UTILITY

Utility means the happiness or satisfaction which you get by consuming a good whether the good is useful or not. In fact,
if a good has an ability to give some satisfaction or happiness to its user, then an economist says that the good has utility.
Utility does not mean the usefulness of a good but it is it’s the capability to satisfy someone’s need or a want. The world
famous painting Mona Lisa by Leonardo da Vinci, has ability to give happiness to an art lover but the painting cannot
be said to be useful to the art lover. Therefore, the painting has utility but still not useful even for the art lover.

TOTAL UTILITY

It means number of utils obtained by consuming all the units of something. In fact, total utility is the summation of
marginal utilities of n units of a good.

n
Total utility =MU 1+ MU 2+ MU 3+… . MU n=∑ MU i
i=1

MARGINAL UTILITY

It means the change in total utility when one extra unit of a good is consumed. Mathematically, it is defined as the ratio of
change in the total utility and the change in the quantity. Therefore

∆ U Change∈the total utility

MU = =
∆Q Change∈the quantity

RELATIONSHIP BETWEEN TOTAL UTILITY AND MARGINAL UTILITY

The relationship between the marginal utility and the total utility is:
1. When the marginal utility decreases, then the total utility increases.
2. When the marginal utility is zero, then the total utility attains its maximum value.
3. When the marginal utility becomes negative, then the total utility declines.

CARDINAL UTILITY THEORY

Economists have tried to understand a consumer’s behavior with the help of various theories or approaches. There are two
categories of utility theories i.e. 1) Cardinal Utility Theory and 2) Ordinal Utility Theory. The cardinal utility theory
assumes that utility is a cardinal concept and therefore can be measured in numbers while the ordinal utility theory
assumes that utility cannot be measured but be ranked/ordered. The assumptions of the cardinal utility theory are as
follows.

1. Rational consumer: It means that a consumer always wants to maximize his or her utility for a given income.
2. Utility is cardinal: It means that utility is a cardinal concept i.e. utility can be measured in numbers. The
measuring unit of utility is util.
 3. Marginal utility of money is constant. The marginal utility of money can also be expressed in utils but remain
constant. The marginal utility of money is calculated by the consumer himself or herself.
4. Law of diminishing marginal utility operates well.
5. Utilities are additive: It means the utilities of derived from the consumption of n goods can be added. However,
this assumption is unnecessary for the cardinal theory.

LAW OF DIMINISHING MARGINAL UTILITY / GOSSEN’ FIRST LAW OF UTILITY

The law of diminishing marginal utility states that marginal utility is a decreasing function of the quantity consumed. In
other words, as the consumption of a good is increased from 1 to 2 to 3 to 4 to...to n units, then the utility derived from the
second i.e. MU2 is less than the utility from the first unit i.e. MU 1, the utility derived from the 3 rd unit i.e. MU3 is less than
the utility from the second unit i.e. MU2, the utility derived from the 4th unit i.e. MU4 is less than the utility from the 3 rd
unit i.e. MU3 and finally the utility derived from the n th unit i.e. MUn is less than the utility derived from the (n-1) th unit
i.e. MUn-1. Symbolically,

MU 1> MU 2> MU 3> … … … … … …> MU n-1 > MU n

In the following diagram we have a downward sloping marginal utility curve showing that as the consumption increases,
then the marginal utility keeps on declining. One point must be keep in mind that is MU may be positive, zero or even
negative when consumption is compelled.

MU (utils)

0
MU
Quantity of the good

ASSUMPTIONS OF THE LAW OF DIMINISHING MARGINAL UTILITY

The law of diminishing marginal utility is based upon the following assumptions:
1. Utility is a cardinal concept i.e. it can be measured in numbers.
2. Marginal utility of money is constant.
3. Consumption should be on continuous basis i.e. there should not be break in consumption.
4. A unit is should be defined properly i.e. if water is being taken, then a unit does not mean a drop rather it should
be a glass of water.
5. Each unit being consumed should be of the same size and quality.
6. Goods are divisible i.e. they can be measured at any point on a number line.
 7. Income of the consumer is constant.

EXCEPTIONS TO THE LAW OF DIMINISHING MARGINAL UTILITY

Is the law of diminishing marginal utility always applicable? The answer is NO. There are some exceptions to the law.
These exceptions are as follows:

1. Consumption of initial units

When someone starts to consume something and the first consumed is not in sufficient quantity, then the second
unit will add to the utility more than the first unit.
2. Rare goods especially bearing historical importance
Rare goods mean those goods which are not available in bulk quantity. Historical Coins, paintings etc. are some
examples of rare goods. It has been found that as one gets more and more of rare goods, then he or she gets more
and more utility or satisfaction.
3. Addicts of drugs or alcohol
It has been found that the more and more wine a drunkard takes the more utility he obtains.
4. Interesting books, religious books, songs or movies
When we read some interesting books/novels/religious books or listen some melodious songs or watch fantastic
movies, then more consumption (reading/listening/watching etc.) give us more marginal utility. Therefore, the law
does not hold good here. However, the law does not operate up to a certain level of time and one time will come
when the law will start to work.
5. Seekers of spirituality
There is a group of people for whom only spirituality matters. Naaga sadhus, Aghori rishis found in India are
classic examples of such people. In case of such people the law fails because except the things relating to
spirituality do not give them happiness or utility.

CONSUMER EQUILIBRIUM: OPTIMISING/MAXIMISING UTILITY

When a consumer finds that re-distribution of his or her limited income over one or two or more goods will not add to his
or her present total utility, then he or she is said to be in equilibrium. In other words, a consumer is in equilibrium when
he or she maximizes/optimizes his or her utility for a given level of income. Economists study equilibrium in three cases.
These cases are as follows:

Case 1: Consumption of one good

Suppose that Px is the price of a good X and MUx is its marginal utility which is measured in utils. Further
suppose that MUM is constant marginal utility of one rupee which is also measured in utils. In other words,
when the ratio of the marginal utility of X and the marginal utility of rupee one is equal to the price of X, then
the consumer gets equilibrium. Symbolically,

MU x
=P x … … … … … … … … … .(1)
MU m

Equation 1 states that when the marginal utility of X per marginal utility of rupee one is equal to the price of X,
then the consumer is in equilibrium.

Rearranging equation 1, we get another version of equilibrium condition i.e.

MU x
=MU m … … … … … … … … (2)
Px

Equation 2 states that when the marginal utility of X per unit of price is equal to the marginal utility of rupee
one, then a consumer is in equilibrium.

Now if we rearrange again any of the above two equations, then we have another version of equilibrium
condition i.e.

MU x=P x × MU m … … … … … … …(3)

The right hand side of this equation is called weighted marginal utility of rupee one. Equation 3 states that when the
marginal utility of X is equal to the weighted marginal utility of rupee one, then a consumer is in equilibrium.

Example: Suppose a consumer Lara is asked about her utility of rupee one and she replies that its 5 utils. Therefore,
MUM=5 utils. Further suppose that the price of a good is `10 and the marginal utility of various units of the good are given
in the second column the following table. In the above table, for the 3 rd unit the MUx is 50 utils and the weighted marginal
utility of rupee one is also 50 utils, therefore equation 3 is satisfied here. Thus, by consuming 3 units of the good Lara is
in equilibrium.

Units MUx in utils MUM in utils Px in ` P x × MU m

1st 70 5 10 50
2nd 60 5 10 50
3rd 50 5 10 50
4th 40 5 10 50
5th 30 5 10 50

If we plot the data from the above table on a graph, then we get a downward sloping marginal utility curve MUx and
horizontal line Px X MUm. Both the curves are intersecting when the quantity is 3 units. At the intersection MUx= Px X
MUm. If the consumption is less than 3 units, then MU x> Px X MUm, then Lara can increase her welfare by increasing
consumption and if the consumption is greater than 3 units, MUx< Px X MUm, then Lara can increase her welfare by
decreasing consumption. In this way when MUx= Px X MUm, then the incentive to go ahead or move backward disappears.
 Utility (utils) 60

50

40
P x × MU m

30

20 MU x

10

0
0.5 1 1.5 2 2.5 3 3.5 4 4.5 5 5.5
Quantity of the good

Case 2: Consumption of two goods: Law of Equi-marginal utility

Suppose that Px and Py are the prices of two goods X and Y respectively and MUx and MUy are their marginal
utilities which are measured in utils. Further suppose that MUM is constant marginal utility of rupee one which
is also measured in utils. Now we know that in case of one good consumption, the equilibrium condition is
attained when the ratio of the marginal utility of a good and the marginal utility of rupee one is equal to the
price of the good, therefore,

Equilibrium in case of good X

MU x
=P x … … … … … … … … … .(1)
MU m

Equilibrium in case of good Y

MU y
=P y … … … … … … … … … .(2)
MU m

Dividing equation (1) by equation (2) we get

MU x P x
= … … … … … … … …(3)
MU y P y

This is the required condition of equilibrium when two goods are consumed. Equation (3) states that when the
ratio the marginal utilities of X and Y are equal to their prices ratio, then a consumer is in equilibrium.

Rearranging equation (3) we get another version of the equilibrium condition i.e.
 MU x MU y
= … … … … … … .(4)
Px Py

Equation (4) states that when the marginal utility of good X per unit of its price is equal to the marginal utility
of good Y per unit of its price, then a consumer is in equilibrium.

This equation is known as the law of Equi-marginal utility.

In the following diagram the MUx/Px and MUy/Py curves denote for marginal utilities per unit of the prices of two goods X
and Y respectively. The MUx/Px tells us how much marginal utility is derived by spending rupee one on X. Similarly,
MUy/Py does. Apart, the movement from left to right on the horizontal axis measures the quantity demanded for X while
the movement from right to left measures the quantity demanded for Y. MUx/Px and MUy/Py curves intersect each other at
point E where
MU X MU Y
=
PX PY
Therefore point E is the equilibrium point where O xQ (from left to right) is the quantity demanded for X while that of Y is
OyQ (from right to left).

MU X MU y
Equilibrium
PX Point Py

MU y
Py
MU X
PX
0x Q 0y
Quantity of X
Quantity of Y

Case 3: Consumption of n goods i.e. more than two goods : Law of Equi-marginal utility

If n goods are consumed, then in equilibrium the ratios of the marginal utilities and their prices are equal. Symbolically,

MU 1 MU 2 MU 3 MU n
= = =… … … … .=
P1 P2 P3 Pn
Derivation of the Demand Curve in Terms of Utility Analysis:
 
Dr. Alfred Marshal was of the view that the law of demand and so the demand curve can be derived with the help of
utility analysis.

 He explained the derivation of law of demand:

 (i) In the case of a single commodity and (ii) in the case of two or more than two commodities. In the utility analysis of
demand, the following assumptions are made:

 Assumptions:

 
(i) Utility is cardinally measurable.
 
(ii) Utilities of different commodities are independent.
 
(iii) The marginal utility of money to the consumer remains constant.
 
(Iv) Utility gained from the successive units of a commodity diminishes.
 
(1) Derivation of Demand Curve in the Case of a Single Commodity (Law of
Diminishing Marginal Utility):
 
Dr. Alfred Marshall derived the demand curve with the aid of law of diminishing marginal utility. The law of diminishing
marginal utility states that as the consumer purchases more and more units of a commodity, he gets less and less utility
from the successive units of the expenditure. At the same time, as the consumer purchases more and more units of one
commodity, then lesser and lesser amount of money is left with him to buy other goods and services.

A rational consumer, before, while purchasing a commodity compares the price of the commodity which he has to pay
with the utility of a commodity he receives from it. So long as the marginal utility of a commodity is higher than its price
(MUx > Px), the consumer would demand more and more units of it till its marginal utility is equal to its price MU x = Px or the
equilibrium condition is established.

To put it differently, as the consumer consumes more and more units of a commodity, its marginal utility goes on
diminishing. So it is only at a diminishing price at which the consumer would like to demand more and more units of a
commodity.

Diagram/Curve:
 
 

In fig. 2.4 (a) the MU x is negatively slopped. It shows that as the consumer acquires larger quantities of good x, its
marginal utility diminishes. Consequently at diminishing price, the quantity demanded of the good x increases as is shown
in fig. 2.4 (b).

At X1, quantity the marginal utility of a good is MU 1. This is equal to P 1 by definition. The consumer here demands OX 1
quantity of the commodity at P 1 price. In the same way X 2 quantity of the good is equal to P 2. Here at P2 price, the
consumer will buy OX2 quantity of commodity. At X3 quantity the marginal utility is MU 3, which is equal to P3. At P3, the
consumer will buy OX3 quantity and so on.

We conclude from above, that as the purchase of the units of commodity X are increased, its marginal utility diminishes.
So at diminishing price, the quantity demanded of good X increases as is evident from fig. 2.4 (b). The rational supports
the notion of down slopping demand curve that when price falls, other things remaining the same, the quantity demanded
of a good increases and vice verse. (The negative section of the MU curve does not form part of the demand curve, since
negative quantities do not make sense in economics).

(2) Derivation of the Demand Curve in the Case of Two or More than Two
Commodities (Law of Equi-Marginal Utility):
 
The law of diminishing marginal utility can also be applied in case of two or more than two goods. When a consumer has
to spend a certain given income on a number of goods, he attains maximum satisfaction when the marginal utilities of the
goods are proportional to their prices as stated below.

MUx / Px = MUy / Py = ……….. MUn / Pn

 
Derivation of Demand Curve:
 
In the fig. 2.5 (a), (b) and (c) given the money income, the price of X commodity (P x) and the price of Y commodity (P y)
and constant marginal utility of money (MU m), the demand curve derived is illustrated. The consumer allocates his money
income between X and Y commodities to get OQ 1 units of good X and OY unit of good Y commodities because the
combination correspondence to:

MUx / Px = MUy / Py = MUm

At the OM level (constant).

Diagram/Curve:
 

 
 

Let us assume that money income and price of Y commodity remain constant but the price of X commodity decreases. As
a result of this money expenditure on commodity X rises resulting MU x / Px curve to shift towards right. The consumer now
allocates his income to OQ2 quantity of X commodity and O y quantity of Y commodity because the combinations
correspondence to

     MUx / Px = MUy / Py = MUm

(constant) at OM level.

Thus in response to decrease in the price from Px to Px 1, the quantity demanded of a good X increases from OQ 1 to OQ2.
The DD is a negatively sloped demand curve.

CRITICISM OF THE CARDINAL UTILITY THEORY

The cardinal utility theory is criticized due to the following reasons:

1. The theory assumes that utility is a cardinal concept i.e. utility can be measured in number but in reality utility
cannot be measured objectively. Utility is a subject matter not cardinal. Therefore, this assumption is unrealistic.
2. Generally, the law of diminishing marginal utility does not operate in case of money. The more money a normal
person obtains the more marginal utility he obtains but the cardinal utility theory assumes that the marginal utility
of money is constant. This assumption also seems to be unrealistic.
3. The law of diminishing marginal utility is a psychological law which must be taken as granted.
4. The cardinal utility theory assumes that the marginal utility of money is calculated by the consumer himself but in
practical life this is not an easy task even this almost impossible because utility is a subjective matter in reality.
ORDINAL UTILITY THEORY

Edgeworth and Pareto suggested the ordinal utility theory. J. R. Hicks and R.G.D Allen further developed the theory in
1939. The theory is based upon the following assumptions:

1. Rational consumer: It means that a consumer always wants to maximize his or her utility for a given level of
income.
2. Utility is ordinal or Completeness: It means that a consumer can rank or maker ordering of his or her
preferences for various market baskets according to the satisfaction/utility of each basket.
3. Consistency in preference: It means that if a consumer prefers market basket A than B at a time, then he or she
will not prefer B than A at other time. Symbolically,
If A> B , then B ≯ A
4. Transitivity in preference: It means that if a consumer prefers market basket A than B and B than market basket
C, then he must prefer A than C.
If A> B∧B>C ,then A >C
5. More is better than less: It means that a consumer prefers more quantity of a good than less quantity even if a
little more and as a result it can be said that a consumer is never satisfied.

INDIFFERENCE CURVE

An indifference curve is a curve showing all those points (or market baskets) giving a consumer equal satisfaction. In
other words, an indifference curve catches all those market baskets which are equally capable of satisfying a consumer.
Thus, on an indifference curve the utility level does not change irrespective of the market baskets being preferred. In the
diagram, IC is an indifference curve that shows that market basket A gives the same satisfaction as market basket B does
even A and B have different quantities of two goods X and Y. Mathematically, an indifference curve can be defined as
follows:

U =f ( X ,Y )

Where U =Constant utility ; X=quantity of good X ; Y =quantity of good Y

Qty. Y

Y1 A

Y2 B

IC
0 X1 X2 Qty. X
In the above diagram, we see that when the quantity of X increases from X 1 to X2, then the quantity of Y decreases from
Y1 to Y2. Thus, for extra X1X2quantity, Y is sacrificed by Y 1Y2. If we want to know that for extra one unit of X how much
quantity of Y should be sacrificed, then we have the answer is the ratio X 1X2/Y1Y2. This ratio is known as the marginal
rate of substitution (MRSXY) and in geometry this ratio is called the slope of the indifference curve. Thus,

−Change∈the quantity of Y −∆Y −Y 1 Y 2

Slope of an indifference curve=MRS xy= = =
Change∈the quantity of X ∆X X1X2

PROPERTIES / ASSUMPTIONS OF AN INDIFFERENCE CURVE

1. Downward sloping
An indifference curve is assumed to be downward sloping and the reason for being so very simple i.e. on a given
indifference curve when X increases, then an adjustment in Y is required so that utility level on the indifference
curve does not change and this adjustment can be made by sacrificing Y. In this way there is negative relationship
between X and Y causing the slope (or MRS) of an indifference curve to be negative.
2. Convex to the origin / Diminishing marginal rate of substitution
An indifference curve is convex to the origin not concave. The reason of convexity of an indifference curve is the
law of diminishing marginal utility. In fact, when we increase the quantity of X, then Y is sacrificed and therefore
in case of X the marginal utility of X declines due the law of diminishing marginal utility while that of Y
increases due to the same law. That is why the marginal rate of substitution (MRS) of an indifference curve is
diminishing. However, in some exceptional cases, indifference curves are found to be concave.
3. The higher indifference curve the higher level of satisfaction
In an indifference map (which means a set of indifference curves on the same graph), the farthest/highest
indifference curve gives a consumer the highest satisfaction due the assumption of ordinal utility theory- more is
better. In the following diagram, we have three indifference curves IC 1, IC2 and IC3 and IC3 is the farthest or
highest, therefore it gives the highest satisfaction in comparison of other two indifference curves. Every market
basket on a higher indifference curve has more quantities of two goods than a lower indifference curve.

Qty. Y

IC3
IC2
IC1
0 Qty. X
4. Two indifference curves cannot intersect each other
To understand the logic of this property we assume that two indifference curves IC1 and IC2 intersect at point A
as shown in the diagram.

Qty. Y

B
IC1
C IC2

0 Qty. X

Since market baskets A and B fall on the same indifference curve IC 1and therefore
A = B………(1)
Since market baskets A and C fall on the same indifference curve IC 2 and therefore
A = C………(2)
From (1) and (2)
B = C……… (3)

Thus, equation 3 states that market baskets B and C are equal i.e. both will equally satisfy a consumer but market
basket B falls on a higher indifference curve therefore it must be preferred than C. Thus,

B > C not B≠ A

The conclusion is that if two indifference curves were allowed to intersect, then equation 3 will provide a
contradiction of the assumption more is better. Therefore, our assumption of intersection of two indifference
curves is wrong.
EXCEPTIONAL SHAPES OF INDIFFERENCE CURVE

Case of Perfect substitute goods

If X and Y are two perfect substitutes, then the MRS is constant due to which the indifference curve is a straight line as
shown in the diagram.
Qty. Y

MRS

MRS

MRS
IC
0 Qty. X

Case of complimentary goods

If X and Y are complimentary goods, then the indifference curve is L-shaped as shown in the diagram. Complimentary
goods are always used in a fixed ratio or proportion. Suppose 2 units of X and 3 units of Y are used together to get a
certain level of satisfaction. This market basket is A in the diagram. Therefore X and Y ratio/proportion is 2:3. Now the
consumer is given 4 units of X with 3 units of Y (denoted by the market basket by B), then extra 2 units of X will be
useless unless extra 3 units of Y are given to the consumer so that X and Y ratio remains at 2:3. Therefore market baskets
A and B give the same utility level and therefore they must fall on the same indifference curve, IC. Similarly, we can
explain market basket C too, we find that A and D give the same utility level and therefore they must fall on the same
indifference curve, IC. In this way we get L-shaped indifference curve.

Qty. Y

6 C

A B
3 IC

0 2 4 Qty. X

BUDGET LINE

A budget line is a line that locates all those market baskets which are affordable and therefore help us in finding those
market baskets which can be and cannot be purchased. Mathematically, a budget line is defined as follows:
P x Q x+ P YQ y=I
Where Px and Py are the per unit prices of two goods X and Y while Qx and Qy are their quantities while I is given income.
Using the mathematics of straight lines we have the following formula of a budget line.
−P x
Slope of a budget line=
Py
In the following diagram we have a budget line BL which shows that all the market baskets on BL are affordable but
those lying beyond it (like D) are not affordable because will need an income higher than I. All the market baskets lying
under a budget line are affordable but in that case there will be saving in the income given.

Qty. Y

L
0 Qty. X

EFFECT OF CHANGE IN INCOME ON A BUDGET LINE WHILE PRICES OF THE GOODS ARE
CONSTANT

Case I: Income increases

If the income of a consumer increases, then the budget line shifts parallel rightward. In the diagram when income is I1,
then the budget line is BL but when the income increased to I2, then the budget line is B’L’.

Qty. Y B’

L L’
0 Qty. X
Case II: Income decreases
If the income of a consumer decreases, then the budget line shifts parallel leftward. In the diagram when income is I1, then
the budget line is BL but when the income decreased to I 2, then the budget line is B’L’.

Qty. Y B

B’

L’ L
0 Qty. X

EFFECT OF CHANGE IN PRICES OF GOODS ON A BUDGET LINE WHILE INCOME IS CONSTANT

Case I: Price of good X decreases while the price of Y is unchanged

When the price of X falls, then a consumer can buy more of it and as a result the initial budget line BL rotates about point
B and becomes BL’. Technically, on fall of the price of X, the slope of the budget line increases and as a result revolves
anticlockwise around point B.

Qty. Y

L L’
0 Qty. X

Case II: Price of good Y decreases while the price of X is unchanged

When the price of Y falls, then a consumer can buy more of it and as a result the initial budget line BL rotates about point
L and becomes B’L. Technically, on fall of the price of Y, the slope of the budget line decreases and as a result revolves
clockwise around point L.

Qty. Y
B’

L
0 Qty. X

CONSUMER EQUILIBRIUM: UTILITY MAXIMISING MARKET BASKET

When a consumer finds that re-distribution of his or her limited income over one or two or more goods will not add to his
or her present total utility, then he or she is said to be in equilibrium. In other words, a consumer is in equilibrium when he
or she maximizes/optimizes his or her utility for a given level of income. In ordinal utility theory a consumer attains
equilibrium when a budget line is tangent to an indifference curve. A budget line is tangent to an indifference curve
when their slopes are equal. Thus the equilibrium condition is
Slope of a budget line=Slope of an indifference curve
We know that
−P x
Slope of a budget line= ∧Slopeof an indifference curve=−MRS
Py
Therefore in equilibrium
−P x
=−MRS
Py
Or
Px
=MRS
Py

In the following diagram, the budget line BL is tangent to the indifference curve IC 2 at point E and therefore the above
condition of equilibrium is satisfied here and E is equilibrium point. Let us understand the logic of the above condition.
Equilibrium point cannot fall on indifference curve IC 3 because that point will be beyond the budget line even IC 3 is the
most preferable indifference curve. Now we consider points A and C lying on the indifference curve IC 1. Although points
A and B are on the budget line and therefore are affordable, yet they cannot be equilibrium because IC 1 is a lower
indifference curve and we already that the higher indifference curve is preferred. Therefore, the consumer would like to
achieve a higher indifference curve like IC 2 but should be in his budget. Now consider points G and H. These points too
are not equilibrium points because they are beyond the budget line. This is point E only which is in budget as well as on
the highest indifference curve IC2.

Qty. Y

B
A

H
IC3
C
IC2
IC1
0 L Qty. X
DERIVATION OF THE DEMAND CURVE

Normal Good
A good is said to be inferior good when there is positive relationship between the income of a consumer and the quantity
demanded. In order to derive a demand curve of a normal good X we have two diagrams. In the upper diagram, E is initial
equilibrium point when the budget line BL is tangent to indifference curve IC 1. At point E the quantity purchased of X is
X1 at price P1. Corresponding to point E we have a point G in the lower diagram.

Qty. Y

E
F
PCC
IC2

L IC1 L’
0 Qty. X
Price of X

D
P1 G

P2 H

0 X1 X2 Qty. X

Suppose the price of X falls from P 1 to P2in the lower diagram, then the budget line rotates about point B and becomes
BL’ which is tangent to a new indifference curve IC 2 at point F where the quantity purchased is X 2in the upper diagram.
Corresponding to point F we have H in the lower diagram. Joining points G and H we get a downward sloping demand
curve, DD. Apart in case of a normal the price consumption curve1 is downward sloping as shown in the upper diagram.

Price consumption curve: When the price a good increases or decreases, then the consumer equilibrium point changes. A
price consumption curve shows the effect of price change on consumer equilibrium and this is drawn by joining all the
consumer points resulting at different prices. In the upper diagram when we join the consumer equilibrium points E and
F, then we get a downward sloping price consumption curve.
Inferior Good
A good is said to be inferior good when there is negative relationship between the income of a consumer and the quantity
demanded. The demand curve of an inferior good with respect to its price is downward sloping. In order to derive a
demand curve of a normal good X we have two diagrams. In the upper diagram, E is initial equilibrium point when the
budget line BL is tangent to indifference curve IC 1. At point E the quantity purchased of X is X 1 at price P1.
Corresponding to point E we have a point G in the lower diagram.

Qty. Y

PCC
F
E
IC2

L IC1 L’
0 Qty. X
Price of X

D
P1 G

P2 H

0 X1 X2 Qty. X

Suppose the price of X falls from P 1 to P2in the lower diagram, then the budget line rotates about point B and becomes
BL’ which is tangent to a new indifference curve IC 2 at point F where the quantity purchased is X 2in the upper diagram.
Corresponding to point F we have H in the lower diagram. Joining points G and H we get a downward sloping demand
curve DD. Apart, in case of an inferior good the price consumption curve (PCC) is upward sloping as shown in the upper
diagram.
Giffen Good
A Giffen good is a special case of an inferior good. The demand curve of a Giffen good in respect of its price is upward
sloping. In order to derive a demand curve of a Giffen good X we have two diagrams. In the upper diagram, E is initial
equilibrium point when the budget line BL is tangent to indifference curve IC 1. At point E the quantity purchased of X is
X1 at price P1. Corresponding to point E we have a point G in the lower diagram.

Qty. Y

B PCC

IC2

IC1 L’
L
0 Qty. X
Price of X

P1 G

H
P2

0 X2 X1 Qty. X

Suppose the price of X falls from P 1 to P2in the lower diagram, then the budget line rotates about point B and becomes
BL’ which is tangent to a new indifference curve IC 2 at point F where the quantity purchased is X 2in the upper diagram.
Corresponding to point F we have H in the lower diagram. Joining points G and H we get an upward sloping demand
curve DD. Apart, in case of a Giffen good the price consumption curve (PCC) is backward bending as shown in the
upper diagram.
PRICE EFFECT, SUBSTITUTION EFFECT, INCOME EFFECT

Price effect is composed of two effects i.e.

1. Substitution Effect
It means replacing a good with its substitute good when the price of the good replaced increases. So, when the
price of a good X rises, then this is replaced by its substitute good Y because Y becomes now relatively cheaper.
In this way, the demand for X falls and the demand for Y rises.
2. Income Effect
It means increase in ability to buy more units of a good due to decline in the price of a good. One point is very
important here i.e. the income effect is strong when the good concerned exhausts a major portion of consumer’s
income.

SEPARATION OF SUBSTITUTION EFFECT, INCOME EFFECT FROM PRICE EFFECT

Normal Good
To decompose substitution effect and income effect from price effect in case of a normal good, we use here the Hicksian
approach. In the diagram point E is initial equilibrium point when the budget line BL is tangent to indifference curve IC 1.
At point E quantity purchased of X is X 1.Suppose the price of X falls, then the budget line rotates about point B and
becomes BL’ which is tangent to a new indifference curve IC 2 at point F. Therefore point F is new equilibrium point
where the quantity purchased is X2. The movement from point E to F is called the price effect. To isolate the substitution
effect and the income effect from the price effect we draw a hypothetical budget line RT such that the line is parallel to
the budget line BL’ and tangent to the initial indifference curve IC 1 at point S. At point S the quantity is X 3. The benefit of
drawing this hypothetical budget line is that it hypothetically withdraws the purchasing power of the consumer increased
due to the fall in the price of X. The movement from point E to S is called the substitution effect while the movement
from point S to F is called the income effect. One point should be noticed here that is the substitution effect, the income
effect both are positive and therefore the price effect is also positive.

Qty. Y

E
F
S
IC2

L IC1 L’
0 X1 X3 X2 T Qty. X
Inferior Good

To decompose substitution effect and income effect from price effect in case of an inferior good, we use here the
Hicksian approach. In the diagram point E is initial equilibrium point when the budget line BL is tangent to indifference
curve IC1. At point E quantity purchased of good X is X 1. Suppose the price of X falls, then the budget line rotates about
point B and becomes BL’ which is tangent to a new indifference curve IC 2 at point F. Therefore point F is new
equilibrium point where the quantity purchased is X 2. The movement from point E to F is called the price effect. To
isolate the substitution effect and the income effect from the price effect we draw a hypothetical budget line RT such that
this is parallel to the budget line BL’ and tangent to the initial indifference curve IC 1 at point S. At point S the quantity is
X3. The benefit of drawing this hypothetical budget line is that it hypothetically withdraws the purchasing power of the
consumer increased due to the fall in the price of X. The movement from point E to S is called the substitution effect
while the movement from point S to F is called the income effect. One point must be noted here that the income is
negative while the substitution effect is positive, however, the substitution effect outweighs the income effect and therefore
the price effect remains positive.

Qty. Y

R F
E

S IC2

IC1

L L’
0 X1 X 3 X2 T Qty. X

Giffen Good

To decompose substitution effect and income effect from price effect we use here the Hicksian approach.In the diagram
point E is initial equilibrium point when the budget line BL is tangent to indifference curve IC 1. At point E quantity
purchased of good X is X 1. Suppose the price of X falls, then the budget line rotates about point B and becomes BL’
which is tangent to a new indifference curve IC 2 at point F. Therefore point F is new equilibrium point where the quantity
purchased is X2. The movement from point E to F is called the price effect. To isolate the substitution effect and the
income effect from the price effect we draw a hypothetical budget line RT such that this is parallel to the budget line BL’
and tangent to initial indifference curve IC1 at point S. At point S the quantity is X3. The benefit of drawing this
hypothetical budget line is that it hypothetically withdraws the purchasing power of the consumer increased due to the fall
in the price of X. The movement from point E to S is called the substitution effect while the movement from point S to F
is called the income effect. One point should be noticed here that is the substitution effect is positive but, the income effect
is negative and the income effect outweighs the substitution effect and therefore the price effect is negative.

Qty. Y

B
F
IC2
R

E
S
IC1
L L’ L’
0 X2 X1 X3 T Qty. X

 Marginalism – pg 36 -37
 Incrementalism – pg 36 -37