10.
Explanation
The "Price Effect" In the context of the Indifference Curve Approach is a concept used in microeconomics to analyse how changes in the price of a good affect a consumer’s consumption choices. It can be bifurcated into two components: the “Income Effect” and the “Substitution Effect.” Let’s break down each component and illustrate them with a diagram.
1. Income Effect: The income effect is the change in consumption of a good due to a change in real income, keeping the consumer’s utility or satisfaction constant. When the price of a good decreases, it effectively increases the consumer’s real income because they can buy the same amount of that good with less money. This can lead to an increase in the quantity consumed of that good if it is a normal good (a good for which demand increases as income increases).
Conversely, if the price of a good rises, the real income decreases, potentially leading to a decrease in consumption if it’s a normal good.
2. Substitution Effect: The substitution effect is the change in consumption of a good due to a change in its relative price, assuming that the consumer’s real income remains constant. When the price of a good falls, it becomes relatively cheaper compared to other goods. Consumers tend to substitute away from more expensive goods toward the now cheaper one. Conversely, when the price of a good rises, it becomes relatively more expensive, leading consumers to substitute toward other goods that are now relatively cheaper.
1. Price Decrease (Left Shift): If the price of good X decreases, the budget line pivots outward from the Y-axis due to the increased real income. The new budget line is parallel but farther away from the origin. The consumer moves to a new equilibrium point, B, consuming more of both X
and Y.
2. Price Increase (Right Shift): If the price of good X increases, the budget line pivots inward toward the Y-axis, reducing the real income. The new budget line is again parallel but closer to the origin. The consumer moves to a new equilibrium point, C, consuming less of both X and Y.
Conclusion : The price effect, when analysed using the indifference curve approach, helps us understand how changes in the price of a good influence a consumer's consumption choices by separating it into the income effect and the substitution effect.