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BCom 1st Year Modern Theory of Consumer Behaviour Notes Study Material

BCom 1st Year Modern Theory of Consumer Behaviour Notes Study Material


Effects of Changes in Income

When the consumer selects the consumption bundle that maximizes his satisfaction, he is in equilibrium. He will go on consuming that bundle unless something changes. It is assumed in this analysis that the consumer’s money income, prices of goods and his tastes (preferences) are given. It is now assumed that his tastes and prices of goods are unchanged, but his money income changes. What is the effect of it on consumer’s equilibrium? This is what we examine now.

A change in the consumer’s money income will, with no change in prices of goods and tastes the consumer, shift the budget line parallel to itself, outwards when income rises and inwards when income falls. The slope of the budget line depends on the ratio of the prices of the two commodities. Since the prices do not change, the slope will remain the same. This is why, the budget lines are drawn parallel to one another in fig.

Income Effect in Business Economics

The effect of income changes is shown in fig. The initial position of equilibrium is P1 where indifference curve IC1 is tangent to the budget line MN. The increase in money income results in the outward shift in the budget line from MN to M’N’. Another change in income leads to further outward shift in the price line and it shifts to M”N”. MN, M’N’ and M”N” are all parallel budget lines because neither the price of X nor that of Y changes.

Equilibrium points also move correspondingly from P1 to P2 and then to P3. By joining up a points of equilibrium, a curve is traced which is called the income-consumption curve. In fig, the income-consumption curve (ICC) has been so drawn that increased income leads to larger purchases of both the commodities. It is due to income effect.

With most indifference maps it will be found that income-consumption curves on them always slope upwards to the right. This means that a rise in a consumer’s income makes him buy more of each of the two goods he is consuming. It is so in the case of all normal goods-goods whose demand rises as income rises. Here the income effect is positive. In the case of an inferior good the income effect is negative, that is, as income rises, the quantity of the good purchased falls. Giffen good is a special case of inferior goods.

Inferior Goods

In the case of inferior goods, the income-consumption curves are of the type of ICC1 or ICC2, as shown in fig, ICC1 is drawn on the assumption that Y is an inferior good, while ICC2 shows that X is an inferior good. In the case of ICC1, income increases lead to lower purchases of Y, whereas in the case of ICC2, income increases cause lesser purchases of X. By comparing P to P1 and P2 this would be clear. Thus the income effect can be positive or negative, depending upon the nature of the commodity.

Effects of Change in the Price

It is now assumed that the price of one good, X changes but the money income and tastes of the consumer and the price of the other good, Y remain unchanged. The effect on consumer behaviour of this type of price change is known as the price effect.

In fig, the price effect is shown. The initial equilibrium position in the diagram is at P, where the budget line MN touches the indifference curve IC1. The consumer buys OX1 of X and OY1 of Y.

Price Effect

Let us now assume that the consumer’s money income remains constant but that the price of X falls. As a result of this, the foot of the price line NM shifts to the right and the new price line becomes NM1.

In the original situation (before price fall) the consumer could buy OM of X if he spent the whole of his money income on it. Now (after the price fall) the same money income will buy OM1 of X instead of OM. Since the price of Y is unchanged and so is the money income, the consumer will buy ON of Y with his whole money income all the time.

In the case of NM1 budget line, the new equilibrium is at point P1 where IC2 is tangent to NM1. In the new situation the consumer buys OX2 of X and OY2 of Y. If the price of X falls again, the new budget line is NM2 and the resulting equilibrium position will be at P2.

By joining all the equilibrium points P, P1, P2, etc., we get a line which is called the price-consumption curve (PCC) showing the price effect. It depicts the way in which the consumption of X changes when its price changes. consumer’s money income and the price of Y remaining unaltered. We will show below that the price effect is the sum of income effect and the substitution effect. Before doing that let us consider the substitution effect.

Substitution Effect

A substitution effect occurs when the relative prices of goods change but the consumer’s real income is unaltered. In other words, in the event of a change in relative prices, consumer’s money income is so altered that he is neither better off nor worse off than before. In spite of the unchanged real income, the consumer rearranges his purchases due to new relative prices.

A substitution effect is shown in fig. In the original situation the consumer is in equilibrium at point P1 where the budget line NM is tangent to indifference curve IC1. His money income is OM in terms of good X or ON in terms of good Y.

Substitution Effect

Now let us assume that the price of X falls, price of Y is unaltered, so that with the same money income he will now buy OM1 instead of OM of X. The fall in the price of X has an effect as if his income had increased because his real income rises. Now assume that at the time when the price of X falls, his money income is so reduced that he is neither better off nor worse off than before, that is, he is on the same indifference curve.

Suppose that as the price of X falls, his money is reduced such that he can purchase only ON’ of Y by spending his whole (reduced) money income. (It should be noted that price of Y is unaltered). In the new situation the budget line is N’M’ to which the indifference curve IC1 tangent at the point P2.

In the initial situation the consumer purchased OX1 of X; now he purchases OX2 of X. The increase in the purchase of X by X1X2 is due to the substitution effect. “The expression ‘substitution effect’ means nothing more than that the consumer buys a larger quantity of a commodity whose price falls, quite independently of the gain in his real income.”

Income Effect and Substitution Effect of a Price Change

There are two explanations of the demand curve, namely, (i) the law of diminishing marginal utility and (ii) income and substitution effects of a price change. In this section we explain the latter.

When the price of a good changes, consumer’s demand for this commodity also undergoes a change due to two reasons. One is the income effect and the other is the substitution effect. Now suppose that the price of X falls, while the price of Y remains unaltered.

Consequently, the demand for X increases, i.e., more of X is purchased. It is for two reasons-income effect of the price decline and the substitution effect of the price fall. Income effect results from the fact that a fall in the price of a commodity is taken as an increase in real income, just as if the money income has risen with prices unaltered.

So he purchases more units of this commodity, as shown in the case of an increase in money income with prices of commodities unchanged. The substitution effect means nothing more than that the consumer buys a larger quantity of a commodity whose price falls, quite independently of the gain in his real income. In this case the cheaper commodity is substituted for dearer one. Hicks explains the income effect thus:

“A fall in the price of a commodity does actually affect the demand for that commodity in two different ways. On the one hand, it makes the consumer better off, it raises his real income, and its effect along this channel is similar to that of an increase in income.”

Substitution effect is explained as:

“On the other hand, it changes relative prices, and therefore, apart from the change in real income, there will be a tendency to substitute the commodity whose price has fallen for other commodities. The total effect on demand is the sum of these two tendencies.”

Let us explain these two effects with the aid of fig. In the diagram the initial point of consumer equilibrium is A where the budget line ML touches the indifference curve IC1. Now assume that the price of X falls, price of Y being unaltered. The new price line in this situation is ML1. Indifference curve IC2 touches the price line ML1 at point B. At the initial equilibrium point A, the consumer purchased OX1 of X; at B he will purchase OX2.

Now assume that the price of X does not fall but that the money income of the consumer goes up. In this situation the price line will be M1L2. At point C on ML2, the consumer is in equilibrium because at this point IC2 touches the budget line ML2. Budget line ML2 is drawn parallel to ML because we assume that there is no change in the relative prices of X and Y, it is only the money income that goes up.

In fig. it has been shown that increased demand for X by X1X2 can be divided into two parts. Increase in demand to the extent of X1X3 is due to the income effect and X3X2 increase is caused by substitution effect. Total increase in demand of X1X2 is called the price effect.

Income and Substitution Effects

It has been shown in the diagram that the income effect is the movement along ICC, while substitution effect is the movement along PCC. Income effect may be positive or negative as the increase in income will lead to greater demand or lesser demand than before, depending on the nature of commodity. Substitution effect is always positive—more of a cheaper commodity is purchased, the exception being the inferior good.

Hicks and Slutsky Effect

It is necessary to distinguish the Slutsky effect from the Hicksian effect. Table will be of immense help to understand this difference. Difference between (a) and (b) is that the price of X is lower while the price of Y and money income are unchanged. The consumer is no doubt better off as he consumers more of both X and Y-80X + 60Y compared to 50X + 50Y.

Situation (c) is what Slutsky would have called “compensated” change in price from situation (a): Income in (c) is less than that in (a) by just that amount so that at the lower price of X the individual could, if he wanted to, buy the same amount of X and Y as in (a)—50X + 50Y.

In Slutsky’s terms, his “apparent real income” is unchanged. But the consumer does not buy 50X and 50Y, rather he purchases 60X and 45Y. Since this is his deliberate choice, we must suppose that he prefers it. It means that his “real” income is higher for (c) than for (a); he is on a higher indifference curve.

For Hicks it would be necessary to take away enough money to keep the consumer on the same indifference curve. It may be Rs. 28 as given in situation (d) so that the budget line obtained from (d) touches the same indifference curve as that obtained from (a).

BCom 1st Year Modern Theory of Consumer Behaviour Notes Study Material

In fig. the difference between the income effects of Hicks and Slutsky has been shown. The initial point of equilibrium (situation a) is P where IC1 touches the budget line ML. As the price of X falls (situation b), the budget line shifts to ML1. Indifference curve IC3 touches it at Q. So in the situation (b), the consumer purchases OX4 of X instead of OX1 as in situation (a-total increase in the purchase of X due to a fall in the price of X being X1X4.

Hicks and Slutsky Income Effect

This increase in a the purchase of X is a compound of an income effect and a substitution effect. This compound can be broken in two different ways. Situation (d), the Hicksian case, results in the M2L2 budget line. Equilibrium point on it is S where the IC1 touches it. Movement from P to S or from X1 to X2 is a result of the substitution effect, whereas the movement from S to Q or X2 to X4 is the consequence of income effect. So

Total Effect = Income Effect + Substitution Effect

(X1X4) = (X1X2) + (X2X4)

We obtain the budget line M3L3 according to situation (c). It is according to Slutsky. The initial equilibrium point was P (situation a). With a money income of Rs. 75 and the prices of X and Y as given by situation (c) in table, the combination of X and Y as obtained at point P is attainable. So the budget line M3L3 passes through this point P.

But the consumer does not choose point P but some other point which, he thinks, puts him on a higher level of satisfaction. Such a point is R where the higher indifference curve IC2 (compared to IC1) is tangent to the budget line M3L3. Following Slutsky, the movement from P to R or from X1 to X3, is the substitution effect and the movement from R to Q or from X3 to X4, is the income effect. Thus

Total Effect = Income Effect + Substitution Effect

(X1X4) = (X3X4) + (X1X3)

The difference between the Hicks and Slutsky approach is X2X3. The approach of Slutsky is superior to that of Hicks in the sense that the substitution effect can be known by the observation of prices and demand in the market. In other words, the real income does not depend on indifference curve or preference order. For the Hicksian approach, the knowledge of preferences is essential. However, if the price change is very small, the difference between the two becomes negligible.


New Difficulties: Both the utility analysis and the indifference curve analysis of consumer demand reach the same conclusion about consumer equilibrium. The basic problem with utility analysis is the absence of any yardstick to measure utility. Indifference curve analysis keeps away from this difficulty.

In spite of this superiority of the indifference curve analysis, it has given rise to new difficulties:

(i) If there is no need to measure utility, one has to be familiar with consumer preferences which is equally difficult.

(ii) Choice is not always clear. From a mathematical point of view, we can imagine a combination in which there are 15 shirts and no shoes. But in real life this is an absurd combination.

(iii) Third difficulty relates to the use of geometry. Preferences are presented in the form of indifference curves. Hicks himself admits that there are several shortcomings in the direct use of geometry. It is useful in simple situations. It is particularly so when the analysis is limited to two commodities, In the analysis of many commodities, one has to take recourse to mathematics which does not always correctly express the economic point of view.

(iv) Armstrong is of the opinion that indifference curves do not express indifference in a proper way. Indifference is due to the fact that the consumer is not clear about the differences between two combinations. Let us look at fig.

BCom 1st Year Modern Theory of Consumer Behaviour Notes Study Material

There are four points A, B, C and D on an indifference curve, IC. The consumer is indifferent between A and B, not because he gets same satisfaction from both combinations but because the difference between the levels of satisfaction between the two is so small that he is unable to distinguish them. The same is the case with C and D. But it is not so with A and Cor B and D. The consumer, in such cases, does not remain indifferent; he will attach more or less importance to the one over the other.


One has to accept that the indifference curve analysis is superior to utility analysis in some respects. This analysis has made the Pareto theory more useful. It has tried to weave together the Marshallian and Paretian threads.

In this attempt the terminology and figures used are Paretian but the substance of the theory is nearer to Marshall. If the difference between two theories is confined to mere terminologies, they do not remain that important. This is true with indifference curve analysis.

Yet one has to accept that the indifference curve analysis is able to explain those situations which Marshall’s theory (utility analysis) failed to do. They are:

(i) Law of demand, as explained by Marshall, is based on the law of diminishing marginal utility. It is an explanation which it is not easy to understand. In order to understand this we must first know the assumptions and the concept of consumer behaviour. The main assumption is the diminishing marginal utility as more of that commodity is purchased. Now, since the marginal utility of additional units declines and price equals marginal utility, a consumer will purchase these additional units when price declines.

The law of demand is explained in terms of income and substitution effects under indifference curve analysis. This explanation is more simple and useful.

(ii) Indifference curve analysis is capable of explaining a Giffen good. In nineteenth century Ireland was struck by a severe famine. Giffen was astonished to see that while the price of potato was rising, its demand too increased. Marshallian demand curve cannot explain it, but indifference curve can do. Fig. should be seen for this.

Let us assume that the price of potato was PX1 before increase. At that price the consumer, with his given money income, purchased OX1 of it. (The initial equilibrium point is P at which the initial budget line ML touches the indifference curve IC2.) Let the price of potato rise to Px2 . At the higher price the budget line shifts to the left to ML1 (Px2). At the higher price of Px2, the consumer purchases larger amount of potato (i.e., OX2). Two factors cause this.


They are income and substitution effects. M1L2 is the compensated budget line. Consumer’s money income is so raised that his real income at price Px2 is the same as it was at price Px1. IC2 touches the budget line M1L2 at point S.

The movement from P to S is the substitution effect which results in a lesser purchase of potato as its price goes up-from OX1 to OX3, less by X1X3. The movement from S to R is the income effect which results in a higher purchase of potato (i.e., X) to the tune of X3X2. Therefore,

Total Effect = Income Effect + Substitution Effect (negative)

(X1X2) = (X3X2) + (X3X1)

Demand tends to rise as the price of a Giffen good rises because the absolute size of the income effect (with respect to price) is greater than the negative size of the substitution effect. In other words, the income effect is so strong as to swamp away the substitution effect.

Sir Robert Giffen’s (1837-1910) observation was not limited to the Irish tamine only. It also relates to the labouring classes and the price of bread. The expression Giffen good is named after him. Giffen goods are those goods which do not obey the law of demand, viz., that more is bought as price falls. Rather, the quantity of a Giffen good demanded rises as price rises—a positively sloped demand curve. The feature of a Giffen good is often expressed as a Giffen paradox.


Indifference curve analysis is capable of explaining all those situations which Marshallian theory is capable of doing. Besides, it explains the Giffen paradox as well. Thus it presents a much better analysis of demand. While doing all this, the need for measuring utility does not arise. This suggests its superiority. Yet, as Samuelson say, indifference curve analysis is a midway house between the psychological utility analysis and scientific revealed preference theory.

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