The indifference curve can be defined as the curve showing all the combinations of two commodities, which give the same level of utility or satisfaction to the consumer, in a two-commodity economy. The budget line, on the other hand, shows the consumer’s ability to buy different combinations of two commodities. The equilibrium occurs at the point, where the indifference curve of a consumer touches his budget line. In this essay, using this approach the effects of a change in price of coffee, on the quantity demanded of coffee and pastries, by a particular consumer, is tried to be analyzed, assuming that both the commodities are normal goods (Rader, 2014).
Effects of increase in the price of coffee
In the given problem, it is assumed that the consumer spends his entire income on the consumption of coffee and pastries, both of which are normal goods, which mean with the increase in price the demand for these commodities decrease and vice versa. When there is a considerable increase in the price of coffee, the effect of the increase in price on the quantity demanded of both the goods can be divided into two parts, the income effect and the substitution effect (Rios, McConnell & Brue, 2013).
The income effect shows the change in consumption of the consumer due to an increase in the price of a commodity, which decreases the purchasing power of the consumer. On the other hand the substitution effect shows the change in the consumption of the commodities that happens due to the change in the relative prices of the two commodities following the hike in the price of one commodity. In the concerned case, coffee being a normal commodity, with the increase in the price of coffee, the relative price of coffee also increases and the overall purchasing power of the consumer also decreases, the effects of which are shown as follows:
Figure 1: Effects of increase in the price of coffee
(Source: As created by the author)
As can be seen from the above diagram, the initial equilibrium of the consumer is at E0, with the indifference curve Ic1 being tangent on the budget line AB0. With the considerable increase in price of coffee, price of pastries remaining unchanged, the budget line rotates to AB1. With the help of the compensated budget line (the dotted line), it can be seen that, assuming that the purchasing power of the consumer is kept at the initial level, with the increase in the price of coffee, the demand for coffee declines from Qc to Qc’ (Hall & Lieberman, 2012). This is the substitution effect, which is negative as coffee is a normal good. Now, given the original income showing a lesser purchasing power, the equilibrium shifts to E2, with the new IC being Ic1 and the quantity of coffee decreasing further to Qc’’. This is the negative income effect. Thus, the entire price effect shows the decrease in demand for coffee from Qc to Qc’’. The change in the demand for pastries, however, depends on the magnitude of the change in purchasing power and the income and substitution effects. It may decrease, remain the same or may even increase to a little extent if the demand for coffee is substantially decreased (Dixon et al., 2012).
Dixon, P. B., Bowles, S., Kendrick, D., Taylor, L., & Roberts, M. (2012). Notes and problems in microeconomic theory (Vol. 15). Elsevier.
Hall, R. E., & Lieberman, M. (2012). Microeconomics: Principles and applications. Cengage Learning.
Rader, T. (2014). Theory of microeconomics. Academic Press.
Rios, M. C., McConnell, C. R., & Brue, S. L. (2013). Economics: Principles, problems, and policies. McGraw-Hill.