Price Effect: Derivation of PCC and Demand Curve for Substitutes and Complementary Goods

Price Effect and Derivation of Price Demand Curve(It is too dependent on figures for explanation)

The term "price effect" refers to the phenomena that occurs when a commodity's price varies (let's say, the price of good X), while the consumer's likes and preferences, his income, and the price of item Y remain same. It displays the overall impact of a change in a commodity's price on consumer demand, all other factors being equal. Depending on whether the price drops or rises when the price of the good changes, the consumer will either be in a better or worse position than previously. His equilibrium position will be on a higher indifference curve in the event of a decrease in price and on a lower indifference curve in the event of an increase in price as a result of a change in the good's price.

Price effect on Substitutable goods

In the figure, S is the initial equilibrium to the consumer where both condition (a PQ1 budget line is tangent to I2 and I2 is convex to the origin). In this equilibrium, he has demanded OB units of X good and OM units of Y good. Suppose, the price of X goods falls, the price of Y good and level of income of the consumer remains constant or unchanged. This results in the increase in the purchasing power of the consumer, the demand for X goods increase and budget line shifts rightwards from PQ1 to PQ2. Now the consumer is in the equilibrium at T points. This equilibrium point shows that the consumer is demanding OC units of X goods and ON units of Y goods. Here, he increases his demand for X by BC units and reduces demand for Y by MN units. He has now thus become better off, therefore his level of satisfaction has increased as a consequence of the fall in the price of good X.

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              Price effect on substitute goods

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Suppose, the price of X good rises, the price of Y good and level of income of the consumer remains constant or unchanged. This results in the decrease in the purchasing power of the consumer, the demand for X goods decrease and budget line shifts leftwards from PQ1 to PQ. Now the consumer is in the equilibrium at R points. This equilibrium point shows that the consumer is demanding OA units of X goods and OB units of Y goods. Here, he reduces his demand for X by BA units and increases demand for Y by LM units. He has now thus become worse off, therefore his level of satisfaction has decreased as a consequence of the rise in the price of good X.

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By joining the equilibrium points R, S and T respectively, we derive price consumption curve (PCC). It has a negative slope. This slope traces out the price effect on normal as well as substitutable goods.

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With the help of consumer's equilibrium point presented in the figure, we can derive price-demand curve. According to the equilibrium point S, OB units of X goods is demanded by the consumer when the price of X good is OY2. As the price of X good increases to OY3, he or she demanded OA units of X goods. When the price of X good decreases to OY, he or she increases their demand for OC units of X goods. By plotting this information in the graph, we can derive price-demand curve. It slopes downwards to the right reflecting the law of demand.

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Price effect on complementary goods

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In the figure, E1 is the initial equilibrium to the consumer where both condition (AB budget line is tangent to IC1 and IC1 is convex to the origin). In this equilibrium, the consumer is demanded OQ1 units of X good and ON1 units of Y good. Suppose, the price of X good falls, the price of Y good and level of income of the consumer remains constant or unchanged. As a result, the initial budget line shifts rightwards from AB to AC. This shift takes place due to increase in consumer's purchasing power in terms of X goods. Now the consumer is in the equilibrium at E2 on higher indifference curves. This equilibrium point shows that the consumer is demanding OQ2 units of X goods and ON2 units of Y goods. Here, he increases his demand for X by Q1Q2 units as well as increases demand Y by N1N2 units. He has now thus become better off, therefore his level of satisfaction has increased as a consequence of the fall in the price of good X.

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Price effect on complementary goods

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Suppose, the price of X goods rises, the price of Y good and level of income of the consumer remains constant or unchanged. As a result, the initial budget line shifts leftwards from AB to AD. This shift takes place due to a decrease in consumer's purchasing power in terms of X goods. Now the consumer is in the equilibrium at E0 on lower indifference curves. This equilibrium point shows that the consumer is demanding OQ0 units of X goods and ON0 units of Y goods. Here, he decreases his demand for X by Q1Q0 units as well as increases demand for Y by N1No units. He has now thus become worse off, therefore his level of satisfaction has decreased as a consequence of the rise in the price of good X.

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By joining the equilibrium points E0, E1, and E2 respectively, we derive price consumption curve (PCC). It has a positive slope. This slope reflects the price effect on normal and complementary goods.

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With the help of consumer's equilibrium point presented in the figure, we can derive price-demand curve. According to the equilibrium point E1, OQ1 units of X goods is demanded by the consumer when the price of X good is OY2. As the price of X good increases to OY3, he or she demanded OA units of X goods. When the price of X good decreases to OY, he or she increases their demand for OC units of X goods. By plotting this information in the graph, we can derive price-demand curve. It slopes downwards to the right reflecting the law of demand.

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Reference

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Koutosoyianis, A (1979), Modern Microeconomics, London Macmillan