Differentiate between cardinal utility and ordinal utility;
Explain the concept of total utility, marginal utility and rule of consumer equilibrium;
Examine the concept of indifference curve and budget line, and consumer equilibrium;
Derive Engel curve and demand curve from income-consumption curve and price consumption curve; and
Distinguish between substitution effect and income effect caused by change in price.
INTRODUCTION
From Topic 1 to Topic 3, you have been exposed to the basics of market behaviour. Now you must be ready to make further analysis towards demand curves. The main question that will be answered in this topic is the factors that influence consumers to behave according to the Law of Demand. The theory of consumer behaviour is crucial in the market economy because producers who always compete with each other to attract consumers to buy their products need to know the motives underlying consumers’ demand.
The theory of consumer behaviour will further clarify the behaviour you have already known. You or anyone else, are consumers who normally have a sum of money at a certain point of time to be spent on any required goods or services. You have to decide on the type and amount of goods that you want to purchase, because you know that every purchase made will take up a part of your limited income. But at the same time, you are also aware of your preferences. In this topic, we will analyse the consumption motives, consumer behaviour and decision making process of consumers. 4.1 CHOICE AND UTILITY THEORY
Utility is the satisfaction gained by consumers from consumption of goods and services, or it can also be defined as the ability of a good to provide satisfaction to its consumer.
According to the theory of utility, consumers use a satisfaction level as the basis to make consumption choices and evaluate goods based on satisfaction. Basically, there are two approaches of utility theory analysis namely, the cardinal approach and ordinal approach. Through the cardinal approach, it is assumed that utility can be measured with util as the unit of measurement. For example, eating a piece of durian gives 2 utils, while eating a piece of rambutan will give 1 util.
Meanwhile, the ordinal approach, assumes that the level of satisfaction cannot be measured. For instance, eating durian gives more satisfaction compared to eating rambutan. In this condition, the measurement unit of satisfaction is not given. The level of satisfaction is determined by means of comparison only.
4.2 CARDINAL UTILITY THEORY
Cardinal utility theory is a method which assumes that satisfaction can be measured using the unit of “util”.
For instance, eating a piece of cake will give 8 utils, while eating biscuits will only give 4 utils. This reflects that a cake gives two-times the utility compared to biscuits. Utility level is normally reflected by the willingness of a person to pay based on the value of money. The higher the price willing to be paid, the higher the level of satisfaction gained.
ACTIVITY 4.1
Do you know who introduced the cardinal utility theory? It was introduced by Alfred Marshall. What are the assumptions or presumptions made based on this theory?
4.2.1 Total Utility and Marginal Utility
Total Utility (TU) is the total satisfaction gained from a given level of consumption of a good.
There are two basic concepts of utility, namely, total utility and marginal utility. Table 4.1 shows the relationship between the consumption of goods with total utility and marginal utility. Observe that total utility for the first unit is 10 utils. When consumption level is increased to 2 units, total utility increases to 22 utils, and so on.
Marginal utility (MU) is the increase in total utility when consumption increases by 1 unit.
As you already know, marginal is addition. The formula for marginal utility is as follows:
Therefore, marginal utility for the first unit is equivalent to the total utility of that unit. As we can see from Table 4.1, MU for the first unit is 10 utils while for the second unit is 12 or (22 – 10) utils and so on.
Table 4.1: Total Utility and Marginal Utility
Quantity (Q)
Total Utility (TU)
Marginal Utility (MU)
1
10
10
2
22
12
3
30
8
4
36
6
5
38
2
6
38
0
When we sum up marginal utility up to 5 consumption levels, we will obtain 38 utils, that is, equivalent to the total utility of the unit. Figure 4.1: Total utility and marginal utilityFigure 4.1 is the illustration of total utility and marginal utility derived from Table 4.1. Observe that marginal utility is equivalent to the gradient of total utility at each unit of consumption. Total utility reaches maximum when marginal utility is zero.
ACTIVITY 4.2
Discuss how total utility affects marginal utility.
If a good is free-of-charge, what will happen to the level of total utility and marginal utility? Explain your opinion.
4.2.2 The Law of Diminishing Marginal Utility
Before this, we defined marginal utility as an increase in satisfaction gained from the consumption of one additional unit of good. We have seen from Table 4.1 and Figure 4.1 that marginal utility shows a small increase in the beginning but later decreases until it reaches zero. This condition is referred to as diminishing marginal utility.
Law of diminishing marginal utility means that the marginal utility obtained from the consumption of additional units will start to decrease after a certain level of consumption when the amount consumed increases.
For example, when you are so thirsty after a game on a hot day, a glass of syrup water might give a certain amount of satisfaction. Since you are still thirsty, a second glass will give a higher satisfaction level than the first. But the third glass will give a decreasing additional satisfaction because you are becoming less thirsty. From Table 4.1, marginal utility starts to decrease by the consumption of the third unit. You might achieve a negative marginal utility when consumption no longer gives satisfaction but discomfort.
If we measure satisfaction in terms of ringgit, then the marginal utility, MUs, for a glass of syrup water is the sum of ringgit you are willing to pay to get that drink. Therefore, when the marginal utility decreases, your willingness to pay for an extra glass also decreases. If MU becomes negative, then somebody else will have to pay for you in order to encourage you to drink.
The concept of diminishing marginal utility gives the reason why individuals have various goods in their carts. The earlier economists explained about the negative gradient of demand curve based on the law of diminishing marginal utility, as what will be discussed in the following section.
ACTIVITY 4.3
Do you agree if it is said that satisfaction and consumption of a good will decrease after a certain level? Why? Explain.
4.2.3 Consumer Equilibrium
What is consumer equilibrium? As a rational consumer, you will maximise your satisfaction from consumption. However, through the definition of demand, we know that wants must be in balance with the ability to pay. Therefore, in maximising satisfaction, consumers are restricted by limited income and price of goods. Consumers’ objectives are achieved and consumers are said to have achieved consumer equilibrium when maximum utility can be attained with a certain sum of expenditure or income.
Consumption Equilibrium for One Good We will first look at consumption equilibrium of one good. If your income is limited, how can you maximise utility while utility is difficult to be measured? One way to gain maximum satisfaction from a limited income is by measuring util in monetary value. Hence, util is the value for consumption. Marginal utility becomes the sum of money willing to be paid to obtain one additional unit of good. If you are willing to pay RM1 for an additional cup of coffee, then the cup has MU = RM1. Here, when consumption only involves one type of good, consumer will maximise satisfaction when marginal utility from the consumption of the good is equivalent to price.
Satisfaction is maximised when price is equivalent to marginal utility because marginal utility indicates the willingness to pay. Therefore, if marginal utility obtained from the consumption of an additional unit is much higher than the price that needs to be paid, consumers will still be able to increase satisfaction with additional purchases.
In the example of the glass of syrup water mentioned before, assume that the first glass costs RM1, but since you are evaluating it at more than RM1, you are definitely willing to buy it. The same goes for the second glass. But for the third glass, if the price does not change at RM1, you will not want to buy it because the value you place for that glass is less than RM1.
This equilibrium concept actually describes why a demand curve has a negative gradient. Value or the willingness you dedicate for the following unit becomes lower when you obtain more units. Along the demand curve, marginal utility is equivalent to price (MU = P), where consumers are at an optimum condition.
Table 4.2: Utility and Price
Quantity X
Total Utility
Marginal Utility
Price (RM)
1
10
10
10
2
22
12
10
3
32
10
10
4
40
8
10
5
46
6
10
6
44
-2
10
Table 4.2 shows total utility, marginal utility and price for good X. From the table, consumers achieved equilibrium at the third unit, that is, when marginal utility is equivalent to price.
What if you can obtain the particular good free-of-charge? When a good is free-of-charge, there are no more budget constraints and you are not restricted by the willingness to pay. Therefore, you will use the good until total utility is maximised at the fifth unit. The sixth unit will not be considered because it decreases the total utility. If you purchase the sixth unit, you will feel uncomfortable or reluctant due to excessive consumption.
Consumer Equilibrium for Two Goods or More We have seen the behaviour of consumers when they deal with the problem of consuming one good. Now, let us look at consumers who have to divide a certain amount of expenditure between two or more goods.
Assume that you have a sum of income (I) to be divided for the purchase of food (X) and text books (Y). As a rational consumer, you will spend all the money to choose a combination where marginal utility per ringgit for both goods are the same, that is:
, where MU = marginal utility, P = price
If > , a rational consumer will increase consumption of good X because for every ringgit spent, consumer will obtain additional satisfaction (that is, marginal utility) that is bigger. At the same time, consumer will reduce the consumption of good Y. Increase in demand of good X will cause price X (PX) to increase and becomes smaller.
At the same time, becomes larger due to decline in demand of good Y.
This condition will prolong until . In this condition, consumer is not inclined to change the combination of goods.
On the other hand, if < , onsumer will increase the consumption of good Y, thus resulting in the increase of price Y (PY). At the same time, PX declines. This causes to become smaller and to become bigger. This will prolong until . Now we look at another example:
Table 4.3: Marginal Utility Per Ringgit
Quantity
MUX
MUX/PX
MUY
MUY/PY
1
30
15
20
10
2
29
14.5
19
9.5
3
28
14
18
9
4
26
13
16
8
5
24
12
14
7
6
22
11
12
6
7
20
10 *
10
5
8
18
9 *
8
4
9
16
8 *
5
2.5
(* Px and Py are RM2 respectively)
Table 4.3 shows the marginal utility (that is, MUx and MUy) and marginal utility per ringgit (that is, MUx / Px, and MUy / Py) obtained by a consumer for the consumption of two goods, that is, X and Y, when price X and Y are RM2 respectively (Px = 2, Py = 2). It is assumed that the consumer’s income of RM22 is only spent for these two goods.
The rule,
is achieved at the combination of (X,Y) = (7,1), (8,3) or (9,4).
However, selection must be made based on the total expenditure allocated, that is RM22. Hence, we will look at the total expenditure needed for the three combinations.
The consumer’s expenditure for the three combinations is:
A = (7,1) = (7 × 2) + (1 × 2) = 16 B = (8,3) = (8 × 2) + (3 × 2) = 22 C = (9,4) = (9 × 2) + (4 × 2) = 26
Since combination B meets the rule of expenditure, combination B is the equilibrium combination.
What if the consumer has to divide his income for consumption of more than two goods?
When consumption involves more than two goods, we still apply the same rule. To achieve equilibrium for 3 goods, namely X, Y, and Z, the rule is . If ‘n’ types of goods are consumed, equilibrium is achieved when
ACTIVITY 4.4
By using the approach of cardinal utility, explain clearly why the demand curve slopes downward from left to right.
4.3 ORDINAL UTILITY THEORY
According to the ordinal utility theory, the benefit or satisfaction gained by consumers cannot be measured in quantitative form, but in terms of comparison to the consumption of other goods.
Consumer behaviour in maximising satisfaction is depicted by an indifference curve. This approach also stresses on comparison with consumption of other goods to determine the level of satisfaction.
4.3.1 Choice and Priority
Do you know the difference between the meaning of “choice” and “priority”? If you do not, let us differentiate between choice and priority. Choice does not depend on price of goods or income. Choice might change but it is not based on the ability to pay. Even though you still cannot afford to own a big house or a luxury car, it does not mean that you cannot like both. You also will not find yourself liking something that you disliked before just because there is a change in your income level or the price of the good. Choice also shows our unlimited wants and needs because rational consumers will always choose something that is more compared to the least.
Priority is contrary to choice. Consumers may have their own choices or preferences, but out of the many choices that they have, consumers will have to choose only one which becomes their priority. Consumers will use the concept of priority when facing various choices and ability to pay. The simplest example will be the fees that you need to pay to take up this course.
4.3.2 Indifference Curve
When choice involves only two goods, that is, good X and good Y, an indifference curve will show various combinations of good X and good Y that can give equal satisfaction to the consumer.
Assume that you seek out the help of a friend to choose his preferred combination of the two combinations of good X and good Y.
Combination A = 2 units of X + 6 units of Y Combination B = 2 units of X + 4 units of Y
Your friend will definitely choose combination A because although the quantity of X is the same in both combinations, combination A has more of good Y. If we assume that combination A is chosen, then we know that any other combination with more of good X or Y or more of both goods, will definitely be preferred than combination A. On the other hand, combination with less of X or Y or less of both, will be less preferred compared to A. Figure 4.2 illustrates the choices. Figure 4.2: Indifference curveWhat if the choices involve combination C with 3 units of X and 5 units of Y? Even though the quantity of Y in combination C is less compared to combination A, quantity X is larger. Your friend may not be able to make a choice because he may feel that both combinations (A and C) can give equal satisfaction.
When you are able to identify all the combinations that can provide an equal level of satisfaction and connect those combinations together, then we will obtain an indifference curve. Furthermore, if you are able to identify other combinations that can give a higher or lower level of satisfaction and build the particular curve, then you have already formed an indifference map.
An indifference map consists of a series or groups of indifference curves showing various levels of satisfaction of consumers. The higher the indifference curve is from the origin, then the higher the level of satisfaction is. For example, curve U3 in Figure 4.3 gives a higher level of satisfaction compared to curve U2 and U1. The same goes for curve U1, the satisfaction gained is much higher than curve U2, but lower than curve U3. Figure 4.3: Indifference map
Assumptions The assumptions that we will use to ensure an accurate consumer analysis are:
Every combination of goods must be on the same indifference curve.
An indifference curve has a negative gradient because you must obtain more of good X if you give up a part of good Y to ensure satisfaction remains unchanged.
A higher indifference curve is preferred because it represents a bigger consumption cart.
It is not possible for an indifference curve to intersect, because if it does, it contravenes the assumption that consumers are rational. For a rational consumer, if A is more preferred than B, and if B is more preferred than C, then A is more preferred than C. According to Figure 4.4, we see that A > B, B = C, but A = C and A ≠ B. Hence, an indifference curve cannot intersect.
Figure 4.4: Indifference curve is non-crossingIndifference curves normally used in analyses are convex in shape. However, there are some exceptions. For example, for two goods that are perfect substitutes, the indifference curve is linear, as in Figure 4.5(a). A linear indifference curve indicates that the consumer does not mind whether he consumes only good X or good Y or any other combinations because both will give the same level of satisfaction. Figure 4.5: Indifference curves for perfect substitutes and perfect complementsFigure 4.5(b) shows the indifference curve for goods that are perfect complements. For example, if you already have a pair of shoes (at point A), an addition of the right pair of shoes (Y) only will not increase satisfaction (point B), because the complement is missing. Satisfaction will only be increased when you have both right and left pair of shoes (point D).
Diminishing Marginal Rate of Substitution The indifference curve we have seen in Figure 4.2 is non-linear, and convexes towards the origin. This shows that the gradient decreases when more good X are consumed. It is a normal form of indifference curve. Why is a normal indifference curve drawn in such a way? This is because most goods are not perfect substitutes or perfect complements.
Some goods cannot substitute the consumption of other goods. Some goods can be substituted but only up to a certain level. You might be able to substitute a glass of syrup water for a plate of rice if you have no rice at all, but if you already have two or three plates of rice and there are two glasses of syrup water left, you might not want to make any more substitution. In an indifference analysis, this imperfect substitution concept is referred to as marginal rate of substitution, and it changes according to consumption level.
What is marginal rate of substitution? When good Y is at the Y-axis and good X at the X-axis, gradient of the indifference curve is obtained from – (∆Y / ∆X).
Example: Gradient at point A
= – (∆Y/∆X) = = – 4
The gradient of the indifference curve (in example = – 4) is referred to as marginal rate of substitution of Y for X [MRSXY = – (∆Y/∆X)]. This gradient indicates the rate where the consumer is willing to give up Y to obtain an additional unit of X and utility remains unchanged. Since an indifference curve has a negative gradient, we will definitely obtain a negative value; however, the negative sign is ignored. We can see that as we move further downward (to the right), the gradient of the curve decreases. Therefore, the marginal rate of substitution also decreases. Try comparing the gradient at point A and point B in Figure 4.6. Figure 4.6: Marginal rate of substitutionThe diminishing marginal rate of substitution is related to the law of diminishing marginal utility that we have discussed earlier. Individuals will obtain diminishing satisfaction from every addition of consumption units. Therefore, when we move downward along the indifference curve, consumption of X increases while consumption of Y decreases, hence, the marginal utility of X decreases and marginal utility of Y increases. Willingness to give up Y for every additional unit of X becomes lesser and MRSXY will decrease further. In short, MRS depends on the consumption level of consumers, whereby the lower the rate of good consumption, the harder it is to be substituted with other goods.
Let us look back at Figure 4.6. Consumption at point A gives equal satisfaction with consumption at point B. Therefore, the drop in satisfaction caused by the 4 units decrease of Y must be balanced with the addition of satisfaction gained from one additional unit of X. Marginal utility from one additional unit of X must be 4 times bigger than the marginal utility of one unit of Y sacrificed (because consumer had given up 4 units of Y).
Hence,
SELF-CHECK 4.1
Through the ordinal approach, consumers are assumed to be rational. Have you ever bought goods in an irrational condition? If you have, describe why. What will happen to the indifference curve? Explain.
4.3.3 Budget Line
You have already seen various types of lines and curves, but what is a budget line? Budget line is important in an indifference analysis because it determines the actual choice that will be made by rational consumers. The indifference curve shows consumers’ priority while the budget line indicates budget constraints or ability to purchase.
Budget line is a curve that shows the combinations of two goods that can be purchased by consumer using a certain amount of income and based on the market price of the good.
Assume that you have an allocation of RM10 to be spent on good X and good Y where the price of X (Px) is RM1 and PY = RM2. The combination of consumption that you can afford to purchase is as shown in Table 4.4 and Figure 4.7.
Table 4.4: Combination of Budget
Combination
X
Y
A
10
0
B
8
1
C
6
2
D
4
3
E
2
4
F
0
5
Figure 4.7: Budget lineIf you spend all the money to purchase Y, you will obtain 5 units of Y; and you will obtain 10 units of X if you decide to spend all the money on X. You can also choose any of the combinations that satisfies the rule I = PxX + PyY, that is, income (I) is equivalent to total expenditure (PxX + PyY).
Effect of Change in Income Now assume that your income has increased from RM10 to RM20 and the price remains unchanged. The increase in your income will allow you to purchase the maximum amount of 10 units for Y and 20 units for X. Therefore, the budget line will shift in parallel with the initial line because the relative price (gradient of the curve) remains unchanged. Figure 4.8 illustrates two budget lines from two different tiers of income, RM10 and RM20, but the relative price is unchanged; RM1 for X, and RM2 for Y.
Figure 4.8: The effect of change in income
Effect of Change in Price Now we will look at the effect of price change on the budget lines. We are aware that along the budget line, income (I) is equivalent to total expenditure (PxX + PyY). Hence, budget line can be stated as the following equation:
I = PxX + PyY
When Y is placed at the Y-axis, the equation can be written as:
Therefore, the price ratio Px/P y is the gradient of the budget line. If either one of the price changes, the gradient of the curve will also change. Figure 4.9: The effect of price change on the budget lineAssume that initially, the price of X is RM1 and price of Y is RM2, and income is RM10, the budget line is the AA line in Figure 4.9(a). When the price of Y drops to RM1, the slope becomes steeper (AA’). This indicates that more Y can be bought with the available income.
The budget line intersects the Y-axis at 10 units of Y, but with no changes on the X-axis. If price X decreases instead, the curve will shift outside of the X-axis.
ACTIVITY 4.5
What will happen when the price of Y increases? You can make your own summary based on Figure 4.9(b). Present your answer during your tutorial.
4.3.4 Consumer Equilibrium
We know that the indifference curve depicts choice and priority, while the budget line shows the ability to pay. Choice and priority can only be achieved when there is affordability. Therefore, in order to obtain consumer equilibrium that maximises utility, we will combine the indifference curve with the budget line to determine the combination of goods that can be purchased within a certain amount of budget. Figure 4.10: Consumer equilibrium – maximisation of satisfactionFigure 4.10 illustrates the 4 levels of satisfaction represented by 4 indifference curves. According to the figure, consumers may definitely want to achieve a high indifference curve like U3. But this may not be achieveable due to budget constraints. Consumers can only choose between U1 or U2.
Consumers can choose combination A, but that point is not optimal since a downward movement along the budget line can still increase satisfaction. When point B is achieved, consumers have yet to achieve the optimal condition due to the same reason. Equilibrium is achieved at point E of curve U2 because after that point, total utility decreases.
Point E is the equilibrium point where the indifference curve is tangent with the budget line. Hence, both have the equal gradient or:
This rule is the same as the equimarginal principle that we obtained from the cardinal theory. Therefore, both approaches are the same in terms of marginal utility concept, only here, utility does not need to be calculated.
Point E is not the only equilibrium point present, because each point where the indifference curve is tangent with the budget line is considered as the equilibrium point that maximises satisfaction given income constraints and relative price of the good.
Another way to state the maximisation rule is . Meaning, the marginal rate of substitution of good Y to good X is the amount of ringgit that we are willing to exchange for one additional unit of good X. Hence, in order to maximise utility, consumer has to choose the combination of goods where the marginal rate of substitution is equivalent to the relative price. In short, this rule states that the willingness to substitute is equivalent to the ability to pay .
For example, MRS between a cake and a glass of syrup water is the number of slices of cake you are willing to give as a substitute for an additional glass of syrup water. The relative price indicates the number of slices of cake that you can give for a glass of syrup water. If what you are willing to do is equivalent to what you can do, hence you will achieve equilibrium. But if what you are willing to do is more than what you can or able to do, you will reduce your willingness, and vice-versa.
Income-consumption Curve and Engel Curve Now we will look at the income-consumption curve and Engel curve. We know that a change in income without any change in price will result in a parallel shift of the budget line. This will also cause the shift of the consumption equilibrium point. Each different tier of income will produce its own consumption equilibrium point. When we connect the equilibrium points of the various tiers of income, we will derive the income-consumption curve.
The shape of income-consumption curve illustrates two topics you have learned earlier, namely, the income elasticity of demand and types of goods. These two concepts can be seen more clearly using the Engel curve derived from the income-consumption curve.
Engel curve is a curve that illustrates the relationship between consumers’ income with the demand towards a particular type of good.
Figure 4.11 illustrates (a) income-consumption curve, and (b) Engel curve for normal goods. The Engel curve for normal goods has a positive gradient due to the positive relationship between income and demand quantity. To obtain an income-consumption curve as the one in Figure 4.11, both good X and Y should be normal goods and the Engel curve derived is the Engel curve for good X. Figure 4.11: Income-consumption curve and Engel curve for normal goodsContrarily, Figure 4.12 shows the Engel curve with a negative gradient for inferior goods. In the diagram, good X is an inferior good and good Y is a luxury good.
Good X is an inferior good because when income increases, consumption of X will decrease. Conversely, good Y is a luxury good because an increase in income will increase the consumption of Y. The Engel curve we have drawn in Figure 4.12(b) is the Engel curve for good X.
SELF-CHECK 4.2
Now, try to draw the income-consumption curve and Engel curve for good X if good X is a necessity. If you place good X at the X-axis, what are the assumptions needed for good Y?
Figure 4.12: Income-consumption curve and Engel curve for inferior good
Price-Consumption Curve and Demand Curve We know that if the price of either goods change, the budget line will revolve at the axis that represents the good with the change of price. If price of X decreases, the budget line will revolve outside the X-axis. Consumer equilibrium will also shift to the new budget line. Figure 4.13 illustrates a series of budget lines revolving at the X-axis. Each budget line represents the different tiers of price. Consumer’s income and price of Y is constant. When the budget line revolves, the equilibrium point will also shift. When we connect the equilibrium points, we have derived a price-consumption curve.
Price-consumption curve shows the change in consumer equilibrium when there is a change in price.
Therefore, we can use this curve to derive an individual demand curve and also to calculate price elasticity of demand. To further clarify on how a demand curve is derived from the price-consumption curve, let us look at the example below. Figure 4.13: Price-consumption curve and demand curveAssume that you have RM20 to be spent on X and Y. Line B1 in Figure 4.13(a) is your budget line when Y is priced at RM2 per unit and X priced at RM1 per unit. Assume point E1 as your equilibrium point and the quantity Y1 and X1 is your optimal consumption combination.
Other budget lines are drawn based on different prices of X, that is, curve B2 for X priced at RM2.50, B3 for X priced at RM3, and curve B4 when X is priced at RM4. Each price level will produce different equilibrium combinations and consumption quantity of X at each price level as shown by X1, X2, X3 and X4. When we connect all the equilibrium points, we have produced a price-consumption curve. When we relate the level of price X with equilibrium quantity X, we will find that a demand curve is produced, as shown by Figure 4.13(b).
Since demand curve is derived from price-consumption curve, satisfaction level will change along the demand curve; lower price will result in higher satisfaction, that is, satisfaction increases from U1 when X is priced at RM4, to U4 when X is priced at RM1.
4.3.5 Substitution Effect and Income Effect
We already know that when price increases, consumers will reduce consumption due to decreasing affordability. This effect is identified as the Income Effect, IE. Consumers will also reduce consumption because the good becomes more expensive compared to other goods and this is known as the Substitution Effect, SE.
Using the marginal utility theory, we have looked at how the effect of substitution causes movement along the curve for the good with price change, and the demand shift for other goods. Substitution effect occurs due to change in relative price. However, change in price will also cause a change in the actual income due to the increasing purchasing power of the consumer. Hence, a part of the curve shift can be caused by the effect of change in actual income. Through the utility theory, we cannot separate the two effects. However, using the indifference analysis, we will be able to separate the two effects.
Income effect is defined as change in quantity demanded due to the change in actual income or purchasing power.
Actual income or purchasing power depends on the quantity of goods able to be purchased by consumers. Assume that income, I = RM10; Px = RM1 and Py = RM2. Before the change in price of X, consumers consumed 2Y and 6X. If Px declines to 50 cents per unit, 2Y and 6X can be purchased at the price of RM7 only. This shows that there is an excess income of RM3 that can be used to add the quantity of X or Y, or both. This is referred to as increase in actual income or purchasing power.
Substitution effect is the change in quantity demanded due to change in relative price, where actual income or purchasing power remains unchanged.
Therefore, if price of X decreases (increases), the relative price of X decreases (increases) and consumers will increase (decrease) consumption of X, even when the actual income is unchanged.
The substitution effect is parallel with change in price, that is, when price increases, substitution effect will result in an increase in consumption, and vice-versa. Conversely, the relationship between income effect and price depends on the type of goods. For normal goods, increase in price will cause a negative income effect (decrease in consumption). For inferior goods, price increase will give a positive income effect (increase in consumption). Figure 4.14: Income effect and substitution effect for decrease in price of normal goodFigure 4.14 illustrates how we separate the two effects for normal goods. Assume B1 is the initial budget line and B2 is the new budget line when price X declines. To separate the income effect from the substitution effect, we must draw a shadow budget line that is parallel with B2 but touches the initial indifference curve (U1). Since it is parallel with B2, B1a shows the new price ratio, but touches U1 at the same time. This enables consumers to obtain utility equal to the initial utility. Therefore, B1and B1ashows the same actual income. Movement from a to b is merely due to the change in relative price and the remaining from b to c is due to the change in actual income.
In Figure 4.14, notice that both IE and SE causes an increase in consumption of good X when its price decreases. Now, observe the IE and SE for the price increase of good X as a normal good in Figure 4.15 and make a comparison. Figure 4.15: Income effect and substitution effect for increase in price of normal goodFigure 4.16 illustrates how we separate the two effects in the case of price decrease of X as an inferior good. Notice how we can obtain a positive SE but a negative IE. Figure 4.16: Income effect and substitution effect for decrease in price of inferior goodThen look at Figure 4.17 in the case of price increase of inferior good and make a comparison and draw a suitable conclusion. Figure 4.17: Income effect and substitution effect for increase in price of inferior good
SELF-CHECK 4.3
Let us test your knowledge by solving the crossword puzzle below.
_________ utility theory states that utility obtained by a consumer cannot be measured quantitatively but can be listed through an indifference curve.
A form of utility measurement.
The two important concepts of utility are _________ utility and marginal utility.
_________ line is the curve that shows the combination of two goods able to be purchased by consumers using a certain amount of income and based on the market price of the good.
_________ utility refers to addition or reduction in satisfaction due to the increase (decrease) in consumption of one unit of a particular good.
A convex _________ curve indicates a diminishing marginal rate of substitution.
Change in _________ will cause the budget line to shift in parallel with the initial budget line.
An indifference curve has a _________ gradient.
SUMMARY
An indifference curve is a curve that connects all the combinations of consumption that gives equal satisfaction.
Marginal rate of substitution is a rate where a good is to be substituted with another. Therefore, it indicates the gradient of the indifference curve.
A convex indifference curve shows a diminishing marginal rate of substitution. Diminishing marginal rate of substitution happens when the rate of willingness to substitute, changes with the total consumption.
A budget line is a line that connects the combinations of goods able to be purchased within an amount of expenditure.
The budget line shifts when total expenditure changes and revolves at the axis when there is a price change in either one of the goods.
Budget line represents the ability to purchase, while indifference curve represents preferences and priority.
Consumer equilibrium is achieved when a consumer gains maximum satisfaction from his spending, that is, when an indifference curve is tangent with the budget line.
Price-consumption curve is a curve that connects the consumer equilibrium when price of one of the goods changes.
Demand curve is derived from price-consumption curve.
An income-consumption curve is a curve that connects consumer equilibrium when income changes. An Engel curve is derived from the income-consumption curve.
When quantity demanded changes due to change in price, the change is caused by two effects, namely, the income effect and substitution effect.
Income effect is the change that is caused by the change in actual income, while substitution effect is caused by the change in relative price.
, where MU = marginal utility, P = price
> 
, a rational consumer will increase consumption of good X because for every ringgit spent, consumer will obtain additional satisfaction (that is, marginal utility) that is bigger. At the same time, consumer will reduce the consumption of good Y. Increase in demand of good X will cause price X (PX) to increase and 
. If ‘n’ types of goods are consumed, equilibrium is achieved when 
. Meaning, the marginal rate of substitution of good Y to good X is the amount of ringgit that we are willing to exchange for one additional unit of good X. Hence, in order to maximise utility, consumer has to choose the combination of goods where the marginal rate of substitution is equivalent to the relative price. In short, this rule states that the willingness to substitute 
is equivalent to the ability to pay 
.
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