Total and marginal utility
gives you less additional satisfaction than the first
People buy goods and services because they get
satisfaction from them. Economists call this
satisfaction ‘utility’.
An important distinction must be made between
total utility and marginal utility.
Total utility (TU) is the total satisfaction a person
gains from all those units of a commodity
consumed within a given time period. Thus if
Tracey drank 10 cups of tea a day, her daily total
utility from tea would be the satisfaction derived
from those 10 cups.
Marginal utility (MU) is the additional
satisfaction gainedfrom consuming one extra unit
within a given period of time. Thus we might refer
to the marginal utility that Tracey gains from her
third cup of tea of the day or her eleventh cup.
A difficulty arises immediately with the utility
approach to explaining demand: how do you
measure utility? Utility is subjective. There is no
way of knowing what another person’s experiences
are really like. Just how satisfying does Brian find
his first cup of tea in the morning? How does his
utility compare with Tracey’s? We do not have
utility meters that can answer these questions!
For the moment, we will ignore this problem and
assume that a person’s utility can be measured in
utils, where a util is one unit of satisfaction.
Diminishing marginal utility
Up to a point, the more of a commodity you
consume, the greater will be your total utility.
However, as you become more satisfied, each extra
unit that you consume will probably give you less
additional utility than previous units. In other
words, your marginal utility falls, the more you
consume. This is known as the principle of
diminishing marginal utility.
The principle of diminishing marginal
utility.
The more of a product a person consumes, the
less will be the additional utility gained from one
more unit.
For example, the second cup of tea in the morning
cup. The third cup gives less satisfaction still.
At some level of consumption, your total utility
will be at a maximum. No extra satisfaction can be
gained by the consumption of further units within
that period of time. Thus marginal utility will be
zero. Your desire for tea may be fully satisfied at
12 cups per day. A thirteenth cup will yield no
extra utility. It may even give you displeasure (i.e.
negative marginal utility).
Total and marginal utility curves
If we could measure utility, we could construct a
table showing how much total and marginal utility
a person would gain at different levels of
consumption of a particular commodity. This
information could then be transferred to a graph.
Table 4.1 and Figure 4.1 do just this. They show
the imaginary utility that Darren gets from
consuming packets of crisps.
Referring first to the table, if Darren consumes no
crisps, he obviously gets no satisfaction from
crisps: his total utility is zero. If he now consumes
1 packet a day, he gets 7 utils of satisfaction. (Sorry
if this sounds silly, but we will tackle this question
of measurement later.) His total utility is 7, and his
marginal utility is also 7. They must be equal if
only 1 unit is consumed. If he now consumes a
second packet, he gains an extra 4 utils (MU),
giving him a total utility of 11 utils (i.e. 7 4).
His marginal utility has fallen because, having
already eaten 1 packet, he has less craving for a
second.
A third packet gives him less extra utility still:
marginal utility has fallen to 2 utils, giving a total
utility of 13 utils (i.e. 11 2).
By the time he has eaten 5 packets, he would rather
not eat any more. A sixth actually reduces his
utility (from 14 utils to 13): its marginal utility is
negative. The information in Table 4.1 is plotted in
Figure 4.1. Notice the following points about the
two curves:
• The MU curve slopes downwards. This is simply
illustrating the principle of diminishing marginal
utility.
• The TU curve starts at the origin. Zero
consumption yields zero utility.
• It reaches a peak when marginal utility is zero.
When marginal utility is zero (at 5 packets of
crisps), there is no addition to total utility. Total
utility must be at the maximum – the peak of the
curve.
• Marginal utility can be derived from the TU
curve. It is the slope of the line joining two adjacent
quantities on the curve. For example, the marginal
utility of the third packet of crisps is the slope of
the line joining points a and b. The slope of such a
line is given by the ∆formula:
In our example ∆TU 2 (total utility has risen from
11 to 13 utils), and ∆Q 1 (one more packet of
crisps has been consumed). Thus MU 2.
. one more unit of a good and what you are actually
The ceteris paribus assumption
The table and graph we have drawn are based on
the assumption that other things do not change. In
practice, other things do change – and frequently.
The utility that Darren gets from crisps depends on
what else he eats. If on Saturday he has a lot to eat,
and nibbles snacks (other than crisps) between
meals, he will get little satisfaction from crisps. If
on Monday, however, he is too busy to eat proper
meals, he would probably welcome one or more
packets of crisps.
Each time the consumption of other goods changed
– whether substitutes or complements – a new
utility schedule would have to be drawn up. The
curves would shift. Remember, utility is not a
property of the goods themselves. Utility is in the
mind of the consumer, and consumers change their
minds. Their tastes change; their circumstances
change; their consumption patterns change.
The optimum level of consumption:
the simplest case – one commodity
Just how much of a good should people consume if
they are to make the best use of their limited
income? To answer this question we must tackle
the problem of how to measure utility, given that in
practice we cannot measure ‘utils’.
One solution to the problem is to measure utility
with money. In this case, utility becomes the value
that people place on their consumption. Marginal
utility thus becomes the amount of money a person
would be prepared to pay to obtain one more unit:
in other words, what that extra unit is worth to that
person. If Darren is prepared to pay 25p to obtain
an extra packet of crisps, then we can say that
packet yields him 25p worth of utility: MU 25p.
So how many packets should he consume if he is to
act rationally? To answer this we need to introduce
the concept of consumer surplus.
Marginal consumer surplus
Marginal consumer surplus (MCS) is the
difference between what you are willing to pay for
charged. If Darren were willing to pay 25p for
another packet of crisps which in fact only cost him
20p, he would be getting a marginal consumer
surplus of 5p. MCS MU – P
Total consumer surplus
Total consumer surplus (TCS) is the sum of all
themarginal consumer surpluses that you have
obtained from all the units of a good you have
consumed. It is the difference between the total
utility from all the units and your expenditure on
them. If Darren consumes four packets of crisps,
and if he would have been prepared to spend £1.20
on them and only had to spend 80p, then his total
consumer surplus is 40p.
TCS TU – TE where TE is the total expenditure
on a good: i.e. P Q.
Let us define rational consumer behaviour as the
attempt to maximise consumer surplus. How do
people set about doing this?
People will go on purchasing additional units as
long as they gain additional consumer surplus: in
other words, as long as the price they are prepared
to pay exceeds the price they are charged (MU
P). But as more units are purchased, so they will
experience diminishing marginal utility. They will
be prepared to pay less and less for each additional
unit. Their marginal utility will go on falling until
MU P: i.e. until no further consumer surplus can
be gained. At that point, they will stop purchasing
additional units. Their optimum level of
consumption has been reached: consumer surplus
has been maximised. If they continue to purchase
beyond this point, MU would be less than P, and
thus they would be paying more for the last units
than they were worth to them.
The process of maximising consumer surplus can
be shown graphically. Let us take the case of Tina’s
annual purchases of petrol. Tina has her own car,
but as an alternative she can use public transport or
walk. To keep the analysis simple, let us assume
that Tina’s parents bought her the car and pay the
licence duty, and that Tina does not have the option
of selling the car. She does, however, have to buy
the petrol. The current price is 80p per litre.
Figure 4.2 shows her consumer surplus.
If she were to use just a few litres per year, she
would use them for very important journeys for
which no convenient alternative exists. For such
trips she may be prepared to pay up to £1.10 per
litre. For the first few litres, then, she is getting a
marginal utility of around £1.10 per litre, and hence
a marginal consumer surplus of around 30p (i.e.
£1.10 – 80p).
By the time her annual purchase is around 250
litres, she would be prepared to pay only around £1
for additional litres. The additional journeys,
although still important, would be less vital.
Perhaps these are journeys where she could have
taken public transport, albeit at some
inconvenience.
Her marginal consumer surplus at 250 litres is 20p
(i.e. £1.00p – 80p). Gradually, additional litres give
less and less additional utility as less and less
important journeys are undertaken. The 500th litre
yields 91p worth of extra utility. Marginal
consumer surplus is now 11p (i.e. 91p – 80p).
By the time she gets to the 900th litre, Tina’s
marginal utility has fallen to 80p. There is no
additional consumer surplus to be gained. Her total
consumer surplus is at a maximum. She thus buys
900 litres, where P MU.
Her total consumer surplus is the sum of all the
marginal consumer surpluses: the sum of all the
900 vertical lines between the price and the MU
curve. This is shown by the total area between P
and MU up to 900 litres (i.e. the pink shaded area in
Figure 4.2).
This analysis can be expressed in general terms. In
Figure 4.3, if the price of a commodity is P1, the
consumer will consume Q1. The person’s total
expenditure (TE) is P1Q1, shown by area 1. Total
utility (TU) is the area under the
marginal utility curve: i.e. areas 1 2. Total
consumer surplus (TU – TE) is shown by area 2.
Marginal utility and the demand
curve for a good
An individual’s demand curve
Individual people’s demand curve for any good will
be the same as their marginal utility curve for that
good, where utility is measured in money.
This is demonstrated in Figure 4.4, which shows
the marginal utility curve for a particular person
and a particular good. If the price of the good were
P1, the person would consume Q1: where MU P.
Thus point a would be one point on that person’s
demand curve. If the price fell to P2, consumption
would rise to Q2, since this is where MU P2.
Thus point b is a second point on the demand
curve. Likewise if price fell to P3, Q3 would be
consumed. Point c is a third point on the demand
curve. Thus as long as individuals seek to maximise
consumer surplus and hence consume where P
MU, their demand curve will be along the same
line as their marginal utility curve.
The market demand curve
The market demand curve will simply be the
(horizontal) sum of all individuals’ demand curves
and hence MU curves.
The shape of the demand curve.
The price elasticity of demand will reflect the rate
at which MU diminishes. If there are close
substitutes for a good, it is likely to have an elastic
demand, and its MU will diminish slowly as
consumption increases. The reason is that increased
consumption of this product will be accompanied
by decreased consumptionof the alternative
product(s). Since total consumption of this product
plus the alternatives has increased only slightly (if
at all), the marginal utility will fall only slowly.
For example, the demand for a certain brand of
petrol is likely to have a fairly high price elasticity,
since other brands are substitutes. If there is a cut in
the price of Texaco petrol (assuming the prices of
other brands stay constant), consumption of Texaco
will increase a lot. The MU of Texaco petrol will
fall slowly, since people consume less of other
brands. Petrol consumption in total may be only
slightly greater, and hence the MU of petrol only
slightly lower.
Shifts in the demand curve.
How do shifts in demand relate to marginal utility?
For example, how would the marginal utility of
(and hence demand for) margarine be affected by a
rise in the price of butter? The higher price of
butter would cause less butter to be consumed. This
would increase the marginal utility of margarine,
since if people are using less butter, their desire for
margarine is higher. The MU curve (and hence the
demand curve) for margarine thus shifts to the
right.
Weaknesses of the one-commodity
version of marginal utility theory

A change in the consumption of one good will
affect the marginal utility of substitute and
complementary goods.
It will also affect the amount of income left over to
be spent on other goods. Thus a more satisfactory
explanation of demand would involve an analysis
of choices between goods, rather than looking at
one good in isolation.
What is more, deriving a demand curve from a
marginal utility curve measured in money assumes
that money itself has a constant marginal utility.
The trouble is that it does not. If people have a rise
in income, they will consume more. Other things
being equal, the marginal utility of the goods that
they consume will diminish. Thus an extra £1 of
consumption will bring less satisfaction than
previously. In other words, it is likely that the
marginal utility of money diminishes as income
rises.
Unless a good occupies only a tiny fraction of
people’s expenditure, a fall in its price will mean
that their real income has increased: i.e. they can
afford to purchase more goods in general. As they
do so, the marginal utility of their money will fall.
We cannot, therefore, legitimately use money to
measure utility in an absolute sense. We can,
however, still talk about the relative utility that we
get from various goods for a given increase in
expenditure. The following sections thus look at the
choice between goods, and how it relates to
marginal utility.
The optimum combination of goods
consumed
We can use marginal utility analysis to show how a
rational person decides what combination of goods
to buy. Given that we have limited incomes, we
have to make choices. It is not just a question of
choosing between two obvious substitutes (like
carrots and peas or a holiday in Greece and
one in Spain), but about allocating our incomes
between all the goods and services we might like to
consume. If you have, say, an income of £10 000
per year, what is the optimum ‘bundle’ of goods
and services for you to spend it on?
The rule for rational consumer behaviour is known
as the equi-marginal principle. This states that a
consumer will get the highest utility from a given
level of income when the ratio of the marginal
utilities is equal to the ratio of the prices.
Algebraically, this is when, for any pair of
goods, A and B, that are consumed:
To see the sense of this, say that the last unit of
good A you consumed gave three times as much
utility as the last unit of B. Yet good A only cost
twice as much as good B. You would obviously
gain by increasing your consumption of A and
cutting your purchases of B. But as you switched B
to A, the marginal utility of A would fall due to
diminishing marginal utility, and conversely the
marginal utility of B would rise. To maximise
utility you would continue this substitution of A for
B until the ratios of the marginal utilities
(MUA/MUB ) equalled the ratio of the prices of the
two goods (PA/PB). At this point, no further gain
can be made by switching from one good to
another. This is the optimum combination of goods
to consume.
Equation (1) is a specific example of the general
equimarginal principle in economics, which applies
to all rational choices between two alternatives,
whether in production, consumption, employment
or whatever:
The multi-commodity version of
marginal utility and the demand
curve
How can we derive a demand curve from the above
analysis? Let us simply reinterpret equation (1) so
that it relates the MU and P of good A to the MU
and P of any other good. In other words, the
equation would be the same for goods B, C, D, E
and any other good. For any given income, and
given prices for good A and all other goods, the
quantity a person will demand of good A will be
that which satisfies equation (1). One point on the
individual’s demand curve for good A has been
determined. If the price of good A now falls, such
that:
 this choice of (a) a change in the consumer’s
income and (b) a change in the price of one or both
goods. It can also be used to analyse the income
the person would buy more of good A and less of and substitution effects of a change in price.
all other goods (B, C, D, E, etc.), until equation (1) Indifference analysis involves the use of
is once more satisfied. A second point on the indifference curves and budget lines.
individual’s demand curve for good A has been
determined. Further changes in the price of good A
would bring further changes in the quantity
demanded, in order to satisfy equation (1). Further
points on the individual’s demand curve would
thereby be derived.
If the price of another good changed, or if the
marginal utility of any good changed (including
good A), then again the quantity demanded of good
A (and other goods) would change, until again
equation (1) were satisfied. These changes in
demand will be represented by a shift in the
demand curve for good A.

The limitations of the marginal

utility approach to demand
Even though the multi-commodity version of
marginal utility theory is useful in demonstrating
the underlying logic of consumer choice, it still has
a major weakness.
Utility cannot be measured in any absolute sense.
We cannot really say, therefore, by how much the
marginal utility of one good exceeds another.
An alternative approach is to use indifference
analysis. This does not involve measuring the
amount of utility a person gains, but merely
ranking various combinations of goods in order of
preference. In other words, it assumes that
consumers can decide whether they prefer one
combination of goods to another. For example, if
you were asked to choose between two baskets of
fruit, one containing 4 oranges and 3 pears and the
other containing 2 oranges and 5 pears, you could
say which you prefer or whether you are indifferent
between them. It does not assume that you can
decide just how much you prefer one basket to
another or just how much you like either.
The aim of indifference analysis, then, is to
analyse, without having to measure utility, how a
rational consumer chooses between two goods. As
we shall see, it can be used to show the effect on

Indifference curves
An indifference curve shows all the various
combinations of two goods that give an equal
amount of satisfaction or utility to a consumer. To
show how one can be constructed, consider the
following example.
Imagine that a supermarket is conducting a survey
about the preferences of its customers for different
types of fruit. One of the respondents is Clive, a
student who likes a healthy diet and regularly buys
fresh fruit. He is asked his views about various
combinations of oranges and pears. Starting with
the combination of 10 pears and 13 oranges, he is
asked what other combinations he would like the
same as this one. From his answers a table is
constructed (Table 4.2). What we are saying here is
that Clive would be equally happy to have any one
of the combinations shown in the table.
This table is known as an indifference set. It shows
alternative combinations of two goods that yield the
same level of satisfaction.
From this we can plot an indifference curve. We
measure units of one good on one axis and units of
the other good on the other axis. Thus in Figure
4.6, which is based on Table 4.2, pears and oranges
are measured on the two axes. The curve shows
that Clive is indifferent as to whether he consumes
30 pears and 6 oranges (point a) or 24 pears and 7
oranges (point b) or any other combination of pears
and oranges along the curve. Notice that we are not
saying how much Clive likes pears and oranges,
merely that he likes all the combinations along the
indifference curve the same amount. All the
combinations thus yield the same (unspecified)
utility.
The shape of the indifference curve
As you can see, the indifference curve we have
drawn is not a straight line. It is bowed in towards
the origin. In other words, its slope gets shallower
as we move down the curve. Indifference curves
are normally drawn this shape. But why?
Let us see what the slope of the curve shows us. It
shows the rate at which the consumer is willing to
exchange one good for the other, holding his or her
level of satisfaction the same. For example,
consider the move from point a to point b in Figure
4.6. Clive gives up 6 units of pears and requires 1
orange to compensate for the loss. The slope of the
indifference curve is thus −6/1 −6. Ignoring the
negative sign, the slope of the indifference curve
(that is, the rate at which the consumer is willing to
substitute one good for the other) is known as the
marginal rate of substitution(MRS).
In this case, therefore, the MRS 6. Note that as we
move down the curve, the marginal rate of
substitution diminishes as the slope of the curve
gets less. For example, look at the move from point
e to point f. Here the consumer gives up 2 pears and
requires 2 oranges to compensate. Thus along this
section of the curve, the slope is −2/2 −1 (and
hence the MRS 1).
The reason for a diminishing marginal rate of
substitution is related to the principle of
diminishing marginal utility that we looked at in
section 4.1. This stated that individuals will gain
less and less additional satisfaction the more of a
good that they consume. This principle, however, is
based on the assumption that the consumption of
other goods is held constant. In the case of an
indifference curve, this is not true. As we move
down the curve, more of one good is consumed but
less of the other. Nevertheless the effect on
consumer satisfaction is similar. As Clive
consumes more pears and fewer oranges, his
marginal utility from pears will diminish, while that
from oranges will increase. He will thus be
prepared to give up fewer and fewer pears for each
additional orange. MRS diminishes.
The relationship between the
marginal rate of substitution and
marginal utility
In Figure 4.6, consumption at point a yields equal
satisfaction with consumption at point b. Thus the
utility sacrificed by giving up 6 pears must be equal
to the utility gained by consuming one more
orange. In other words, the marginal utility of an
orange must be six times as great as that of a pear.
Therefore, MUoranges /MUpears 6. But this is
the same as the marginal rate of substitution. With
X measured on the horizontal axis and Y on the
vertical axis, then:
An indifference map
More than one indifference curve can be drawn.
For example, referring back to Table 4.2, Clive
could give another set of combinations of pears and
oranges that all give him a higher (but equal) level
of utility than the set shown in the table. This could
then be plotted in Figure 4.6 as another indifference
curve.
Although the actual amount of utility
corresponding to each curve is not specified,
indifference curves further out to the right would
show combinations of the two goods that yield a
higher utility, and curves further in to the left
would show combinations yielding a lower utility.
In fact, a whole indifference map can be drawn,
with each successive indifference curve showing a
higher level of utility. Combinations of goods along
I2 in Figure 4.7 give a higher utility to the
consumer than those along I1. Those along I3 give
a higher utility than those along I2, and so on.
The term ‘map’ is appropriate here, because the
indifference curves are rather like contours on a
real map. Just as a contour joins all those points of
a particular height, so an indifference curve shows
all those combinations yielding a particular level of
utility.
The budget line
We turn now to the budget line. This is the other
important element in the analysis of consumer
behaviour. Whereas indifference maps illustrate
people’s preferences, the actual choices they make
will depend on their incomes.
The budget line shows what combinations of two
goods you are able to buy, given (a) your income
available to spend on them and (b) their prices.
Just as we did with an indifference curve, we can
construct a budget line from a table. The first two
columns of Table 4.3 show various combinations of
two goods X and Y that can be purchased assuming
that (a) the price of X is £2 and the price of Y is £1
and (b) the consumer has a budget of £30 to be
divided between the two goods.
In Figure 4.8, then, if you are limited to a budget of
£30, you can consume any combination of X and Y
along the line (or inside it). You cannot, however,
afford to buy combinations that lie outside it: i.e. in
the darker shaded area. This area is known as the
infeasible region for the given budget.
We have said that the amount people can afford to
buy will depend on (a) their budget and (b) the
prices of the two goods. We can show how a
change in either of these two determinants will
affect the budget line.
A change in income
If the consumer’s income (and hence budget)
increases, the budget line will shift outwards,
parallel to the old one. This is illustrated in the last
two columns of Table 4.3 and in Figure 4.9, which
show the effect of a rise in the consumer’s budget
from £30 to £40. (Note that there is no change in
the prices of X and Y, which remain at £2 and £1
respectively.) More can now be purchased. For
example, if the consumer was originally purchasing
7 units of X and 16 units of Y (point m), this could
be increased with the new budget of £40, to 10
units of X and 20 units of Y (point n) or any other
combination of X and Y along the new higher
budget line.
The relative prices of the two goods are given by
the slope of the budget line. The slope of the budget
line in Figure 4.8 is 30/15 2. (We are ignoring the
negative sign: strictly speaking, the slope should be
the same. Similarly, the slope of the new higher
budget line in Figure 4.9 is 40/20 2. But in each
case this is simply the ratio of the price of X (£2) to
the price of Y (£1). Thus the slope of the budget
line equals PX/PY.
A change in price
If the price of either good changes, the slope of the
budget line will change. This is illustrated in Figure
4.10 which, like Figure 4.8, assumes a budget of
£30 and an initial price of X of £2 and a price of Y
of £1. The initial budget line is B1.
Now let us assume that the price of X falls to £1
but that the price of Y remains the same (£1). The
new budget line will join 30 on the Y axis with 30
on the X axis. In other words, the line pivots
outwards on point a. If, instead, the price of Y
changed, the line would pivot on point b.
The optimum consumption point
We are now in a position to put the two elements of
the analysis together: the indifference map and a
budget line.
 has been no need to measure utility. All we have
needed to do is to observe, for any two
combinations of goods, whether the consumer
preferred one to the other or was indifferent
between them.

The effect of changes in income

As we have seen, an increase in income is
represented by a parallel shift outwards of the
budget line (assuming no change in the price of X
and Y). This will then lead to a new optimum
consumption point on a higher indifference curve.
A different consumption point will be found for
each different level of income.
This will enable us to show how much of each of In Figure 4.12 a series of budget lines are drawn
the two goods the ‘rational’ consumer will buy representing different levels of consumer income.
from a given budget. The corresponding optimum consumption points (r,
Let us examine Figure 4.11. The consumer would s, t, u) are shown. Each point is where the new
like to consume along the highest possible higher budget line just touches the highest possible
indifference curve. This is curve I3 at point t. indifference curve.1
Higher indifference curves, such as I4 and I5,
although representing higher utility than curve I3,
are in the infeasible region: they represent
combinations of X and Y that cannot be afforded
with the current budget. The consumer could
consume along curves I1 and I2, between points r
and v, and s and u respectively, but they give a
lower level of utility than consuming at point t.
The optimum consumption point for the consumer,
then, is where the budget line touches (is
‘tangential to’) the highest possible indifference
curve. At any other point along the budget line, the
consumer would get a lower level of utility.
If the budget line is tangential to an indifference
curve, they will have the same slope. (The slope of
a curve is the slope of the tangent to it at the point
in question.) But as we have seen: The line joining these points is known as the
income– consumption curve.
If your money income goes up and the price of
goods does not change, we say that your real
income has risen. In other words, you can buy more
than you did before. But your real income can also
rise even if you do not earn any more money. This
will happen if prices fall. For the same amount of
money, you can buy more goods than previously.
But this is the equi-marginal principle that we
We analyse the effect of a rise in real income
established in the first part of this chapter: only this
caused by a fall in prices in just the same way as
time, using the indifference curve approach, there
we did when money income rose and prices stayed
the same. Provided the relative prices of the two
goods stay the same (i.e. provided they fall by the
same percentage), the budget line will shift
outwards parallel to the old one.
Income elasticity of demand and the
income–consumption curve
The income–consumption curve in Figure 4.12
shows that the demand for both goods rises as
income rises. Thus both goods have a positive
income elasticity of demand: they are both normal
goods.
Now let us focus just on good X. If the income–
consumption curve became flatter at higher levels
of income, it would show an increasing proportion
of income being spent on X. The flatter it became,
the higher would be the income elasticity of
demand for X.
If, by contrast, X were an inferior good, such as
cheap margarine, its demand would fall as income
rose; its income elasticity of demand would be
negative. This is illustrated in Figure 4.13. Point b
is to the left of point a, showing that at the higher
income B2, less X is purchased.
The effect of changes in price
If either X or Y changes in price, the budget line
will ‘pivot’. Take the case of a reduction in the
price of X (but no change in the price of Y). If this
happens, the budget line will swing outwards. We
saw this effect in Figure 4.10 (on page 108).
These same budget lines are reproduced in Figure
4.14, but this time we have added indifference
curves. The old optimum consumption point was at
j. After the reduction in the price of good X, a new
optimum consumption point is found at k.
A series of budget lines could be drawn, all
pivoting round point a in Figure 4.14. Each one
represents a different price of good X, but with
money income and the price of Y held constant.
The flatter the curve, the lower the price of X. At
each price, there will be an optimum consumption
part of the diagram corresponds to one of the four
points on the price–consumption curve. (Note that
P2 is half of P1, P3 is one-third of P1 and P4 is
one-quarter of P1.)
point. The line that connects these points is known
as the price–consumption curve.
Deriving the individual’s demand
curve
We can use the analysis of price changes to show
how in theory a person’s demand curve for a
product can be derived. To do this we need to
modify the diagram slightly.
Let us assume that we want to derive a person’s
demand curve for good X. What we need to show is
the effect on the consumption of X of a change in
the price of X assuming the prices of all other
goods are held constant. To do this we need to
redefine good Y. Instead of being a single good, Y
becomes the total of all other goods. But what units
are we to put on the vertical axis? Each of these
other goods will be in different units: litres of
petrol, loaves of bread, kilograms of cheese,
numbers of haircuts, etc. We cannot add them all
up unless we first convert them to a common unit.
The answer is to measure them as the total amount
of money spent on them: i.e. what is not spent on
good X.
With expenditure on all other goods plotted on the
vertical axis and with income, tastes and the price
of all other goods held constant, we can now derive
the demand curve for X. This is demonstrated in
Figure 4.15.
We illustrate the changes in the price of X by
pivoting the budget line on the point where it
intersects the vertical axis. It is then possible, by
drawing a price–consumption line, to show the
amount of X demanded at each price. It is then a
simple matter of transferring these price–quantity
relationships on to a demand curve. In Figure 4.15,
each of the points a, b, c and d on the demand
curve in the lower
part of the diagram corresponds to one of the four
points on the price–consumption curve. (Note that
P2 is half of P1, P3 is one-third of P1 and P4 is
one-quarter of P1.)
The income and substitution effects
of a price change
In Chapter 2 we argued that when the price of a
good rises, consumers will purchase less of it for
two reasons:
• They cannot afford to buy so much. This is the
income effect.
• The good is now more expensive relative to other
goods. Therefore consumers substitute alternatives
for it. This is the substitution effect.
We can extend our arguments of Chapter 2 by
demonstrating the income and substitution effects
with the use of indifference analysis. Let us start
with the case of a normal good and show what
happens when its price changes.
A normal good
In Figure 4.16 the price of normal good X has risen
and the budget line has pivoted inwards from B1 to
B2. The consumption point has moved from point f
to point h. Part of this shift in consumption is due
to the substitution effect and part is due to the
income effect.
The substitution effect. To separate these two
effects a new budget line is drawn, parallel to B2
but tangential to the original indifference curve I1.
This is the line B1a. Being parallel to B2, it
represents the new price ratio (i.e. the higher price
of X). Being tangential to I1, however, it enables
the consumer to obtain the same utility as before: in
other words, there is no loss in real income to the
consumer. By focusing on B1a, then, which
represents no change in real income, we have
excluded the income effect.
The movement from point f to point g is due purely
to a change in the relative prices of X and Y. The
movement from QX1 to QX2 is the substitution
effect.
The income effect. In reality, the budget line has
shifted to B2 and the consumer is forced to
consume on a lower indifference curve I2: real
income has fallen. Thus the movement from QX2
to QX3 is the income effect.
In the case of a normal good, therefore, the income
and substitution effects of a price change reinforce
each other. They are both negative: they both
involve a reduction in the quantity demanded as
price rises (and vice versa). The bigger the income
and substitution effects, the higher will be the price
elasticity of demand for good X.
An inferior good
As we saw above, when people’s incomes rise, they
will buy less of inferior goods such as poor-quality
margarine and cheap powdered instant coffee, since
they will now be able to afford better-quality goods
instead. Conversely, when income falls, they will
now have to reduce their living standards: their
consumption of inferior goods will thus rise.
The substitution effect. If the price of an
inferior good (good X) rises, the substitution effect
will be in the same direction as for a normal good:
i.e. it will be negative. People will consume less X
relative to Y, since X is now more expensive
relative to Y. For example, if the price of inferior-
quality margarine (good X) went up, people would
tend to use better-quality margarine or butter (good
Y) instead. This is illustrated in Figure 4.17 by a
movement along the original indifference curve
(I1) from point f to point g. The quantity of X
demanded falls from QX1 to QX2.
The income effect. The income effect of the
price rise, however, will be the opposite of that for
a normal good: it will be positive. The reduction in
real income from the rise in price of X will tend to
increase the consumption of X, since with a fall in
real income more inferior goods will now be
purchased – including more X. Thus point h is to
the right of point g: the income effect increases
quantity back from QX2 to QX3.
.
A Giffen good: a particular type of
inferior good
If the inferior good were to account for a very large
proportion of a consumer’s expenditure, a change
in its price would have a significant effect on the
consumer’s real income, resulting in a large income
effect. It is conceivable, therefore, that this large
abnormal income effect could outweigh the normal
substitution effect. In such a case, a rise in the price
of X would lead to more X being consumed!
This is illustrated in Figure 4.18, where point h is to
the right of point f. In other words, the fall in
consumption (QX1 to QX2) as a result of the
substitution effect is more than offset by the rise in
consumption (QX2 to QX3) as a result of the large
positive income effect.
Such a good is known as a Giffen good, after Sir
Robert Giffen (1837–1910), who is alleged to have
claimed that the consumption of bread by the poor
rose when its price rose. Bread formed such a large
proportion of poor people’s consumption that, if its
price went up, the poor could not afford to buy so
much meat, vegetables, etc. and had to buy more
bread instead. It is possible that in very low income
countries in Africa today, staple foods such as
manioc and maize are Giffen goods. Naturally,
such cases must be very rare indeed.

The usefulness of indifference

analysis
Indifference analysis has made it possible to
demonstrate the logic of ‘rational’ consumer
choice, the derivation of the individual’s demand
curve, and the income and substitution effects of a
price change. All this has been done without having
to measure utility. Nevertheless there are
limitations to the usefulness of indifference
analysis:
• In practice it is virtually impossible to derive
indifference curves, since it would involve a
consumer having to imagine a whole series of
different combinations of goods and deciding in
each case whether a given combination gave more,
equal or less satisfaction than other combinations.
• Consumers may not behave ‘rationally’, and
hence may not give careful consideration to the
satisfaction they believe they will gain from
consuming goods. They may behave impetuously.
• Indifference curves are based on the satisfaction
that consumers believe they will gain from a good.
This belief may well be influenced by advertising.
Consumers may be disappointed or pleasantly
surprised, however, when they actually consume
the good. In other words, consumers are not
perfectly knowledgeable. Thus the ‘optimum
consumption’ point may not in practice give
consumers maximum satisfaction for their money.
• Certain goods are purchased only now and again,
and then only one at a time. Examples would
include consumer durables such as cars, televisions
and washing machines. Indifference curves are
based on the assumption that marginal increases in
one good can be traded off against marginal
decreases in another. This will not be the case with
consumer durables.