Subject: Microeconomic Theory II

Instructor Name: Mariam Abbas Soharwardi

Semester: Spring

Class: BS 6th

Session: 2017-21

Lecture Notes: 1st

Consumer Behavior
Utility Maximization
Axioms of Rationality

The consumer is assumed to be rational. Given his income and the market prices of the various
commodities, he plans the spending of his income so as to attain the highest possible satisfaction
or utility. This is the axiom of utility maximization. In the traditional theory it is assumed that the
consumer has full knowledge of all the information relevant to his decision, that is he has complete
knowledge of all the available commodities, their prices and his income. In order to attain this
objective the consumer must be able to compare the utility (satisfaction) of the various 'baskets of
goods' which he can buy with his income. There are two basic approaches to the problem of
comparison of utilities, the cardinalist approach and the ordinalist approach.

The cardinalist school postulated that utility can be measured. Various suggestions have been made
for the measurement of utility. Under certainty (complete knowledge of market conditions and
income levels over the planning period) some economists have suggested that utility can be
measured in monetary units, by the amount of money the consumer is willing to sacrifice for
another unit of a commodity. Others suggested the measurement of utility in subjective units,
called utils.

The ordinalist school postulated that utility is not measurable, but is an ordinal magnitude. The
consumer need not know in specific units the utility of various commodities. The utility function
and its Arguments, Law of diminishing marginal and equi marginal utility, Indifference curves,
Marginal Rate of (commodity) substitution (MRCS).

CONSUMER BEHAVIOR

The principle assumption upon which the theory of consumer behavior and demand is built is; a
consumer attempts to allocate his/her limited money income among available goods and services
so as to maximize his/her utility (satisfaction)
“Consumer behavior refers to the study of consumer while engaged in the process of consumption.
The theory of consumer behavior is based on the assumption that the consumer is a rational human
being” Ekelund and Robert (1994.) Given his income and the market prices of the various
commodities, he plans the spending of his income so as to attain the highest possible satisfaction
of utility. Utility is the extent of satisfaction obtained from the consumption of products and
services by consumers. There are two basic approaches to the problem of comparison of utilities
and hence to determine consumer’s equilibrium namely Cardinal Approach and Ordinal Approach.
In economic sense, consumer behavior theory explains the relationship between the changes in
price and consumer demand. It explains various assumptions of utility theory: consumers are
rational, they always prefer more quantity, and they are ready to make tradeoffs, there is also the
diminishing marginal rate of substitution and the concept of total utility and marginal utility. “An
individual has to play his role in two markets: Factor market where he decides how much of his
resources he should sell to the firm and Product market where he decides how much of a product
to buy and at what price” Frank, R.H. (1991). Demand is determined by the behavior of
consumers. It is of utmost importance for managers to understand the dynamics of demand in the
market for the particular product. Consumers have unlimited wants which are constrained by
limited resources / limited income. Due to scarcity of resources and unlimited wants, consumer
has to allocate scarce resources to attain maximum possible satisfaction.
Utility reflects a rank ordering of preferences and is a magnitude indicating the direction of
preferences. As an individual move towards the most preferred state, he moves towards
maximization of utility / satisfaction.

UTILITY

“Utility is the scientific contrast that economists use to understand how rational consumers divide
their limited resources among the commodities that provide them with satisfaction” (Samuelson,
2005). Utility is the satisfaction or pleasure a consumer derives from the consumption or
possession of a good (or service) or an activity (or lack thereof), over a certain span of time. An
economic “bad” is an object, a condition, or an activity that brings on harm or displeasure to a
consumer. A consumer derives utility from having an economic “bad” reduced or eliminated.

CARDINAL APPROACH

“Consumer’s equilibrium is a situation in which a consumer has allocated his given income on
different available commodities in such a manner that he gets the highest possible utility. Utility
can be measured in monetary units (i.e. the amount of money) that the consumer is prepared to pay
for another unit of the from unit to unit, place to place and time to time.” Samuelson, P.A. (1965).
Utility varies we measure utility in units called utils, and as utils are not defined properly, so, it is
not possible to measure utility in terms of units but it helps to understand consumers behavior.
Utility is cardinally measurable and the objective is to maximize utility. It is possible to make
interpersonal comparisons of utility.

There are mainly two concepts of utility: The Total utility which refers to the sum total of
satisfaction which a consumer receives by consuming the various units of the commodity and
Marginal Utility which is defined as the change in the total utility resulting from 1 unit of change
in the consumption of good, i.e.

MUx = dTU/ dQx

There are also some Assumptions of Cardinal Utility Theory:

1. Rationality: Consumers are rational & aims at the maximization of his/her utility subject
to the given income constraints.

2. Cardinal Utility: The utility of each commodity is measurable.

3. Constant marginal utility of money: If the monetary unit is used as the measure of utility,
it should be constant.

4. Diminishing marginal utility: The utility gained from successive units of a commodity
diminishes.

The total utility of a ‘Basket of goods’ depends on the individual commodities, i.e. if there are n
commodities in the bundle with quantities X1, X2, ……… Xn the total utility is U = f (X1, X2,
……. Xn).As it is assumed that the total utility is addictive, so, U = U1(X1) + U2(X2) +
…………… + Un(Xn). This additivity assumption was dropped later.

Law of Diminishing Marginal Utility

The diagram below shows the diminishing marginal utility.

 Marginal Utility
MU
Change in U U
MU x = -------------------- = -----------
Change in X X

0 X

“The diminishing marginal utility is the basic hypothesis of Cardinal Utility Theory, which states
that the Marginal Utility of a good diminishes as an individual consumes more units of a good or
the law states that with every successive increase in the consumption of a commodity, the marginal
utility of the commodity will fall. Here the marginal Utility Declines and the total utility increases
at a decreasing rate. In order to maximize the total utility, consumer will spend his income on a
combination of goods.” Katz and Harvey (1991).

The law is based on two important facts: When an individual no longer wants anymore units of
goods, marginal utility of the good become zero and the different goods are not perfect substitutes
for each other in the satisfaction of various particular wants.

Assumptions: Goods are homogeneous, No time gap between the consumption of the different
units, Consumers are rational, Taste, Preferences Fashions remain unchanged and Income of the
consumer is constant.

The optimization rules of cardinal approach

Optimization Rule 1: When only one good is consumed and is available for free, consume till

MUx = 0
Optimization Rule 2: When only one good is consumed and is available for a price:

Consume till MUx = Pricex

Optimization Rule 3: Law of Equal Marginal Utility or Law of Substitution: The law states that
the consumer will spend his income on different goods in such a way that marginal utility of each
good is proportional to its price i.e. when more than one good is consumed and the goods’ prices
are different:

Consume till MUx/Px = MUy/Py = MUz/Pz

Cardinal Approach has some Limitation towards the consumer behavior or theory, which is as
follows; Utility cannot be measured cardinally, Utility is not additive, Utility is interdependent and
decisions are seldom taken in isolation, and Unrealistic assumption.

ORDINAL APPROACH

Ordinal Approach or Indifference Curve dispenses with the need of the measurement of utility for
the maximization of consumer’s satisfaction. As utility is subjective it is not possible to measure
it in real life and though cardinal approach prompted economists to give sight into consumer
behavior, but due to the limitation economists develop an alternative approach called Ordinal
Approach or Ordinal Utility theory. According to High, Jack, and H. Bloch the theory deals with
the fact that utility from different goods can be ranked but not measurable” (1989). According to
the Ordinal Approach a consumer has a given scale of preferences for different combination of
two goods. Ordinal approach states that utility can be measured in order of preferences.

The assumptions of this theory are: Rationality; Aim to maximize utility under condition of
certainty, Complete Ordering: All possible goods can be offered into preferred, Consistency: If
consumer prefers bundle B to bundle A at the same time he does not prefer bundle A to bundle B,
Transitivity: If Commodity basket A is preferred to B is preferred to C implies that, A is preferred
to C and Non Satiety: Bigger is preferred to a small bundle. This theory can also be described with
the help of Indifference Curve Approach.

According to an Indifference curve is the locus of points indicating particular combinations of

goods or the baskets of two commodities from which the consumer derives the same level of utility
or satisfaction.” The I.C. is the locus of successive indifferent points or combinations which yield
equal level of satisfaction. This curve is also known as Iso Utility curve and the different point on
the curve represents the same level of satisfaction. Economists following the lead of Hicks, Slutsky
and Pareto believe that utility is measurable in an ordinal sense--the utility derived from consuming
a good, such as X, is a function of the quantities of X and Y consumed by a consumer.
The equation Indifference curve can be written as:

U = f(x, y)

Total Differentiation of the equation represents:

➢ dU = df/dx.dx + df/dy.dy
➢ = MUx.dx + MUy.dy
➢ Along in the I.C curve satisfaction is constant, so,
➢ dU = 0, so dy/dx = - (MUx/MUy), so slope of the I.C. curve is < 0.

According to the following are the Properties of Indifference Curve: “Indifference curve is down
wards sloping, it is Convex to the origin, and Higher Indifference curve represents higher level of
satisfaction, two Indifference curves never intersect each other, Indifference curve never intersect
the axis and the collections of Indifference curves are known as indifferent Map.”

Assumptions of Indifference Curve:

• Existence of two products X and Y in a commodity space where both the products are
normal and the consumption combinations are positive definite.

• The utility function is dependent which can be written as U = f (x, y) and I.C considers
related product where both the products are substitute to each other.

• The level of satisfaction is ordinarily measurable which means ranking of different

combinations is possible according to the preference of the consumer.

• The relationship may be indifferent, i.e. if the combinations on A & B or B & C are equally
preferable then the combination of A & C must be equally preferable to the consumer.

• The relation may be transitive.

• Application of the diminishing marginal rate of substitution.

• (The marginal rate of substitution of X for Y (MRSx,y) is defined as the no of units of good
Y that must be given up in exchange for an extra unit of good X, so that the consumer maintains
the same level of satisfaction.)

Marginal Rate of Substitution

Marginal Rate of Substitution is the rate at which a consumer is willing to substitute one good for
another good while remaining at the same level of satisfaction. That is the amount of good X
needed to replace one unit of (lost) good Y to keep the consumer’s level of satisfaction (utility)
unchanged.

MRS = Slope of the indifference curve

Properties of an Indifference Curve or IC

Here are the properties of an indifference curve:

An IC slopes downwards to the right

This slope signifies that when the quantity of one commodity in combination is increased, the amount
of the other commodity reduces. This is essential for the level of satisfaction to remain the same on
an indifference curve.

An IC is always convex to the origin

From our discussion above, we understand that as Peter substitutes clothing for food, he is willing to
part with less and less of clothing. This is the diminishing marginal rate of substitution. The rate gives
a convex shape to the indifference curve. However, there are two extreme scenarios:

1. Two commodities are perfect substitutes for each other – In this case, the indifference curve is
a straight line, where MRS is constant.

2. Two goods are perfect complementary goods – An example of such goods would be gasoline
and water in a car. In such cases, the IC will be L-shaped and convex to the origin.
Indifference curves never intersect each other

Two ICs will never intersect each other. Also, they need not be parallel to each other either. Look at
the following diagram:

Fig 3 shows tow ICs intersecting each other at point A. Since A and B lie on IC1, the give the same
satisfaction level. Similarly, A and C give the same satisfaction level, as they lie on IC2. Therefore,
we can imply that B and C offer the same level of satisfaction, which is logically absurd. Hence, no
tow ICs can touch or intersect each other.

A higher IC indicates a higher level of satisfaction as compared to a lower IC

A higher IC means that a consumer prefers more goods than not.

An IC does not touch the axis

This is not possible because of our assumption that a consumer considers different combinations of
two commodities and wants both of them. If the curve touches either of the axes, then it means that
he is satisfied with only one commodity and does not want the other, which is contrary to our
assumption.

Budget Line

Since a higher indifference curve represents a higher level of satisfaction, a consumer will try to reach
the highest possible IC to maximize his satisfaction. In order to do so, he has to buy more goods and
has to work under the following two constraints:
1. He has to pay the price for the goods and

2. He income is limited, restricting the availability of money for purchasing these goods

As can be seen above, a budget line shows all possible combinations of two goods that a consumer
can buy within the funds available to him at the given prices of the goods. All combinations that are
within his reach lie on the budget line.

A point outside the line (point H) represents a combination beyond the financial reach of the
consumer. On the other hand, a point inside the line (point K) represents under-spending by the
consumer.

Changes in Price and Shift in Budget Line:

Now, what happens to the price line if either the prices of goods change or the income changes.
Let us first take the case of the changes in prices of the goods. This is illustrated in Fig. 8.16.
Suppose the budget line in the beginning is BL, given certain prices of the goods X and Y and a
certain income. Suppose the price of X falls, the price of Y and income remaining unchanged.

Now, with a lower price of X the consumer will be able to purchase more quantity of X than before
with his given income. Let at the lower price of X, the given income purchases OL’ of X which is
greater than OL. Since the price of Y remains the same, there can be no change in the quantity
purchased of good Y with the same given income and as a result there will be no shift in the point
B. Thus, with the fall in the price of good X, the consumer’s money income and the price of Y
remaining constant, the price line will take the new position BL’.
Now, what will happen to the budget line (initial budget line BL) if the price of good X rises, the
price of good Y and income remaining unaltered. With higher price of good X, the consumer can
purchase smaller quantity of X, say OL”, than before. Thus, with the rise in price of X the price
line will assume the new position BL”.

Fig. 8.17 shows the changes in the price line when the price of good Y falls or rises, with the price
of X and income remaining the same. In this the initial budget line is BL.

With the fall in price of good Y, other things remaining unchanged, the consumer could buy more
of Y with the given money income and therefore budget line will shift to LB’. Similarly, with the
rise in price Y, other things being constant, the budget line will shift to LB”.

Changes in Income and Shifts in Budget line:

Now, the question is what happens to the budget Y line if the income changes, while the prices of
goods remain the same. The effect of changes in income on the budget line is shown in Fig. 8.18.
Let BL be the initial budget line, given certain prices of goods and income.’ If the consumer’s
income increases while the prices of both goods X and Y remain unaltered, the price line shifts
upward (say, to B’L’) and is parallel to the original budget line BL.

This is because with the increased income the consumer is able to purchase proportionately larger
quantity of good X than before if whole of the income is spent on X, and proportionately greater
quantity of good Y than before if whole of the income is spent on Y. On the other hand, if the
income of the consumer decreases, the prices of both goods X and

Y remaining unchanged, the budget line shifts downward (say, to B”L”) but remains parallel to
the original price line BL. This is because a lower income will purchase a proportionately smaller
quantity of good X if whole of the income is spent Changes in Income on X and proportionately
smaller quantity of good Y if whole of the income is spent on Y.

It is clear from above that the budget line will change if either the prices of goods change or the
income of the consumer changes.

Thus, the two determinants of the budget line are:

(a) The prices of goods, and

(b) The consumer’s income to be spent on the goods.

Slope of the Budget Line and Prices of two Goods:

It is also important to remember that the slope of the budget line is equal to the ratio of the prices
of two goods. This can be proved with the aid of Fig. 8.14. Suppose the given income of the
consumer is M and the given prices of goods X and Y are Px and Py respectively. The slope of the
budget line BL is OB/OL. We intend to prove that slope OB/OL is equal to the ratio of the price
of goods X and Y.
The quantity of good X purchased if whole of the given income M is spent on it is OL.
Now, the quantity of good Y purchased if whole of the given income M is spent on it is OB.

It is thus proved that the slope of the budget line BL represents the ratio of the prices of two goods.

Consumer Equilibrium
Conditions of Consumer’s Equilibrium:
The consumer’s equilibrium under the indifference curve theory must meet the following two
conditions:

(i) MRSXY = Ratio of prices or PX/PY

Let the two goods be X and Y. The first condition for consumer’s equilibrium is that

MRSXY = PX/PY
a. If MRSXY > PX/PY, it means that the consumer is willing to pay more for X than the price
prevailing in the market. As a result, the consumer buys more of X. As a result, MRS falls till it
becomes equal to the ratio of prices and the equilibrium is established.
b. If MRSXY < PX/PY, it means that the consumer is willing to pay less for X than the price
prevailing in the market. It induces the consumer to buys less of X and more of Y. As a result,
MRS rises till it becomes equal to the ratio of prices and the equilibrium is established.
(ii) MRS continuously falls:
The second condition for consumer’s equilibrium is that MRS must be diminishing at the point of
equilibrium, i.e. the indifference curve must be convex to the origin at the point of equilibrium.
Unless MRS continuously falls, the equilibrium cannot be established.

Thus, both the conditions need to be fulfilled for a consumer to be in equilibrium.

Let us now understand this with the help of a diagram:

In Fig. 2.12, IC1, IC2 and IC3 are the three indifference curves and AB is the budget line. With the
constraint of budget line, the highest indifference curve, which a consumer can reach, is IC 2. The
budget line is tangent to indifference curve IC2 at point ‘E’. This is the point of consumer
equilibrium, where the consumer purchases OM quantity of commodity ‘X’ and ON quantity of
commodity ‘Y.
All other points on the budget line to the left or right of point ‘E’ will lie on lower indifference
curves and thus indicate a lower level of satisfaction. As budget line can be tangent to one and
only one indifference curve, consumer maximizes his satisfaction at point E, when both the
conditions of consumer’s equilibrium are satisfied:

(i) MRS = Ratio of prices or PX/PY:

At tangency point E, the absolute value of the slope of the indifference curve (MRS between X
and Y) and that of the budget line (price ratio) are same. Equilibrium cannot be established at any
other point as MRSXY > PX/PY at all points to the left of point E and MRSXY < PX/PY at all points
to the right of point E. So, equilibrium is established at point E, when MRSXY = PX/PY.
(ii) MRS continuously falls:
The second condition is also satisfied at point E as MRS is diminishing at point E, i.e. IC2 is convex
to the origin at point E.

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 for a good can take horizontal shape too. It means that when the price of
the good X declines, its quantity purchased rises proportionately but quantity purchased of Y
remains the same. Horizontal price consumption curve is shown in Fig. 8.34. We obtain horizontal
price consumption curve of good X when the price elasticity of demand for good X is equal to
unity.

But it is rarely found that price consumption curve slopes downward throughout or slopes upward
throughout or slopes backward throughout. More generally, price consumption curve has different
slopes at different price ranges. At higher price levels it generally slopes downward, and it may
then have a horizontal shape for some price ranges but ultimately it will be sloping upward. For
some price ranges it can be backward sloping as in case of Giffen goods. A price consumption
curve which has different shapes or slopes at different price ranges is drawn in Fig. 8.35.

Income Effect: Income Consumption Curve (with curve diagram)

With a given money income to spend on goods, given prices of the two goods and given an
indifference map (which portrays given tastes and preferences of the consumers), the consumer
will be in equilibrium at a point in an indifference map.

We are interested in knowing how the consumer will react in regard to his purchases of the goods
when his money income changes, prices of the goods and his tastes and preferences remaining
unchanged.

Income effect shows this reaction of the consumer. Thus, the income effect means the change in
consumer’s purchases of the goods as a result of a change in his money income. Income effect is
illustrated in Fig. 8.28.
With given prices and a given money income as indicated by the budget line P1L1 the consumer is
initially in equilibrium at point Q1 on the indifference curve IC1 and is having OM1 of X and
ON1 of Y. Now suppose that income of the consumer increases. With his increased income, he
would be able to purchase larger quantities of both the goods.
As a result, budget line will shift upward and will be parallel to the original budget line P 1L1. Let
us assume that the consumer’s money income increases by such an amount that the new budget
line is P2L2(consumer’s income has increased by L1L2 in terms of X or P1P2 in terms of Y). With
budget line P2L2, the consumer is in equilibrium at point Q2 on indifference curves IC2 and is
buying OM2 of X and ON2 of Y.
Thus as a result of the increase in his income the consumer buys more quantity of both the goods
Since he is on the higher indifference curve IC2 he will be better off than before i.e., his satisfaction
will increase. If his income increases further so that the budget line shifts to P3L3, the consumer is
in equilibrium at point Q3 on indifference curve IC3 and is having greater quantity of both the
goods than at Q2.
Consequently, his satisfaction further increases. In Fig. 8 28 the consumer’s equilibrium is shown
at a still further higher level of income and it will be seen that the consumer is in equilibrium at
Q4 on indifference curves IC4 when the budget line shifts to P4L4. As the consumer’s income
increases, he switches to higher indifference curves and as a consequence enjoys higher levels of
satisfaction.
If now various points Q1, Q2, Q3 and Q4 showing consumer’s equilibrium at various levels of
income are joined together, we will get what is called Income Consumption Curve (ICC). Income
consumption curve is thus the locus of equilibrium points at various levels of consumer’s income.
Income consumption curve traces out the income effect on the quantity consumed of the goods.
Income effect can either be positive or negative.
Income effect for a good is said to be positive when with the increase in income of the consumer,
his consumption of the good also increases. This is the normal good case. When the income effect
of both the goods represented on the two axes of the figure is positive, the income consumption
curve ICQ will slope upward to the right as in Fig. 8.28. Only the upward- sloping income
consumption curve can show rising consumption of the two goods as income increases.

However, for some goods, income effect is negative. Income effect for a good is said to be negative
when with the increases in his income, the consumer reduces his consumption of the good. Such
goods for which income effect is negative are called Inferior Goods. This is because the goods
whose consumption falls as income of the consumer rises are considered to be some way ‘inferior’
by the consumer and therefore he substitutes superior goods for them when his income rises.

When with the increase in his income, the consumer begins to consume superior goods, the
consumption or quantity purchased by him of the inferior goods falls. When the people are poor,
they cannot afford to buy the superior goods which are often more expensive. Hence as they
become richer and can afford to buy more expensive goods they switch to the consumption of
superior and better quality goods.

For instance, most of the people in India consider cheaper common food grains such as maize,
jawar, bajra as inferior goods and therefore when their income rises, they shift to the consumption
of superior varieties of foodgrains like wheat and rice. Similarly, most of the Indian people regard
Vanaspati Ghee to be inferior and therefore as they become richer, they reduce its consumption
and use ‘Desi Ghee instead.

In case of inferior goods, indifference map would be such as to yield income consumption curve
which either slopes backward (i.e., toward the left) as in Fig. 8.29, or downward to the right as in
Fig. 8.30. It would be noticed from these two figures that income effect becomes negative only
after a point. It signifies that only at higher ranges of income, some goods become inferior goods
and up to a point their consumption behaves like those of normal goods. In Fig. 8.29 income
consumption curve (ICC) slopes backward i.e., bends toward the Y-axis.

This shows good X to be an inferior good, since beyond point Q2, income effect is negative for
good X and as a result its quantity demanded falls as income increases. In Fig.8.30 income
consumption curve (ICC) slopes downward to the right beyond point Q2 bends towards the X-axis.
 This signifies that good Y is an inferior good
because beyond point Q2, income effect is negative for good Y and as a result its quantity
demanded falls as income increases. It follows from above that the income consumption curve can
have various possible shapes.
But normal goods can be either necessities or luxuries depending upon whether the quantities
purchased of the goods by the consumers increase less than or more than proportionately to the
increases in income. If the quantity purchased of a commodity rises less than proportionately to
the increases in consumer’s income, the commodity is known as a necessity.

On the other hand, if the quantity purchased of a commodity increases more than proportionately
to the increases in income, it is called a luxury. In Fig. 8.31, the slope of income consumption
curve ICC1 is increasing which implies that the quantity purchased of the commodity X increases
less than proportionately to the increases in consumer’s income.
Therefore, in this case of ICC1, good X is a necessity and good Vis luxury. On the other hand, the
slope of income consumption curve ICC3is decreasing which implies that the quantity purchased
of good X increases more than proportionately to increases in income and therefore in this case
good X is luxury and good Vis necessity. It will be seen from Fig. 8.31 that the income
consumption curve ICC2 is a linear curve passing through the origin which implies that the
increases in the quantities purchased of both the goods are rising in proportion to the increase in
income and therefore neither good is a luxury or a necessity.
If income effect is positive for both the goods X and Y, the income consumption curve will slope
upward to the right as in Fig. 8.28 given earlier. But upward-sloping income consumption curves
to the right for various goods may be of different slopes as shown in Fig. 8.31 in which income
consumption curves, with varying slopes, are all sloping upward and therefore indicate both goods
to be normal goods having positive income effect.

ADVERTISEMENTS:

If income effect for good X is negative, income consumption curve will slope backward to the left
as ICC in fig 8.31. If good Y happens to be an inferior good and income consumption curve will
bend towards X-axis as shown by ICC” in Fig. 8.32. In Figs. 8.31 and 8.32, various possible shapes
which income consumption curve can take are shown bereft of indifference curves and budget
lines which yield them. It may however be pointed out that given an indifference map and a set of
budget lines there will be one income consumption curve.
A noteworthy point is that it is not the indifference curves which explain why a good happens to
be an inferior good. In other words, indifference curves do not explain why income effect for a
good is negative. Indifference curves can only illustrate the inferior good phenomenon.

Books

1. Pindyck and Rubinfled with Mehta (2005), Microeconomics- latest available Edition in market.
2. D.N Dwivedi (2016), Microeconomics Theory and Application-- latest available Edition
in market.
3. Walter Nicholosn,Microeconomic Theory,Tenth Edition ,Thomas Learning Newyork
4. Koutsoyiannis,A.,Modern Microeconomics, Macmillan, London.