BCA Unit 3 Theory of Consumer Behaviour

Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)
Unit 3: Theory of Consumer Behavior Sub: - Applied Economics
Unit: 3 (Three)
Theory of Consumer Behavior
3.1 Concept of Cardinal and Ordinal Utility Analysis
Generally, the characteristics of a commodity are known as utility. But in economics ‘utility
is the capacity of a commodity and services to satisfy human wants.’ So, consumers
consume goods and services according to their utility. According to Marshall, “Utility is
the measure not of usefulness, not of satisfaction, but of the intensity to desire.”
Utility refers to the benefit derived from the consumption of commodities. It is the
subjective approach because it is different on the basis of time, place and person to person.
This is because due to consumption of same amount of commodity one may get high
satisfaction and other may get less satisfaction. Thus, when defining utility, the following
should be kept in mind:
a) There is different between utility and usefulness.
b) Utility is not synonymous with pleasure.
c) Utility is subjective.
d) Utility varies in different situation.
 Approaches of Utility Analysis
There are two basic approaches to study the consumer behaviors.
1. Cardinal Approaches
2. Ordinal Approaches
1. Cardinal Approaches: The cardinal utility approach was developed by neo-
classical economists like Marshal, Pigou, Robertson, etc. It is based on quantitative
measurement of utility or satisfaction.
2. Ordinal Approaches: Ordinal utility approach was developed by Pareto, W. E.
Johanson, Slutsky, J. R. Hicks and R.G.D. Allen. It is based on qualitative
measurement of utility or satisfaction. It does not measure quantitatively the utility
derived from consumption of commodity. Under this method consumer ranks the
alternative combinations available for him by a simple comparison of the
satisfaction obtained from the given combination of goods and services.
3.1.1 Concept of Cardinal Utility Analysis

The cardinal utility approach was developed by neo-classical economists like Marshal,
Pigou, Robertson, etc. It is based on quantitative measurement of utility or satisfaction
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which assume that utility is measurable and additive. It is expressed as quantity measured
in hypothetical units, which is called utils. If a consumer imagines that one mango has 8
utils and an apple 4 utils, it implies that the utility of one mango is twice that of an apple.
3.1.1.2 Assumption of Cardinal Utility Analysis

Cardinal Utility analysis is based on the following assumption:
1. Rational Consumer: The consumer is assumed to be rational. S/he tries to
maximize his/ her total utility under income constraint.
2. Cardinal Utility: Utility is a cardinal concept; i. e. the utility of each commodity is
measurable. The most convenient measure is money. Thus, utility can be measured
quantitatively in monetary units or cardinal units. A consumer can express the level
of utility obtained from the commodity in quantitative term. For example, S/he can
say that s/he would obtained 5 utils utility from one unit of apple Consumption.
3. Constant Marginal Utility of Money: The utility derived from a commodity is
measured in terms of money. So, money is a unit of measurement in cardinal
approach. Hence marginal utility of money should be constant. Otherwise, it
becomes an elastic ruler. So, it is expressed as MUm = K (constant).
4. Diminishing Marginal Utility: If the stock of commodity increases with the
consumer, each additional stock or unit of the commodity gives him/ her and less
satisfaction. It means total utility increases at a decreasing rate.
5. Independent Utilities: It means the utility obtained from the commodity X which
is not dependent on utility obtained from the Commodity Y. It does not affect and
is not affected by the consumption of other commodities.
3.1.1.3 Consumer Equilibrium

A consumer is in equilibrium position when s/he maximizes his/her total utility with given
money income and market prices of goods consumed. At the equilibrium point, the
consumer spends all his income among different goods and services and derives maximum
satisfaction.
3.1.1.3.1 Consumer Equilibrium: One Commodity Model

Consumer Equilibrium under One Commodity Model can be explained by the help of law
of diminishing marginal utility:
This law was first of all developed by Hermann Heinrich Gossen in 1854 AD, which is also
the first law of Gassen. This law is based on universal human experience. It explains that
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for more units of commodity; its M.U derived from each additional unit diminishes in
comparison to the previous unit. Hence the law of diminishing marginal utility implies that
consumption of each successive units of a particular commodity gives less and lesser
satisfaction to the consumer if a consumer consumes it in a certain time period.
According to Marshall, “The additional benefit which a person derives from a given
increase in the stock of a thing diminishes, other thing being equal, with every increase in
the stock that he already has.”
According to K.E. Boulding, “As a consumer increases the consumption of any one
commodity, keeping constant the consumption of other commodity, the marginal utility if
the variable commodity must eventually decline.”
According to prof. Briggs, “The marginal utility of a stock of similar goods decreases with
an increase in the number of unit of the stock.”
According to the definitions given above, it can be concluded that the marginal utility of
the commodity decreases with the increase of each additional unit of such commodity. The
reason is that the human wants are unlimited.
Assumptions of Law of Diminishing Marginal Utility

1. Cardinal Utility: According to Marshall, Utility can be measures cardinally.
Means, satisfaction received from commodity can be expressed cardinally. So, this
law is also called cardinal utility.
2. Rational consumer: This law assumes that all the consumers are rational.
Consumer must be rational all the time. So, he wants to get maximum satisfaction
from his expense on goods. Thus, he has to expense rationally.
3. Independent Utility: It does not affect presentation of other goods to satisfaction
and utility of goods. For increase and decrease utility of a commodity requires that
units of commodity only.
4. Constant marginal utility of money: Marshall has used money as measurement
of utility. So, utility of money or marginal utility of money does not change due to
change in its quantity. Means marginal utility of money will be constant.
5. Introspective Method: Introspective method can be defined as; a consumer can
estimate other consumers experience as his own experience of consumption of
commodity.
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We can explain this law by the help of given table and figure:
Units of commodity Marginal Utility (M.U.) Total Utility (T.U.)
1 10 10
2 8 18
3 6 24
4 4 28
5 2 30
6 0 30
7 -2 28
On the above table, when the consumer consumes one unit of commodity then marginal
utility is 10. When consumption of commodities gradually increases from 1st to 7th, unit of
commodity the marginal utility decreases from 10 to -2. When consumer consumes 6th units
then at that time marginal utility is 0. We can explain the same table by the help of following
figure:
12
10
6
Marginal utility
Marginal
Utility(M.U.)
4
0
1 2 3 4 5 6 7
-2
-4
Units of commodity
On the above graph x and y-axes measures units of commodity and M.U respectively.
Marginal utility curve is derived on the basis of above table which is negatively slopped
and tends to negative. It indicates when consumer consumes more and more commodity
M.U starts to decline and it tends to the negative.
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3.1.1.3.2 Consumer Equilibrium: Two Commodity Model
Consumer Equilibrium under One Commodity Model can be explained by the help of law
of Substitution:
This law is developed by Herman Heinrich Gossen so it is also called the second law of
Gossen. We know human wants are unlimited but the resources to fulfill the wants are
limited. A rational consumer always tries to maximize his satisfaction by spending his
limited money income. Consumer can maximize his satisfaction if he is able to equalize the
marginal utility derived from the consumption of different units of several commodities by
spending his all limited money income so that this law is known as law of maximum
satisfaction or law of equi-marginal utility.
According to Marshall, “If a person has a thing which he can put to several uses, he will
distribute it among these uses in such a way that it has the same marginal utility in all.”
According to Watson and Getz, “The best or optimum allocation is one that causes the
marginal utilities in each use to be equal.”
This law is also known as law of substitution because consumer can maximize his/her
satisfaction when he/she substitutes the commodities having high marginal utility instead
of commodities having the low marginal utility. Mathematically it is expressed as:
In the above equation, MUx and MUy represent the marginal utilities of commodities
respectively. Px and Py represent prices of commodities X and Y respectively. MUm is the
marginal utilities of money. Here, MUm is taken as constant according to the concept of
cardinal utility. This law is based on the following assumptions:
1. Consumers should be rational.

2. Price of commodity remains constant.
3. Income of consumers remains constant.
4. Utility can be measured in numbers.
5. Marginal utility of money remains constant.
We can describe this theory by the help of given table and figure: Suppose income of
consumer is Rs.24. There are two commodities i.e. X and Y for consumption. Price of per
unit of X and Y commodity is Rs.2 and Rs.3, respectively.
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Units M.U of x M.U of y MUX/PX MUY/PY
1 20 24 10 8
2 18 21 9 7
3 16 18 8 6
4 14 15 7 5
5 12 12 6 4
6 10 9 5 3
In the given table, the consumer will be in equilibrium when s/he purchases 6 units of X
and 4 units of Y because it satisfies the following condition required for consumer’s
equilibrium.
At the 6th unit of X and 4th unit of Y
𝑀𝑈𝑋 𝑀𝑈𝑌
=
𝑃𝑋 𝑃𝑌
10 15
𝑂𝑟, =
2 3
∴5=5
The same concept can be explained by given figure:
In the given figure,

Marginal utility of
commodity with its
price ratio is
measured on the Y-
axis and unit of X
commodity is
measured on the X-
axis. A consumer
will get maximum
satisfaction or
utility when s/he purchases 6 units of X commodity and 4 units of Y commodity because
at the 6th units of X and 4th unit of Y, = =MUM = 5. So, the consumer is in
𝑃𝑋 𝑃𝑌
equilibrium when s/he purchases 6 units of X and 4 units of Y. No any other combinations
will yield him/her greater utility than this combination.
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Suppose, if the consumer purchases one unit less of Y, i.e., 3 units and one unit more of X
i.e., 7 units, this will lead to the decrease in total utility than before. When s/he purchases
one unit less of Y i.e., 3 units, there is a loss in utility by the shaded area ABCD and when
s/he purchases one unit more of X i.e., 7 units, there is a gain in utility by the shaded area
STUV. Here, area of loss is greater than area of gain, i.e., ABCD>STUV. So, the consumer
is in equilibrium at the point where 𝑃𝑋
=
𝑃𝑌
=MUM. this condition is satisfied when the
consumer purchases 6 units of X and 4 units of Y.
3.1.1.4 Criticism and Derivation of Demand Curve

3.1.1.4.1 Derivation of Demand Curve: One Commodity Model
In cardinal utility analysis, a consumer will be in equilibrium when marginal utility of a
commodity equals to price of the commodity or marginal utility of money, i.e. [MUX = PX
(MUm)]. According to the law of diminishing marginal utility as the quantity of the
commodity increases with a consumer, marginal utility diminishes. Therefore, marginal
utility curve is downward sloping, i.e. as the price of the commodity falls, more of it will
be bought to attain equilibrium. It can be shown by the help of given figure.
In the upper portion of the figure, MU curve represents the diminishing marginal utility of
the commodity X. initially, the consumer is in equilibrium at point E1 where price of
commodity X is P1 and MUX = P1 (MUm). At the equilibrium position, the equilibrium
quantity is OQ1 unit. It the price of the commodity X falls to P2, the consumer will be in
equilibrium at point E2 where MUX =
P2 (MUm). Here, the equilibrium
quantity is OQ2 units. Similarly, the
consumer will be in equilibrium at
point E3 when price falls to P3. At this
price the equilibrium quantity is OQ3
units.
The lower portion of the figure shows
the relationship between price and
quantity demanded for X commodity.
When price is P1, consumer purchase
OQ1 unit of commodity. It is indicated
by J. Similarly, when price fall to P2
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and P3, the quantity purchases increase to OQ2 and OQ3 units, respectively which are
marked by points K and L respectively. It we join all these points, we get downward sloping
demand curve DX.
3.1.1.4.2 Derivation of Demand Curve: Two Commodity Model

The demand curve for two commodity can be derived with the help of law of equi-marginal
utility. According to this law, the consumer is in equilibrium by equalizing the ratios of
marginal utility and price of each commodity to the marginal utility of money. It can be
expressed as
𝑃𝑋
=
𝑃𝑌
=MUm.
Let us suppose that the price of commodity X falls whereas price of Y commodity and
income of the consumer are constant. will become greater than due to fall in price
𝑃𝑋 𝑃𝑌
of X commodity. To restore the equilibrium, marginal utility of commodity X must be

reduced. It is possible only by consuming more unit of commodity X. So, it is clear that
when price of the commodity falls, the consumer must purchases more units of that
particular commodity to attain the equilibrium. Hence, demand curve is downward sloping
as shown in the figure.
In figure, consumer’s income is given;
MUm is the marginal utility of money
which is constant. Therefore, MUm
Curve is horizontal straight line. At
price P1 the consumer purchase OQ1
𝑀𝑈𝑋
unit of the commodity X where =
𝑃1
𝑀𝑈𝑚 . Hence, Point E1 is the initial

equilibrium position. This gives the
combination J in the lower portion of
the figure where the consumer purchase
OQ1 unit at price P1. As the price of X
falls to P2, the quantity purchase
𝑀𝑈𝑋
increases to OQ2 units and the new equilibrium is established at point E2 where =
𝑃2
𝑀𝑈𝑚 . This gives combination K in the lower portion of figure.

Similarly, as the price falls to P3, the quantity purchase increases to OQ3 units and the new
equilibrium is obtained at point E3 which gives combination K in the lower portion of figure
by joining combinations J, K and L we get downward sloping demand curve DX.
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3.1.2 Concept of Ordinal Utility Analysis
Ordinal utility approach uses indifference curve to analyze consumer’s behavior. The
indifference curve was invented and used by Francis Y. Edgeworth (1880) to show the
possibility of commodity exchange between two individuals and not to explain consumer’s
demand. About a decade later, Irving fisher used indifference curve in 1892 to explain
consumer’s equilibrium. Both Edgeworth and Fisher believed only in cardinal
measurability of utility. Later Vilfredo Pareto introduced the ordinal utility hypothesis to
the indifference curve analysis in 1906. For this utility many significant contributions were
made by Eugen E. Slutsky, W. E. Johnson and A. L. Bowley. Indifference curve
technique could not gain much ground in analysis if consumer behavior till the early 1930s.
In 1934 John R. Hicks and R.G.D. Allen developed the ordinal utility theory as a powerful
analytical tool of consumer’s analysis. Finally, Hicks provided a complete exposition of
indifference curve technique.
 Concept of Ordinal Utility

The ordinal utility analysis believes that, as a subjective phenomenon, utility only
can be ranked and put in order. It is impossible to measure utility in cardinal
number. It is only an expression of the consumer’s preference for one commodity
over another or for one basket of goods over another. The concept of ordinal utility
is based on the following axioms.
 It is not possible for a consumer to express his utility in quantitative term. But
it is always possible for him to tell which of any two goods he prefers. For
example, an individual may not be able to specify how much utility he derives
by eating a mango. But he can what he prefers between mango and apple.
 A consumer can list all the commodities he consumes in the order of his
preference.
Assumptions
The ordinal utility analysis is based on the following assumptions:
1. The consumer must be rational: A consumer is assumed to be rational. S/he
always tries to maximize his/ her utility, given his/her income and market prices. It
is assumed that he has full knowledge of all relevant information.
2. Ordinal Measurement of utility: it is assumed that the consumer can rank his
preferences according to the satisfaction derived from each bundle of goods. He
does not need to know the amount of satisfaction.
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3. Diminishing Marginal rate of Substitution: The Marginal rate of Substitution is
the rate at which a consumer is willing to substitute one commodity (X) for another
∆𝑌
(Y) so that his total satisfaction remains the same. This rate is given by . The
∆𝑋
∆𝑌
assumption is ∆𝑋 goes on decreasing, when the consumer continues to substitute X
for Y.
4. Transitivity and Consistency of choice: Consumer’s choice are assumed to be
transitive. Transitivity of choice means that if a consumer prefers A to B and B to
C, he must prefer A to C.
Symbolically, If A>B and B>C, then A>C.
It is assumed that a consumer is consistent in choice. Consistency of choice means
that if the consumer prefers A to B in one period, he must not prefer B to A in
another period.
Symbolically, If A>B in one period, then B≯A in another.
5. Non-Satiety: Non-satiety means that the consumer has not reached the point of
saturation in case of any commodity. Therefore, a consumer always prefers a large
quantity of all the goods.
3.1.2.1 Concept of Indifference Curve

An indifference curve is the locus of all those combinations of two goods which yields the
same level of utility/satisfaction to the consumer, so that consumer is indifferent to
purchase the particular combination s/he selects. It explains consumer’s behavior in terms
of his/ her preferences of ranking for different combination of two goods.
We know that one commodity serves as a substitute for another. It provides an opportunity
to substitute one commodity for another. Therefore, a consumer can make various
combination of two goods which give him/her same level of satisfaction. When such
combinations are plotted graphically it gives a curve. This curve is known as indifference
curve. It is also called iso-utility curve or equal utility curve.
According to A. Koutsoyiannis, “An indifference curve is the locus of points particular

combinations or bundles of goods, which yield same utility (level of satisfaction) to the
consumer, so that he is indifferent to the particular combination he consumes.”
In the words of Dominick Salvatore, “An indifference curve shows the various
combinations of two goods that give the consumer equal utility or satisfaction.”
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Thus, indifference curve is the locus of different combinations of two goods which
represent equal satisfaction or utility.
Assumptions:
1. Two Commodity: It is assumed that the consumer has fixed amount of money, all
of which is to be spent only on two goods. It is also assumed that prices of both the
commodities are constant.
2. The consumer should be rational.
3. Utility is ordinally measurable.
4. The marginal rate of substitution diminishes when one commodity is substituted for
another.
5. The consumer does not reach to the point saturation in case of any commodity.
6. There is consistency and transitivity in choice.
A table shows the various combination of two goods that yield the same level of satisfaction
to the consumer is called indifference schedule. The given example of is of indifference
schedule which shows 5 different combinations A, B, C, D, and E of two goods Mangos
and Oranges. All these combinations yield the same level of satisfaction to the consumer.
Therefore, the consumer is indifferent between them.
Combinations Commodity X (Mangos) Commodity Y (Oranges)
A 1 14
B 2 9
C 3 6
D 4 4
E 5 2.5
The above table shows all the combinations of Commodity X (Mangos) and Commodity Y
(Oranges) goods gives the same level of satisfaction to the consumer. When indifference
schedule is plotted in the graph, we will get an indifference curve as shown in the figure.
In the given figure, Mangos are
measured in X-axis and Oranges are
measured in Y-axis. The points A, B,
C, D, and E are different combination
of Mangos and Oranges which gives
the same level of satisfaction to the
consumer. When we join these
combinations, we will get a smooth
and continuous curve. This curve is called indifference curve (IC).
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3.1.2.2 Indifference Map
A set of indifference curves is called indifference map. An indifference map shows different
indifference curves which rank the preference of the consumer. Combinations which lie on
an indifference curve give the same level of satisfaction to the consumer. However, higher
indifference curve represents higher level of
satisfaction than a lower indifference curve.
An indifference curve far from the origin is
called higher indifference curve and near to
the origin is called lower indifference curve.
In the given Figure, Goods X is measured on
X-axis and Y Goods on y-axis indifference
curve shows those combinations of two goods
that yield the same level of satisfactions to the
consumer. IC3 yields the higher satisfaction than IC2 IC1 yields the lowest level of
satisfaction. This is because higher IC contains more units at least one Goods.
3.1.2.3 Properties of Indifference Curve

The properties or characteristics of indifference curve are as follows:
1. Indifference curve has a negative slope: An indifference curve slopes downward
from left to right, i.e., it has a negative slope. Negative slope implies that the two
goods are substitutes from one another. Therefore, if the quantity of one commodity
decreases, the quantity of the other commodity must increase to stay at the same
level of satisfaction.
In the given Figure, when the consumer moves from point A to B, on the same
indifference curve IC, the quantity of Y
decreases from 12 to 6 and the quantity
of X increases from 1 to 2 keeping the
level of satisfaction same. Same thing
happens as the consumer moves from
point B to C. But commodity Y
decreases at a decreasing rate and
commodity X increases at the same
rate. Therefore, decrease in Y i.e., 6,4 and 3 is less than previous and increases in
X, i.e., 2,3 and 4 is equal to each.
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2. Convex to the origin: Indifference curves for normal goods are convex to the
origin. This implies that the two goods are imperfect substitutes for one another and
the marginal rate of substitution between the two goods decreases as a consumer
moves along an indifference curve. Diminishing marginal rate of substitution means
that as the quantity of X increased by equal amount, the quantity of Y diminishes
by smaller amount.
In the given Figure, indifference curve

IC is convex to the origin. It implies
slope of indifference curve diminishes
because consumer gives up less and less
units of Y in order to have equal
additional unit of X. The slope of IC
curve measures the marginal rate of
substitution (MRS). Therefore, MRS also diminishes.
3. Higher indifference curve represents higher level of satisfaction that the lower
ones: A higher indifference curve represents higher level of satisfaction than the
lower one. The reason is that an upper indifference curve contains larger quantity
of one or both the goods than the lower one.
Let us consider two indifference curves

IC1 and IC2. IC2 is higher indifference
curve than IC1. Point Q lies on IC2 and
points S lies on IC1. Combination Q will
give more satisfaction to the consumer
than the combination S because the
combination Q contains more quantity of
both goods than the combination S.
Hence, by the assumption of non-satiety,
the consumer prefers Q than S.
4. Two indifference curves never intersect each other: If two indifference curves
intersect to each other, an indifference curve indicates two different level of
satisfaction. It means that as two indifference curves intersect to each other, it gives
conflicting result. It can be shown by given Figure.
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In the given figure, two indifference curves IC1 and IC2 are intersecting to each
other at point A. Point A lies on both indifference curves where point B and C lie
on IC1 and IC2 curves respectively. Points A and B lie on the same indifference
curve IC1. It means that points A and B give the same level of satisfaction.
Similarly, points A and C lie on the same indifference curve IC2 It implies that
points A and C give the same level
of satisfaction. It shows that utility
from points B and C will also be the
same. But it is a conflicting result
because higher indifference curve
yields higher level of satisfaction
than lower one. Thus, two
indifference curves cannot intersect
to each other.
5. Indifference curves are not necessarily parallel: Though indifference curves are
falling downward, the rate of fall will not be the same for all indifference curves. In
other words, the diminishing marginal rate of substitution between the goods is not
the same in the case of all indifference schedules. Therefore, no necessary to be
parallel of two indifference curves.
In the given Figure the starting

point of IC1, IC2 and IC3 is very
Commodity Y
nearby. When ICs are nearer to X

axis their gap becomes higher and
higher. The diminishing marginal
rate of substation between X and Y
commodity is not equal. So IC1, IC2
Commodity X
and IC3 are not parallel.
6. Indifference curve does not touch either axis: Indifference curve approach is a
two commodity model. Therefore, we must have to two commodities. If IC touches
any axis, it implies that consumer purchases single commodity.
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If indifference curve IC2 touches X-axis as
shown in the given Figure at M, the consumer
will be having OM units of good X and no Y.
Similarly, if an indifference curve IC1
Commodity Y
touches the Y-axis at L, the consumer will be
having only OL units of good Y and no X.
Such curves violate the assumption that the
consumer buys two goods in a combination. Commodity X
Therefore, indifference curves do not touch
either of the axes.
3.1.2.4 Marginal Rate of Substitution (MRS)

The marginal rate of substitution is the rate at which one commodity can be substituted for
another without affecting total satisfaction. The MRS is given by the slope of the
Indifference curve. To explain the concept of MRS, let us suppose that a consumer
consumes only two goods X and Y. The utility function of the consumer is given as
U = f (X, Y) Where, X and Y are substitutes
Let us suppose that the consumer substitutes X for Y without affecting total utility. When
the consumer sacrifices some units of Y, his stock of Y decreases by ΔY and he loses a part
of his total utility. His loss of utility may be expressed as -ΔY.MUY
On the other hand, as a result of substitution, his stock of X increases by ΔX. His gain of
utility from X equals +ΔX.MUX
The total utility remains the same only when -ΔY.MUY = +ΔX.MUX
∆𝑌 𝑀𝑈𝑋
𝑀𝑅𝑆𝑋𝑌 = − =
∆𝑋 𝑀𝑈𝑌
∆𝑌
Here is simply the slope of the indifference curve, which gives the MRSXY when X is
∆𝑋
substituted for Y.
∆𝑋
Similarly, ∆𝑌 gives MRSYX when Y is Substituted for X. Symbolically,
∆𝑋 𝑀𝑈𝑌
𝑀𝑅𝑆𝑌𝑋 = − =
∆𝑌 𝑀𝑈𝑋
 Principle of Diminishing MRS
The marginal rate of substitution is the amount of one good that an individual a willing to
give up for an additional unit of another good without affecting the level of satisfaction.
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For example, the marginal rate of substitution of good X for unit of good Y (MRSXY) is the
amount of Y that an individual is willing to exchange per unit of X by maintain the same
level of satisfaction.
Marginal rate of substitution of X for Y diminishes as more and more units of good X is
substituted for Y. In other words, as a consumer has more and more units of goods X, he is
willing to forgo less and less units of good Y. The principle of diminishing MRS can be
explained with the help of table and figure.
Combination Goods X Goods Y MRSXY
A 1 12 -
B 2 8 4
C 3 5 3
D 4 3 2
E 5 2 1
In given table, the rate of substitution of good X for good Y is shown. In the beginning, as
the consumer moves from A to B, he is ready to give up 4 units of Y for the one extra unit
of good X. In this process, his level of satisfaction remains same. It follows that one unit
gain in X fully compensates him for the loss of 4 units of Y. At this stage, marginal rate of
substitution of X for Y is 4.
When the consumer moves from combinations B to C, C to D and D to E, he is willing to

sacrifice 3 units, 2 units and 1 unit of good Y for the one additional unit of X. Hence,
marginal rate of substitution of X for Y is 3, 2 and 1 respectively. So, the table shows that
the rate of substitution is diminishing.
In the given Figure, starting at

point A, the individual is willing
to give up 4 units of Y for one
additional unit of X and reaches A
Commodity Y
point B on IC. Thus, MRSXY = 4.

B
Between points B and C, MRSXY
C
= 3, between C and D, MRSXY =
D
E
2, between D and E, MRSXY = 1.
Thus, MRSXY declines as the
consumer moves down on the Commodity X
same indifference curve. As a result, IC is convex to the origin.
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 Why does MRS Diminish?
The following three factors are responsible for diminishing MRS.
1. The particular want is satiable: The want for a particular commodity is satiable
so that as the consumer has more and more units of a commodity, the intensity of
his want for those good goes on falling. Due to this reason, when the stock of a
commodity, say X, increases with the consumer, he is willing to forgo less and less
of another commodity, say Y, for every increase in X. In the beginning, when the
consumer's stock of good Y is relatively large and his stock of good X is relatively
small consumer's Marginal significance for good Y will be low while his marginal
significance for good X will be high. Therefore, the consumer will be willing to
give up a larger amount of Y for a unit increase in good X.
But as the stock of good X increases the marginal significance for good X will
diminish. On the other hand, as the stock of good Y decreases, the marginal
significance for good Y will go up. As a result, as the individual substitute more
and more of X for Y, he is prepared to give up less and less of Y for a unit increases
in X.
2. Goods are not perfect substitute for each other: Marginal rate of substitution
diminishes because goods are not perfect substitute for each other. If the two goods
are perfect substitute of each other, they are to be regarded as the one goods and
decrease in the quantity of the other goods would not make any difference in the
marginal rate of substitution of the goods. Hence, in case of perfect substitutability
of goods, the marginal rate of substitution remains the same and does not decline.
3. Increase in the quantity of one good does not increase the want satisfying of
the other: The principle of diminishing marginal rate of substitution will hold good
only if the increase in the quantity of one good does not increase the want satisfying
power of the other. If with the increase in the stock of good X, the want satisfying
power of good Y increases, the greater and greater amount of good Y will be
required to be given up for a unit increase in good X. As a result, the consumer's
satisfaction remains same.
3.1.2.5 Budget Line

Budget line is the locus of different combinations of two goods which a consumer can
purchase by spending his/her given money income and market prices. In other words, the
56
budget line shows different combinations of two goods, which a consumer can purchase by
spending his/her given money income and market prices. A consumer can purchase any
combination of two goods that lies on the budget line with his/her given money income and
market prices of goods.
Budget line can be presented by a budget equation. If the X and Y commodity are multiplied
by their respective price and add, we get budget line. Consumer has a limited income
(budget constraint). Due to the budget constraint, consumer needs to decrease one
commodity to increase another commodity. So, budget line is downward sloping. Slope
means change. So, the slope of budget line is the change in budget due to change in its
determinants. Slope of the budget line is the first order derivative of budget equation. The
budget constraint may be expressed as
𝑃𝑋 ∙ 𝑄𝑋 + 𝑃𝑌 ∙ 𝑄𝑌 = 𝑀 … (𝑖)
Where,
PX = Price of the commodity QX = Quantity of X Commodity
PY = Price of the commodity QY = Quantity of Y Commodity
M = Money income (Budget)
It is based on the following assumptions:

o Consumer consumes two goods.
o Consumer has to pay price for the goods.
o A consumer has a limited income.
Suppose, a consumer has Rs. 50 spend on goods X and Y. Price of X is Rs. 10 per unit and
the price of Y is Rs. 5 per unit. If the consumer spends all his/her money income on the
purchase of good X, s/he would buy 5
units of X. If he spends all his income
on the purchase of Y, he would buy 10
𝑩𝒖𝒈𝒆𝒕 𝑳𝒊𝒏𝒆: 𝑴 = 𝑷𝑿 ∙ 𝑸𝑿 + 𝑷𝒀 ∙ 𝑸𝒀
units of Y. If we join these two
Commodity Y
combinations, we will get a line which

is called budget line of price line.
The combinations of goods lying to the

right of the budget line are unattainable
because income of the consumer is not
sufficient to purchase those
Commodity X
57
combinations. The combinations lying to the left of the budget line are attainable but not
desirable.
The intercept of OB on the Y-axis equals the amount of this entire income divided by the
𝑀
prices of commodity Y, i.e., 𝑂𝐵 = . Likewise, the intercept OL on the X-axis measures
𝑃𝑌
𝑀
the total income divided by the price of commodity X. Thus, 𝑂𝐿 = . If the consumer
𝑃𝑋
𝑀
spends all his income on Y commodity, then 𝑄𝑌 = (Since X = 0). Similarly, if he spends
𝑃𝑌
𝑀 𝑀
whole income on X commodity, then 𝑄𝑋 = (since, Y = 0). shows the amount of
𝑃𝑋 𝑃𝑌
𝑀
commodity Y that can be purchased if the quantity of X is zero. shows the amount of
𝑃𝑋
commodity X that can be purchased if the quantity of Y is zero.
 Slope of Price Line (Budget Line)

In order to obtain the slope of budget line, let's rewrite equation (i) as
𝑀 𝑃𝑋
𝑄𝑌 = − 𝑄 … (𝑖𝑖)
𝑃𝑌 𝑃𝑌 𝑋
Differentiating equation (ii) with respect to X partially, we get the slope of budget line.
𝜕𝑄𝑌 𝑃𝑋
=−
𝜕𝑄𝑋 𝑃𝑌
Since, prices are always positive, the slope of the budget line is negative. Negative slope of
the budget line indicates that if the consumer wants to spend more on one commodity, he
must decrease the money expenditure for another commodity because of the budget
constant.
 Swing in price Line (Budget Line) (Price Charges)

Swing in budget line is the process of change in budget line where one point is constant
and another point moves up and down. Other things remaining the same, if price of the
particular commodity changes, then budget line will swing upward or downward. If price
of the commodity decreases than purchasing capacity of consumer will increase, which
causes the upward swing in price line. Similarly, when price increases then purchasing
capacity of a consumer will decrease, which causes downward swing in price line. It is
clear from the Figure.
Suppose, the total income of the consumer is Rs.36 where price of X commodity is Rs. 12
and price of 'Y' commodity is Rs. 9. If the consumer spends all his/her money income on
58
the purchase of commodity X, S/he would by 3 units of X. If s/he spends all his income on
the purchase of Y, he would buy 4
as shown in Figure.
Suppose, price of X
commodity falls from Rs. 12 to
Commodity Y
6, keeping the price of Y
commodity and budget
constraint, consumer increases
the purchases of X commodity
from 3 units to 6 units without
reducing Y commodity. As a
result, price line swing upward
Commodity X
from LM to the position LN.
Similarly, if price of X commodity rises from Rs. 12 to Rs. 18, the consumer decreases the
purchase of X commodity from 3 units to 2 units. Consequently, the price line swing
downward to the position from LM to LP.
 Shift in Price Line (Budget Line) (Income Charges)

Shift is the process of change in position of budget line on the both axes. Other things
remaining the same, when income of consumer changes, there is shift in budget or price
line. When income increases, budget line will shift rightward, where consumer can
consume more units of both X and Y commodity. On the other hand, if income decreases,
consumption level decreases, which causes leftward shift in price line as shown in figure.
In the Figure, the total income

(budget) of the consumer is
Rs. 50 where price of X
commodity is Rs. 10 and
price of Y commodity is Rs.
5. In the figure, LM is the
initial budget line or price
line. At this income, the
consumer purchases 5 units
of commodity X and 10 units
of commodity Y. When
59
consumer's income increases to Rs. 100 then the initial budget line LM shifts rightward to
JK, where consumer can purchase 10 units of X commodity and 20 units of Y commodity.
On the other hand, when consumer's income decreases to Rs 20, the initial budget line LM
shifts leftward to NQ where the consumer purchases 2 units of X commodity and 4 units of
Y commodity.
3.1.2.6 Price Effect

Price effect explains how the consumer reacts to change in the price of a commodity, other
things remaining the same. When the price of the commodity changes, consumer's
equilibrium position would lie in higher or lower indifference curve accordingly to fall or
rise in price respectively.
If price of the particular commodity falls then real income of the consumer will increase. It
leads to rise the purchasing power of the consumer. It causes to upward swing in budget
line where consumer reaches in new equilibrium at higher indifference curve. Similarly, if
price of the particular commodity increases, consumer's real income decreases which
decreases purchasing capacity of the consumer. It causes to downward swing in budget line
where consumer reaches in new equilibrium at lower indifference curve. Price effect
depends upon the nature of the commodity. Price effect in case of different goods is explain
below:
 Price Effect on Substitute Goods: Those goods are substitute goods which can be
used in place of each other to satisfy a particular want. In case of substitute good,
there is positive relationship between price of a commodity and demand for related
commodity. For example, let us suppose, X and Y are substitute goods. If price of
good X falls, the demand for good Y decreases and vice versa. Thus, in case of
substitute good, price consumption curve (PCC) is downward sloping as show in
the figure.
In the Figure, the initial

budget line is PL2 where
consumer is in equilibrium
at point E2 on IC2 curve. At
this equilibrium, consumer
purchases OX2 units of X
goods and OY2 units of Y
goods. If price of X falls,
60
the budget line will swing rightward to PL3 where consumer purchases OX3 units
and OY3 units of X and Y goods respectively. If the price of X rises, budget line
will swing downward to PL1 and the consumer is in equilibrium at point E1. If we
join these equilibrium points E1, E2 and E3, we will get downward sloping price
consumption curve (PCC). PCC is downward sloping because goods X and Y are
substitutes. It indicates that the demand for commodity X is elastic. PCC explains
price effect on the consumer's equilibrium.
 Price Effect on Complementary Goods: Those goods are complementary goods

which are jointly used to satisfy a particular want. In case of complementary goods,
there is inverse relationship between price of a good and demand for related good.
Therefore, if the price of one good fall, then the demand for related goods will
increase and vice-versa. For example; let us suppose, X and Y are complementary
goods. If price of good X falls, the demand for good Y increases and vice versa.
Therefore, in case of complementary goods, price consumption curve (PCC) is
upward sloping from left to right as shown in the figure.
In the Figure, initial budget
line is PL2 and equilibrium
is obtained at point E2 on
indifference curve IC2
where consumer purchases
OX2 unit of X goods and
OY2 unit of Y goods. When
price of X falls then the
purchasing power of the
consumer will increase. As
a result, the budget line will swing upward to the position PL3. At the condition, the
consumer is in equilibrium at point E3 on IC3 curve. In this equilibrium point,
purchase of both X and Y increase. When price of X rises, the purchasing power of
the consumer decreases. Consequently, the budget line swing downward to the
position PL1 from initial position and the consumer is in equilibrium at point E1 on
IC1 curve. At this equilibrium point, the purchase of both X and Y decrease.
 Price Effect on Giffen Goods: Those good are Giffen goods which have positive
price effect. it means that price and demand for Giffen goods are positively related.
61
For example, let us suppose that X is a Giffen goods. Therefore, as the price of X
falls, the purchase of X decreases but the purchase of Y increases. Hence, PCC
slopes backward in case of Giffen goods as shown in the Figure.
In the Figure, initial

budget line is PL2 and
equilibrium is obtained
at point E2 on IC2 curve
where consumer
purchases OX2 units of
X goods and OY2 units
of Y goods. When price
of X falls then the
purchasing power of the
consumer will increase.
As a result, the budget line shifts upward to the position PL3 and new equilibrium
is established at point E3 on IC3 curve where the purchase of X decreases to OX3
units and the purchase of Y increases to OY3 units. When price of X rises, the
purchasing power of the consumer reduces. Consequently, the budget line shifts
downward to the position PL1, from original position and again new equilibrium is
obtained at point E1 on IC1 curve. At this equilibrium condition, the purchase of X
increases to OX1 unit and the purchase of Y decreases to OY1 unit. It means that
good X is Giffen goods. Therefore, PCC is backward bending.
3.1.2.7 Income Effect (Derivation of ICC)

Income effect is defined as the change in quantity purchased due to the change in money
income, other things remaining the same. If income of a consumer changes, then original
equilibrium point will also change. If money income increases, budget line shift upward
where consumer will be in equilibrium at higher indifference curve. Similarly, if income
decreases, budget line will shift downward where consumer will be in equilibrium at lower
indifference curve. New equilibrium point will be set up giving higher or lower level of
satisfaction as his/her income increases or decreases. The income effect is different for
different goods. The income effect in case of different types of goods is explained below.
62
 Positive Income Effect (Income Effect on Normal goods): Those goods are
normal goods whose income effect is positive. It means that when income of a
consumer increases, the quantity purchase also increases and vice-versa. Therefore,
in case of normal goods, income consumption curve (ICC) is upwards sloping as
shown in the given figure below. Income consumption curve is the locus of
equilibrium points at different level of income.
In the figure, P2 L2 is the

initial budget line and E2
is the initial equilibrium
point where a consumer
purchases OX2 units of X
good and OY2 units of Y
good. Suppose, income
of the consumer
increases. As a result, the
budget line will shift to
the position P3 L3 and the
consumer will be in equilibrium at point E3 on indifference curve IC3 by purchasing
OX3 units of X and OY3 units of Y. Again, suppose the income of the consumer
decreases. Consequently, the budget line will shift to the position P1 L1 from initial
position. The equilibrium will be obtained at point E1 on indifference curve IC1
where the purchase of both X and Y decreases to OX1 unit and OY1 unit
respectively. By joining these equilibrium points E1, E2 and E3 we get a curve. This
curve is called income consumption curve (ICC) which shows the income effect on
consumer's equilibrium.
 Negative Income Effect (Income Effect on Inferior Goods): Those goods are
inferior goods, whose income effect is negative. It means that with the increase in
income, the quantity purchase of inferior goods decreases because the consumer
substitutes the inferior goods by superior goods. In case of inferior goods, the
income consumption curve slopes backward to the left or downward to the right as
shown in the Figure.
63
In the Figure, X-axis
represents quantity of
good X, which is
assumed to be inferior
and Y-axis represents
quantity of Y good. P2
L2 is the initial budget
line and the consumer
is in equilibrium at
point E2 on
indifference curve IC2.
At this equilibrium point, the consumer purchases OX2, units of good X and OY2
units of good Y. When money income of the consumer increases, the initial budget
line P2 L2 will shift upward to P3 L3. The new equilibrium is obtained at point E3 at
the higher indifference curve IC3. At this point the purchase of good X decreases to
OX3 units and the purchase of good Y increases to OY3 units. Similarly, when
income decreases, the initial budget line will shift downward to P1 L1 and new
equilibrium is established at point E1 at the lower indifference curve IC1. At this
point the purchase of good X increases to OX1 unit and the purchase of good Y
decreases to OY1 unit. By joining equilibrium points, we get backward bending,
income consumption curve (ICC).
Thus, if we assumed good X is inferior and it is measured on X-axis, the ICC will
bend backward or toward the Y-axis as shown in Figure. Similarly, if we assumed
good Y is inferior good and it is measured on Y-axis, the ICC will bend downward
or toward the X-axis.
3.1.2.8 Substitutional Effect (Decomposition of price effect into income and

Substitutional effect: Hicksian approach and Slusky Method)
Substitution effect is defined as the change in purchase of a commodity as a result of a
change in relative prices alone, money income remaining constant. If the price of a
commodity changes, the real income or purchasing power of a consumer also changes. If
there is price effect, income and substation effects simultaneously occur. To find out the
substitution effect, we must decompose price effect in to income and substitution effect.
For this purpose, it is necessary to keep real income of the consumer constant, price change
64
is compensated by a simultaneous change in money income, but how? we have two
different approaches suggested by two different economists (i) Hicks and (ii) Slutsky.
Hicksian Approach: In Hicksian substitution effect, money income of the consumer

is changed by an amount which keeps the consumer in the initial level of satisfaction at the
same indifference curve on which he was in equilibrium before the change in price. The
amount by which the money income of the consumer is changed so that consumer stays on
the same indifference curve is called compensating variation in income. In other words,
compensating variation in income is a change in the income of the consumer which is just
sufficient to compensate the consumer for a change in the price of good. To find out the
substitution effect, we must draw one hypothetical budget line which must be parallel to
new budget line at the same time it must tangent with initial indifference curve. It can be
shown in the Figure.
In the figure, PL1 is the initial

price line with a given money
income and prices. The consumer
is the equilibrium at point E1 on
the indifference curve IC1 where
the consumer purchases OX1 unit
of good X and OY1 unit of good
Y. Suppose the price of good X
falls and the real income of the
consumer increases due to fall in
price. As a result, price line will swing to PL2 and the equilibrium is obtained at point E2
on the indifference curve IC2 where the consumer purchases OX2 units of good X and OY2
units of good Y. The movement from E1 to E2 represents the price effect. Price effect is the
result of income effect and substitution effect. In order to keep the consumer in the same
indifference curve, some money is taken away (by way of taxation) from the consumer to
cancel out the increased real income. This adjustment in income is called compensating
variation. When the increased real income cancel out, the budget line PL2 will parallel shift
downward to the position AB as shown in figure. The budget line AB is tangent at point E3
on indifference curve IC1 where the purchase of X increases to OX3 units and the purchase
of Y deceases to OY3 units. With price line AB, consumer is in equilibrium at E3 on
indifference curve IC3. At point E3, consumer gets same level of satisfaction as at point E1.
65
Movement from E1 to E3 on the same indifference curve is due only to the relative fall in
price of X. At point E3, the consumer purchase X1 X3 more of goods X than at E1 and Y1Y3
less of good Y than at point E1. Thus, the movement from E1 to E3 represents the
substitution effect.
If reduced money from his/her money income is given back, the consumer would move
from E3 to E2. So, the movement from E3 to E2 represents income effect. Thus, price effect
is the sum of substitution effect and income effect.
Price Effect = Substitution Effect + Income Effect

X1X2 = X1X3 + X2X3
Slutskian Approach: In Slutsky's approach, consumer's income has to be so changed

that the consumer returns not only to his/her original indifference curve but also to the
original equilibrium point. In other words, the income of the consumer is changed in such
a way that the consumer is able to purchase the original combination of the two goods if he
so desires. Consumer's income-adjusted budget line must pass through the initial
equilibrium point on the original indifference curve. Slutskian method of splitting the total
price effect into income and substitution is explained in the Figure.
In the Figure, PL1 is the

initial price line with a given
money income and prices.
The consumer is in
equilibrium at point E1 on the
indifference curve IC1 by
purchasing OX1 unit of good
X and OY1 unit of good Y.
Supposes the price of good X
falls, keeping price of Y good
and money income constant.
The real income of the
consumer increases due to fall in price. As a result, the price line will shift to PL2 and
equilibrium is obtained at point E2 on the indifference curve IC2 by purchasing OX2 units
of good X and OY2 units of good Y. The movement from E1 to E2 represents the price
effect. Price effect is the result of income effect and substitution effect.
66
In order to find out slutsky's substitution effect, consumer's real income is so reduced (by
way of taxation) that he returns to the original equilibrium point E1 and s/he is able to
purchase the original combination of goods X and Y at new price, if he so desires. For this
purpose, a price line AB parallel to PL2 has been drawn which passes through the original
equilibrium point E1. It means that income equal to PA in terms of Y or L2B in terms of X
has been taken away from the consumer. As a result, s/he can purchase the original
combination E1, if s/he so desires. But the consumer will not purchase the original
combination E1 because X has become relatively cheaper and Y has become relatively
dearer than before. The imaginary price line AB is tangent to the indifference curve IC 1 at
point E3. Therefore, the consumer will be in equilibrium at a point E3 on a higher
indifference curve IC3. The movement from equilibrium point E2 to E3 shows a fall in the
purchase of X by X2 X3. This is income effect. We can easily find out the substitution effect
by subtracting the income effect from price effect as shown below:
Substitution Effect = Price Effect – Income Effect

S.E. = P.E. – I.E.
= X1 X2 - X3 X2
⸫ S.E. = X1 X3
In the Figure, the movement from E1 to E3 and consequent increase in the quantity
purchased of good X (i.e., X1 X2) is the substitution effect and movement from E3 to E2 and
the consequent increase in the quantity purchased of good X (i.e., X3 X2) is the income
effect.
3.1.2.9 Derivation of Demand Curve from Indifference Curve (demand for

Complementary and Substitution goods)
Those goods are normal good s where there is a negative relationship between price and
quantity demand. If price of a particular commodity falls, real income of the consumer
increases, which also increases the purchasing capacity of the consumer. It causes to
upward swing in budget line where he consumes more commodity. Similarly, if price of
the particular commodity increases, consumer’s real income decreases, which also
decreases purchasing capacity of consumer. It causes to downward swing in budget line
where consumer equilibrium at lower indifference curve where he consumes less unit of
that commodity. With this concept, demand curve can be derived as follows:
On the upper portion of the figure, commodity X and Y measured in X and Y axis
respectively. Similarly, at the lower portion of the figure commodity X and Price of X
67
measured in X and Y axis
respectively. The initial budget
line is PL2 where consumer is
equilibrium in IC2 at point R.
which determine OY2 of
commodity Y and OX2 unit of
commodity X. it gives the
combination ‘A’ at the lower
portion of the figure where
consumer consume OX2
commodity at OP2 price. If we
allow the price of X to fall
continuously, the budget line will
swing rightward to PL3 and new
equilibrium points S will be
obtained. Where consumer
consume OX3 and OY3 units of X
and Y commodity respectively.
It gives the combination ‘B’ at the lower portion of the figure where consumer consumes
OX3 units at OP3 price. If the price of X increases, budget line swing downward to PL1
where consumer is equilibrium at point Q. it gives the combination C where consumer
consumes OX1 commodity at OP1 price. If we join all those combination A, B, C we get
one downward sloping curve Dx which is a demand curve of a consumer for commodity X.
 Derivation of demand curve for Giffen Goods:

In case of Giffen goods the price and demand are positively related therefore demand curve
is upward sloping where PCC is backward banding. Therefore, as the price of X falls, the
demand for X decreases but the quantity demanded for Y increases. PCC slopes backward.
The demand curve can derive as follows:
In the upper port of the figure, Commodity X and Commodity Y measured in X and Y axis
respectively where, commodity X is Giffen Goods. Similarly, in the lower part of the figure,
commodity X and Price of X measured in X and Y axis respectively. Due to fall in price of
X, the price line swing from PL1 to the position PL2 and PL3 which causes to change the
consumer’s equilibrium from E1 to E2 and E3 respectively.
68
In the lower part of the figure,
consumer consumes OX1
units of X commodity at OP3
price with the help of initial
equilibrium E1 which gives
combination A. if price
decreases consumer
consumes OX2 unit of X
commodity at OP2 price
which gives the combination
B. Again, the price decreases
to P1, consumption also
decreases to OX3 which gives
the combination C. By
joining combination, A, B
and C we get one upward
sloping curve Dx which is a
demand curve of commodity X.
3.1.2.10 Derivation of Engel Curve from Income Consumption Curve

 Derivation of ICC and Engle Curve for Normal Goods
Normal goods are those goods whose demand or consumption increases with increase in
consumer's income and vice versa. It means that in case of normal goods income effect is
positive and income consumption curve (ICC) slopes upward from left to right. The
positive income effect can be explained by the help of the given Figure.
In the given Figure, A2 B2 is the initial budget line, which is tangent to the indifference
curve IC2 at point E2. Hence, initial equilibrium point is E2. Let us suppose, the income of
the consumer increases. As a result, the initial budget line A2B2 will shift rightward to A3B3.
With the budget line A3B3, the consumer is in equilibrium at point E3 on higher indifference
curve IC3, which shows OX3 units of good X and OY3 units of good Y purchased by the
consumer. Again, when income of the consumer decreases, the consumer will be in
equilibrium at point E1 on lower indifference curve IC1, which shows OX1 units of good X
and OY1 units good Y purchased by the consumer. If equilibrium points E1, E2 and E3 are
joined, a curve is obtained, which is known as the income consumption curve (ICC).
69
With the help of consumers'
equilibrium points shown is
figure (A), income demand
or Engel curve for normal
good X has been derived in
Figure (B). According to
initial equilibrium point E2,
at income OY2, the demand
for X good is OX2 unit. It is
denoted by point 'B'.
Similarly, according to the
equilibrium point E3, at
income OY3, the demand for
good X is OX3 units. It is
denoted by point 'C'. Again,
similarly, according to
equilibrium point E1, we get
point 'A'. When points A, B
and C are joined, income demand curve or Engel curve DD is derived.
 Derivation of ICC and Engle Curve for Inferior Goods

Those goods are inferior goods, whose income effect is negative. It means that with the
increase in income, the quantity purchase of inferior goods decreases because the consumer
substitutes the inferior goods by superior goods. In case of inferior goods, the income
consumption curve slopes backward to the left or downward to the right as shown in the
Figure.
In the Figure A, X-axis represents quantity of good X, which is assumed to be inferior and
Y-axis represents quantity of Y good. A2B2 is the initial budget line and the consumer is in
equilibrium at point E2 on indifference curve IC2. At this equilibrium point, the consumer
purchases OX2, units of good X and OY2 units of good Y. When money income of the
consumer increases, the initial budget line A2 B2 will shift upward to A3B3. The new
equilibrium is obtained at point E3 at the higher indifference curve IC3. At this point the
purchase of good X decreases to OX3 units and the purchase of good Y increases to OY3
units. Similarly, when income decreases, the initial budget line will shift downward to A1
70
B1 and new equilibrium is
established at point E1 at the
lower indifference curve IC1. At
this point the purchase of good X
increases to OX1 unit and the
purchase of good Y decreases to
OY1 unit. By joining equilibrium
points, we get backward bending,
income consumption curve
(ICC).
Thus, if we assumed good X is
inferior and it is measured on X-
axis, the ICC will bend backward
or toward the Y-axis as shown in
Figure. Similarly, if we assumed
good Y is inferior good and it is
measured on Y-axis, the ICC will X3 X2
bend downward or toward the X-axis.

In the figure “B”, income demand curve or Engel curve has been derived by the help of
figure “A”. According to equilibrium point E1, OX1 quantity of goods X is purchased at
income OY1 which is shown by point ‘a’ in figure “B”. Similarly, according to equilibrium
point E2, quantity of goods X is purchased deceases to OX2 due to rise in income from OY1
to OY2 which is shown by point ‘b’ in figure “B”. Similarly, we get point ‘c’. When we
joint points a, b and c, we get income demand curve or Engel curve DD as shown in the
figure “B”. Thus, in case of inferior goods, income demand curve (Engel Curve) slopes
downward to right, which indicates that demand for inferior goods is inversely related with
income of the consumer.
3.1.2.11 Criticism of Indifference Curve

Indifference curve/ordinal utility analysis can be criticized as follows.
1. Two commodity model: Indifference curve only analyses the combinations of two
goods at a time. But in reality, a consumer needs to consumer many goods at the
same time, which cannot be shown in a two-dimension graph.
71
2. Wrong assumption of rational consumer: The indifference curve analysis
assumes that the consumer acts rationally. But in this modern changing situation, it
is very difficult for consumer to gather all necessary information. It is time
consuming, and costly. So, they are behaving whatever way they like. Therefore,
consumers may not be rational.
3. No Newness: professor Robertson does not find anything new in the indifference
curve technique and he regards it simply the old wine in a new bottle, it replaces
introspective cardinalism by introspective ordinalism instead of the cardinal
numbers such as 1, 2, 3 etc. ordinal numbers I, II, III, etc., are used to indicate
consumer's preference. It substitutes marginal utility by marginal rate of
substitution. Thus, this technique is failed to bring a positive change in the utility
analysis and merely gives new name to the old concept.
4. Income, preference and habit change: The ordinal utility analysis is based on the
assumption that income, preference and habit of the consumer remain same. But in
this changing world, it is very hard to find a constant income, preference and habit
of the consumers. It means that these elements change with the change in time.
5. Cannot explain about uncertainty: The ordinal utility theory is not capable of
formulating consumers' behavior when their preferences involve risk or uncertainty
in expectations.
6. Unrealistic assumption of perfect competition: The indifference curve technique
is based on the unrealistic assumptions of perfect completion and homogeneity of
good, in reality, consumer is confronted with differentiated products and
monopolistic competition. Since, the indifference curve analysis is based on
unwarranted assumption, it becomes unrealistic.
 Difference between ordinal and Cardinal Utility Analysis

1. The concept of cardinal utility analysis was developed by H.H. Gossen, and
popularized by Alfred Marshall and other economists. According to cardinal
economists, utility can be measured in number in term of money.
The concept of ordinal utility analysis was developed by the economist J.R. Hicks
and R.G.D. Allen. They have expressed that utility is only psychological or a
subjective factor. So, this can be felt but not measured in a numerical form.
2. The cardinalists assumed that marginal utility of money is constant. But the
ordinalists opposed this assumption. In practical life marginal utility of money.
72
Rather indifference technique analyzes the income effect when the income of the
consumer changes.
3. As pointed by cardinalists, utility can be measured in terms of number, But the
ordinalists rejected this assumption. The ordinal approach doesn't say that utility
has to be measured by using cardinal number. It says that utility cannot be measured
quantitatively.
4. The ordinal approach explains price effect into income effect and substitution effect
which is not possible under cardinal utility analysis. It discusses the price of a good
changes. Thus, it discusses dual effect in the form of the income and substitution
effect. But cardinal approach cannot explain dual effect.
5. Ordinal approach explains that the two-commodity model which discuss about the
consumer's behavior in the case of substitutes, complementary and unrelated goods.
But cardinal approach explains that single commodity model.
6. The ordinal analysis explains the law of demand more realistically by considering
inferior and different goods as well. This makes the IC technique definitely superior
to the cardinal utility analysis.
 Similarities between Ordinal and cardinal Utility Analysis

1. Both approaches assume the rational behavior of the consumer that he seeks to
attain an equilibrium position by maximizing satisfaction.
2. Both techniques used the same proportionality rule for the consumer to maximize
satisfaction or to reach in equilibrium position.
According to cardinal utility analysis, the equilibrium condition is:
𝑴𝑼𝑿 𝑴𝑼𝒀
∴ = … (𝒊)
𝑷𝑿 𝑷𝒀
According to ordinal utility analysis, consumer is in equilibrium when his MRS is
equal to price ratio, i.e.,
𝑷𝑿
𝑴𝑹𝑺𝑿,𝒀 =
𝑷𝒀
𝑴𝑼𝑿
𝐵𝑢𝑡, 𝑴𝑹𝑺𝑿,𝒀 =
𝑴𝑼𝒀
Therefore,
𝑴𝑼𝑿 𝑷𝑿
𝑶𝒓, =
𝑴𝑼𝒀 𝑷𝒀
𝑴𝑼𝑿 𝑴𝑼𝒀
∴ =
𝑷𝑿 𝑷𝒀
Which is same with (i)
3. Both approaches assume diminishing utility, i.e., diminishing marginal utility in one
case and diminishing marginal rate of substitution in another case.
4. Both approaches apply the psychological or introspective method. The law of
diminishing utility which is psychological in nature lies at the bottom of law of
73
demand being based on introspection. The indifference curve technique too, is
based on introspection. Thus, both approaches are introspective.
 Superiority of ordinal utility (Indifference Curve Approach)

Ordinal utility is superior because of the following causes.
1. More realistic measurement of Utility: Marshall examined consumer's behavior
assuming that utility is measurable and additive. The consumer was assumed to be
capable of assigning a number representing the amount of utility associated with it.
On the other hand, indifference curve technique assumes ordinal measurement of
utility. The consumer arranges the various combinations of goods in a scale of
preference marked as first, second, third, etc. He can tell whether he prefers the first
to the second or second to the first or he is indifferent between them. But he cannot
tell by how much he prefers one to the other like in cardinal approach.
2. No assumption of constant marginal utility of money: Ordinal utility is not based
on the assumption of constant marginal utility of money.
Marshall ignored the income effect of a price change and thus failed to distinguish
between the two components of the price effects but indifference technique is able to
draw a distinction between the income effect and substitution effect of price change.
3. Study of combination of two goods: The cardinal approach was a single good model
in which utility of one commodity is regarded independent of the other. Marshall
avoided the discussion of substitutes and complementary goods by grouping them
together as one commodity. But it is far from reality because a consumer buys not
one but combination of different goods at a time. The indifference curve technique is
two commodity model which give importance to both goods.
4. Less assumptions: Indifference curve arrives at the same equilibrium condition for
a consumer as the Marshallian analysis, but with less restrictive and fewer
Marshallian analysis.
5. More general theory of demand: Even with less restrictive and fewer assumption,
it gives us more general theory of demand. For the demand of Giffen goods,
Marshallian utility theory fails to explain where indifference technique explains this.
6. Closer analysis of price effect: The indifference curve technique is also superior to
the Marshallian utility analysis in the sense that its furnishers a closer analysis of the
effect of a change in price on consumer demand for a good by bringing out clearly
the distinction between the income effect and substitution effect.
74

BCA Unit 3 Theory of Consumer Behaviour

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Class: BCA (5th Semester) By Jagarnath Sah (MA-Economics, MBS)

Unit 3: Theory of Consumer Behavior Sub: - Applied Economics

3.1.1 Concept of Cardinal Utility Analysis

3.1.1.2 Assumption of Cardinal Utility Analysis

3.1.1.3 Consumer Equilibrium

3.1.1.3.1 Consumer Equilibrium: One Commodity Model

Assumptions of Law of Diminishing Marginal Utility

1. Consumers should be rational.

In the given figure,

consumer purchases 6 units of X and 4 units of Y.

3.1.1.4 Criticism and Derivation of Demand Curve

3.1.1.4.2 Derivation of Demand Curve: Two Commodity Model

of X commodity. To restore the equilibrium, marginal utility of commodity X must be

𝑀𝑈𝑚 . Hence, Point E1 is the initial

𝑀𝑈𝑚 . This gives combination K in the lower portion of figure.

 Concept of Ordinal Utility

3.1.2.1 Concept of Indifference Curve

According to A. Koutsoyiannis, “An indifference curve is the locus of points particular

3.1.2.3 Properties of Indifference Curve

In the given Figure, indifference curve

Let us consider two indifference curves

In the given Figure the starting

nearby. When ICs are nearer to X

3.1.2.4 Marginal Rate of Substitution (MRS)

U = f (X, Y) Where, X and Y are substitutes

When the consumer moves from combinations B to C, C to D and D to E, he is willing to

In the given Figure, starting at

point B on IC. Thus, MRSXY = 4.

3.1.2.5 Budget Line

It is based on the following assumptions:

combinations, we will get a line which

The combinations of goods lying to the

commodity X that can be purchased if the quantity of Y is zero.

 Slope of Price Line (Budget Line)

 Swing in price Line (Budget Line) (Price Charges)

 Shift in Price Line (Budget Line) (Income Charges)

In the Figure, the total income

3.1.2.6 Price Effect

In the Figure, the initial

 Price Effect on Complementary Goods: Those goods are complementary goods

In the Figure, initial

3.1.2.7 Income Effect (Derivation of ICC)

In the figure, P2 L2 is the

3.1.2.8 Substitutional Effect (Decomposition of price effect into income and

Hicksian Approach: In Hicksian substitution effect, money income of the consumer

In the figure, PL1 is the initial

Price Effect = Substitution Effect + Income Effect

Slutskian Approach: In Slutsky's approach, consumer's income has to be so changed

In the Figure, PL1 is the

Substitution Effect = Price Effect – Income Effect

3.1.2.9 Derivation of Demand Curve from Indifference Curve (demand for

 Derivation of demand curve for Giffen Goods:

3.1.2.10 Derivation of Engel Curve from Income Consumption Curve

 Derivation of ICC and Engle Curve for Inferior Goods

bend downward or toward the X-axis.

3.1.2.11 Criticism of Indifference Curve

 Difference between ordinal and Cardinal Utility Analysis

 Similarities between Ordinal and cardinal Utility Analysis

 Superiority of ordinal utility (Indifference Curve Approach)

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