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Unit-4: Ordinal Utility Theory: Indifference Curve Approach

on point E. When the income of consumer and the price of oranges are stable and the price of apple downs Notes
from 1.00 to 0.50, then there is a new price line AD. This AD price line touches the uppermost indifference
curve IC to point G. Point G is new equilibrium point. In another words, the demand of apples will increase
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from ON to OT, means the demand will increase by NT, which would be called Price Effect due to Fall
of Price. On the other hand, if the price of apple increases by 2.00 per unit with another thing remains
constant, then price line will go downward to AC. This indifference curve IC will touch new equilibrium
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point F. This shows that the demand of apple will decrease from ON to OM, means the demand will decrease
by MN which shows the price effect due to rise in the price. After mixing the various equilibrium points E,
F and G, the new curve is called Price Consumption Curve (PCC). The price effect consumption curve for
commodity X represents the points of the consumer’s equilibrium when only the price of X varies, the price
of Y and income of the consumer remain constant. In another word, Price Consumption Curve is a curve
which states that what changes will affect on consumer equilibrium if the consumer income and product
value do not change. There may be so many slopes of Price Consumption Curve. But the Price Consumption
Curve of Giffen products are backward slopped. But this is always not essential that it looks backward
sloping for lower grade products. More detail of Price Consumption Curve is given in next stage.

4.18 Income Effect

The income effect is effect to change the demand of quantity of a product which starts due to the
increasing of product’s price and the original income of consumer. We should assume the effect of
income effect from price effect that the price of product Y does not change in respect to the price of
product X. In other words, the comparison price remains constant.
This assumption is that the comparison price of product X and product Y remains constant proves when
two price lines are drawn in parallel because the slope of this line is equal and the slope of price line
presents the comparison price of product X and Y.

4.19 Substitution Effect

The meaning of substitution effect is the changes of the demand of a product, i.e, if price affects a
product and it costs more or less against another product. The cheap products are always substitution
for the costly products. To extract the substitution effect from the price effect, it should assume that the
real income of consumer always remains constant. If it does not do so then it would be very difficult
to get effect of substitution effect from income effect.

4.20 Identification of Substitution Effect and Income Effect of Splitting
Price Effect into Substitution Effect and Income Effect

The extraction of substitution effect and income effect from price effect has two approaches: (a) The
Hicksian Approach and (b) The Slutsky’s Approach.

4.21 The Hicksian Approach

1. Separation of Substitution Effect and Income Effect for Normal Goods

The general products are those products whose substitution effect is negative but income effect is
positive. Actually, the substitution effect is always positive. It means that demand of quantity of a

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