ADVERTISEMENTS:
Learn about the derivation of Price Consumption Curve (PCC) with the help of suitable diagrams.
Effect of Change in Prices or the Price Effect:
When price of one of the two products changes, the consumer has to readjust and find a new equilibrium. If the price of a product falls, consumer will move on to a higher indifference curve and vice versa. We will show this in case of product X which is conventionally taken on the X-axis. The price of the other product and income of the consumer will be considered as unchanged in the course of this study.
Starting with a situation of consumer’s equilibrium, we assume that the price of X falls successively. As a result, the budget line will shift away from the point of origin on X-axis and become flatter and flatter with every fall in the price of the product X.
ADVERTISEMENTS:
This will lead consumer to find a new equilibrium every time on a higher and higher indifference curve in the process of maximizing satisfaction. Thus, a fall in price of one of the two products leads a consumer to increase his satisfaction by way of moving on a higher and higher indifference curve, away from the point of origin. Such an effect is called as price effect.
The price effect can be defined as an effect of a change in price of a product on consumer’s equilibrium and on the quantity consumed of that product by the consumer, price of other product and the income of the consumer remaining same.
Such a price effect, with regard to a fall in the price of product X, is presented in Figure-3.16.
Based on it, we may observe that —
ADVERTISEMENTS:
i. The consumer is in a state of equilibrium at point R, given his initial budget line as AB and an indifference map consisting of four indifference curves, IC1 to IC4. At equilibrium, the consumer is on IC1 consuming OX1 of product X.
ii. Both the conditions of equilibrium are satisfied at this point. That is, the budget line is forming a tangent at point R on IC1 and the indifference curve is convex to the point of origin.
iii. When price of the product X falls, the budget line shifts from point B on the X-axis to point B1 and becomes flatter. This implies that at a lower price, the consumer is capable of buying a larger quantity of X (OB1) than before (OB). Since the price of Y remains unchanged, there will be no change in point A on the Y-axis.
ADVERTISEMENTS:
As such, the new budget line assumes the shape AB1 and the consumer finds his equilibrium at point S on IC2. At this point, the consumer opts for OX2 of X. Such an effect is also in accordance with the law of demand which implies a larger demand of the product at a lower price.
iv. A further fall in the price of X will shift the budget line further away from the point of origin on the X-axis to the point B2 forming a new budget line AB2 and the consumer’s equilibrium at point T on the IC3. The consumption of X, as a result, further increases to OX3.
v. The equilibrium point will shift further to the point V on the budget line AB3 when the price of X further falls and the consumption of X will increase to OX4.
vi. Thus, as the price of X continue to fall, the budget line will keep on moving away from the point of origin and the consumer’s equilibrium will shift representing higher and higher consumption of X.
ADVERTISEMENTS:
vii. If all the points of equilibrium viz., R, S, T and V, are joined, the curve so formed is termed as price consumption curve (PCC). As the name indicates, the PCC shows a relationship between changes in consumption as a result of change in price of one of the two products.
viii. One can further observe that slope of a PCC varies at different price levels.
a. At lower price levels, it assumes a positive slope and becomes upward looking. This can be noticed between points S and V on the PCC.
b. At middle level of prices, i.e. between R and S, it becomes somewhat horizontal.
ADVERTISEMENTS:
c. While at higher levels of prices, prior to R, it takes a negative slope and, thus, the PCC assumes a downward looking shape.
Derivation of Demand Curve from the PCC:
The PCC shows the relationship between consumption of a product and its price – lower the price more will be the consumption and vice versa. This is broadly the same as the law of demand which also shows an inverse price-quantity relationship – lower the price more will be the quantity demanded. Hence, it should be possible to derive a demand curve from a PCC.
Why a demand curve needs to be derived from a PCC? It is because of the fact that while price levels are explicitly used in drawing a demand curve, it is implicitly involved in a PCC. Therefore, a derivation of demand curve from a PCC has been attempted in Figure-3.17 which has two panels. The upper panel shows construction of a PCC while in the lower panel, derivation of the corresponding demand curve has been attempted.
Based on the figure, following discussion may be carried out:
i. To derive a demand curve, we require information on quantity demanded at different prices.
ii. The different price levels can be identified from the budget line relating to a point of equilibrium. For example, we can identify the price of X associated with the equilibrium point R from the budget line AB in the upper panel of the figure.
iii. The price level so identified (P1) is marked on the Y-axis of the lower panel.
iv. At this price, quantity demanded can be taken as equal to consumption of X by the consumer, which is OX1, in the upper panel.
v. This level of consumption is extended to lower panel to represent quantity demanded.
vi. The two co-ordinates will provide us a point R on the demand curve in the lower panel.
vii. Similarly, co-ordinates of more points (say, point S) can be identified and a demand curve (DD1) can be constructed by joining all such points.
PCC for an Inferior and Giffen Good:
Inferior goods are those whose consumption falls with the rise in income. They are not the exception to the law of demand but the demand is less responsive to the price change. Thus, demand curve in case of an inferior good will be steeper.
Likewise, Giffen goods are those inferior goods which are exception to the law of demand. That is, their demand will increase with a rise in price and their demand will fall with a fall in price of the product. In case of such products, the PCC will be backward sloping and the demand curve will be upward looking or positively sloped.
The method of derivation of the demand curve in cases of both the inferior and Giffen goods will however be same as in case of a normal good.
Shape of PCC and Price Elasticity of Demand:
The shape of a PCC could be upward looking or downward looking or a straight line parallel to X-axis. As a matter of fact, its shape or slope will depend upon the price elasticity of demand. Let us consider all the three possible shapes of a PCC separately, in this regard.
An upward sloping PCC indicates that a fall in price of X will result into an increase in consumption of both X and Y by the consumer. Price of Y remaining same, an increase in consumption of Y means more expenditure on it. As such, consumer’s expenditure on product X will fall since total expenditure of the consumer is given.
As per the total expenditure method of the elasticity of demand, if the total expenditure declines following a fall in price of the product, the demand will be less elastic (see, Table 5.3 in this regard). Hence, in above case, product X will be relatively inelastic.
Thus, it can be stated that when the PCC is upward sloping, the demand for the product will be less elastic or relatively inelastic. Such an inelastic demand is reflected in a steeper demand curve.
A horizontal PCC indicates that a fall in price of X will result into an increase in consumption of X but the consumption of Y will remain unchanged. It means that when the price of X has fallen, its consumption will increase but consumer’s expenditure on it will remain same.
It implies that when the PCC is horizontal, the product will be unit elastic. The demand curve will, therefore, be a rectangular hyperbola which shows that the proportionate change in quantity will be equal to the proportionate change in price.
A downward sloping PCC indicates that a fall in price of X will result into an increase in consumption of X but a fall in consumption of Y by the consumer. As such, the consumer’s expenditure on Y will fall and on X will rise.
This shows that the price change and the change in total expenditure on the product X are in opposite direction and, hence, the product will be more elastic. The demand curve in this case will be a flatter one indicating a proportionately large change in quantity vis-a-vis a change price.
In case of a backward sloping PCC, as in case of a Giffen goods, demand curve will be an upward sloping or a positively sloped one, which is an exception to the law of demand. It indicates a positive price elasticity coefficient or a positive relationship between price of the product and its quantity demanded.
In nut shell, it can be argued that the slope of PCC also reflects price elasticity of the product. Important characteristics of a PCC with regards to its price elasticity can be, thus, summarized as follows in Table 3.3.
Comments are closed.