Figure 3.12: Income-consumption curve and Engel curve for inferior good (ii)Price-Consumption Curve and Demand Curve We know that if price of either goods change, the budget line will revolve at the axis that represents the good with the change of price. If price of X decreases, the budget line will revolve outside the X-axis. Consumer equilibrium will also shift to the new budget line. Figure 3.13 illustrates a series of budget lines revolving at the X-axis. Each budget line represents the different tiers of price. ConsumerÊs income and price of Y is constant. When the budget line revolves, the equilibrium point will also shift. When Now, try to draw the income-consumption curve and Engel curve for good X if good X is a necessity. If you place good X at the X-axis, what are the assumptions needed for good Y? YOUR IDEA (a)(b)
XTOPIC 3 UTILITY ANALYSIS 72we connect the equilibrium points, we have derived a price-consumption curve. Therefore, we can use this curve to derive individual demand curve and also to calculate price elasticity of demand. To further clarify on how demand curve is derived from the price-consumption curve, let us look at one example. Figure 3.13: Price-consumption curve and demand curve Assume that you have RM20 to be spent on X and Y. Line B1in Figure 3.13(a) is your budget line when Y is priced at RM2 per unit and X priced at RM1 per unit. Assume point E1as your equilibrium point and the quantity Y1and X1is your optimal consumption combination. Other budget lines are drawn based on different prices of X, that is, curve B2for X priced at RM2.50, B3for X priced at RM3, and curve B4when X is priced at RM4. Each price level will produce different equilibrium combinations and Price-consumption curve shows the change in consumer equilibrium when there is a change in price.
TOPIC 3 UTILITY ANALYSIS W73consumption quantity of X at each price level as shown by X1, X2, X3and X4. When we connect all the equilibrium points, we have produced a price-consumption curve. When we relate the level of price X with equilibrium quantity X, we will find that a demand curve is produced, as shown by Figure 3.13(b). Since demand curve is derived from price-consumption curve, satisfaction level will change along the demand curve; lower price will result in higher satisfaction, that is, satisfaction increases from U1when X is priced at RM4, to U4when X is priced at RM1. Indifference curve is a curve that connects all the combinations of consumption that gives equal satisfaction. Marginal rate of substitution is a rate where a good is to be substituted with another. Therefore, it indicates the gradient of the indifference curve. A convex indifference curve shows a diminishing marginal rate of substitution. Diminishing marginal rate of substitution happens when the rate of willingness to substitute, changes with the total consumption.