AN INDIFFERENCE CURVE IS FORMED

BY SUBSTITUTING ONE GOOD FOR

ANOTHER.
THE MRS IS THE RATE AT WHICH ONE
COMMODITY CAN BE SUBSTITUTED
FOR
ANOTHER
THE
LEVEL
OF
SATISFACTION REMAINING THE SAME

 MRS BETWEEN 2 COMMODITITES X AND

Y, MAY BE DEFINED AS THE QUANTITY
OF X WHICH IS REQUIRED TO REPLACE
ONE UNIT OF Y IN THE COMBINATION OF
THE 2 GOODS SO THAT THE TOTAL
UTILITY REMAINS THE SAME.
IT IMPLIES THAT UTILITY OF X GIVEN UP
IS
EQUAL
TO
THE
UTILITY
OF
ADDITIONAL UNITS OF Y
MRS = Y
X

DIMINISHING MRS
IT MEANS THAT THE QUANTITY OF A
COMMODITY THAT A CONSUMER IS
WILLING
TO
SACRIFICE
FOR
AN
ADDITIONAL UNIT OF ANOTHER GOES
ON DECREASING WHEN HE GOES ON
SUBSTITUTING ONE COMMODITY FOR
ANOTHER.

Indifferenc
e Points

Combinatio
ns
Y + X

Change in
Y
(- Y)

Change in
X
(X)

MRSY,X
(Y/ X)

25 + 5

15 + 7

-10

-5.0

10 + 12

-5

-1.0

6 + 20

-4

-0.5

4 + 30

-2

10

-0.2

MRSy,x = - Y = -10 = -5
X
2

BUDGETARY CONSTRAINT/BUDGET
LINE
A utility maximising consumer would like the
reach the highest possible indifference curve.
(as shown on the OHP)
i.e he would like be on IC 3
But consumer has limited income and this
sets a limit to which a consumer can
maximise his utility.

 The limitedness of income acts as a

constraint. This is called the budgetary
constraint.
This
budgetary
constraint
may
expressed as a budget equation.

be

PxQx+ Py Qy = M (Px & Py are respective prices

Qx & Qy are quantities
M = income)

Qx =

Qx

Qy =

M + P y Qy
Px
Px
M/ Px
M + P x Qx
Py
Py

Suppose entire income is spent for

buying commodity x only ie Qy = 0
Similarly Qy = M/ Py when QX = 0

BUDGET LINE/PRICE LINE When the values of

Qx and Qy are plotted on X and Y axis, it
gives line with a negative slope which
is called budget line or price line.

M/Py N
Qo
Tr
Ya
n
g
Oe
Fs

NM IS THE CONSUMERS
BUDGET LINE

M
QUANTITY OF
X
apples

M/Px

Suppose consumer has Rs 300 to spend

on fruit items oranges and apples a
week.
Suppose price of oranges is Rs 50 per Kg
apples is Rs 75 per Kg
Suppose Qx = 0, i.e all income is
spend on oranges alone.
Qy = 300/50 = 6
If Qy = 0 then Qx = 300/75 = 4

C
6
o
r
a
n
g
e
s

apples

oranges

5
N

4
3

Consumers budget line

2
1
M
0

F
5

The straight budget line NM shows all the

possible combinations of the 2 goods that
would just exhaust the consumers
income.
The slope of NM is 3/2 which is the ratio of
the apples price to oranges price.
i.e, everytime a consumer gives up 3 units
of oranges, he can gain 2 units of apples

CONSUMERS EQUILIBRIUM
Now we can combine the budget line and
the indifference curves on one diagram.
(As shown on OHP)
The consumer reaches the highest
indifference curve attainable with fixed
income at point B, which is at a tangent to
the
budget
line
with
the
highest
indifference curve.
At Point B or at the point of equilibrium
substitution ratio equals price ratio

MUM = Substitution
= Price of
apples (x)
MUc
Ratio
Price of oranges (y)

CONSUMER EQUILIBRIUM IS ATTAINED

AT THE POINT WHERE THE BUDGET
LINE IS TANGENT TO THE HIGHEST
INDIFFERENCE CURVE

SHIFTS IN BUDGET LINE

Budget line changes its position
following the change in consumers
income and price of the commodities.
1. If consumers income increases, prices
remaining the same, budget line shifts
upwards parallel to the original budget
line.

CD IS THE NEW BUDGET

LINE

Q
t
y
O

D
Qty X

Y
If income
decreases, budget line will shift downwar

2. IF INCOME REMAINS SAME AND PRICE

CHANGES.
IF PX REMAIN CONSTANT & PY INCREASES.
A

Q
t
y

AB ORIGINAL
CB NEW BUDGET
LINE

B
Qty X

3. IF INCOME REMAINS SAME AND PRICE

CHANGES.
IF PY REMAIN CONSTANT & PX DECREASES.
A

Q
t
y

AB ORIGINAL
AC NEW BUDGET
LINE

C
Qty X

EFFECTS OF CHANGE IN INCOME ON

CONSUMER DEMAND
HIS CAPACITY TO BUY
CONSUMER
GOODS AND SERVICES
INCOME
CHANGES, ALL THE
CHANGES
OTHER THINGS
REMAINING SAME
IT SHOWS A PARALLEL UPWARD OR
DOWNWARD SHIFT IN THE CONSUMERS
BUDGET LINE

AS SHOWN ON THE OHP

THE EFFECT OF CHANGE IN INCOME IS

ILLUSTRATED
HERE.
THE
INDIFFERENCE CURVES IC1, IC2, IC3,
IC4
REPRESENT
CONSUMERS
INDIFFERENCE MAP AND LINES AJ,
BK, CL AND DM REPRESENT BUDGET
LINES AT 4 DIFFERENT LEVELS OF HIS
INCOME.

SUPPOSE INITIALLY HES AT EQUILIBRIUM AT

E1 ON IC1.

LET THE CONSUMERS INCOME

INCREASE NOW- BUDGET LINE SHIFT FROM

AJ TO BK. THE CONSUMER REACHES A NEW
EQUILIBRIUM

POINT

E2

ON

IC2.

THE

SUCCESSIVE EQUILIBRIUM COMBINATION OF

GOODS AT 4 DIFFERENT LEVELS OF INCOME
ARE INDICATED BY POINTS E1, E2, E3 AND E4.
IF THESE POINTS OF EQUILIBRIUM ARE
JOINED BY A CURVE, IT GIVES THE PATH OF
INCREASE IN CONSUMPTION RESULTING
FROM INCREASE IN INCOME.
THIS

CURVE

IS

CALLED

INCOME

THE ICC IS DEFINED AS THE LOCUS OF

POINTS
REPRESENTING
VARIOUS
EQUILIBRIUM
QUANTITITES
OF
2
COMMODITIES
CONSUMED
BY
A
CONSUMER AT DIFFERENT LEVELS OF
INCOME
ALL
OTHER
THINGS
REMAINING
CONSTANT.
THE
MOVEMENT FROM POINT E1 TOWARDS
POINT E4 INDICATES INCREASE IN THE
CONSUMPTION
OF
THE
NORMAL
GOODS, X + Y.

INCOME EFFECT - MAY BE POSITIVE

OR

NEGATIVE

NORMAL GOODS Income effect is +ve

INFERIOR GOODS Income effect is ve
An inferior good is one whose
consumption decreases when income
increases.

EFFECTS OF CHANGES IN PRICES

WHEN PRICE OF A COMMODITY
CHANGES, THE SLOPE OF THE BUDGET
LINE CHANGES, WHICH DISTURBS THE
CONSUMERS
EQUILIBRIUM.
A
RATIONAL CONSUMER ADJUSTS HIS
CONSUMPTION WITH A VIEW TO
MAXIMISE HIS SATISFACTION UNDER
THE NEW PRICE SITUATIONS.

PRICE EFFECT
MAY BE DEFINED AS THE TOTAL
CHANGE IN THE QUANTITY OF
CONSUMED GOODS AND SERVICES
DUE TO CHANGE IN THEIR RELATIVE
PRICES.

E1

E
2

Q
t
y

E
4

PC
C

IC4
IC3

IC1
O

u Mr

IC2

s Nt
Qty X

Suppose Consumer is initially in

equilibrium at point E1. Let price of x
fall,
CETRIUS
PARIBUS,
so
that
Consumers Budget Line shift from its
initial position LM to position LN. The
consumer
now
reach
a
higher
indifference curve IC2 and his view
equilibrium point is E2.
Here the
consumption of x increases by UR.
This is the price effect on the
consumption of commodity X.

Due to successive fall in price of X,

consumers equilibrium shifts from E2
to E3 and from E3 to E4.
By joining the points of equilibrium E1,
E2, E3 AND E4 we have a curve called
PRICE CONSUMPTION CURVE
PCC is a locus of points of equilibrium
on indifference curves, resulting from
the change in price of a commodity.

INCOME & SUBSITITUTION EFFECT OF A

PRICE CHANGE.
Price-effect combines both
effect and substitution effect.

income-

INCOME-EFFECT results
from
the
increase in real income due to decrease
in the price of a commodity. Incomeeffect is similar to the movement along
the income consumption curve which
has a positive slope

SUBSTITUTION-EFFECT
arises due
to consumers tendency to substitute
cheaper goods for the relatively
expensive ones.
SE causes movement along the priceconsumption curve which generally
has a negative slope.

There are 2 methods of decomposing

the Total Price-effect into income &
substitution effects
(1)

HICKSIAN APPROACH

(2)

SCUTSKYS APPROACH

THE END