IC2 Q Good X Substitution Effect The document discusses concepts of utility theory including cardinal and ordinal utility, law of diminishing marginal utility, indifference curves, and consumer equilibrium. It provides explanations and diagrams to illustrate: - The law of diminishing marginal utility and how total utility and marginal utility are related. - Indifference curves and how they represent combinations of goods that provide the same level of satisfaction. - How a consumer reaches equilibrium where marginal utility per dollar spent is equal across all goods, given prices and income. - How changes in income or prices can shift the budget line or indifference curves and impact equilibrium.

2. In This Lecture…
 Concepts of Utility:
Cardinal and Ordinal
 Law of Diminishing
Marginal Utility
 Indifference Curve (IC)
Analysis : Concept,
Properties, MRS

3. In This Lecture…
 Consumer’s Equilibrium :
Budget Line and IC Curve
Analysis, Price Effect,
Income Effect, Substitution
Effect, Effects of changes in
Income and Prices.

4. Utility Theory
 Utility is the want satisfying power of a good.
 There are two approach in this theory.
- Cardinal Utility Theory
- Ordinal Utility Theory
 Cardinal Utility Theory : Classical school
believes that utility can be measured using an
absolute/ quantitative scale like the other
physical characteristics – height and weight –
and are comparable.
 A util is an artificial construct used to measure
utility.

5. No Interpersonal Utility
Comparison
Caution: The utility obtained by one
person cannot be scientifically or
objectively compared with the utility
obtained from the same thing by another
person because utility is subjective.

6. Total Utility
 Total utility is the total satisfaction a
person receives from consuming a
particular quantity of a good.
TUn = MU1 + MU2 + …….. + Mun
 Marginal utility is the additional utility a
person receives from consuming one extra
unit of a particular good.
MUn = TUn – TUn-1
or, MUx = Δ TUx
ΔX

7. Law of Diminishing
Marginal Utility
 As you consume more and more of a same
commodity at a point of time the marginal
utility derived from each successive unit
goes on declining assuming that the utility
each unit of money paid as price of
commodity is constant.
 Law of DMU can be explained by the
relationship between TU and MU.

8. TU and MU
TU and MU Schedule
Quantity of X
MUx
TUx
0
-
0
1
8
8
2
6
14
3
4
18
4
2
20
5
0
20
6
-2
18
7
-4
14
8
-6
8

9. Contd..
•Graphical Presentation:TUx
TUx
O
MUx
Quantity
MUx=0
O
MUx
Quantity

10. TU and MU
 TU curve starts from the origin, reaches a
maximum point and starts declining.
 When TU is maximum, called saturation point,
MU is zero. Units of goods are consumed till
saturation point.
 When TU is rising, MU curve falls.
 When TU is falling, MU curve becomes
negative.
 The falling MU curve exhibits the law of
diminishing marginal utility.

11. Consumer’s Equilibrium
The consumer is in equilibrium when he
maximizes his level of satisfaction with
given income and market price.
Assumption : Rational Consumer
 Cardinal Utility
 Independent Utility
 MU of money is constant

12. Rationality
A rational consumer is the one who wants
to get maximum satisfaction out of his
given income.

13. Cardinal Utility
Utility can be cardinally measured, i.e. can
be expressed in exact units.
Utility is measurable in monetary terms.

14. Independent Utility
The utility that the consumer derives from
a commodity depends upon the quantity
of that very commodity alone and is not
affected by the consumption of other
goods.

15. MU of Money is Constant
It means that importance of money
remains unchanged.
MU of money is addition made to utility
of consumer as he spends one more unit
of money income. This is assumed to be
constant.

16. Consumer’s Equilibrium – One
Commodity Case
 When a consumer buys a commodity he
pays a price for it. For each unit he makes
a sacrifice in terms of price. In turn he gets
utility from each unit. We know that the
utility of each successive unit goes on
diminishing as we consume more and
more of it according to law of DMU with
the assumption that that the utility each
unit of money paid as price of commodity
is constant.

17. Consumer’s Equilibrium – One
Commodity Case
 A rational consumer will be in equilibrium when
he consumes that quantity at which utility value
of money price is equal to marginal utility of the
commodity.
 Marginal Utility = Utility of Price
of good
Paid
MUX = MUM X PX
MUX = MUM
PX

18. Consumer’s Equilibrium – One
Commodity Case
Geometrically,
Price, Utility
CONSUMER’S EQULIBRIUM
10
E
MUx = Px (MUm)
MUx
O
Here, MUm is constant and is equal to 10 utils.
9
Quantity

19. Consumer’s Equilibrium – One
Commodity Case
 If the consumer consumes more than
equilibrium point, then the utility value of
money price is higher than the marginal utility
of the commodity and hence, consumer will be
in disequilibrium.
 If the consumer consumes less than equilibrium
point, then the utility value of money price is
lower than the marginal utility of the
commodity and that there is the further scope of
maximization of satisfaction/utility. Hence,
consumer will be in disequilibrium.

20. Consumer’s Equilibrium – Two
Commodity Case
 In reality consumer spends his income on
many goods.
 A rational consumer will be in
equilibrium when he consumes that
quantity of Good X and Y at which utility
value of money price is equal to marginal
utility of the commodities.

21. Consumer’s Equilibrium – Two
Commodity Case - contd.
 Suppose a consumer spends on two goods
X and Y. Then he will be in equilibrium
when,
MUX = MUM X PX ……………… (i)
MUY = MUM X PY………………. (ii)
Or, MUX / PX = MUM and MUY / PY = MUM
Or, MUX / PX = MUY / PY = MUM
This is subject to money income of
the consumer being constant.

22. Consumer Equilibrium – Multiple
Commodity Case
 The analysis is based on the assumption that
individuals seek to maximize utility.
 Occurs when the consumer has spent all income
and the marginal utilities per dollar spent on
each good purchased are equal:
where the letters A–Z represent all the goods a
person buys.

23. Ordinal Utility Theory
 Modern school does not believe that utility can
be measured using an absolute/ quantitative
scale like the other physical characteristics –
height and weight – and are comparable.
 All desires of a consumer are not of equal
importance or urgency. Due to resources being
scarce, the problem of choice arises and that a
consumer cannot satisfy all his desires. So some
desires take precedence over others. It is
consumer’s scale of preference that determines
his expenditure pattern.

24. Ordinal Utility Theory –
Indifference Curve Analysis
 It is consumer’s scale of preference that the
consumer determines his expenditure pattern in
such a way that maximizes his level of
satisfaction. For this Indifference Curves or IC
curves are drawn.
 IC curve is the diagrammatic representation of a
set of combinations of two commodities that
offers a consumer same level of satisfaction and
that he is indifferent between these
combinations given his level of income and price
of the commodities.
 IC curve is also known as Iso-utility curve.

25. IC Curve – Schedule
Combinations
Apples
Oranges
A
B
C
D
1
2
3
4
10
7
5
4
 Satisfaction level at A = Satisfaction level
at B = Satisfaction level at C = Satisfaction
level at D

26. IC Curve – Diagrammatic
Representation
Oranges
10
8
6
4
IC Curve
2
0
1
2
3
4
Apples

27. IC Curve Map
 A set of family of IC
curves is called IC Curve
Map.
 Higher the IC curve from
the origin the higher will
be the level of
satisfaction.
 Level of satisfaction of F
> Level of satisfaction of
E > Level of satisfaction
of A > Level of
satisfaction of D > Level
of satisfaction of C

28. Indifference Curve AnalysisAssumptions
 Rationality : Consumers are assumed to be
rational and aims at maximizing his
benefits from consumption, given his
income and price of good.
 Ordinality : Utility is expected satisfaction
that a consumer gets and is subjective in
nature. He ranks utilities derived from the
commodities and has a scale of preferance
between different combination of two
goods.

29. Indifference Curve Analysis –
Assumptions Contd.
 Consistancy of Choice : If consumer prefers
good X over good Y in one time period, the
consumer will not prefer Y over X in another in
another time period.
 Transitivity of Choice : If good X is preferred to
good Y, and good Y is preferred to good Z, then
good X is preferred to Z.
 Convexity : IC curve is always convex to the
origin due to diminishing marginal rate of
substitution (MRS).

30. What is diminishing MRS?
 MRS shows how much of one commodity is substituted
for how much of another.

Combinations
Apple
A
B
C
D
Orange
1
2
3
4
10
7
5
4
 For combination B 3 oranges are sacrificed for 1 apple
and C, 2 for 1 and D, 1 for 1..
 It can be observed that as the consumer consumes more
and more of a same good he is prepared to forego less
and less of other as his desire for the former becomes
less and less intense with more and more of it.
 Therefore, MRS of apple to orange fall as he has more of
apple.

31. What is diminishing MRS? Contd.
 As more and more of good Y is substituted for X MRS
starts to diminishes because X and Y are imperfect
substitutes to one another.
Orange
ΔY1/ ΔX1 > ΔY2 / ΔX2 > ………. > ΔYn/ ΔXn
ΔY1
ΔX1
ΔY2
ΔX2
O
Apple

32. IC Curve - Characteristics
 Downward Sloping to the right : It is
because when the consumer decides to
have more of one good he will have to
reduce the number of consumption of
other good to remain on the same level of
satisfaction / IC curve.
 The further away the IC curve from the
origin the higher the level of satisfaction
and are preferred by the rational consumer.

33. IC Curve - Characteristics
 IC curves never intersect each other.
A
B
C
Here, level of satisfaction at A = B and A = C . But B ≠ C
 IC curves are always convex to the origin
due to diminishing MRS.

34. Budget Line
 A rational consumer would always like to be on
the highest IC curve signifying highest level of
satisfaction. But it is governed by the level of
income of the consumer and prices of goods in
the market.
 Budget line is a line that shows the different
possible combinations of two goods X and Y,
which a consumer can buy given his budget and
the prices of good X and Y.
 Anywhere on the budget line a consumer is
spending his entire income either on Good X or
on Good Y or the combination of both X and Y.

35. Budget Line – Diagrammatic
Representation with example
 Suppose the income of a consumer is $60,
price of apples is $2 per unit and oranges
$1 per unit.
Apples
Oranges
0
10
20
30
60
40
20
0

36. Budget Line – Diagrammatic
Representation with example Contd.
Good Y
60
50
Budget Line or Price Line
40
30
20
10
0
10
20
30
Good X
Consumer cannot go beyond Budget line as any
point beyond it shows a non-attainable / nonfeasible combination.

37. Shifting of Budget Line
Good Y
A’
Good Y
A
A
O
B
B’
Good X
Budget line when money income increases
prices remaining unchanged – that is why
there is a parallel shift in budget line.
O
B’
B Good X
Budget line when price of X increases
price of Y and money income
remaining unchanged

38. Consumer’s Equilibrium
 All bundles of goods are available to the
consumer in the sense that he can buy them if he
can. The consumer’s IC map establishes a rank
ordering of these bundles.
 The consumer’s budget space is established by
his fixed money income and relative commodity
prices; it shows bundles he can purchase.
 Rational consumer selects the most preferred
bundle of goods in his budget space.

39. Consumer’s Equilibrium
Good Y
60
Equilibrium Point
50
40
Q
IC4
30
IC3
20
IC2
10
0
IC1
10
20
30
Good X
Given the IC map consumer is in equilibrium when the
budget line is tangent with the highest possible IC curve
where he maximizes his level of satisfaction with his
given income and the market prices.

40. Income Effect on Equilibrium
Good Y
S
P
ICC (Income Consumption Curve)
B
A
IC2
IC1
O
Q
R
Good X
With a rise in the income of the consumer he attains a higher level of
equilibrium from A to B. ICC traces the income effect. It shows how the
changes in income of the consumer will affect the consumer’s purchases
of good X and Y– price of X and Y, taste and income being constant

41. Price Effect on Equilibrium
 The consumer will either be better off or
worse off depending on the change in
price of a good.
 With a change in price of a good, the
consumer will be at a higher level of
satisfaction with a fall in price and will be
at a lower level of satisfaction with a rise
in price.

42. Price Effect on Equilibrium
Good Y
PCC (Price Consumption Curve)
P
C
IC3
B
IC2
A
O
IC1
Q
R
S Good X
With a fall in the price of Good X the consumer attains a higher level of
equilibrium from A to B and B to C. PCC traces the price effect. It
shows how the changes in price of good X will affect the consumer’s
purchases of good X and Y – price of Y, taste and income being
constant

43. Price Effect on Equilibrium
Good Y
PCC (Price Consumption Curve)
P
C
B
IC3
IC2
A
O
IC1
Q
R
S Good X
If PPC curve is backward sloping it indicates that good X is an inferior
good because with a fall in price of X less of X is demanded.
(PED<1)

44. Price Effect on Equilibrium
Good Y
IC1
PCC (Price Consumption Curve)
IC2
P
IC3
B
C
A
O
Q
R
S Good X
If PPC curve is forward sloping it indicates that good X is a superior
good because with a fall in price of X more of X is demanded
(PED>1)

45. Price Effect on Equilibrium
Good Y
IC1
PCC (Price Consumption Curve)
IC2
P
IC3
C
B
A
O
Q
R
If PPC curve is horizontal it indicates PED = 1
S Good X

46. Price Effect and Substitution
Effect and Income Effect
A change in the price of a commodity leads to
a change in the relative prices of the goods – a
change in terms at which a consumer can
exchange one good for another (substitution
effect) and a change in the real income of the
consumer.
If the price of a good X falls then the real
income of the consumer goes up leading to
income effect and that the relative price of X
to Y will be lower as well and consumers will
substitute more of X to Y.

47. Substitution Effect
It is a change in quantity demanded
resulting from a change in relative
price while retaining the same level
of satisfaction or on same IC curve.

48. Substitution Effect on
Equilibrium
R
Good Y
A
P
C
O
B
T
IC1
S
IC2
Q Good X
With a fall in the price of X consumer can move from C to A – Income
Effect or to B – Price Effect; and since the relative price of X is lower to Y,
consumer can move from A to B by retaining the same level of
satisfaction, nominal income being constant.

49. Substitution Effect on
Equilibrium
R
Good Y
Income Consumption Curve (ICC)
A
Price Consumption Curve (PCC)
P
C
O
B
T
IC1
S
With ICC and PCC curves.
Movement from C to A – Income Effect
Movement from C to B – Price Effect
Movement from A to B – Substitution Effect
IC2
Q Good X

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