be fulfilled for a consumer to attain equilibrium.

These two conditions are as follows:

Necessary Condition: as per this, MRS must be equal to Px/Py, i.e. the slope of the budget line must be equal to the slope of the IC.
Sufficient Condition: The necessary condition must prevail on the highest IC.

Hence, consumer equilibrium is attained where the above-mentioned two conditions prevail. This is illustrated as follows:

As the above diagram shows, ‘E’ is the equilibrium point where the slope of the budget line and that of the IC is the same. Thus, the consumer will consume Qx and Qy quantity of X and Y in order to maximize his utility, given his money income M and the prices of X and Y as Px and Py.

As we can see that the equilibrium takes place on IC’. It does not take place at IC nor on IC”. The reason for this is that IC comes in the feasible area under the budget line but the consumer does not maximize his utility on IC because he has a higher income, and thus using that income, he can increase his consumption of both the goods and can move to IC’. So on IC’ both the necessary as well as sufficient conditions apply.

However, if he further moves from IC’ to IC” then all those combinations lying on IC” are not feasible because his money income is less. All the points on IC” would definitely give the consumer a higher utility as compared to the combinations lying on IC’ but the combinations on IC” are not attainable. Hence the consumer equilibrium cannot take place on IC” too.

Effect of Change in Income on Consumer Equilibrium: ICC (Income Consumption Curve)

As we have seen in the above section that consumer equilibrium happens at the point where the IC is tangent on the budget line. But when the income of the consumer changes, then the budget line also changes, and correspondingly the IC also changes.

For instance, if the income of the consumer increases, then the budget line will shift upward. This represents that now the consumer can afford more of both goods. Hence his IC will also shift, and the tangency of the new IC with this new budget line gives new consumer equilibrium.

Similarly, if the process goes on, then the equilibrium points will keep on changing. If we connect all these equilibrium points with a line, then this line joining all the equilibrium points is known as the income consumption curve, which shows the changes in the consumer equilibrium due to a change in the income of the consumer. This is represented in the following diagram.

The above is the case of normal goods. Here normal goods are the goods which show a positive relationship between the demand for the good and the income of the consumer, i.e. if the income of the consumer increases, his demand for normal goods also increases and vice versa.

However, in the case of inferior goods, the ICC would not be upward-sloping because inferior goods show an inverse relationship between the demand for the inferior good and the income of the consumer, i.e. if the income of the consumer increases, his demand for the inferior good reduces. In such a case, the ICC would be downward sloping, as given below:

Income Consumption Curve of an Inferior Good

As has been represented in the above diagram, as the income of the consumer increases, his demand for the inferior good reduces and that of normal goods increases.

Hence based on this, his budget line is shifting, and IC is also increasing, but the combination which he chooses for each increased income comprises less inferior goods and more normal goods in order to maximize his utility.

ICC (Income Consumption Curve) is also known as the Engel curve.

We can further derive the demand curve for goods based on his ICC.

Note that here we are only showing how to derive the demand curve of the normal good. You can derive the demand curve of the inferior good in the same way.

Let us now derive the demand curve from the ICC of a normal good:

Derivation of Demand Curves from Income Consumption Curve

Clearly, for a given price of a good, if the consumer’s income increases, he demands more of good X. This gives points E, E’ and E” and three different demand curves emerge with ICC for good X.

Note that here we can see that the demand curve is downward sloping, representing an inverse relationship between the price and quantity of the good.

Effect of Change in Prices of Goods on Consumer Equilibrium: PCC (Price Consumption Curve)

If the price of any of the goods changes, then this leads to a change in the consumer equilibrium too.

For instance, if the price of X falls, then this will make X relatively cheaper, and the consumer will demand more of X and the same quantity of Y, and thus this will pivot his budget line outward.

But when the budget line pivots, then the consumer will change his combination of goods which will maximize his consumption. Now his new basket of goods will comprise more of X and less or the same quantity of Y. Hence his IC will shift upward too.

The tangency of the new IC with the new budget line gives the new equilibrium point to the consumer. Joining all such points gives the price consumption curve (PCC). This is depicted in the following diagram:

The above is the case of the normal good, where normal goods show the inverse relationship between the price of the good and the quantity of the good, i.e. if the price of the consumer falls, its quantity consumed or demanded increases.

However, if there exists a positive relationship between the price of the good and the quantity of the good, then that type of good is known as a Giffen good. In such a case, if the price of the Giffen good falls, its quantity also falls. This is depicted in the following diagram:

Price Consumption Curve of a Giffen Good

In the above diagram, we can see that if the price of the Giffen good falls, the budget line pivots outward, but the quantity demanded of the Giffen good reduces. And hence the points joining the consumer equilibrium, i.e. e, e’, e” gives a downward sloping PCC.

We can also derive the demand curve with the help of PCC in the following way.

Derivation of Demand Curves from Price Consumption Curve

The above graph clearly shows that as the price of X reduces, the budget line pivots outside, and then the quantity of X increases. When these points are drawn below, then they form a demand curve for X.

Consumer Equilibrium: Ordinal Approach, Income & Price Consumption Curve