3.1 Consumer preferences and choice

  • Given the prices of different commodities, consumers decide on the quantities of these commodities according to their paying capacity, and tastes and preferences.
  • Consumers’ choices, tastes and preferences rests on the following assumptions:
        Completeness: A consumer would be able to state own preference or indifference between two distinct baskets of goods.
        Transitivity: An individual consumer’s preferences are always consistent.
        Non-satiation: A consumer is never satiated permanently. More is always wanted; if “some” is good, “more” of the good is better.
  • Commodities are desired because of their utility

Utility is the attribute of a commodity to satisfy or satiate a consumer’s wants
Utility is the satisfaction a consumer derives from consumption of a commodity

  • Mathematically: utility is the function of the quantities of different commodities consumed:

U= f(m1, n1, r1)

3.2 Cardinal Utility Analysis

Marshall and Jevons opined that Utility is a cardinal concept and is measurable (in utils) like any other physical commodity
Total Utility (TU)
Sum total of utility levels out of each unit of a commodity consumed within a given period of time
Marginal Utility (MU)
Change in total utility due to a unit change in the commodity consumed within a given period of time.

Law of Equimarginal Utility

  • Marginal utilities of all commodities should be equal

                The consumer has to distribute his/her income on different commodities so that utility derived from last unit of each commodity is equal for all other commodities in the consumption basket.

Law of Diminishing Marginal Utility

  • Marginal utility for successive units consumed goes on decreasing.
  • When the good is consumed in standard quantity, continuously and in multiple units and the good is not addictive in nature.

The following diagrams show Total Utility (TU) and Marginal Utility (MU) curves

3.3 Diamond-water paradox

  • As noted by Adam Smith, water is essential for life and has a low market price (often a price of zero) while diamonds are not as essential yet have a very high market price.
  • Smith’s explanation: “value in use” vs. “value in exchange”
  • value in exchange: labor theory of value

Marginal Utility and Demand Curve

  • MU curve is downward sloping.
  • For any given amount of income when price of the commodity is PC, the consumer would consume QC quantity of the commodity (point C on the MU curve, where MU=” PC)
  • When price increases to PB, the consumer has to readjust consumption to restoring level of utility.
  • the new equilibrium is at point B on the MU curve where MU=” PB
  • As price goes on increasing, the desired consumption of the commodity for the consumer goes on diminishing and vice versa.
  • Points A, B, C, and so on, would thus lie on the demand curve of the consumer for the commodity.

Ordinal Utility Analysis

  • Edgeworth, Fisher and others negate the physical measurement of utility.
        a. A consumer is able to rank different combinations of the commodities in order of preference or indifference.
        b. Utility is not additive but comparative.
  • Indifference Curve Analysis (J.R. Hicks and R.G.D. Allen )
        a. Indifference curve: Locus of points which show the different combinations of two commodities among which the consumer is indifferent, i.e. derives same utility.
                1.Since all these points render equal utility to the consumer, an indifference curve is also known as an isoutility (“iso” meaning equal) curve.
        b. Indifference map: group of indifference curves

Properties of Indifference Curves

  • Indifference curves are downward sloping.

            This is because of the assumption of non-satiation.

  • Higher indifference curve represents higher utility.
  • Indifference curves can never intersect.
  • Indifference curves are convex to the origin.

            This is because two goods cannot be perfect substitutes of each other

Diminishing Marginal Rate of Substitution

  • MRS is the proportion of one good (M) that the consumer would be willing to give up for more of another (N)
  • MRS is the ratio between rates of change in M and N, down the indifference curve :

  • To increase consumption of M, the consumer has to reduce consumption of N and hence the negative sign. MRSMN goes on diminishing as we move down the indifference curve.
  • Gain in utility due to consumption of more units of one commodity must be equal to the loss in utility due to consumption of less units of the other commodity

3.4 Consumer’s Equilibrium

  • Consumer would reach equilibrium point, i.e. highest level of  satisfaction given all constraints at the highest indifference curve he/she can reach.
  • Budget line of a consumer, consists of all possible combinations of the two commodities that the consumer can purchase with a limited budget:
  • Budget constraint depends upon income of the consumer and prices of the commodities in the consumption basket.

Mathematically

  • Conditions for consumer’s equilibrium:
         Consumer spends all income in buying the two commodities; hence point of equilibrium will always lie on the budget line.
         Point of equilibrium will always be on the highest possible indifference curve the consumer can reach with the given budget line.
  • Consumer is able to maximize utility at a point where the budget line is tangent to an indifference curve
        This is the highest possible curve attainable by the consumer, subject to budget constraint.
  • Budget line may
        shift either upwards or downwards due to any change in income of the consumer while price of the commodities remaining same
        Swivel at one point when price of one of the commodities changes, while income and price of other commodity remain same.
 

Revealed Preference Theory

  • Indifference curves analysis had limitations in terms of its highly theoretical structure and simplifying assumptions.
  • Samuelson came up with an approach to assessing consumer behaviour and introduced the term ‘revealed preference’.
  • The basic hypothesis of the theory is ‘choice reveals preference’.
  • Demand for a commodity by a consumer can be ascertained by observing the actual behaviour of the consumer in the market in various price and income situations.
  • This gives us a demand curve for an individual consumer on the basis of observed behaviour.

  • AB is the budget line. OAB is the feasible set, given the price and income constraints for two goods M and N.
  • If out of all the possible combinations of two goods M and N, the consumers chooses C, it may be deduced that the consumer has revealed his/her preference for C over all other possible combinations (say D, L, R).
  • Demand increases when price falls money income remaining same and vice versa.
  • Fall in price of M will shift the budget line to AB’.
  • New preference will be at C’
  • Remaining on the same point C will imply a fall in income (budget line) to A1 B1

Consumer Surplus

  • The difference between the price consumers are willing to pay and what they actually pay is called consumer surplus.
  • Individual consumer surplus measures the gain that a consumer makes by purchasing a product at a price lower than what he/she had expected to pay.
  • In a market the total consumer surplus measures the gain to the society due to the existence of a market transaction.

3.5 Income effect and Engel curve, case of giffen goods

It was assumed that the income level of the consumer remains constant or unchanged in the consumer’s equilibrium analysis, given the prices of two goods X and Y. If the income level of the consumer changes (i.e. either increases or decreases), then there is the effect in the purchase decision, given the prices of the two good, and tastes & preferences of the consumer. This effect on the demand or purchasing decision is known as income effect. Income effect shows the total effect on demand for goods due to the change in income of the consumer, other things being equal.

Positive income effect: It shows the total effect on demand for normal goods due to change in the income level of the consumer, other things remain constant or unchanged. There is a positive relationship between normal goods and level of the income of the consumer.

In the figure, S is the initial equilibrium where two conditions for equilibrium are satisfied (a P1Q1 budget line is tangent to the I2 and I2 is convex to the origin). Here, he maximizes the level of satisfaction by consuming S combination which contains OB units of X goods and some units of Y goods. When the income of the consumer increases, at constant prices of two goods, budget constraints shifts rightwards from P1Q1 to P2Q2 and attains new equilibrium at T. This equilibrium shows that he consumes OC units of X good and some unit of Y good. Here, he increases his demand BC units of X good as well as some units of Y goods. Similarly, when the income of the consumer decreases, at constant prices of two goods, budget constraints shifts leftwards from P1Q1 to PQ and attains new equilibrium at R. This equilibrium shows that he consumes OA units of X goods and some unit of Y good. Here, he decreases his demand BA units of X goods as well as some units of Y goods.
By joining various consumer’s equilibrium points R, S, and T, we derive income consumption curve (ICC). It is the locus of various levels of consumer’s income. It slopes upward to the right tracing positive income effect.
With the help of consumer’s equilibrium point presented in the figure, we can derive income demand curve (or Engel curve). Suppose, OB units of X goods is demanded by the consumer when his income is OY2, according to the equilibrium point S. As his income increases to OY3, he or she demanded OC units of X goods. When his income decreases to OY, he or she decreases their demand to OA units of X goods. By plotting this information in the graph, we can derive income-demand curve. It slopes upwards to the right indicating that demand for the normal goods varies positively with income.
Negative income effect: Income effect for a good is supposed to be negative when with an increase in his income, the consumer reduces his consumption of the good. Such goods for which income effect is negative are called inferior goods. If the consumption of which falls as the income of the consumer rises, they are considered to be some way ‘inferior’ by the consumer. Therefore, he substitutes superior goods for them within his income rises. If there is an 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 become poor, they cannot 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 as well as high or better quality goods.
In the figure, E2 is the initial equilibrium where two conditions for equilibrium are satisfied (CD budget line is tangent to the IC2 and IC2 is convex to the origin). This equilibrium shows that he consumes ON2 units of Y good and OQ2 units of X good. When the income of the consumer increases, at constant prices of two goods, budget constraints shifts rightwards from CD to EF. EF budget line is tangent to the IC3 and attains new equilibrium at E3. This equilibrium shows that he consumes OQ3 units of X good and ON3 units of Y goods. Here, he increases his demand for normal goods by Q2Q3 units and reduces the demand for inferior good by N2 N1 units. Similarly, when the income of the consumer decreases or falls, at constant prices of two goods, budget constraints shifts leftwards from CD to AB. AB budget line is tangent to the IC1 and attains new equilibrium at E1. This equilibrium shows that he consumes OQ1 units of X good and ON1 units of Y goods. Here, he reduces his demand for normal goods by Q2Q1 units and increases the demand for inferior good by N2N3 units.
By joining various consumer’s equilibrium points E1, E2, and E3 we derive income consumption curve (ICC). It is the locus of various levels of consumer’s income. It slopes downwards to the right tracing negative income effect.
With the help of consumer’s equilibrium point presented in the figure, we can derive income demand curve (or Engel curve). According to the equilibrium point E2, ON2 units of Y goods is demanded by the consumer at the income level Y2. Similarly, according to the equilibrium point E1 and E3, ON1 and ON3 units of Y goods are demanded by the consumer at the income level N3 and N1 respectively. By presenting the above information in the piece of the graph paper, we derive income-demand curve for inferior goods which slopes downwards to the right. This slope indicates that demand for inferior goods varies inversely with income.
The Engel curve and Income elasticity of Demand
Since, Engel curve is the same as the income demand curves as it gives the quantity demanded of a commodity at various level of consumer’s income. Therefore, following relationship between Engel curve and income elasticity of demand can be observed.
  • If the good is normal luxurious, Engel curve slopes upwards to the right and ey is positive and greater than 1.
  • If the good is normal necessities, Engel curve slopes upwards to the right and ey is positive and less than 1.
  • If the good is an inferior, Engel curve slopes downwards to the right and ey is negative.

3.6 Income and Substitution Effects of a Price Change

A change in the price of a commodity alters the quantity demanded by consumer. This is known as price effect. However, this price effect comprises of two effects, namely substitution effect and income effect.

Substitution Effect
Let us consider a two-commodity model for simplicity. When the price of one commodity falls, the consumer substitutes the cheaper commodity for the costlier commodity. This is known as substitution effect.
Income Effect
Suppose the consumer’s money income is constant. Again, let us consider a two-commodity model for simplicity. Assume that the price of one commodity falls. This results in an increase in the consumer’s real income, which raises his purchasing power. Due to an increase in the real income, the consumer is now able to purchase more quantity of commodities. This is known as income effect.
Hence, according to our example, the decline in the price level leads to an increasing consumption. This occurs because of the price effect, which comprises income effect and substitution effect. Now, can you tell how much increase in consumption is due to income effect and how much increase in consumption is due to substitution effect? To answer this question, we need to separate the income effect and substitution effect.
How to separate the income effect and substitution effect?
Let us look at figure 1. Figure 1 shows that price effect (change in Px), which comprises substitution effect and income effect, leads to a change in quantity demanded (change in Qx).
The splitting of the price effect into the substitution and income effects can be done by holding the real income constant. When you hold the real income constant, you will be able to measure the change in quantity caused due to substitution effect. Hence, the remaining change in quantity represents the change due to income effect.
To keep the real income constant, there are mainly two methods suggested in economic literature:
  • The Hicksian Method
  • The Slutskian method

3.6.1 The Hicksian Method

Let us look at J.R. Hicks’ method of bifurcating income effect and substitution effect

In figure 2, the initial equilibrium of the consumer is E1, where indifference curve IC1 is tangent to the budget line AB1. At this equilibrium point, the consumer consumes E1X1 quantity of commodity Y and OX1 quantity of commodity X. Assume that the price of commodity X decreases (income and the price of other commodity remain constant). This result in the new budget line is AB2. Hence, the consumer moves to the new equilibrium point E3, where new budget line AB2 is tangent to IC2. Thus, there is an increase in the quantity demanded of commodity X from X1 to X2.
An increase in the quantity demanded of commodity X is caused by both income effect and substitution effect. Now we need to separate these two effects. In order to do so, we need to keep the real income constant i.e., eliminating the income effect to calculate substitution effect.
According to Hicksian method of eliminating income effect, we just reduce consumer’s money income (by way of taxation), so that the consumer remains on his original indifference curve IC1, keeping in view the fall in the price of commodity X. In figure 2, reduction in consumer’s money income is done by drawing a price line (A3B3)parallel to AB2. At the same time, the new parallel price line (A3B3) is tangent to indifference curve IC1 at point E2. Hence, the consumer’s equilibrium changes from E1 to E2. This means that an increase in quantity demanded of commodity X from X1 to X3 is purely because of the substitution effect.
We get the income effect by subtracting substitution effect (X1X3) from the total price effect (X1X2).
        Income effect = X1X2 – X1X3 = X3X2

3.6.2 The slutskian Method

Now let us look at Eugene Slutsky’s method of separating income effect and substitution effect. Figure 3 illustrates the Slutskian version of calculating income effect and substitution effect.

In figure 3, AB1 is the initial budget line. The consumer’s original equilibrium point (before price effect takes place) is E1, where indifference curve IC1 is tangent to the budget line AB1. Suppose the price of commodity X falls (price effect takes place) and other things remain the same. Now the consumer shifts to another equilibrium point E2, where indifference curve IC3 is tangent to the new budget line AB2. Consumer’s movement from equilibrium point E1 to E2 implies that consumer’s purchase of commodity X increases by X1X2. This is the total price effect caused by the decline in price of commodity X.
Now the task before us is to isolate the substitution effect. In order to do so, Slutsky attributes that the consumer’s money income should be reduced in such a way that he returns to his original equilibrium point E1 even after the price change. What we are doing here is that we make the consumer to purchase his original consumption bundle (i.e., OX1 quantity of commodity X and E1X1 quantity of commodity Y) at the new price level.
In figure 3, this is illustrated by drawing a new budget line A4B4, which passes through original equilibrium point E1 but is parallel to AB2. This means that we have reduced the consumer’s money income by AA4 or B4B2 to eliminate the income effect. Now the only possibility of price effect is the substitution effect. Because of this substitution effect, the consumer moves from equilibrium point E1 to E3, where indifference curve IC­2 is tangent to the budget line A4B4. In Slutsky version, the substitution effect leads the consumer to a higher indifference curve.
        Thus, income effect = X1X2 – X1X3 = X3X2