Lecture 8

Dr Soumyatanu Mukherjee
A consumer purchases two goods, food and clothing. The utility function is 𝑈 𝑥, 𝑦 = ln 𝑥 + ln 𝑦, where
ln . stands for natural logarithm, 𝑥 denotes the amount of food consumed, let 𝑦 be the amount of clothing.

• The marginal utilities are 𝑀𝑈 = and 𝑀𝑈 = .

• The price of food is 𝑃 , the price of clothing is 𝑃 , and

income is 𝐼 = $120.

• Demand for 𝑥 = 120⁄2𝑃 . We can denote this as D1, the

consumer’s demand curve for food. Connecting two
consumption points on D1, point A (when 𝑃 = $4, 𝑥 =
15) and point B (when 𝑃 = $6, 𝑥 = 10).

• Income increases to $200. Then demand for 𝑥 at each given

level of price, increases to 𝑥 = 200/2𝑃 .
•
ACTIVE LEARNING
Inferior vs. normal goods
 We Know: an increase in income increases the
quantity demanded of normal goods and
reduces the quantity demanded of inferior
goods.
 Suppose fish is a normal good
but mangos are an inferior good.
 Use a diagram to show the effects of
an increase in income on your optimal bundle of
fish and mangos.
ACTIVE LEARNING
Answers
Quantity
of Mangos

If mangos are
inferior, the new
optimum will
contain fewer
mangos.
A
B

Quantity
of Fish
The Effects of a Price Change When Both Are Normal Goods,
But Fish Mangoes
Quantity
Initially, of Mangos

PF = ₹40 1200
initial
PM = ₹30 optimum

new
PF falls to ₹20 optimum
600
budget constraint 500
rotates outward,
You buy more fish
and fewer mangos.
150 300 600 Quantity
350 of Fish
The Income and Substitution Effects
A fall in the price of fish has two effects on your
optimal consumption of both goods.
 Income effect
A fall in PF boosts your purchasing power on pocket
money, allows you to buy more mangos and more
fish.
 Substitution effect
A fall in PF makes mangos more expensive relative
to fish, causes you to buy fewer mangos and
more fish.
Notice: The net effect on mangos is ambiguous.
 The Income and Substitution Effects
Initial Quantity In this example,
optimum at A. of Mangos
the net effect
PF falls. on mangos is
negative.
Substitution effect:
from A to B,
buy more fish and fewer A
mangos. C

So SE shows movement along B

the initial IC.
Income effect: Quantity
from B to C, of Fish
buy more of both goods.
•
Quantity Substitutes (Coke and Pepsi)
of Pepsi

Quantity
of Coke Algebraic example:
Food is Inferior Good Food is Giffen Good