UNIT – 2 MICRO ECONOMICS

BCOM – 103

Ques-1) Write short notes on

a) Distinguish between Giffen goods and Inferior goods

b) Marginal rate of substitution
c) Demand forecasting
d) Ordinal utility
e) Movement along v/s shift in demand curve
f) Cross elasticity of demand
g) Income elasticity of demand

Ans-1)

a) Distinguish between giffin goods and inferior goods:-

Giffen goods Inferior goods

1. Giffin goods are those type of special 1. Inferior goods are those goods in
goods in which the consumer demand which the consumer demand less if
when the price rises and less if it falls. their income rises and vica-versa.

2. Giffin goods do not have any close 2. Inferior goods have close substitutes.
substitutes.

3. Law of demand fails to operate in 3. It takes into consideration the

case of giffin goods. “income effect”.

4. Rice (in China) is considered to be a 4. A radio is an inferior product, and as

giffen good because people tend to consumer income rises they will
purchase less when price falls because demand less radios and switch to a
when the price of rice falls, people have better more expensive substitute such
more money to spend on meat and as a TV set.
dairy.
 b) Marginal rate of substitution:- The marginal rate of substitution is
the rate at which a consumer is ready to give up one good in
exchange for another good while maintaining the same level of utility.

It is also known as slope of indifference curve. When the consumer

sacrifices some units of good X and to gain additional units of good Y is
MRS. It also keeps on declining as the consumer cannot sacrifice same
amount of good X every time know as “Law of diminishing MRS”.

c) Demand forecasting:- Demand forecasting is predicting future

demand for the product. In other words it refers to the prediction of
probable demand for a product or a service on the basis of the past
events and prevailng trends in the present. Demand forecasting may
be used in production planning, inventory management, and at times
in assessing future capacity requirements.

Demand forecasting is of two types-

 Qualitative
 Quantitative

Demand forecasting can is needed for short run and long run.

d) Ordinal Utility:- Ordinal utility is a view of utility measurement based

on the presumption that the satisfaction of wants and needs is not a
quantifiable characteristic of human activity and that preferences are
subjective. Preferences among goods can be ranked (first, second,
third, etc.) but not measured according to a scale.

Ordinal utility consists of 1 theory i.e “ The indifference curve approach”.

Assumptions:-

1. A consumer substitutes commodities rationally in order to maximize

his level of satisfaction.
2. A consumer can rank his preferences according to the satisfaction of
each basket of goods.
3. The consumer is consistent in his choices.
4. It is assumed that each of the good is divisible.
5. It is assumed that the consumer has full knowledge of prices in the
market.

e) Movement along v/s shift in demand curve:- When quantity demanded

of a commodity changes due to a change in its price, keeping other factors
constant, it is known as change in quantity demanded. It is graphically
expressed as a movement along the same demand curve.

It is of two types:-

1) Expansion along the demand curve:- Expansion in demand refers to a rise

in the quantity demanded due to a fall in the price of commodity, other
factors remaining constant. It leads to downward movement along the
demand curve.

2) Contraction along the demand curve:- Contraction in demand refers to a

fall in the quantity demanded due to a rise in the price of commodity, other
factors remaining constant. It leads to upward movement along the demand
curve.
Shift in the demand curve:- When quantity demanded of a commodity
changes price remaining constant due to changes in other factors such as
taste and preference, necessity, seasonal changes etc.

It is of 2 types:-

1) Increase in demand:- It means that when the demand curve shifts

rightward leading to increase in the quantity demanded of the commodity.

2) Decrease in demand:- It means that when the demand curve shifts

leftward leading to decrease in the quantity demanded of the commodity.

f) Cross elasticity of demand:- The cross elasticity of demand or cross-

price elasticity of demand measures the responsiveness of the demand for a
good to a change in the price of another good. It is measured as the
percentage change in demand for the first good that occurs in response to a
percentage change in price of the second good.

g) Income elasticity of demand:- Income elasticity of demand measures the

responsiveness of the demand for a good to a change in the income of the
people demanding the good. It is calculated as the ratio of the percentage
change in demand to the percentage change in income.
Ques-2) What is indifference curve? Explain the properties of indifference
curve. What will be the shape of IC if-

a) When both commodities are perfect substitute

b) When both commodities are complementary

Ans-2) An indifference curve is a graph showing combination of two goods

that give the consumer equal satisfaction and utility. In other words an
indifference curve is the locus of various points showing different
combinations of two goods providing equal utility to the consumer.

A collection of indifference curves, illustrated graphically, is referred to

an indifference map.

Properties:-

1) Downward sloping left to right:- Indifference curve being downward

sloping means that when the amount of one good in the combination is
increased, the amount of the other good is reduced. This must be so if the
level of satisfaction is to remain the same on an indifference curve. For
example, some units of good X must be sacrificed in order to gain additional
units of good Y.

2) Convex to the origin:- This means that indifference curves are convex to
the origin when MRSxy goes on diminishing. MRS diminishes because more of
good X is substituted for good Y. As the consumer goes on consuming,
he/she will start to substitute less of good X to gain additional unit of good Y
thereby leading to decline in MRS. The degree of convexity of an indifference
curve depends on the rate of fall in the marginal rate of substitution of X for
Y.

3) Indifference curves cannot intersect each other:- It means that only one
indifference curve will pass through a point in the indifference map. If the
indifference curves intersect each other it will mean that at that point both
the indifference curve provide the same level of satisfaction to the consumer
which is not possible because each indifference curve provide different level
of satisfaction to the consumer.

4) Higher IC gives higher satisfaction:- A higher IC will provide more

satisfaction than a lower IC because it contains combinations which give
more satisfaction. The consumer will go for higher IC because of “monotonic
preferences” to gain the maximum level of satisfaction possible.

a) When goods are perfect substitute:- When the goods are perfect
substitute of each other the indifference curve is downward sloping
from left to right. This is due to the fact that MRSxy is 0. The
indifference curves are parallel straight lines because the consumer
equally prefers the two goods and is willing to exchange one good for
the other at a constant rate. For eg- Pepsi and coke.
b) When goods are complementary:- Perfect complementary goods are
used in some fixed ratio. The indifference will consist of two straight line
joint together at right angles. The left- hand portion of an indifference
curve of the perfect complementary goods is a vertical straight line which
indicates that an infinite amount of Y is necessary to substitute one unit
of X and the right-hand portion of the indifference curve is a horizontal
straight line which means’ that an infinite amount of X is necessary to
substitute one unit of Y.

Ques-3) What is demand? What are the determinants of demand

function? Why does demand curve slopes downward from left to right?

Ans-3) The term “demand” refers to the desire, backed by the ability to
pay. In other words, it means that having the desire to buy the
commodity and also having the purchasing power to actually buy it.

Determinants of demand function:-

Q = f(p)

Q represents the quantity demanded

F represents the function

P represents the price of the good

1. Price of the good:- The first and foremost determinant for demand of
good is price. Usually, higher the price of the goods, lesser will the
quantity demanded for them and vice a versa.
2. Income of the buyer:- The size of income of the buyers also influences
the demand of the commodity. Mostly “larger the income, higher the
quantity demanded.” Consumers are ready to spend more even of the
prices of the goods are high.
3. Prices of related goods:- The prices of related also affects the demand
of a good. In some cases, the demand of the good rises as the prices of
related goods also rises this is known as “substitute goods.” Eg- pepsi
and coke.

In other cases, the demand of the good falls due to rise in the price of
related goods this is known as “complementary goods”. Eg- car and
petrol.

4. Taste of the buyer:- This a subjective factor. A commodity may not be

purchased by the consumer even though it is very cheap and useful but is
not upto his/her liking. Similarly a consumer might buy a costly product, if
they like it.

5. Seasonal changes:- In winter, the demand for woollen clothes will rise.
Similarly in summer, the demand for cool drinks will rise. So the seasonal
changes can also affect the demand of the commodity.

The demand curve slopes downward because of “Law of demand”.

The law of demand states that other factors being constant such as taste
and preferences, seasonal changes, no of related goods. Price and
quantity demand of any good and service are inversely related to each
other. When the price of a product increases, the demand for the same
product will fall.

Demand schedule- It is the tabular representation of the inverse

relationship between price and demand of a commodity.
 Let us take and example where the consumer is rational and has a give
income of 5Rs.

Price Quantity

5 1

4 2

3 3

2 4

3 Expectations why demand curve is downward sloping:-

 The law of diminishing MU

 Income effect
 Substitution effect

1. The law of diminishing marginal utility:- This law suggests that as more
of a product is consumed the marginal (additional) benefit to the
consumer falls, hence consumers are prepared to pay less. Most
benefit is generated by the first unit of a good consumed because it
satisfies all or a large part of the immediate need or desire. With less
benefit derived, the rational consumer is prepared to pay rather less
for the second, and subsequent, units, because the marginal utility
falls.
 2. Income effect:- If we assume that money income is fixed, the income
effect suggests that, as the price of a good falls, real income - that is,
what consumers can buy with their money income - rises and
consumers increase their demand. Therefore, at a lower price,
consumers can buy more from the same money income, and demand
will rise. Conversely, a rise in price will reduce real income and force
consumers to cut back on their demand.
3. Substitution effect:- In addition, as the price of one good falls, it
becomes relatively less expensive. Therefore, assuming other
alternative products stay at the same price, at lower prices the good
appears cheaper, and consumers will switch from the expensive
alternative to the relatively cheaper one.

Ques-4) Define law of demand? What are the exceptions of law of

demand?

Ans-4) The law of demand states that other factors being constant such as
taste and preferences, seasonal changes, no of related goods. Price and
quantity demand of any good and service are inversely related to each
other. When the price of a product increases, the demand for the same
product will fall.

Exceptions to the law of demand:-

1.Giffin goods:-

Some special varieties of inferior goods are termed as Giffin goods. Cheaper
varieties of this category like bajra, cheaper vegetable like potato come
under this category. When the price of potato increased, after purchasing
potato they did not have so many surpluses to buy meat. So the rise in price
of potato compelled people to buy more potato and thus raised the demand
for potato. This is against the law of demand.

2. Ignorance:-

A consumer’s ignorance is another factor that at times induces him to

purchase more of the commodity at a higher price. This is especially so when
the consumer is haunted by the phobia that a high-priced commodity is
better in quality than a low-priced one. Consumer is not aware of different
commodity that will give him more satisfaction.

3. Emergencies:-
Emergencies like war, famine etc. negate the operation of the law of
demand. At such times, households behave in an abnormal way. Households
accentuate scarcities and induce further price rises by making increased
purchases even at higher prices during such periods. During depression, on
the other hand, no fall in price is a sufficient inducement for consumers to
demand more.

4.Future changes in price:- Households also act speculators. When the prices
are rising households tend to purchase large quantities of the commodity out
of the apprehension that prices may still go up. When prices are expected to
fall further, they wait to buy goods in future at still lower prices. So quantity
demanded falls when prices are falling.

Ques-5) Using cardinal utility analysis, explain the conditions for consumer
equilibrium?

Ans-5) Cardinal utility is a view of utility measurement based on the

presumption that the satisfaction of wants and needs is a quantifiable
characteristic of human activity. In other words, utility can be measured with
numerical values (1, 2, 3, etc.) along a scale.

Assumptions of cardinal utility approach-

1. Consumer is rational
2. Diminishing marginal utility
3. Constant marginal utility of money
4. Independent utilities

Cardinal utility has 2 theory’s under it:-

 Law of diminishing marginal utility

 Law of equi marginal utility

1. Law of diminishing marginal utility:- The Law Of Diminishing Marginal

Utility is a law of economics stating that as a person increases
consumption of a product - while keeping consumption of other products
 constant - there is a decline in the marginal utility that person derives
from consuming each additional unit of that product.

Condition for consumer equilibrium:-

Px = MUx

It means that the consumer is in equilibrium when amount of money

spent on buying the commodity is equal to the amount of satisfaction
derived from consumption of that commodity.

 MUx > Px = Then the consumer can increase his welfare by

consuming more of x. He will continue to do that until his marginal
utility for x falls sufficiently, to be equal with its price.

 MUx < Px = Then the consumer can enhance his welfare by cutting
down on his consumption of x. He will be persisting on doing this,
until his MUx increases to equal the price Px.

2. Law of equi marginal utility:- The law of equi-marginal utility explains the
behaviour of a consumer when he consumers more than one commodity.
Wants are unlimited but the income which is available to the consumers
to satisfy all his wants is limited. This law explains how the consumer
spends his limited income on various commodities to get maximum
satisfaction.

Assumptions:-

 Consumer is rational
 Utility of each commodity is measureable
 MUm remains constant
 Income of the consumer is given
 Prices of the commodities are give.

Conditions:-

1. MUx/Px = MUy/Py = MUm – A consumer is in equilibrium when the

quantities of various commodities are bought in such a way that the
 ratios of marginal utilities of various commodities to their respective
prices are same and equal to the marginal utility of money.

2. MUx/MUy = Px/Py - A consumer is in equilibrium when the ratios of

marginal utilities of two goods and respective prices are equal.

Ques-6) Using ordinal utility, decompose, price effect into income effect
and substitution effect?

Ans-6) Ordinal utility is a view of utility measurement based on the

presumption that the satisfaction of wants and needs is not a quantifiable
characteristic of human activity and that preferences are subjective.
Preferences among goods can be ranked (first, second, third, etc.) but not
measured according to a scale.

 Price effect:- If the price of one commodity changes, everything else

including consumer income remains constant, the consumer will shift
to a new budget line. The point of equilibrium corresponding to each
price change will be given by the point at which the corresponding
budget line touches the highest IC.

Price consumption curve is the curve formed by connecting the various

points consumer equilibrium. PCC traces out price effect, which measures
the effect of the changes in the price of one commodity on the
consumer’s demand.

 Substitution effect:- Whenever the price of a commodity falls, the

consumer substitutes the commodity for the other one. Thus,
substitution effect may be defined as the change in the consumption
of two commodities due to changes in their relative prices.
 Income effect:- The effect of changes in consumer’s income on his
total satisfaction, prices of two commodities remaining constants
referred to as income effect. The curve obtained by connecting
successive consumer’s equilibrium at various levels of income is knows
as income consumption curve (ICC).
 PE = IE + SE
Separation of price effect into substitution effect and income for fall in the
price of commodity on x-axis.

Q12) What is Budget line? How budget line concept is useful in determining
consumer equilibrium?

A12) Budget line represents all possible combinations of two goods that a
consumer can purchase with his limited money income at given prices of two
goods. Using indifference curve approach.

Assumptions:-

1. Consumer is rational.
2. Consumer income is constant.
3. Prices of goods remain constant.
4. Goods are indivisible.
5. Perfect competition in the market.

In order for the consumer to be at equilibrium there are 2 conditions-

1. Slope of budget line(Px/Py) = Slope of IC(MRS)

2. IC is convex to the origin.

Let’s suppose the consumer consumes 2 goods i.e Commodity X and

Commodity Y.

The money income of the consumer is 4Rs.

Income (Y) Commodity X Commodity Y

4 0 4

4 1 3

4 2 2

4 3 1

 In this figure, we can see that the consumer has 3 alternatives IC

available to him. Higher IC providing the maximum satisfaction
i.e IC3 providing most satisfaction.
 The consumer cannot consume IC3 because it is not possible to
go beyond the budget line.
 The consumer can consume combination F and G but they are
on lower IC. So, the consumer will consume the combination E
providing him maximum satisfaction.
 At point E, the consumer will consume OM of commodity X and
ON of commodity Y.

Q8) Discuss the need, objective and methods of demand forecasting with
examples?
A8) Demand forecasting refers to estimating the quantity of a product
demanded or services that will be demanded by consumer in the near
future.

Demand forecasting involves techniques both:

 Qualitative- Like educated guesses.

 Quantitative- Like historical data analysis.

NEED AND OBJECTIVE OF DEMAND FORECASTING:-

 In Short Run-
1. Production Policy:- Appropriate scheduling of production to
avoid the problem of over-production & under-production.
2. Proper management of inventories:- Inventories should be
managed properly so that there shouldn’t be any excess of
inventories left over.
3. Pricing Policy:- Formulating suitable prices, strategy in order to
maintain constant sales. Also considering the prices of our
competitors.
4. Effective sales:- Evolving a suitable sales strategy in accordance
with the change in pattern of demand & competition.

 In Long Run-
1. Planning for a new project & modernization.
2. Diversification
3. Assessing long term financial needs.
4. Planning for factors of production.

METHODS-

1. Survey or Buyers intentions:- The most direct method of

estimating demand in the short run is to ask the customers directly
what they are going to buy next.
2. Delphi Method:- It is a method conducted to arrive at consensus of
opinion. In this method, the participants are supplied with
responses to the survey questions by a leader. The leader then
 provides the experts with the opportunity to react to the
information given by others.
3. Collective Opinion:- In this method opinion is taken in the form the
collective wisdom of the departmental heads like production
manager, sales manager and top executives as well as dealers &
distributers.
4. Time Series:- A firm which has been inexistence for some time will
have accumulated data on sales pertaining past time periods. Such
data when arranged chronologically with the help of frequencies
yield time service. This technique provides, acceptable results as
long as the time series shows tendency to move in the sales
direction.

Q8) Define elasticity of demand. What are the factors affecting elasticity of
demand? Discuss the methods of measuring price elasticity of demand?

A8) Elasticity of demand refers to the ratio of % change in quantity

demanded to the % change in price of the good.

 FACTORS AFFECTING ELASTICITY OF DEMAND-

1) Nature of commodity:-

Elasticity of demand of a commodity is influenced by its nature. A commodity

for a person may be a necessity, a comfort or a luxury.

i) When a commodity is a necessity like food grains, vegetables, medicines

its demand is generally inelastic as it is required for human survival and its
demand does not fluctuate much with change in price.

ii) When a commodity is a comfort like fan, refrigerator its demand is

generally elastic as consumer can postpone its consumption.

iii) When a commodity is a luxury like AC, DVD player, car its demand is
generally more elastic as compared to demand for comforts.
2) Availability of substitutes:-

Demand for a commodity with large number of substitutes will be more

elastic. The reason is that even a small rise in its prices will induce the buyers
to go for its substitutes. For example, a rise in the price of Pepsi encourages
buyers to buy Coke and vice-versa.

Thus, availability of close substitutes makes the demand sensitive to change

in the prices. On the other hand, commodities with few or no substitutes like
wheat and salt have less price elasticity of demand.

3) Income Level:-

Elasticity of demand for any commodity is generally less for higher income
level groups in comparison to people with low incomes. It happens because
rich people are not influenced much by changes in the price of goods. But,
poor people are highly affected by increase or decrease in the price of goods.
As a result, demand for lower income group is highly elastic.

4) Level of price:-

Level of price also affects the price elasticity of demand. Costly goods like
laptop, Plasma TV, etc. have highly elastic demand as their demand is very
sensitive to changes in their prices. However, demand for inexpensive goods
like needle, match box, etc. is inelastic as change in prices of such goods do
not change their demand by a considerable amount.

5) Time Period:-

Price elasticity of demand is always related to a period of time. It can be a

day, a week, a month, a year or a period of several years. Elasticity of
demand varies directly with the time period. Demand is generally inelastic in
the short period.

It happens because consumers find it difficult to change their habits, in the

short period, in order to respond to a change in the price of the given
commodity. However, demand is more elastic in long rim as it is
comparatively easier to shift to other substitutes, if the price of the given
commodity rises.
6) Habits:-

Commodities, which have become habitual necessities for the consumers,

have less elastic demand. It happens because such a commodity becomes a
necessity for the consumer and he continues to purchase it even if its price
rises. Alcohol, tobacco, cigarettes, etc. are some examples of habit forming
commodities.

Finally it can be concluded that elasticity of demand for a commodity is

affected by number of factors. However, it is difficult to say, which particular
factor or combination of factors determines the elasticity. It all depends
upon circumstances of each case.

 METHODS TO MEASURE PRICE ELASTICITY OF DEMAND:-

1. Proportionate Method:- It refers to the % change in quantity
demanded to % change in price of the goods.

If % change in quantity demanded > % change in the price of the good

then Ed > 1.

If % change in quantity demanded < % change in the price of the good

then Ed < 1.

If % change in quantity demanded = % change in the price of the good

then Ed = 1.
2. Total Expenditure:- It refers to the multiplication between price and
quantity demanded. (P*Q.D)
 If there is inverse relationship between demand and total expenditure
then Ed > 1.
 If there is positive relationship between demand and total expenditure
then Ed < 1.
 If there is no relation between demand and total expenditure then E d = 1.
 3. Geometric Method:- = Lower segment/Upper segment

Ed

Consumer’s Equilibrium - Indifference Curve Analysis

According to the ordinal approach, a consumer has a given scale of

preference for different combinations of two goods. By just comparing
the levels of satisfaction, he can derive maximum satisfaction out of a
given money income.

Consumer’s equilibrium refers to a situation in which a consumer

with given income and given prices purchases such a combination of
goods and services as gives him maximum satisfaction and he is not
willing to make any change in it.
1.1 Assumptions:

1. Consumer is rational and so maximises his satisfaction from the

purchase of two goods.

2. Consumer’s income is constant.

3. Prices of the goods are constant.

4. Consumer knows the price of all things.

5. Consumer can spend his income in small quantities.

6. Goods are divisible.

7. There is perfect competition in the market.

8. Consumer is fully aware of the indifference map.

1.2 Conditions of Consumer’s Equilibrium

There are two main conditions of consumer’s equilibrium;

(i) Price line should be tangent to the indifference curve,

i.e.
MRSxy = Px / Py

(ii) Indifference curve should be convex to the point of origin.

(iii) Price line should be tangent to indifference curve:

In this diagram AB is the price line. IC 1, IC2 and IC3 are indifference
curves. A consumer can buy those combinations which are not only on
price line AB but also coincide with the highest indifference curve which
is IC2 in this case. The consumer will be in equilibrium at combination D
(2 apples + 4 oranges) because at this point price line AB is tangent to the
indifference curve IC2. At equilibrium point D, slope of indifference curve
and price line coincide. Slope of indifference curve is indicative of
marginal rate of substitution of good x for good y (MRSxy) and slope of
price line is indicative of the ratio of price of good x (Px) and price of
good y (Py). In case of equilibrium:

Slope of indifference curve = slope of price

line Px

MRSxy = Py

(ii) Indifference Curve must be convex to the origin: It means that

marginal rate of substitution of good x for good y should be
diminishing. If at the point of equilibrium, indifference curve is
concave and not convex to the origin, it will not be a position of
permanent equilibrium.
 In this diagram AB is the price line. IC is the indifference curve. At
point E, price line AB is tangent to indifference curve, which is convex to
the point of origin.

1.3 Income, Substitution and Price Effect:

Consumer’s equilibrium is affected by change in his income,

change in the price of substitutes, and change in the price of good
consumed. These changes are known as (1) Income effect (2)
Substitution effect and (3) Price effect, respectively.

1. Income Effect

The income effect is the effect on the consumption of two goods

caused by change in income, if prices of goods remain constant.

The income effect may be defined as the effect on the purchases

of the consumer caused by change in income, if price remains constant.
Income effect indicates that, other things being equal, increase in income
increases the satisfaction of the consumer. As a result, equilibrium point
shifts upward to the right. On the contrary, decrease in income decrease
the satisfaction of the consumer and his equilibrium point shifts
downwards to the left.
 In this diagram consumer’s initial equilibrium is at point E on price
line AB. When his income increases, his equilibrium point shifts to the
right i.e. E, on price line A1-B1. With decrease in his income, his
equilibrium point shifts to the left i.e. E 2 on price line EF. Locus of all
these equilibrium points is called income consumption curve. It starts
from the point of origin 0 meaning thereby that when the income of
the consumer is zero, his consumption of good x and good y will also
be zero.
1.4 Income Consumption Curve:

As shown in figure No. 16, effect of change in income is reflected

in Income Consumption Curve (ICC). This curve is a locus of tangency
points of price lines and indifference curves.

Income consumption curve refers to the effect of change in

income on the equilibrium of the consumer.

Slope of income consumption curve is positive in case of normal

goods, but it is negative in case of inferior goods.

(i) Positive Slope

Income consumption curve is positive in case of normal goods. In other
words, consumption of both normal goods (x and y) increases with
increase in income. As shown in the diagram, income consumption curve
(ICC) of normal goods slopes upwards from left to right signifying that
more of both the goods will be bought when income increases. ICC curve
indicates that expenditure on both the goods will increase in almost the
same ratio. ICC, curve indicates a higher proportionate increase in the
expenditure on good - x, and ICC2 curve indicates a higher proportionate
increase in expenditure on good - y.
(ii) Negative Slope:
Income effect of inferior goods is negative. It means inferior goods
are brought in less quantity when income of the consumer increases.
Suppose x-good is inferior and y-good is normal. Price line P1L1, drawn
on the basis of given income of the consumer and given prices of the two
commodities, touches indifference curve IC 1 at point E which is the point
of consumer’s equilibrium. As the income of the consumer goes on
increasing, price line goes on shifting to the right as P2L2 and P3L3
touching IC2 and IC3 at points E1 and E2, respectively. Consequently, the
quantity of good x falls from OM to OM1 and OM2. In this way, increase in
the income of the consumer is followed by decrease in the quantity
demanded for inferior good-x by MMI and M1M2 respectively. This
decline in quantity demanded reflects negative income effect. By joining
together different equilibrium points E, E 1 and E2 one gets income
consumption curve which slopes backward to the left. It indicates
negative income effect.
INCOME CONSUMPTION CURVE AND ENGEL CURVE

Income consumption curve is the locus, in indifference curve map, of the

equilibrium quantities consumed by an individual at different levels of his
income. Thus, the income consumption curve (ICC) can be used to derive
the relationship between the level of consumer’s income and the quantity
purchased of a commodity by him.
A nineteenth century German statistician Ernet Engel (1821-1896) made an
empirical study of family budgets to draw conclusions about the pattern of
consumption expenditure, that is, expenditure on different goods and
services by the households at different levels of income. The poor families
spend a relatively large proportion of their income on necessaries, whereas
rich families spend a relatively a large part of their income on luxuries. This
change in the pattern of consumption expenditure (that is, decline in the
proportion of income spent on food and other necessities and increase in
the proportion of income spent on luxuries) with the rise in income of the
families has been called Engel’s law.
Engel curve shows relationship between income and quantity demanded,
other influences on quantity purchased such as prices of goods, consumer
preferences are assumed to be held constant.
For deriving Engel curve from income consumption curve we plot level of
income on the Y-axis and quantity purchased of a commodity on the X-axis.
Given the indifference map representing the preferences of a consumer
and the prices of two goods X and Y, ICC is the income consumption curve
showing the equilibrium quantities purchased chased of a commodity by
the consumer as his income increases from Rs.300 to Rs. 400 and to Rs.
500 per day. It will be seen from diag that when income is Rs. 300, given
prices of goods X and Y, the consumer is buying OQ1 quantity of the
commodity.
In panel (b) of Fig. 8.26 in which level of income is represented on the
vertical axis and quantity purchased of commodity X on the horizontal axis
we directly plot quantity OQ1 against income level of Rs. 300. As the
income increases to Rs. 400, prices of goods remaining constant, the
budget line in panel (a) shifts outward to the left to the new position B2L2
with which consumer is in equilibrium at point S and the consumer buys
OQ2 quantity of good X.
Thus, in panel (b) of Fig. 8.26 we plot quantity purchased OQ2 of
commodity X against income level of Rs. 400. Likewise, as income further
rises to Rs. 500, budget line in panel (a) shifts to B3L3 and the consumer
buys OQ3 quantity of X in his new equilibrium position at T. Therefore, in
panel (b) of Fig. 8.26, we plot OQ3 against income of Rs. 500. Thus
equilibrium points constituting the income consumption curve in
consumer’s indifference map have been transformed into Engel curve
depicting quantity-income relationship.
Each point of an Engel curve corresponds to the relevant a point of income
consumption curve. Thus R’ of the Engel curve EC corresponds to point R
on the ICC curve. As seen from panel (b) Engel curve for normal goods is
upward sloping which shows that as income increases, consumer buys
more of a commodity.
The slope of Engel curve EC drawn in panel (b) of Figure 5.26 equals
OM/OQ where AM stands for income and AQ a for change in quantity
demanded of good X and has a positive sign. It is important to note that
the slope of the Engel curve in Fig. 8.26 (panel (b)) increases as income
increases. This indicates that with every equal increase in income,
expansion in quantity purchased of the good successively declines.
This upward-sloping Engel curve with increasing slope as income rises
depicts the case of necessities, consumption of which increases relatively
less as income rises. For instance, in Fig. 8.26 when income is initially Rs.
300 (= M1) per week, the quantity purchased of the good X equals OQ, and
when income rises by Rs. 100 to Rs. 400 (= M2) per week he increases his
consumption to OQ2, that is, by quantity Q1Q2.
Now when his income per week further increases by Rs. 100 to Rs. 500 per
week, the quantity consumed increases to OQ3, that is, Q2Q3 which is less
than Q1Q2. Thus, an Engel curve drawn in panel (b) of Fig. 8.26 the
quantity purchased of the commodity increases with the increase in
income but at a decreasing rate. This shape of the Engel curve is obtained
for necessaries.

2. Substitution Effect :

If with the change in the prices of goods the money income of the
consumer changes in such a way that his real income remains constant,
the consumer will substitute cheaper good for the dearer ones.
Consequently, it will affect the quantity purchased of both the goods.
This effect is known as substitution effect.

Substitution effect shows the change in the quantity of the goods

purchased due to change in the relative prices alone while real income
remains constant.

Supposing the income of the consumer is Rs.4.00 which he spends

on the purchase of bread and eggs. Price of egg is 50 paise per egg and
that of bread Re. 1.00 . With this income he buys 4 eggs and 2 breads
and finds himself in an equilibrium.
 In this, diagram AB is the price line and IC 1 is the original
indifference curve. Consumer is in equilibrium at point 1. He is getting
OQ1 units of breads and OM units of eggs. Supposing eggs become
cheaper. Consequently, AB Price line will shift towards the right on ox-
axis as AC and be tangent to higher indifference curve IC2 at Point 3
which will be the new equilibrium point of the consumer. Now his real
income will be more than before. If the real income of

the consumer should remain the same as before, we will have to take
away some of his money income. Now his price line will be AC’
which will be parallel to price line AC. The new price line AC’ is tangent
to indifference curve IC1 at point 2 which will be the new point of
equilibrium. He will substitute eggs for breads. This substitution of
relatively cheaper good for dearer ones is called substitution effect. Thus
movement from equilibrium point 1 to equilibrium point 2 on the same
indifference curve IC1 indicates the substitution effect.
 Price Effect is the Sum of Substitution Effect and Income Effect :

When the price of a commodity changes, it has two effects: (i) There is
change in the real income of the consumer leading to change in his
consumption. It is called income effect; (ii) Secondly, due to change in
relative prices, the consumer substitutes relatively cheaper goods for the
dearer ones. It is called substitution effect. The combination of this income
and substitution effect is called price effect. Thus, Price Effect = Income
Effect + Substitution Effect.

Supposing AB is the original price line and IC the original indifference

curve. Consumer is in equilibrium at point 1. When the price of bread falls,
the new price line shift from AB to AC. The new price line touches higher
indifference curve IC at point 3, which is the new equilibrium point.
Movement from 1 to 3 signifies the Price Effect.

Fall in price of bread means increase in the real income of the consumer. If
the monetary income of the consumer is reduced to such an extent that
the real income remains the same as before, in that case the new price line
will be AC’ and new equilibrium point 3’ The movement from 1 to 2 reflects
the Substitution Effect. If due to fall in price of bread, the money income of
the consumer is not reduced, the consumer will move from equilibrium
point 2 to 3. Thus movement from 2 to 3, shows the Income Effect.
Movement from 1 to 3 shows price effect.

PRICE CONSUMPTION CURVE: WITH DIAGRAM | INDIFFERENCE CURVE

We will now explain how the consumer reacts to charges in the price of a
good, his money income, tastes and prices of other goods remaining the
same. Price effect shows this reaction of the consumer and measures the
full effect of the change in the price of a good on the quantity purchased
since no compensating variation in income is made in this case.

When, the price of good charges, the consumer would be either better off
or worse off than before, depending upon whether the price falls or rises.
In other words, as a result of change in price of a good, his equilibrium
position would lie at a higher indifference curve in case of the fall in price
and at a lower indifference curve in case of the rise in price.

Price effect is shown in Fig. 8.31. With given prices of goods X and Y, and a
given money income as represented by the budget line PL1, the consumer
is in equilibrium at Q on indifference curve C1. In this equilibrium position
at Q, he is buying OM1 of X and ON1 of Y. Let price of good id X fall, price
of Y and his money income remaining unchanged.

As a result of this price change, budget line shifts to the position PL2. The
consumer is now in equilibrium at R on a higher indifference curve IC2 and
is buying OM2 of X and ON2 of Y. He has thus become better off, that is, his
level of satisfaction has increased as a consequence of the fall in the price
of good X. Suppose that price of X further falls so that PL3 is now the
relevant price line.

With budget line PL3 the consumer is in equilibrium at S on indifference

curve IC3 where he has OM3 of X and ON3 of Y. If the price of good X falls
still further so that budget line now takes the position of PL4, the
consumer now attains equilibrium at T on indifference curve IC4 and has
OM4 of X and ON4 of Y.

When all the equilibrium points such as Q, R, S, and T are joined together,
we get what is called Price Consumption Curve (PCC). Price consumption
curve traces out the price effect. It shows how the changes in price of good
X will affect the consumer’s purchases of X, price of Y, his tastes and
money income remaining unaltered.

In Fig. 8.31 price consumption curve (PCC) is sloping downward. Downward

sloping price consumption curve for good X means that as the price of
good X falls, the consumer purchases a larger quantity of good X and a
smaller quantity of good Y. This is quite evident from Fig. 8.31.

In elasticity of demand, we obtain downward-sloping price consumption

curve for good X when demand for it is elastic (i.e., price elasticity is
greater than one). But downward sloping is one possible shape of price
consumption curve. Price consumption curve can have other shapes also.
In Fig. 8.32 upward-sloping price consumption curve is shown. Upward-
sloping price consumption curve for X means that when the price of good X
falls, the quantity demanded of both goods X and Y rises. We obtain the
upward-sloping price consumption curve for good X when the demand for
good is inelastic, (i.e., price elasticity is less than one).

Price consumption curve can also have a backward-sloping shape, which is

depicted in Fig. 8.33. Backward-sloping price consumption curve for good X
indicates that when price of X falls, after a point smaller quantity of it is
demanded or purchased. This is true in case of exceptional type of goods
called Giffen Goods.

PRICE CONSUMPTION CURVE AND DERIVATION OF DEMAND CURVE

The price-consumption curve (PCC) indicates the various amounts of a

commodity bought by a consumer when its price changes. The Marshallian
demand curve also shows the different amounts of a good demanded by the
consumer at various prices, other things remaining the same. Given the
consumer’s money income and his indifference map, it is possible to draw his
demand curve for any commodity from the PCC.

Assumptions:

This analysis assumes that:

(a) The money to be spent by consumer is given and constant. It is Rs 10.

(b) The price of good X falls.

(c) Prices of other related goods do not change.

(d) Consumer’s tastes and preferences remain constant.

(1) IN CASE OF NORMAL GOODS

We know how the price consumption curve traces the effect of a change in
price of a good on its quantity demanded. However, it does not directly show
the relationship between the price of a good and its corresponding quantity
demanded. It is the demand curve that shows relationship between price of
a good and its quantity demanded. Here we are going to derive the
consumer's demand curve from the price consumption curve. Figure.1 shows
derivation of the consumer's demand curve from the price consumption
curve where good X is a normal good.

The upper panel of Figure.1 shows price effect where good X is a normal
good. AB is the initial price line. Suppose the initial price of good X (Px) is OP.
e is the initial optimal consumption combination on indifference curve U. The
consumer buys OX units of good X.

When price of X (Px)falls, to say OP1, the budget constraint shift to AB1. The
optimal consumption combination is e1 on indifference curve U1. The
consumer now increases consumption of good X from OX to OX1 units. The
Price Consumption Curve (PCC) is rising upwards.

Chart.1 shows the demand relationship derived from the price consumption
curve.

The lower panel of Figure.1 shows this price and corresponding quantity
demanded of good X as shown in Chart.1. At initial price OP, quantity
demanded of good X is OX. This is shown by point a. At a lower price OP1,
quantity demanded increases to OX1. This is shown by point

b. DD1 is the demand curve obtained by joining points a and b. The demand
curve is downward sloping showing inverse relationship between price and
quantity demanded as good X is a normal good.

(2) IN CASE OF GIFFEN GOODS

In this section we are going to derive the consumer's demand curve from the
price consumption curve in the case of inferior goods. Figure.2 shows
derivation of the consumer's demand curve from the price consumption
curve where good X is an inferior good.
The upper panel of Figure.2 shows price effect where good X is an inferior
good. AB is the initial price line. Suppose the initial price of good X (Px)is OP.
e is the initial optimal consumption combination on indifference curve U. The
consumer buys OX units of good X. When price of X Px) falls, to say OP1, the
budget constraint shift to AB1. The optimal consumption combination is e1
on indifference curve U1. The consumer now reduces consumption of good X
from OX to OX1 units as good x is inferior. The Price Consumption Curve
(PCC) is rising upwards and bending backwards towards the Y-axis.

The lower panel of Figure.2 shows this price and corresponding quantity
demanded of good X as shown in Chart.2. At initial price OP, quantity
demanded of good X is OX. This is shown by point a. At a lower price OP1,
quantity demanded decreases to OX1. This is shown by point b. DD1 is the
demand curve obtained by joining points a and b. The demand curve is
upward sloping showing direct relationship between price and quantity
demanded as good X is an inferior good.
Revealed Preference Theory

Revealed Preference Theory was put forward by Somvelson in

1938 and it is based on the actual market behaviour of consumer.
Accordingly, it is a behaviouristic approach. On the other hand, utility
and Indifference Curve Approaches are the psychological and
interospective approaches.

1.5 Assumptions :

Revealed Preference Theory involves the following assumptions :

1. There is no change in the taste of the consumers.

2. The choice of the consumer for a particular combination
reveals his preference.
3. The consumer chooses only one combination on a given price
income line.

4. Assumption of consistency in the consumer’s behaviour. That is if

combination B can’t be preferred to A is another situation.

A > B, then B |> A

5. Assumption of transitivity in consumer’s behaviour: Transitivity

means that if combination A is preferred to B and, B>C, then A
must be preferred to C. This assumption is necessary for Revealed
Preference Theory.

6. Assumption of the concept of ordinal utility, i.e., Revealed

preference Theory regards utility to be merely comparable.

Theme of Revealed Preference Theory :

Prof. Samuelson’s theory of demand is based on the revealed preference

axiom or hypothesis which states that choice reveals preference. Keeping
this fact into view, a consumer buys a combination of two goods either
because he likes this combination in relation to others or this is cheaper than
others. Suppose the consumer buys combination A rather than combination
В. С or D. It means that he reveals his preference for combination A. He can
do this for two reasons. First, combination A may be cheaper than the other
combinations B, C, D. Seconds combination A may be dearer than others and
even then he likes it more than other combinations. In such a situation, it can
be said that A is revealed preferred to В, C, D or В, C, D are revealed inferior
to A. This is explained in Figure 14.1.

Given the income and prices of the two goods X and Y. LM is the price-
income line of the consumer. The triangle OLM is the area of choice for the
consumer which shows the various combinations of X and Y on the given
price- income situation LM. In other words, the consumer can choose any
combination between A and В on the line LM or between С and D below this
line. If he chooses A, it is revealed preferred to B. Combinations С and D are
revealed inferior to A because they are below the price-income line LM. But
combination E is beyond the reach of the consumer being dearer for him
because it lies above his price-income line LM. Therefore, A is revealed
preferred to other combinations within and on the triangle OLM