Bachelor Level Microeconomics

Unit 3: Ordinal
Approach to Utility
Analysis: The Indifference
Curve Approach

@ Prof. M. P. Dahal, PhD

1
 Indifference Curve Approach
• An indifference curve also called iso-utility curve is a
graph that shows all combinations of two goods that will
give the same total satisfaction/utility to a consumer.

• In the words of D. S. Watson and M. Getz, “The

indifference curve shows all combinations of two
commodities that give the same satisfaction to a
consumer”.

2
 Indifference Curve …
• Indifference curves illustrate subjective (individual or
personal nature tastes, opinions, perceptions, judgement,
or feelings) information about consumer preferences for
two goods. These subjective preferences mean that a
consumer will derive the same total utility from any
combination of two goods, A and B. As a result, the
consumer will be indifferent, meaning they will not care
which specific combination is obtained.

3
 Brief History in the Evolution of
Indifference Curve
1. Early Development: It is believed that indifference
curves were first introduced by the English economist F.
Y. Edgeworth (1845–1926) in the 1880s.
2. Further Refinement: The concept was refined and used
widely by the Italian economist Vilfredo Pareto (1848–
1923) in the early 1900s. He introduced the concept as
part of his work on microeconomics and welfare
economics. Pareto used indifference curves to illustrate…

4
 Brief History in the Evolution of Indifference
Curve
•…. to illustrate consumer preferences without needing a
cardinal utility function. His work laid the foundation for
modern microeconomic theory, emphasizing ordinal
utility, where the exact level of satisfaction is not
measured, only the order of preferences.
•3. Modern Application: In the 1930s, John Hicks and
R.G.D. Allen, both British economists, made significant
contributions by integrating indifference curves into
mainstream economic analysis. Their work helped
establish the indifference curve approach as a fundamental
tool in consumer theory, used to analyze choices and
preferences. They popularized and significantly widened
the application of indifference curve.

5
Illustration of the Same Level of Satisfaction
as Sensed in Indifference Curve
Combination Food Clothing Utility
[Good X] [Good Y]
J 1 20 Constant (U)
K 2 14 Constant (U)
L 3 10 Constant (U)
M 4 8 Constant (U)
N 5 7 Constant (U)

6
Indifference Curve of Two Goods
25

J 1, 20
20
Indifference Curve
K Fig.3-1
Clothing (Y)

15 2, 14

L 3, 10
10 M 4, 8
N 5, 7

0
0 1 2 3 4 5 6
Food (X)

7
 Indifference Map
• An indifference map is a set/series of indifference
curves for a consumer. Indifference map is used to
describe preferences of a consumer for all
combinations of two goods.

• Each indifference curve in the map represents a

different level of utility. Each curve shows the
market bundles among which the consumer is
indifferent.

8
Indifference Map
An indifference map is a graph containing a set of
indifference curves showing the market baskets among
which a consumer is indifferent.

Bundle A is preferred to B.
Clothing (Y)

Bundle B is preferred to D.
D
B A Fig.3-2

IC3
IC2
IC1
0
Food (X) 9
Assumptions of Indifference Curve(the
Ordinal Utility Approach)

1. Rationality
2. Utility is Ordinal
3. Preferences are complete
4. Consistency
5. Transitivity
6. Non-satiation

10
 Assumptions of IC Analysis…
1)Rationality of consumer: The consumer is rational in the
sense that his/her objective is to maximize utility with the
given income and prices of goods.

2)Utility is Ordinal: It is assumed that the consumer can

rank their preferences (arrange the various 'baskets of
goods') based on the satisfaction derived from each
basket. It is sufficient for the consumer to express their
preference for the different bundles of commodities.
There is no need to assume that utility can be measured
in absolute terms.
11
 Assumptions of IC Analysis…
•3.Preferences are complete: We assume that consumers
can compare and rank the benefits associated with
consumption. They can compare and choose between
two or more bundles, and with two bundles (A and B),
the consumer either prefers A to B, prefers B to A, or
has no preference. If both bundles provide the same
level of satisfaction or utility, the consumer is
considered indifferent between them. Indifference
means that, in the consumer's view, the two bundles
are the same. A consumer can be indifferent between
goods and services that are physically distinct.

12
 Assumptions of IC Analysis…..
• 4)Consistency: Consumer remains consistent/stable in
his/her choice. This means that if there are two packets
A and B of two goods , and if in one period he/she
prefers A to B (A > B), he/she will not choose B over A
in another period if both packets are available to
him/her.
• 5)Transitivity: Preferences/Choices are transitive which
means consumers are able to rank the order and the
desirability of bundles. With three bundles (A, B and
C) we assume that if the consumer prefers A to B
(A>B), and prefers B to C(B >C), he will prefer A to
C(A>>C). This assumption means that we have
consistency in preference ordering among bundles.
13
 Assumptions of IC Analysis…
• 6)Non-satiation: The Non-satiation principle is a
psychological belief which means that more of a
bundle (of goods not of bads) is preferred to less. We
expect that for two goods X and Y, 𝑿 ≥ 𝒀 implies
𝐔(𝑿) ≥ 𝑼(𝒀).

• When a consumer likes both goods (i.e., when MUx

and MUy are both positive), he/she always prefers
more over less if there is choice available to him/her.

14
 Marginal Rate of Substitution (MRS)
• The Marginal Rate of Substitution (MRS) in the context of
indifference curves represents the rate at which a consumer
is willing to substitute(replace or exchange) one good for
another while maintaining the same level of utility or
satisfaction.
• In the words of Dominik Salvatore, “The marginal rate of
substitution (MRS) refers to the amount of one good that an
individual is willing to give up for an additional unit of
another good while maintaining the same level of
satisfaction or remaining on the same indifference curve”.
• It reflects the consumer's preferences and the trade-
offs(exchange) they are willing to make between two goods.

15
 Marginal Rate of Substitution (MRS)
• Mathematically, the MRS is the absolute value of the
slope of the indifference curve at any given point. It is
given by the ratio of the marginal utilities of the two
goods. Specifically, if a consumer is choosing between
good X and good Y, the MRS is defined as:

𝑴𝑼𝑿
• 𝑴𝑹𝑺𝑿𝒀 =
𝑴𝑼𝒀

where 𝑴𝑼𝑿 and 𝑴𝑼𝒀 are the marginal utilities of goods X

and Y, respectively.

16
An Illustration of MRS
Combination X Y MRS
Fig.3-3 A 1 16 -
B 2 10 6
16 A D 3 6 4
14 E 4 4 2
Clothing(Y)

G 5 3 1
12 -6

10 B Observation: The amount

1 of clothing given up for 1
8 -4 unit of food decreases
D from 6 to 1
6 1
-2 E
4
3
1 -1 G
2 1
0 1 2 3 4 5 Food(X)

17
 An Illustration of MRS …
The marginal rate of substitution is the negative of the slope of an indifference
curve at a point(𝑀𝑅𝑆𝑋𝑌 = − Δ𝑌ΤΔ𝑋). MRS is defined only for movements along an
indifference curve, never for movements among curves.
A
16 The MRS decreases as we move
MRS = 6 down the indifference curve.
14 Along an indifference curve
12 -6
there is a diminishing MRS. The
MRS went from 6 to 4 to 1
Clothing(Y)

10 B
1
8 -4
D MRS = 2
6 1
-2 E Fig.3-4
4 1 -1 G
3 1
2
0
1 2 3 4 5 Food(X)
18
 MRS as Ratio of Marginal Utilities
• The MRS for any two goods can be expressed as a ratio
of the marginal utilities of the two goods. To see how, let
us consider any specific basket on an indifference curve.

• Let the utility function be U=f(X,Y)

• Where U is utility , X and Y are two goods in the bundle.

• Suppose the consumer changes the level of consumption

of X and Y by ΔX and ΔY, respectively. The
corresponding impact on utility ΔU will be:

• ∆𝑼 = 𝑴𝑼𝑿 × ∆𝑿 + 𝑴𝑼𝒀 × ∆𝒀

19
 MRS as Ratio of Marginal Utilities…….

• This equation is an estimate of the change in utility that

results from changing X and Y by ΔX and ΔY,
respectively.

• But by definition total utility remains constant everywhere

along an indifference curve, and changes in X and Y
along the curve keeps utility unchanged. So, ∆𝐔 = 𝟎

20
MRS as Ratio of Marginal Utilities &
Slope of Indifference Curve
• Therefore, it must be that 𝟎 = 𝑴𝑼𝑿 × ∆𝑿 + 𝑴𝑼𝒀 × ∆𝒀
which can be written as : 𝑴𝑼𝒀 × ∆𝒀 = −𝑴𝑼𝑿 × ∆𝑿

• We can now solve for the slope of the indifference

𝚫𝐘 𝑴𝑼𝑿
curve : =-
𝚫𝐗 𝑴𝑼𝒀

• Finally, since 𝑴𝑹𝑺𝑿𝒀 is the negative of the slope of the

𝚫𝐘 𝑴𝑼𝑿
indifference curve, we observe that - = =𝑴𝑹𝑺𝑿𝒀
𝚫𝐗 𝑴𝑼𝒀

21
 MRS as the Ratio of Marginal Utilities
and Slope of the Indifference Curve…

𝚫𝒚 𝑴𝑼𝑿
•The equation - = =𝑴𝑹𝑺𝑿𝒀 tells that the
𝚫𝒙 𝑴𝑼𝒀

negative of the slope of an indifference curve at any one

point is called the MRS of the two commodities, X and Y,
and is given by the slope of the tangent at that point. On
a graph with good X on the horizontal axis and good Y
on the vertical axis, MRSxy at any point is the negative of
the slope of the indifference curve at that point.

22
 MRS as the Slope of Indifference Curve…
• For example, if the slope and MRS of the curve is -2/1, or
simply 2 (taking absolute value), it means that the
consumer is willing to give up ( substitute) 2 units of good
Y to get 1 more unit of X. This shows consumer’s
subjective willingness to substitute Y for X.

• If the slope of the indifference curve at a point is −5, it

means that at the level of consumption represented by that
point, the consumer would be willing to trade 5 units of Y
commodity for 1 additional unit of X: His MRS of X for Y
at that point is therefore 5 units of Y.
23
Principle of Diminishing MRS of two Goods

• The Principle of Diminishing Marginal Rate of Substitution

(MRS) states that as a consumer substitutes one good for
another along an indifference curve, the amount of the good
being given up decreases for each additional unit of the
other good obtained. In other words, as a consumer
consumes more of one good, they are willing to give up
fewer units of the other good to obtain additional units of
the first good, assuming that the level of overall satisfaction
or utility remains the same.

24
Principle of Diminishing MRS of two Goods

• Explanation

• In the context of an indifference curve, the MRS between

two goods typically decreases as one moves down the curve.
This principle reflects the idea that as a consumer has more
of one good, the additional satisfaction (marginal utility)
derived from consuming even more of that good decreases.
Conversely, the consumer becomes less willing to give up
the other good, which has become relatively scarcer and
hence more valuable in terms of utility.
25
Principle of Diminishing MRS of two Goods…
• Diminishing MRS is the property of indifference curves
due to their convex-to the origin shape. So if MRSxy
diminishes as the consumer increases X along an
indifference curve, then the slope of the indifference curve
must be getting flatter (less negative). Therefore,
indifference curves with diminishing MRSxy must be
bowed in(convexed ) toward the origin.
• The MRS approaches to zero as the consumer moves
down and to the right along an indifference curve. That is
the indifference curve becomes flatter (less sloped) as the
consumer moves down to the right.
26
Principle of Diminishing MRS of two Goods…
• Intuition Behind the Principle
i. Diminishing Marginal Utility: The utility gained from
each additional unit of a good decreases as its quantity
increases. Thus, when a consumer has a lot of apples, the
value of an additional apple is lower, and they are less
willing to give up oranges for more apples.
ii. Scarcity of the Substitute Good: As the consumer has
fewer oranges, each additional orange becomes more
valuable, and they are less willing to give up many
oranges for more apples.

27
Principle of Diminishing MRS of two Goods…
❖ Conclusion

• The Principle of Diminishing Marginal Rate of

Substitution highlights the idea that consumers face
decreasing trade-offs between two goods as they allocate
more of one good and less of the other, reflecting the
decreasing additional satisfaction gained from consuming
more of the same good. This principle helps explain the
convex shape of indifference curves and the nature of
consumer preferences and choices.

28
Characteristics of Indifference Curves
 Indifference Curves for ordinary goods are:

1)Negatively Sloped,

2)Convex from the Origin,

3) Indifference Curves Do Not Intersect, and

4) Higher the IC Higher the Level of

Satisfaction

29
(1)ICs are Negatively Sloped
25

Fig.3-3
J 1, 20
20

K Indifference Curve
Clothing (Y)

15 2, 14

L 3, 10
10 M 4, 8
N 5, 7
5

0
0 1 2 3 4 5 6
Food (X)

30
 (1)ICs are Negatively Sloped….
❑ Generally an indifference curve slopes downward from
left to the right. This feature takes place from the fact
that along an indifference curve two normal goods are
rival/competing. As more of one good is consumed, a
consumer would have to give up units of a second good
to derive the same utility (i.e., to remain on the same
indifference curve). Hence an indifference curve slopes
downward because more of one product means less of
the other if total utility is to remain unchanged.

31
(2)ICs are Convex from the Origin
This feature comes up from the
Fig.3-4 principle of diminishing marginal
utility. When a consumer has
Clothing

diminishing marginal utility,

consumption of another unit of a
A good gives a smaller increase in
total utility than the previous unit
consumed.

IC1
0
Food
32
(2)ICs Are Convex…
• As more of one good is consumed, a consumer would
prefer to give up fewer units of a second good to get
additional units of the first one.
• In Figure 3-4, the slope of the indifference curve IC1
changes as you move down the curve to the right: the
curve gets flatter. If you move up along an indifference
curve to the left, the curve gets steeper. So the
indifference curve is steeper at A than it is at B. When
this occurs, we say that an indifference curve has a
convex shape—it is bowed - in toward the origin.

33
 (3)ICs Do Not Cross
Fig.3-5 •Along indifference curve IC2, A~B ……(i)
•Along indifference curve IC1, A~ D…(ii)
IC1 •Because of transitivity assumption, from (i) and
IC2 (ii) , B~D ………………(iii)
Clothing

which is wrong following the definition of

indifference curve.
Hence two ICs don’t cross(do not intersect). If
they did, the point of their intersection would
imply two different levels of satisfaction, which is
impossible.
A
B
IC2
D IC1

0 Food
34
(4)Higher IC Represents Higher Level of
Satisfaction
The farther out an indifference curve
lies (the farther it is from the
origin),the higher the level of total
utility it indicates. That is
R IC1<IC2<IC3.
Clothing

Market basket A is preferred to B

because combination A has more of
A both goods.
Market basket B is preferred to D.
B HenceIC1<IC2<IC3.
D
IC3

IC2

IC1
Fig.3-6
0
Food
35
(4) Higher IC Represents Higher
Level of Satisfaction …….

■The reason is that we suppose that more is better.

Bundle A, on the outer indifference curve (IC3),
contains more of both goods than bundle B on the
inner indifference curve. So A which gives higher
total utility level (IC3 > IC2) , lies on a higher
indifference curve than B.

36
 Indifference curves for Substitute
and Complement Goods

■ Although indifference curves are usually

negatively sloped and convex to the origin, they
may sometimes assume other shapes. Indifference
curves with different shapes indicate a different
willingness to substitute. Two polar cases on the
shape of ICs are of interest : Perfect substitutes
and Perfect complements.
37
 Indifference curves for Perfect
Substitute Goods
▪Two goods are perfect substitutes of each other, if they
can be used in place of one another with equal simplicity
to satisfy consumer want.
▪Indifference curves are straight lines for substitute goods
and the MRS of one good for the other is constant
irrespective of how much of each good an individual
consumes.
▪ Example: a person might consider apple juice and orange juice perfect
substitutes. They would always trade 1 glass of Orange Juice for 1 glass of
Apple Juice

38
Indifference curves for Substitute
Goods…..

4
Apple Straight line ICs for
Juice
(glasses) Perfect Substitutes
3

2 Fig.3-7

1 IC2 IC3
IC4
IC1
Orange Juice
0 1 2 3 4 (glasses)
39
 MRS for Perfect Substitute Goods
❑ More generally, indifference curves for perfect substitutes are
straight lines, and the marginal rate of substitution is constant, though
not necessarily equal to 1.
❑Let the linear utility function be 𝑼 = 𝒂𝑿 + 𝒃𝒀 ( where a and b are
positive constants).Then marginal utilities are :

𝝏𝑼 𝝏𝑼
𝑴𝑼𝑿 = = 𝒂; 𝑴𝑼𝒀 = =𝒃
𝝏𝑿 𝝏𝒀
𝑴𝑼𝑿 𝒂
𝑴𝑹𝑺𝑿𝒀 = = (MRS is constant)
𝑴𝑼𝒀 𝒃

𝒂
And, slope of the indifference curve = -
𝒃
❑If X and Y are exchanged in the same/equal proportion, then a=b
𝑴𝑼𝑿 𝒂
𝑴𝑹𝑺𝑿𝒀 = = = 𝟏(𝑨𝒔 𝒂 = 𝒃)
𝑴𝑼𝒀 𝒃
𝒂
And, slope of the indifference curve = - = −𝟏
𝒃
40
 Indifference curves for Perfect
Complement Goods
❑ Two goods are perfect complements if they must be
consumed together in a fixed ratio in order to produce
utility.

❑ Two perfect complements goods have right angle

indifference curves(L-shaped).

❑ Example: If you have 1 left shoe and 1 right shoe, you

are indifferent between having more left shoes only.
You must have one right for one left.

41
Indifference curves for Complement
Goods ICs for complement goods are L-
shaped or right-angled. Perfect
complements are goods the
consumer always wants in fixed
proportion to each other; in this
case of shoes, the desired
proportion of left shoes to right
shoes is 1:1. The consumer wants
exactly one left shoe for every
right shoe. For example, his utility
at basket G, with two left shoes
and two right shoes, is not
increased by moving to basket H,
containing two left shoes and three
right shoes. In this case the
horizontal part of each
indifference curve has a MRS = 0
and the vertical part a MRS = ∞.

42
Slope of L-shaped curve of complement goods
𝟏
❑ The slope of a vertical line is undefined like is undefined.
𝟎
Explanation:
If a line passes through distinct points 𝒙𝟏 , 𝒚𝟏 and 𝒙𝟐 , 𝒚𝟐 , then the
𝜟𝒚 𝒚 −𝒚
slope of the line is given by the formula:𝒔𝒍𝒐𝒑𝒆 𝒎 = = 𝟐 𝟏
𝜟𝒙 𝒙𝟐 −𝒙𝟏
If the line is vertical then 𝒙𝟐 = 𝒙𝟏 so the denominator is 0. Hence
𝜟𝒚 𝒚 −𝒚
𝒔𝒍𝒐𝒑𝒆 𝒎 = = 𝟐 𝟏 = ∞(Undefined)
𝜟𝒙 𝟎
𝟎
❑ The slope of a horizontal line is zero like is zero.
𝟏
Explanation:
If a line passes through distinct points 𝒙𝟏 , 𝒚𝟏 and 𝒙𝟐 , 𝒚𝟐 , then the
𝜟𝒚 𝒚 −𝒚
slope of the line is given by the formula:𝒔𝒍𝒐𝒑𝒆 𝒎 = = 𝟐 𝟏
𝜟𝒙 𝒙𝟐 −𝒙𝟏
If the line is horizontal then 𝒚𝟐 = 𝒚𝟏 so the numerator is 0. Hence
𝜟𝒚 𝟎
𝒔𝒍𝒐𝒑𝒆 𝒎 = = =𝟎
𝜟𝒙 𝒙𝟐 −𝒙𝟏

43
Consumer’s Budget Constraint/Line: What
the consumer Can Afford
■Most people would like to increase the quantity or
quality of the goods they consume, e.g., to take
longer vacations, drive fancier cars, or eat at better
restaurants. People consume less than they desire
because their spending is constrained, or limited, by
their income (budget) as goods and services have
price. Hence preferences alone cannot explain
consumer’s complete behavior.

44
 Consumer’s Budget Constraint/Line: What
the consumer Can Afford
■Budget constraint is the limit on the consumption
bundles that a consumer can afford. Consumers
face budget constraint as a result of limited incomes.
The budget constraint defines the set of baskets that
a consumer can purchase with a limited amount of
income. It refers to the ceiling on the quantity of
goods that a consumer can purchase with his/her
limited income ,given the prices of the goods.
45
 Consumer’s Budget Constraint/Line: What
the consumer Can Afford
■Budget constraint : For example, suppose in a
consumer’s purchase bundle consists of
paperback books and movies with prices of $10
and $20 respectively and he/she has an income of
$120 to spend. The budget constraint is
graphically shown as below:

46
Consumer’s Budget Constraint/ Line

47
 Consumer’s Budget Line…….
❑The budget line is a curve that indicates all
combinations of (two) goods for which the total
amount of money spent is equal to income, i.e., all
possible combinations of goods that a consumer
can purchase by spending all his/her limited
money income.

❑Suppose a consumer can purchase only two

goods, food (X) and clothing (Y) with his fixed
income. 48
The Budget Line…..
❑ Suppose we have two goods food X and clothing Y .
The price of a unit of food is PX , and the price of a
unit of clothing is PY and the consumer has a fixed
income of $I per month.

❑ If he spends all of his available income on the two

goods , the equation of the budget line can be
expressed as: 𝑷𝑿 . 𝑿 + 𝑷𝒀 . 𝒀 = 𝑰

❑ Although we assume two products, the analysis

generalizes to the full range of products available to
49
consumers.
 Budget Line….
■ In the budget equation, PXX is the amount of money spent
on food, and PYY is the amount of money spent on clothing.

■ We can calculate different combinations of food(X) and

clothing (Y) that can be purchased by spending all of the
limited income. And these combinations can be graphed as
the budget line. For example, suppose income of a family is
$ 800 per week, PX = $20 and PY = $40. The
construction of the budget schedule in shown in the
following table:

50
 Budget Constraint Schedule
Market Food Clothing Income
Basket PX = $20 PY = $40 I = P𝑿X + PYY
A 40 0 $800
B 30 5 $800
D 20 10 $800
E 10 15 $800
G 0 20 $800

• Then the consumer’s budget line is given as: 𝟐𝟎𝑿 + 𝟒𝟎𝒀 =

$ 𝟖𝟎𝟎.
• If consumer spends all income to buy X, then the maximum
𝟖𝟎𝟎
amount of X that can be purchased, 𝑿 = = 4𝟎
𝟐𝟎
• And maximum amount of Y that be purchased if all income is
𝟖𝟎𝟎
spent on it is, Y= =𝟐𝟎
𝟒𝟎
 Consumer’s Budget Line
■ The budget set:
X=40-2Y 40 30 20 10 0
Y 0 5 10 15 20
Good Y Consumer’s Budget Line

A (0,20)

Fig.3-12.

(40,0)
0
B Good X
52
Consumer’s Budget and Purchase
Assuming that good X is represented With I=$800,
along the horizontal axis, slope of the PX=$20, & PY=$40,
𝟐𝟎
budget line = − 𝟒𝟎 =− 𝟐
𝟏 the consumer can
buy any basket on or
inside the budget
line—baskets A–F
(note that basket F
would cost him only
$600). However, he
cannot buy a basket
outside the budget
line, such as basket
G, which would cost
him $1,000, more
than his monthly
income.

53
 Budget Constraint ….
• The vertical intercept, I/PY , in the budget line
diagram illustrates the maximum quantity of
cloth(Y) that can be purchased with income I.

• The horizontal intercept, I/PX , in the budget line

diagram illustrates the maximum quantity of
food (X) that can be purchased with income I.

54
 Slope of the Budget Line
𝑷𝑿
•The slope of the budget line, − , is the negative
𝑷𝒀

of the ratio of the prices of the two goods, and

measures the relative price of one good compared
with another. The magnitude of the slope tells us
the rate at which the two goods can be substituted
for each other without changing the total amount
of money spent.

55
 Slope of the Budget Line
•Thus, the slope of the budget line tells us how
many units of the good on the vertical axis a
consumer must give up to obtain an additional
unit of the good on the horizontal axis.

56
 Slope of the Budget Line…..
• We can rearrange the equation of the budget
line 𝐏𝐗 X+ 𝐏𝐘 𝐘 =I and solve for commodity Y
measured on the vertical axis. Hence,
𝐈 𝐏𝐗
𝐘= - 𝐗
𝐏𝐘 𝐏𝐘
𝐈 𝐏𝐗
• Then differentiating 𝐘 = - 𝐗 with respect to
𝐏𝐘 𝐏𝐘
𝒅𝒀 𝑷𝑿
X: = − = Slope of the budget line.
𝒅𝑿 𝑷𝒀

• The slope of the budget line tells us how many

units of the good on the vertical axis a consumer
must give up to obtain an additional unit of the
good on the horizontal axis.
57
 Slope of the Budget Line…..
•As the consumer moves down along a budget line from
the Y-intercept, the consumer spends less on one item
and more on the other.

•If the price of good X is three times the price of good Y,

the consumer must give up 3 units of Y to get 1 more
unit of X, and the slope is −3. If the prices are equal, the
slope of the budget line is −1, the consumer can always
get 1 more unit of X by giving up 1 unit of Y.

58
 Shift and Rotation of the Budget Line

 As incomes of consumer and prices of goods

change, there is change in budget lines.

 We can show the effects of income and price

changes on budget lines and consumer
choices.

59
 Shift of the budget line

❑ Consumer’s Budget Line shifts due to:

(i) change in consumer’s income with prices

remaining constant

(ii)a proportionate change in all prices (a rise or

fall in the prices of both two goods) with
consumer’s money income remaining constant.

60
Effect of Income Change on Budget Line
♦ A change in consumer’s income shifts the budget line
parallel to itself:

i. A rise in income causes the budget line to shift

outward, parallel to the original line (holding prices
constant) and the consumer can buy more of both
goods with more income.

ii. A decrease in income causes the budget line to shift

inward, parallel to the original line (holding prices
constant) and the consumer can buy less of both goods
with less income.
61
Income Change & Shift of the
Budget Line
Suppose Px=$1,Py=$2, and initial income is $80
per week , and the initial budget line is L1
Clothing(units per week)

80 An increase in income (e.g., from $80

L2
to $160) with constant prices shifts the
budget line outward to L2
60
Fig.3-13

40 L1

20 L3
(I = $80) (I = $160)
(I =$40)
Food
0 40 80 120 160 (units per week)
62
 Proportionate Change in Prices and Shift
of Budget Line
• A proportionate change in all money prices (a rise or fall in the prices of

both two goods) of goods, with money income held constant, shifts the

budget line parallel to itself- towards the origin when prices rise and

away from the origin when prices fall.

➢ For illustration the previous figure can be used by keeping money

income constant but decreasing prices of both goods(outward/rightward

shift) or increasing prices of both goods(inward shift).

• If the price of two goods increases but the ratio of the two prices (Px/Py)

is unchanged, the slope will not change. However, the budget line will

shift inward parallel to the original budget line.

63
 Rotation/Pivot of the Budget Line
❑The change in the price of one good holding constant
price of another good and consumer’s money income,
rotates the budget line spinning from the other good’s
intercept.

➢ For example, if the price of food(X) increases , and you

buy only food you can buy less food (X-intercept
decreases) but if you buy only clothing(Y) you can buy the
same amount of cloth. No change in y-intercept.

64
Rotation/Pivot of the Budget Line….

♦If the price of one good decreases, the budget line

rotates outward, pivoting from the other good’s
intercept.

➢ For example, if the price of food decreases and you

buy only food you can buy more food (X-intercept
increases ) , X-intercept shifts out but if you buy
only clothing (Y-intercept), you can buy the same
amount. No change in Y-intercept.

65
 Rotation/Pivot of the Budget Line
Suppose initial budget line is L1 with PX=$1,
Clothing (Y) PY=$2 and budget=$80.
(units
per week) An increase in the price of food to $2 changes
the slope of the budget line and rotates it
40 inward.

A decrease in the price of food to

$.50 changes the slope of the
budget line and rotates it outward.

L1 L2 Fig.3-14
L3
(PX = 1) (PX = 1/2)
(Px = 2)
0 Food (X)
40 80 120 160
(units per week)
66
 Consumer’s Optimum/Equilibrium :
Maximizing Utility with a Given Budget
♦Theory of consumer behaviour assumes that consumers try to
maximize total satisfaction allowed by their budget limitation.
Consumer’s equilibrium position in the indifference curve model
represents the combination of two goods at which a consumer
maximizes his/her utility (reaches the highest attainable indifference
curve), given a fixed amount to spend (a budget constraint).

♦Graphically consumer’s optimum is the point on the budget line that

tangents/touches the highest possible indifference curve .Consumer’s
equilibrium/optimum in the indifference curve approach is shown
with the aid of Figure 3-15.

67
 Consumer’s Optimum Choice
•A, E, B are on the budget line
•D is highest utility but not affordable
•F if affordable but not efficient
Fig.3-15 •E represents the best affordable bundle,
highest affordable utility, so consumer
chooses E.
•E is also an interior optimum basket at
M=40 which the consumer will be purchasing
positive amounts of two commodities.
A
•Points A and B do not maximize utility as
(units per week)

they are in lower indifference curve

Clothing

30
D
E
20
F
IC3

B IC1

0 20 40 N=80 Food (units per week)

68
Consumer’s Optimum…..
♦ In Figure 3-15, point E is such a point where the
indifference curve IC2 is just tangent to the budget line
MN, at point E the two curves just touch. This
condition determines the optimal consumption bundle
when the indifference curves have the typical convex
shape.

♦ At the point of tangency (at point E) of the

indifference curve and the budget line , slope of the
budget line equals the slope of the indifference curve.

69
Consumer's Optimum/Equilibrium…
❑ For two goods food (X) and clothing(Y) measured on the horizontal
and vertical axis respectively, slope of an indifference curve is:
𝚫𝐘 𝑴𝑼𝑿
=−
𝚫𝐗 𝑴𝑼𝒀
Further the slope of the budget line Px.X+Py.Y=I is
𝚫𝐘 𝑷𝑿
=−
𝚫𝐗 𝑷𝒀
❑ So at consumer’s optimal consumption point:
𝑺𝒍𝒐𝒑𝒆 𝒐𝒇𝑰𝑪 = 𝑺𝒍𝒐𝒑𝒆 𝒐𝒇 𝒕𝒉𝒆 𝒃𝒖𝒅𝒈𝒆𝒕 𝒍𝒊𝒏𝒆
𝑴𝑼𝑿 𝑷𝑿
Or, − =−
𝑴𝑼𝒀 𝑷𝒀
𝑴𝑼𝑿 𝑷𝑿
i.e. =
𝑴𝑼𝒀 𝑷𝒀
𝑴𝑼𝑿 𝑴𝑼𝒀
Or, =
𝑷𝑿 𝑷𝒀

70
Consumer’s Optimum: Relative Price Rule

❑ The relative price rule says that at the optimal

consumption bundle, the marginal rate of
substitution between two goods is equal to their
𝑴𝑼𝑿 𝑷𝑿
relative price, =
𝑴𝑼𝒀 𝑷𝒀

❑ So the optimal /equilibrium consumption rule:

𝐌𝐔𝐗 𝐌𝐔𝐘
=
𝐏𝐗 𝐏𝐘

71
Consumer’s optimum …
❑ The point of tangency between the budget line
and indifference curve satisfies two conditions:

i. slope of indifference curve = slope of the

budget line,

ii. Income =PX.X + PYY (fixed budget is fully

spent).

72
 Two conditions required for
Consumer’s Optimal Point
❑ The consumer is in equilibrium when he/she maximises

his/her utility, given his/her income and the market prices.

❑ Two conditions must be fulfilled for the consumer to be in

equilibrium:

(i) Necessary condition: The first condition is that the

marginal rate of substitution(MRS) be equal to the ratio

𝑴𝑼𝑿 𝑷𝑿
of goods prices: 𝑴𝑹𝑺𝑿𝒀 = =
𝑴𝑼𝒀 𝑷𝒀

73
 Two conditions required for
Consumer’s Optimal Point…
(ii) Second Condition: Sufficient condition: The second
condition for consumer’s optimal is that at the point of
tangency of the budget line and indifference curve, the
indifference curve be convex to the origin. This condition is
fulfilled by the principle/law of diminishing 𝑴𝑹𝑺𝑿𝒀 , which
states that the slope of the indifference curve decreases (in
absolute terms) as we move along the curve from the left
towards to the right.

74
 Corner Solution (Consumer’s Choice
at Extreme)
♦A corner solution exists if a consumer buys in extremes,
and buys all of one category of good and none of another.

♦Corner point is a solution to the consumer’s optimal

choice problem at which some good is not being
consumed at all, in which case the optimal basket lies on
an axis.

♦In the case of corner solution, MRS is not necessarily

equal to the ratio of prices.
75
Corner Point …
At basket S the slope of the
indifference curve U1 is
steeper (more negative) than
the budget line. This means
that the marginal utility per
dollar spent on food is higher
than on clothing, so the
consumer would like to
purchase less clothing and
more food. He would move
along the budget line until he
reaches the corner point
basket R, where no Further
substitution is possible
because he purchases no
Clothing at R.

76
 Corner Equilibrium

Frozen
Yogurt
(cups A A corner solution
monthly) IC3 IC4
IC1 IC2 exists at point B.

E Fig.3-16

o
B Ice Cream (cup/month)
77
 Corner Solution…
♦ In Figure 3-16, at point B, the MRS of ice cream
for frozen yogurt is greater than the slope of the
budget line

♦ If the consumer could give up more frozen yogurt

for ice cream, he would do so; however, there is no
more frozen yogurt to give up

♦ Opposite is true if corner solution was at point A

78
 A Corner Solution…
■ When a corner solution arises, the consumer’s
MRS does not necessarily equal the price ratio.
In this instance it can be said that:
PIceCream
MRS 
PFrozen Yogurt

■ If the MRS is, in fact, significantly greater than

the price ratio, then a small decrease in the price
of frozen yogurt will not alter the consumer’s
market basket.
79
Change in Consumer’s Optimum

❑ Consumer’s optimum/equilibrium changes when

there is change in :

➢ Prices of the commodity ,or

➢ Consumer’s money income.

80
 How Changes in Prices Affect the
Consumer's Choices and
Equilibrium
❑ Change in the price of a commodity changes the
optimal of the consumer, holding price of
another commodity and money income of the
consumer constant .

❑ The effect of price change will depend on

whether the commodity in question is normal or
inferior or Giffen.
81
 Normal Goods
❑ Normal good is any good or service whose
consumption increases with increase in income and
falls when income falls, other things remaining
constant.

❑ This applies to most goods. Normal goods are

divided between necessities, with *income elasticities
of demand of less than one, and luxuries, with
income elasticities of demand of over one.

82
 Inferior Good
❑ An inferior good is the one which is less demanded
at any given price as income rises, over some range
of incomes.

❑ An inferior good thus has a negative *income

elasticity of demand, over this income range. A good
is most likely to be inferior if it has a close substitute
of higher quality. It should be noted that a good
cannot be inferior at all levels of income.

83
 Giffen Good
❑ A Giffen good is the one for which quantity demanded
falls when its price falls. Thus Giffen good violates the law
of demand.

❑A Giffen good must be inferior and also have poor

substitutes. A fall in the price of a good increases real
purchasing power: if the good is inferior the *income effect
of this rise in real income is negative. The *substitution
effect of a price fall cannot be negative, but if the good has
poor substitutes the positive substitution effect is small.

84
 Price-consumption curve(PPC)
❑ In the analysis of consumer’s behaviour, economists use the price
consumption curve(PCC) to show the effect of price-change of a
commodity on consumer’s purchases.

❑ Price consumption curve (PCC) shows the series of utility-

maximizing bundles as the price of one good varies (holding constant
income and the prices of other goods).

■According to J.P. Gould and E.P. Lazear, “Price consumption curve is a

locus of points in the commodity space showing the equilibrium bundles
resulting from variation in the price ratio, money income remaining
constant”.

■Thus PCC a curve tracing the utility maximizing combinations of two

goods as the price of one of the goods changes.

85
 Price Consumption Curve: Diagram
•Price consumption curve(PCC) is the set of utility
maximizing baskets as the price of one good varies
(holding constant income and the prices of other goods).
Initial optimum is at point A. Other things being equal ,
as price of food falls, new budget line is MN1 and
optimum is at E. As price of food further falls, new
optimum is at F. By joining A,E and F , we obtain PCC.
M
(units per week)
Clothing

PCC

C1
A

Fig.3-17
IC1
N2
0 F1 N N1
Food (units per week) 86
 Splitting/Decomposing Price Effects
♦A change (fall) in the price of a good has two effects:
1)Consumers will tend to buy more of the good that has
become cheaper and less of those goods that are now
relatively more expensive. This response to a change in
the relative prices of goods is called the substitution
effect.
2)Because one of the goods is now cheaper, consumers
enjoy an increase in real purchasing power. They are
better off because they can buy the same amount of the
good for less money, and thus have money left over for
additional purchases. The change in demand resulting
from this change in real purchasing power is called the
income effect.
87
Income and Substitution Effects of a Price
Change of a Normal Good

88
 Effects of a Price Fall
PX falls

Income effect - Substitution Effect

consumer feels richer X now looks relatively cheaper

Quantity demanded Quantity demanded Quantity demanded

increases decreases increases

Thus total effect of a price change is the sum of

substitution effect AND the income effect.
89
 Substitution Effect of a Price Change
♦According to P.A. Samuelson and W.D. Nordhaus, "Substitution
effect (of a price change) is the tendency of consumers to consume
more of a good when its relative price falls (to “substitute” in
favor of that good) and to consume less of the good when its
relative price increases (to “substitute” away from that good)”.

♦A substitution effect is a consumption change that results when

a price change moves the consumer along a given indifference
curve. Think if the price of jeans is cut in half, e.g., instead of
$50 per pair, they are now $25 per pair. You might react like:
this is super news: “jeans are now relatively cheap compared to
sweaters, so I will buy more jeans and fewer sweaters.”
90
 Income Effect of a Price Change
♦ According to J. P. Gould and E. P. Lazear, “The income effect of
a change in the price of a commodity is the change in quantity
demanded resulting exclusively from a change in real income,
all other prices and money income held constant”.

♦ An income effect is a consumption change that results when a

price change moves the consumer to a lower or higher
indifference curve. Think about if the price of jeans is cut in half:
instead of $50 per pair, they are now $25 per pair. You might
react like: this is super news: “I feel 'wealthier’ now, so I am
going to buy more jeans and sweaters.” Change in the price of a
commodity directly affects the real income(purchasing power).
91
 Income Effect of Price Change…
❑ A fall in price increases real income as more of the
cheaper good and/or other goods could now be
purchased from current money income. The
consumer will respond to their increased purchasing
power by rearranging their income between goods.

❑If price of the commodity rises , a consumer cannot

buy as much as he/she once did with the same
nominal income because of the loss of real income
due price rise .

92
Price effect = Substitution effect +
Income effect
❑ The overall effect of a price change (PE) is
therefore the combined effect of both the income
and substitution effects, PE=SE+IE.

❑ We use indifference curve and budget line concepts

together to analyse and isolate these two effects.

93
 Two Approaches to
Splitting/Decomposing Price Effect
◆The decomposition of the price effect into the
income and substitution effect can be done
mainly in two ways:

i. The Hicksian method, and

ii. The Slutsky method

94
 Hicks Approach of PE=SE+IE:
Normal Goods Case
◆ Hicks approach uses the idea of Compensation
variation which is the necessary adjustment in money
income to maintain the real purchasing power (or
real income) of the consumer resulting from a price-
change. If price falls, the compensating variation
requires a compensating (balancing) decrease in
money income, and vice versa.

95
Income and substitution Effects: Both
Normal Goods : Hicks Method
Price Fall:
A decrease in the price of food has both
an income effect and a substitution
effect. The consumer is initially at A, on
budget line RS. When the price of food
falls, the new budget line is RT,
consumption increases by F1F2 as the
consumer moves to B. GH is the
compensated budget line drawn parallel
to RT.
The substitution effect F1E (associated
with a move from A to D) changes the
relative prices of food and clothing but
keeps real income (satisfaction) constant.
The income effect EF2 (associated with a
move from D to B) keeps relative prices
constant but increases purchasing
power. Food is a normal good because
the income effect EF2 is positive.

96
 Hicks Approach of PE=SE+IE: Normal
Goods Case…
❑ After the fall in the price of food, its quantity
demanded increases due to the substitution and
income effects. Consumers substitute the now cheaper
good for ones whose price has not fallen, real income
holding constant.

❑ Due to the decrease in price real income (purchasing

power) is now higher and the consumer can buy more
with the same money income. For normal goods the
income effect of a price fall is positive.

97
 Hicks Approach of PE=SE+IE: Case of
Normal Goods .…
❑ In the case of a normal good , the income and substitution
effects reinforce/support each other and quantity
demanded of the cheaper good increases.

❑ As the price of food falls, the income effect leads to an

increase in food consumption. Also, because the MRS is
diminishing, the substitution effect leads to increased food
consumption as well. Thus, the income and substitution
effects work in the same direction.

98
FIGURE : Income and Substitution Effects of a Fall in Price (PA=$1, PB=$2 & Budget=$20; both
normal goods )
When the price of product B falls, the budget line rotates out from L1 to L2 and consumer
Bayu demands more of product B and less of product A. In panel (a) the fall in price of
product B leads Bayu to move to point Z on a higher indifference curve I4. The move from X
to Z in panel (a) represents the increased quantity demanded of product B due to both the
substitution effect and the income effect.
In panel (b), if Bayu’s income is held constant (dashed line L* parallel to L2 and tangent to I3)
the now-lower price of B leads him to demand more of it and he moves to point Y on
indifference curve I3.This rise in quantity demanded is the substitution effect due to the lower
price of product B. The shift from Y on indifference curve I3 to Z on indifference curve I4
represents the increased demand of product B due to the income effect as a result of the lower
price of product B. At point Y the MRS is equal to the new price ratio.

99
Substitution and Income Effects with Normal
Goods: The Case of Rise in Price
Suppose budget=$30, PM=$1, and PT =$0.5. Initially
consumer John’s optimum is at point e1, at the
tangency of budget line L1 and indifference curve I1. A
doubling of the price of music tracks from $0.5 to $1
causes John’s budget line to rotate inward from L1 to L2
where he can buy 30 music tracks if all budget is spent on
it.The compensated budget line L* is drawn tangent to
the initial indifference curve I1 and parallel to the
inward-rotated budget line L2 so that L* and L2 has the
same slope. The shift of the optimal bundle from e1 to e2
is the total effect of the price change. The total effect can
be decomposed into the substitution effect which equals
the movement from e1 to e*, and the income effect which
equals the shift from e* to e2.

100
 Hicks Approach of PE=SE+IE:
Normal Goods Case…Demand Curve
❑ The demand curve for food will be downward
sloping because the quantity of food purchased
will increase when the price of food
falls.(Similarly, if the price of food were to rise,
both effects-substitute and income- would be
negative. At a higher price of food, the consumer
would buy less food.)

101
Deriving the Demand Curve
In panel (a) when the price of product B is increased from $1 to $1.50,
the budget line L1 rotates inward to L2 moving the equilibrium position
from X to X′, decreasing the quantity of product B demanded from six to
three units. In panel (b) The demand curve for product B is determined
by plotting the $1–six-unit and $1.50–three-unit price–quantity
combinations for product B.

102
Derivation of Demand Curve from the Price Consumption Curve
Panel (a) also shows the price-consumption curve(PCC),
which is the line through the optimal bundles, such as e1 ,
e2 , and e3 , that John would consume at each price of beer,
when the price of wine and John’s budget are held
constant. Because the PCC is upward sloping, we know
that John’s consumption of both beer and wine increases
as the price of beer falls.
If the price of beer falls, holding the price of wine, the
budget, and tastes constant, the typical consumer, John,
buys more beer. In panel (a) at the actual budget line,L1,
where the price of beer is $12 per unit and the price of
wine is $35 per unit, the average consumer’s indifference
curve I1 is tangent at bundle e1, 26.7 gallons of beer per
year and 2.8 gallons of wine per year. If the price of beer
falls to $6 per unit, the new budget constraint is L2, and
the average consumer buys 44.5 gallons of beer per year
and 4.3 gallons of wine per year. In panel(b) by varying
the price of beer, we trace out John’s demand curve for
beer. The beer price-quantity combinations E1, E2 ,and E3
on the demand curve for beer in panel (b) correspond to
optimal bundles e1, e2 , and e3 in panel a.
We can use the same information in the price-
consumption curve to draw John’s demand curve, D1, for
beer in panel (b). For each possible price of beer on the
vertical axis of panel (b), we record on the horizontal axis
the quantity of beer demanded by John from the price-
consumption curve in panel (a).

103
The Slutsky Approach of PE=SE+IE:
Normal Goods Case…
❑There is difference between Hicks and Slutsky method
is separating the price effect into substitution and income
effect.

❑In Slutsky approach (Eugene Slutsky,1880-1948),

increased real income (due to a price fall) is
compensated/balanced in such a way that the consumer
is able to purchase the same bundle of commodities as
before but in Hicks it is adjusted so as to keep the
consumer on the initial level of satisfaction.

104
The Slutsky Approach of
PE=SE+IE: Normal Goods Case…
■ The separation of price effect resulting from the
fall in the price of a normal good into
substitution and income effects by using Slutsky
approach is illustrated in Figure 3.23.

105
 Slutsky Approach of PE=SE+IE: Normal
Goods Case…
Initial optimum is at point E1.As PX falls, new budget line
is AD with new optimum at E2 on higher IC3.The
hypothetical budget line A1D1 is drawn passing through
Y E1 and making parallel to AD. IC2 and A1D1 are tangent
at E3. The shift from E1 to E3 is the substitution effect
A
Clothing

and shift from E3 to E2 is income effect of a price fall of

X. In terms of quantity, F1F3 and F3F2 are respectively
the SE and IE of a price fall in the price of food (X).
A1 IC1
IC2
E1
E2
Fig.3-25
E3 IC3
o F1 B F3 D1 F 2 D
Food(X)
Sub
Income
Effect
Effect
106
Income and Substitution Effects
when Goods are Inferior
❑ In the case of inferior goods, the income and
substitution effects work in opposite directions.
When a good is inferior, the indifference curves
will show that the income effect is negative as
the budget line shifts out from initial position
due to the fall in the price of the inferior good.

107
Income and substitution Effects: Inferior good
(Price fall) Hicks Method
Assume that food is inferior good. The
consumer is initially at A on budget line RS.
With a decrease in the price of food, budget
line rotates out as indicated by the dotted
line RT and the consumer moves to B on U2
reducing purchase of food. The resulting
change in food purchased can be broken
down into a substitution effect, for which
GH is the compensated budget line drawn
parallel to RS and making tangent to the
initial indifference curve U1. The
substitution effect is F1E (associated with a
move from A to D), and an income effect,
EF2 (associated with a move from D to B).
As food is an inferior good, the income
effect is negative. However, because the
substitution effect exceeds the income effect,
the decrease in the price of food leads to an
increase in the quantity of food demanded.

108
Income and substitution Effects: Inferior good
Hicks Method

Positive substitution effect

=+F1E
Negative income effect= - EF2
Total price effect = + F1E +(-
EF2)
= + F1E - EF2
= + F1F2 (As F1E > EF2)

109
Price effect in Giffen Goods
◆Giffen good is a good so strongly inferior
that the income effect is greater than the
substitution effect, resulting in an upward-
sloping demand curve over some region of
prices.

110
Price Change Effect on Giffen Good: The
Hicksian Method
Giffen good is a good so strongly
inferior that the income effect exceeds
the substitution effect, resulting in an
upward sloping demand curve over
some region of prices. The consumer is
initially at point A on budget line RS,
but, after the price of food falls, budget
line rotates out as indicated by the
dotted line RT, and the consumer moves
to B and consumes less food. The
compensated/imaginary budget line is
GH drawn tangent to U1 and parallel to
RT. Because the income effect EF2 is
larger than the substitution effect F1E,
the decrease in the price of food leads to
a lower quantity of food demanded.

111
Price Change Effect on Giffen Good: The
Hicksian Method

Positive substitution effect =+F1E

Negative income effect = -EF2
Total price effect = + F1E +(-EF2)
= - F1F2 ( as EF2 >EF1)

The decrease in the price of food

leads to a lower quantity of food
demanded.

112
 Effect of Income Change and the
Income Consumption Curve(ICC)
❑ Other things (e.g., prices of goods) remaining
constant change in the level of income changes
consumer’s optimum purchase.

❑ An increase in income increases the quantity

demanded of normal goods and decreases the
quantity demanded of inferior(low quality)
goods.

113
 Income Consumption Curve(ICC)
❑In analyzing consumer behaviour, economists use the concept
of income consumption curve (ICC) to show the set of utility
maximizing bundles of goods as income changes holding
prices constant. According to J.P. Gould and E. P. Lazear,
“The income consumption curve is a locus of points in the
commodity space showing the equilibrium commodity bundles
associated with different levels of money income for constant
money prices”.
■ Thus the income consumption curve traces out the effect of
income change on the utility maximizing combinations of two
goods , prices remaining constant.
114
 ICC…Effect of Income Change

❑ The slope of the ICC shows how the consumer reacts to

the change in income, that is, whether the commodity is
normal or inferior.

✓ Positively sloped ICC indicates that goods are normal.

A normal good is the one that responds positively to an
increase in income, and vice versa.

✓ An inferior good responds negatively to an increase in

income, and vice versa.

115
 ICC for Normal Goods
Initial optimum is at point E1. An increase in income
shifts the budget line outward with prices remaining
Clothing constant, the new optimums are at point E2 and E3.
A2 The line passing through E1,E2 and E3 is ICC. As
both goods are normal , ICC is upward sloping.

A1
IC1 E3 ICC
A E2
E1 IC3

IC2
o F1 D F2 F3 D1 D2
Food(X)
Fig.3-28
116
 ICC for an Inferior Good
Grilled Fish (units per month)
15
Income-Consumption Curve

Beyond B hamburger
C becomes an inferior good
10 when the income
consumption curve bends
IC3
backward between B and C.

B
5

IC2
Fig.3-29
A
IC1
0 8 10
5 20 30 Hamburger
(units per month)
 Income Change and Engel Curve
❑ Engel curves relate the quantity of good consumed to income.
It is named after Ernst Engel (1821–1896), a German
statistician who investigated the impact of income changes
upon the food consumption of families in the mid-nineteenth
century. His general conclusion was that as income rises the
proportion of income spent on food declines.
❑ If the good is a normal good, the Engel curve is upward
sloping.

❑ If the good is an inferior good, the Engel curve is downward

sloping.
118
 Income Change and Engel Curve
❑ Engel’s law is the idea that with given tastes and
preferences, the proportion of income spent on food
falls as income rises.

❑ The ‘law’ is then often extended to imply that the

proportion of expenditure on all necessities (e.g.
food) declines as incomes rise. In contrast, the
proportionate expenditure on luxuries (or non-
necessities) would increase.

119
Deriving Engel Curve(EC) from Income Consumption
Curve in Case of Normal Necessities

Deriving Engel Curve from Income Consumption Curve in Case of Necessities

120
 Engel Curves

Income(thousand $ per month) C

30
Inferior

B
20

Normal

A
10

0
5 10 Hamburger
(units per month)
 Questions for practice
(1) Suppose a consumer has an income of Rs.2,000.She chooses two goods
X and Y for consumption. Their prices are Rs.400 and Rs.200
respectively.

a) Derive the budget line.

b) Show her equilibrium point when she allocates her income equally
between X and Y.

c) Suppose the price of X falls to Rs.200. Derive the new budget line.

d) Suppose after the fall in price ,she spends Rs.800 on X and Rs.12,00
on Y. Show the new equilibrium.

e) Derive the price demand curve.

122
 Questions for practice
(2)The Trustees of a University have allocated Rs.500,000 to one of the
affiliated colleges for spending on new faculty positions and undergraduate
scholarships. Each faculty position costs Rs.50,000 and each scholarship costs
Rs.10,000.The principle of the college is trying to decide how to spend the
money.

a) Write the formula for the Principal’s budget constraint.

b) How can you describe the opportunity cost of faculty position ?

c) Sketch the constraint and show the feasible set.

d) Show what happens to the constraint if the trustees reduce funding to

Rs.300,000.

e) Show the effect on the constraint if funding is returned to Rs.500,000 but

the price of the faculty position decreases to Rs.25,000.

123
 Questions for practice
(3) The Federal Government of Nepal has allocated Rs.800,000 for a
Rural Municipality to spend on road construction and health services in
the municipality. On the average each road construction costs Rs.40,000
and health services costs Rs.20,000. The Mayor is thinking to decide on
how to spend the allocated fund.
a)Express the budget constraint for the Mayor in the form of a formula.
b)Express the budget constraint graphically and indicate the attainable
region.
c) If the Government of Nepal increases the allocated fund to Rs.1,800,000
while the average cost of road construction goes up to Rs.120,000 and
health services to Rs.60,000, how do you think the budget constraint of
the Mayor is going to get affected? Show this diagrammatically.
d)In which case, before or after the rise in the allocated budget for the
Rural Municipality that the Mayor will attain higher level of
satisfaction ?Why?

124
 Questions for practice
(4) Suppose consumer Kranti’s income is Y=Rs.1,200 per week , all of
which she spends on some combination of rent and restaurant meals.
Restaurant meals cost Rs.12 each and the monthly rent for the apartment
is Rs.3 per square foot.

(a) Draw her budget constraint with her monthly quantities of restaurant
meals per month on the vertical axis and apartment size on the horizontal
axis.

(b) Is the bundle (300 square feet per month, 50 meals per month)
affordable ?How will Kranti attain her equilibrium? Explain.

125
 Questions for practice
(5) A low-income family has Rs.10,000 available monthly to spend on food and
shelter. Food costs Rs.2 per unit , and shelter costs Rs 1 per square foot per
month. The family is currently dividing the Rs.10,000 equally between food and
shelter.
(a) Draw the family’s budget constraint on a diagram with food on the vertical
axis and shelter on the horizontal axis. Label their current consumption choice.
How much do they spend on food and how much on shelter?
(b) Suppose the price of shelter rises to Rs.2 per square foot. Draw the new
budget line .Can the family continue the same amounts of food and shelter as
previously ?
(c) In response to the increased price of shelter, the government makes available
a special income supplement. The family receives a cash grant of Rs.5,000 that
must be spent on food and shelter. Draw new budget line and compare it to the
line you derived in part a .Could the family consume the same combination of
food and shelter as in part a ?
(d) With cash grant and with shelter priced at Rs.2 per square foot, will the
family consume the same combination as in part a ? Why or why not ?
126
 Solution to Question 5
Part (a)Let food be denoted by 'F' and Shelter by 'S'. Then the
equation of budget line is: 2F + 1S = 10,000
In the case of extreme choice (i.e., in the case of corner solution):
Maximum units of Food, F =Rs.10,000/Rs.2 = 5,000 units
or, Maximum units of Shelter, S =Rs.10,000/Rs.1 = 10,000 units.
The plot of A (5000, 0) and B (0, 10000) gives the budget constraint
AB as shown in the figure:

(in '000' units)

As the budget of Rs.10,000 is 11

equally distributed between 10

9
'F' and 'S', the family will be at 8
New Budget Line 2
equilibrium when it buys: 7
H

Food, F=Rs.5000/Rs2 = 2,500 6 New Budget Line 1

Food (R)

A
units and Shelter, S 5
Initial Budget Line
=Rs.5000/Rs.1= 5,000 units. 4
3
This is indicated by point 'E' 2.5
2
E

on the budget line AB. 1

G J B
O
1 2 3 4 5 6 7 8 9 10 11
Shelter (S) (in '000' u n its)
127
 Solution to Question 5 contd…..
Part (b) At new price of Rs.2 per square foot, maximum units of shelter
that can be purchased =Rs.10,000/Rs.2 = 5,000 units
There is no change in price of Food (F). So units of food purchased will be
the same as in part (a).
No, the family cannot continue to consume the same amounts of food and
shelter as consumed previously as indicated by the New Budget Line1,
AG.
Part (c) Total budget of the family after a grant of Rs.5,000 is 10,000 + 5,000
= Rs.15,000
Then, maximum shelter units that can be purchased =Rs.15,000/Rs.2 =
7,500 units.
or,
Maximum food units that can be purchased =Rs.15,000/Rs.2 = 7,500 units.
The budget line in this new context is represented by line HJ in the
figure. As the budget line HJ passes through the point 'E', the family can
consume the combination as of part (a).

128
 Solution to Question 5……
Part (d) If the family spends total budget of Rs.15,000
(=10,000 + 5,000) equally on food and shelter with
prices Rs.2 for each unit of both, the family can
consume the same combination of food and shelter
because in equation:
Budget=2F + 2S
After substituting F = 2500 and S = 5000, we get
Budget = 2 × 2500 + 2 × 5000
=Rs.15,000

129
(6) Assume that the data in the following table are an
indifference curve for a consumer :
Choice Units of Y Units of X

A 10 2

B 6 4

C 4 6

D 2 12
(a) Graph this indifference curve and label “Quantity of Y” on the vertical
axis and “Quantity of X” on the horizontal axis. Label the points A-D.
(b) Assume the consumer’s budget Rs.12 and prices of X and Y are Rs.1
and Rs.1.50, respectively .Draw the budget line in the above graph.
(c) Which combination of X and Y will the consumer purchase ?Why?
(d) State the value of the MRS and the slope at consumer equilibrium.
130