1. Price effect: substitution effect
+ Income effect
Effect on consumer equilibrium if price of
a commodity changes.
It has 2 parallel effects:
◦ Substitution effect: as price of a commodity
falls, it becomes cheaper to its substitutes, so
consumer will purchase more units of this
product.
◦ Income effect: as price of a commodity falls,
real income of consumer increases which
increases their purchasing power &
consumer can purchase more units of this
commodity.
Real Income = Money Income/ Price of
goods
2. Price Effect in case of :
Normal Goods:
◦ As income increases, demand also
increases
◦ goods on which law of demand follows.
◦ There is positive S.E. & positive I.E.
◦ overall positive P.E.
◦ E.g. normal priced goods
3. Inferior Goods:
◦ As income increases, demand decreases
◦ low priced goods, inferior in quality, on which
law of demand follows.
◦ There is +ve S.E. & -ve I.E. , but +ve S.E.> -
ve I.E.
◦ Thus there is an overall +ve P.E.
◦ E.g. cheaper as compared to normal goods (
cheaper cars, cheaper cloths, etc.)
4. Giffen Goods:
◦ very low priced & low quality inferior goods,
on which LOD does not operates.
◦ Does not have many close substitutes & are
essential in nature.
◦ There is +ve S.E. & -ve I.E. , +ve S.E.<-ve
I.E.
◦ Thus there is an overall –ve P.E.
◦ E.g. very cheap n inferior quality Staple goods,
like wheat, rice, barley, potato, etc.
5. Income Consumption Curve
(ICC):
Locus of points representing different
consumer’s equilibrium when income
of the consumer changes, prices of
both the goods being constant.
At each point on ICC,
Slope of IC= Slope of BL
MRSxy = Px/Py
6. Derivation of Engel Curve with
ICC:
Indicates the relationship b/w the
income level of the consumer & the
quantity of commodity purchased by
him.
In case of:
◦ Normal goods
◦ Inferior or giffen goods
7. Price Consumption Curve (PCC):
It is a locus of points representing
different consumer’s equilibrium when
price of one commodity changes,
while the price of other commodity &
the income level of the consumer
remains constant.
8. Derivation of Demand Curve with
PCC:
Indicates the relationship b/w the price
of the commodity & the quantity of it
purchased by the consumer given his
money income.
In case of:
◦ Normal goods
◦ Inferior goods
◦ Giffen goods
9. Criticism of IC Theory:
Assumption of Two-good analysis is
unreal.
Diminishing MRS is also questionable.
Assumption of consistency of choice is
not always true.
Assumptions of rationality are also
questionable.
Assumption that consumer can
order/rank his scale of preferences is
also debatable.
10. Contributions of the IC
Theory:
It explains price effect by splitting it
into substitution & income effect.
It further explains “Giffen Paradox”.
It also explains elasticity of
substitution with the help of MRS.
11. Similarities b/w MU Theory & IC
Theory:
Rationality of consumers
Assumption of consistency of choice.
Law of DMU & diminishing MRS.
Equilibrium condition
12. Differences b/w MU Theory & IC
Theory:
Cardinality v/s ordinality
One good v/s two goods analysis
Price Effect
Giffen Paradox
