Income and Substitution Effects of a Price Change Essay

Income and Substitution Effects of a Price Change - Essay Example Complete, reflexive and transitive are the axioms of consumer theory. The theory of consumer preferences can be formulated on the basis of the above axioms (Samuelson, 1956. p.3). The two axes represent a typical consumption of a consumer of goods 1 and 2. A consumption bundle (x1,x2) is taken along with the other consumption bundles that are preferred weakly to the selected bundle. This is what we mean by a set that is weakly preferred. The indifference curve is formed by the bundles forming the boundary of the selected set i.e. the bundles that will provide the consumer as much satisfaction as the selected bundle. The indifference curve can be drawn through any consumption bundle. One of the disadvantages in using indifference curve analysis is that it shows only the consumption bundle perceived by the consumer is indifferent. It fails to capture the bundles which are better or worse. One of its characteristics is indifference curve that represents distinct preferential levels cannot cross. The rate at which the consumer likes to substitute goods is called the marginal rate of substitution. MRS is derived from the slope of the indifference curve The budget constraint of the consumer is p1x1+p2x2=m. The consumption of good 1 is taxed at a rate of t. The new budget constraint will be (p1+t)x1+p2x2=m. The effect of the change in price on the demand conditions is shown in the figure below. The set of bundles that are preferred by a consumer to the optimal choice is above the indifference curve and the set of bundles that is against the affordability is above the indifference curve. Hence the optimal choice is the best bundle that can be chosen by the consumer. Now, an income tax is taken into consideration which raises the revenue by the same amount as the tax. The form of that budget constraint will be p1x1+p2x2=m-tx1*, where tx1* is the rise in revenue because of tax.