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Unit-4: Ordinal Utility Theory: Indifference Curve Approach

Initially, consumer is in equilibrium point Q where budget line AB and indifference curve IC touch each Notes
other. The price line slopped to AC due to the price fall of apples. Consumer now in equilibrium on
point R where indifference curve IC and budget line AC touch each other. The movement from point Q
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to R represents the change of quantity from OL to OM. This is the price effect. So,

Price Effect = OM – OL = LM

Slutsky divides the substitution effect by taking
income units to AS to untouch the real income Some Important Points
of consumer. So the real income of consumer is (a) The negative substitution effect represents
unaffected on point Q. So the new budget line SS the relation of price of product and demanded
is drawn from point Q and parallel to line AC. The quantity of product as per theory of demand.
new budget line is touching indifference curve IC (b) The negative income effect represents the positive
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on point T which comes by lower money income and relation of price of product and demanded
stable real income. But the real income of consumer quantity of product as per theory of demand.
is stable. The consumer demands ON quantity of (c) The theory of demand does not apply when income
apples on point T, while initially he was demanded effect is more powerful than substitution effect
for quantity OL. The substitution effect for this is and this situation occurs with Giffen’s goods.
(ON – OL = LN). So,
Substitution Effect = ON – OL = LN
Income Effect = LM – LN = NM
Price Effect (LM) = Substitution Effect (LN) + Income Effect (NM)

4.26 How Slutsky’s Approach Differs from Hicks’ Approach

Both Hicks and Slutsky isolate the substitution effect from price effect by neutralizing income effect.
Both extract a part of money income from consumer to stabilize the real income of consumer. But there
are the differences in both of the principles.
As per Hicks, the part of money income from consumer should retain as he gets old level of satisfaction
from his income and stood on initial indifference curve. In this situation the drawn new budget line
touches the initial indifference curve.
As per Slutsky, the part of money income from consumer should retain as consumer stood on old
combination of the two goods.
In the words of Lipsey, “In Hicks’ approach, the income effect is removed by holding satisfaction
constant, while in Slutsky’s approach, it is removed by holding purchasing power constant.”
Figure 4.30 represents the differences between Slutsky’s and Hicks’ view. The consumer slopped from
point Q to point R if the price of apples falls. Price Effect = LM.
(i) Hicks draws a new budget line HH parallel to line AC. This touches the indifference curve IC
to point T. Hence the substitution effect would equal to LK on equilibrium point T.
(ii) Slutsky draws a new budget line SS parallel to line AC which crosses to Q and Q is old
equilibrium point of consumer.
HH: Hicks it touches the new budget line IC to point T. The substitution effect is LK.
SS: Hicks the new budget line of Slutsky crosses the initial equilibrium point Q. Hence, the substitution
effect is equal to LN on equilibrium point E.
It must be aware that the budget line SS drawn by Slutsky is upward and right-side from the Hicks’
budget line HH. This proves that as per Slutsky, the consumer is in equilibrium on point E where IC
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curve is touching the budget line SS.

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