Consumer’s

UNIT 2 CONSUMER’S EQUILIBRIUM Equilibrium

Structure
2.0 Objectives
2.1 Introduction
2.2 The Concept of Consumer’s Equilibrium
2.3 Consumer’s Equilibrium with the Method of Lagrangian Multiplier
2.3.1 The Equi-marginal Principle
2.3.2 Marginal Rate of Substitution
2.3.3 Marginal Utility of Income
2.3.4 Indirect Utility Function and Expenditure Function

2.4 Consumer’s Equilibrium with Income Tax vs Quantity Tax

2.5 Consumer’s Equilibrium with Change in Price
2.5.1 Slutsky’s Approach
2.5.2 Hicksian Approach
2.5.3 Estimation of Substitution and Income Effect through Slutsky’s and Hicksian
Approach

2.6 Consumer’s Equilibrium under Special Circumstances

2.6.1 Perfect Complements
2.6.2 Perfect Substitutes
2.6.3 Quasi Linear Preferences

2.7 Let Us Sum Up

2.8 References
2.9 Answers or Hints to Check Your Progress Exercises

2.0 OBJECTIVES
After going through this unit, you will be able to :
• state the concept of consumer’s equilibrium;
• find out the optimal consumption bundle of the consumer using the
Lagrangian method;
• describe the indirect utility function, the expenditure function, the equi-
marginal principle, marginal rate of substitution and the marginal utility
of income;
• critically analyse the consumer’s equilibrium in the real world
phenomena;
• discuss the impact of economic policy tool such as taxes on the
consumer’s equilibrium;
• use Slutsky’s and Hicksian approach to decompose the price effect into
income effect and substitution effect; and 25
Consumer Theory
• explain the extent of substitution and the income effect of a price
change in case of perfect substitutes, perfect compliments and quasi-
linear preferences.

2.1 INTRODUCTION
How does a consumer with a limited income decide which goods and
services to buy, constitutes the essence of consumer behaviour. In this
context it becomes relevant to know how consumers allocate their incomes
across goods and services. This, in turn, enables us to know how changes in
income and prices affect the demand for goods and services. To answer
these questions you need to be exposed to the consumer preferences,
budget constraints and consumer choices. Hence all these three concepts
have been explained in Unit 1.
We have learned in the previous unit that consumers as an economic agent
have preferences among the various goods and services available to them.
Further they face budget constraints which put limits on what they can buy.
In this unit we shall explain the consumer’s optimisation (consumer’s
equilibrium) i.e. how the consumers decide which combination of goods and
services to buy, given their income and prices so as to maximise their
satisfaction, pre-supposing that consumers are rational and well informed.
For this purpose we shall illustrate the application of Lagrangian method.
The impact of income tax vs commodity tax on consumer’s equilibrium will
be examined in the subsequent section. How the changes in price and
income influence the consumer’s equilibrium have also been elaborated
with the help of Slutsky’s approach and Hicksian’s approach.
Let us begin with explaining the concept of consumer’s equilibrium.

2.2 THE CONCEPT OF CONSUMER’S EQUILIBRIUM

This section focuses on what are thought to be fairly common factors that
influence consumer behaviour. Two factors are emphasised. First is the
objective ability of the consumer to acquire goods, which is determined by
income and by the prices of the goods. Second are the subjective attitudes,
or tastes, of the consumer concerning the relative desirability of various
combinations of goods and services. Indifference curves represent the
consumer’s subjective attitude towards various market baskets whereas the
budget line shows what market baskets the consumer can afford. Putting
the two pieces of apparatus together, we can determine what market
basket the consumer will actually choose.
The consumer is said to be in equilibrium when he maximises his
satisfaction, given his money income and the prices of the commodities he
consumes.
The following assumptions are made in order to explain how a consumer
reaches the equilibrium position:
1) The consumer acts rationally, that is, he is guided by the objective to
26 maximise his satisfaction.
2) The prices of the goods are given and remain unchanged. Consumer’s
Equilibrium
3) He has a given amount of money income to spend on the goods. There
are no savings.
4) The scale of preferences of the consumer for various combinations of
the two goods, X and Y, are represented by an indifference map, which
is defined by his utility function. This scale of preferences remains the
same throughout the analysis.
5) Each of the good is an economic ‘good’ and is assumed to be completely
divisible.
The two conditions need to be fulfilled for a consumer to be in equilibrium:
Necessary Condition
The budget line must be tangent to the indifference curve i.e.
�� ��
MRS�,� = ��� = ��
�

Marginal rate of substitution (MRS) is a measure of the consumer’s

subjective marginal benefit. On the other hand, the price ratio is effectively
a measure of marginal cost. At equilibrium, marginal benefit is equal to
marginal cost. This is necessary but not a sufficient condition for
equilibrium.
Sufficient Condition
At the point of tangency, the indifference curve must be convex to the
origin, that is, MRSxy must be diminishing at the point of tangency.
Graphically, given the indifference map of the consumer and his budget line,
the equilibrium is defined by the point of tangency of the budget line with
the highest possible indifference curve as is represented by point e* in Fig.
2.1. The consumer will reach equilibrium at point e* (i.e. he will purchase
OX* units of good X and OY* units of good Y) where the budget line RS is
tangent to the highest possible indifference curve IC2.

Fig. 2.1

27
Consumer Theory
i) The consumer would not like to choose a combination of X and Y
represented by point T or W (although they lie on the budget line RS),
because he will be on a lower indifference curve IC1 and would thus be
getting less satisfaction vis-à-vis point e*, which is on the same budget
line RS but on a higher indifference curve, IC2.
ii) The consumer cannot move to indifference curve IC3, as this is beyond
his means (money income) given by the budget line.
iii) Even on the indifference curve IC2, all other points, except e*, are
beyond his means.
Therefore, the optimal consumption position is where the indifference curve
is tangent to the budget line, given by e* = (X*, Y*), where
Slope of indifference curve = Slope of budget line
�
MRSxy = ��
�

2.3 CONSUMER’S EQUILIBRIUM WITH THE METHOD

OF LAGRANGIAN MULTIPLIER
The method of Lagrangian multiplier is a technique that can be used to
maximise or minimise a function subject to one or more constraints. The
aim of the consumer is to purchase some quantities of the two goods which
maximise his total utility i.e.
Maximise U(X, Y) (1)
subject to the constraint that all income is spent on the two goods:
Px X + Py Y = M (2)
Here, U(X, Y) is the utility function, X and Y the quantities of the two goods
purchased, Px and Py the prices of the goods, and M is the income.
This is a constrained optimisation problem which can be solved for optimal
quantities of the two goods (X* and Y*) through a mathematical technique
called Lagrangian method which is explained below:
1) Stating the Problem: First, we write the Lagrangian for the problem.
The Lagrangian is the function to be maximised or minimised (here,
utility is being maximised), plus a variable denoted by ‘λ’ times the
constraint (here, the consumer’s budget constraint), λ > 0.
The Lagrangian function is then given by
ℒ = U (X, Y) – λ (Px X + Py Y – M) (3)
Note that we have written the budget constraint as
Px X + Py Y – M = 0
i.e., entire income is exhausted in consumption of X and Y. We then
multiplied it by λ and subtracted it from U function.
28
2) Differentiating the Lagrangian: If we choose values of X and Y that Consumer’s
satisfy the budget constraint, then the second term in Equation (3) will Equilibrium

be zero. Maximising will therefore be equivalent to maximising U(X, Y).

By differentiating ℒ with respect to X, Y and λ and then equating the
derivatives to zero, we obtain the necessary conditions for a maximum.
You should note that these conditions are necessary for an ‘interior’
solution in which the consumer consumes positive amounts of both
goods. The solution, however, could be a “corner” solution in which all
of one good and none of the o�her is consumed. But the corner solution
cannot be solved by the Lagrangian technique. The implicit assumption
of Lagrangian technique is that the solution is interior.
The resulting equations from the first order conditions are:

�ℒ ��(�,�)
��
= ��
− λP� = 0 ⟹ MU� = λP�
�ℒ ��(�,�)
��
= ��
− λP� = 0 ⟹ MU� = λP� (4)
�ℒ
��
= P� X + P� Y − M = 0 ⟹ P� X + P� Y = M

�� (�,�)
Here as before, MU stands for marginal utility. That is, MUX = �� ,
the incremental change in utility from a very small increase in the
consumption of good X.
3) Solving the Resulting Equations: The three Equations in (4) can be
rewritten as
MUX = λPX
MUY = λPY (5)
PX X + PyY = M
Now we can solve these three equations for the three unknowns (X, Y and λ)
in terms of the parameters PX, PY, M. The resulting values of X and Y are the
solution to the consumer’s optimisation problem. Thus the utility
maximising quantities are X ∗( PX, PY, M) ��� Y∗( PX, PY, M). The functions
X∗and Y ∗, called the ordinary or uncompensated or Walrasian or Marshallian
demand functions, are the functions of own price (Px), cross price (PY) and
income (M) of the consumer.

2.3.1 The Equi-Marginal Principle

The third equation in the Equation set (5) is the consumer’s budget
constraint with which we started. The first two equations in (5) tell us that
each good will be consumed up to the point at which the marginal utility
from consumption is a multiple (λ) of the price of the good. To see the
implication of this, we combine these first two equations to obtain the equi-
marginal principle:

29
Consumer Theory ��� ���
λ= ��
= ��
(6)

In other words, the marginal utility of each good divided by its price is the
same. To optimise, the consumer must get the same utility from the last
rupee spent by consuming either X or Y. If this is not the case, consuming
more of one good and less of the other would increase utility.
To characterise the individual’s optimum in more detail, we can rewrite the
information in (6) to obtain
��� �
���
= �� (7)
�

In other words, the ratio of the marginal utilities is equal to the ratio of the
prices.
Disequilibrium Cases
�� �� � ��� ���
• If MRSxy > ��
⟹ �� � > �� ⟹ ��
> ��
, the consumer must increase
� �
the consumption of good X (as he obtains greater per rupee utility from
consumption of good X) till the equality between the MRSXY and the
price ratio is restored.
�� �� � ��� ���
• If MRSxy < ��
⟹ �� � < �� ⟹ ��
< ��
the consumer must increase
� �
the consumption of good Y (as he obtains greater per rupee utility from
consumption of good Y) till the equality between the MRSXY and the
price ratio is restored.

2.3.2 Marginal Rate of Substitution

An indifference curve is the locus of all possible commodity baskets that give
the consumer the same level of utility. If U* is a fixed utility level, the
equation of the indifference curve that corresponds to this utility level is
given by
U (X, Y) = U*
As the commodity baskets are changed by adding small amounts of X and
subtracting small amounts of Y, the total change in utility must equal to zero
along the indifference curve.
On total differentiating the above utility function we get,
�� ��
dX + �� = �� ∗
�� ��
Here, along an Indifference curve utility remains constant, that is, dU ∗ the
erefore,= 0.
Thus, we get MUX dX + MUY dY = 0 (8)
�� ��
where, ��
= MUX and �� = MUY
Rearranging,
�� ��
− �� = ��� = MRSXY (9)
�

30
where MRSXY represents the individual’s marginal rate of substitution of X Consumer’s
for Y. Because the left-hand side of (9) represents the negative slope of the Equilibrium

indifference curve, it follows that at the point of tangency, individual’s

MRSXY (which trades off goods while keeping utility constant) is equal to the
ratio of marginal utilities of the two goods X and Y, which in turn is equal to
the ratio of the prices of the two goods from Equation (7). When the
individual indifference curves are convex, the tangency of the indifference
curve to the budget line solves the consumer’s optimisation problem.

2.3.3 Marginal Utility of Income

Whatever be the form of the utility function, the Lagrangian multiplier λ
represents the extra utility generated when the budget constraint is
relaxed— in this case by adding one rupee to the budget. To show how the
principle works, we differentiate the utility function U(X, Y) totally with
respect to M:
�� �� ��
��
= ��� ���� + ��� ���� (10)

Substituting from (4) into (10), we get

dU dX dY
= λP� � � + λP� � �
dM dM dM
�� �� ��
��
= λ � P� ���� + P� ����� (11)

Because any increment in income must be divided between the two goods,
by differentiating the budget equation with respect to income (M) it follows
that
�� ��
1 = PX �� + PY�� (12)

Substituting Equation (12) in Equation (11), we get

��
��
= λ(1) = λ

Thus, the Lagrangian multiplier is the extra utility that results from extra
rupee of income.

2.3.4 Indirect Utility Function and Expenditure Function

When we plug the values of optimal quantities of both the goods, that is, X*
and Y* (or Marshallian/ Walrasian/ ordinary demand functions) into the
original utility function U(X, Y), we obtain the indirect utility function—a
function of prices and income only. That is,
V(PX, PY, M) = U[X∗(PX, PY, M), Y∗(PX, PY, M)]
where, V(�X, �Y, �) represents the indirect utility function, giving the
maximum utility that can be achieved given the prices (PX, PY) and income
levels (M). It is indirect because while utility is a function of the commodity
bundle consumed — X and Y, indirect utility function is a function of
commodity prices and income—PX, PY and M.
31
Consumer Theory
Instead of maximising utility [U(X, Y)] subject to a given income (M) we can
also minimise expenditure incurred on consumption of commodities (X and
� . In this case, the consumer
Y) subject to achieving a given level of utility U
optimises by spending as little money as possible to enjoy a certain utility
level. Formally, the optimisation exercise now becomes
Minimise Px X + Py Y
subject to the constraint of the given level of utility
�
U (X, Y) ≥ U
Solving the above optimisation problem using the method of Lagrangian like
we did in the case of utility maximisation yields Compensated or Hicksian
demand functions given by X∗(PX, PY, U � ) and Y∗(PX, PY, U
� ), which are a
function of prices (PX, PY) and given utility level (U � ). On plugging the
compensated demand functions into the objective function (PX X + PY Y), we
obtain the expenditure function E(PX, PY, U � )—a function of prices (PX, PY) and
� ). It measures the minimal amount of money required to
given utility level (U
buy a bundle that yields a utility of U�.

Example
Consider a Cobb-Douglas utility function
U (x1, x2) = x1αx2β
Assuming price of good x1 and good x2 to be P1 and P2, respectively and
income be M. Determine the optimal choice of consumption of goods x1 and
x2. Also find the expression for the indirect utility function.
Solution
Solving the problem using the equilibrium condition
��
����� �� =
��
�
�� (�� , �� )⁄� �� ������ ��
����� ,�� = − = −
�� (�� , �� )⁄� �� ���
��� ���

αx������ αx�
= − �����
⟹−
βx� βx�
�� �
Now, MRS�� �� = − ��� and slope of the budget line is − ��
� �

�� ���
Therefore, − ��� = ��
or – αx2P2 = – βx1P1
�

��� ��
���
= x� (13)

Equation of the budget constraint is given by P1x1 + P2x2 = M

On inserting the value of x1 from (13) in this constraint, we get
32
 ��� �� Consumer’s
P� � ���
� + P� x� = M
Equilibrium
��� ��
�
+ P� x� = M ⟹ αP� x� + βx� P� = Mβ

⟹ (α + �)x� P� = Mβ
� �
⟹ x� = ����� � (14)
�

Now, substituting value of x2 from (14) in Equation (13) we get

� �
��� � �
�����
x� = ���
= ����� �
�

� � � �
Therefore, x� = ��� . � and x� = ��� . � are the ordinary or Walrasian or
� �
Marshallian demand functions.
For Indirect utility function, substitute the optimal values of x1 and x2 in the
original utility function U (x1, x2) = x1αx2β . Thus, expression for Indirect utility
function is given by,
V(P1, P2, M) = U[x1(P1, P2, M), x2(P1, P2, M)]
� � � � � �
⟹ V(P , P2, M) = ������ � � ������ � �
� �

� ��� � � � �
⟹ V(�1, �2, �) = ����� �� � �� � is the required indirect
� �
utility function.
Suppose consumer purchase x1* units of good x1. Therefore, the total
expenditure on x1* will be x1*P1. The fraction of income spent on good x1
�∗� ��
shall be �
� � � � � �
We know ��∗ = ���
. � .Therefore, ������ . � . �� � = ����� will be the
� �
� � � �
fraction of income spent on good x1. Also, ������ . � . �� � = ����� will be
�
the fraction of income spent on good x2. Thus, a consumer having Cobb-
Douglas utility function always spends a fixed fraction of his income on each
good.
Check Your Progress 1
1) Consumer A consuming goods x1 and x2 has utility function of form U(x1,
x2) = 4√�� + x2
a) ‘A’ originally consumed 9 units of x1 and 10 units of x2. His
consumption of x1 is reduced to 4 units. After change, how much of
x2 should he be consuming to maintain same level of utility?
…………………………………………………………………………………………………………
…………………………………………………………………………………………………………
…………………………………………………………………………………………………………
………………………………………………………………………………………………………… 33
Consumer Theory
b) If A is consuming the bundle (9, 20), what would be his MRS (x1, x2)
and when is he consuming (9, 10)? Also, write MRS in general form.
…………………………………………………………………………………………………………
…………………………………………………………………………………………………………
…………………………………………………………………………………………………………
2) Utility function of an individual is given by U(X, Y) = X3/4 ��/� . Find out
the optimal quantities of the two goods X and Y using Lagrangian
method, if it is given that price of good X is Rs 6 per unit, price of good Y
is Rs. 3 per unit and income of the individual is equal to Rs. 120.
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………

2.4 CONSUMER’S EQUILIBRIUM WITH INCOME TAX

VS QUANTITY TAX
There are various economic policy tools (such as taxes, subsidies, rationing,
etc.) that affect the budget constraint of the consumer. In this section, we
shall study the impact of quantity tax and income tax on the consumer’s
equilibrium.
In case of a quantity tax, the consumer has to pay a certain amount to the
government for each unit of the good purchased on which the tax is
imposed. Suppose, before any quantity tax, the price of good X is PX. Now
the government imposes a quantity tax of Rs. t per unit on good X. This
quantity tax changes the price of good from PX to PX + t. Graphically, this
would cause the budget line to become steeper. An income tax on the other
hand is a tax on the income of the consumer. Graphically, this would cause
the budget line to shift parallel leftwards as if the income has fallen.
The analysis is based on the following assumptions:
1) The consumer initially has a money income M, and the prices of the two
goods X and Y are PX and PY respectively.
2) The government has two economic policy tools to raise revenue:
a) Quantity tax of Rs. t per unit on good X
b) Income tax
3) The magnitude of revenue collected from taxes, is the same, either
from quantity tax or income tax. The economic implication of this
assumption is that the government is indifferent as to whether tax
revenue is collected from quantity tax or income tax.
4) The consumer is rational guided by the objective of utility maximisation
subject to the budget constraint.
34
 Consumer’s
Equilibrium

Good Y A

F Original choice
Optimal choice
e1 with income tax

Optimal e2
choice with IC3
quantity tax e3 Budget constraint
with income tax
�
Slope = − ��
�
IC1 IC2
O XB XA XC C G B
Budget constraint with quantity Good X
(�� � �)
tax, Slope = −
��

Fig. 2.2: Consumer’s Equilibrium with Income Tax vs Quantity Tax

Now, consider Fig. 2.2 above. The consumer is initially in equilibrium at

point e1 where the budget line AB is tangent to IC3. AB is defined by the
equation
P XX + PY Y = M (15)
and consumer consumes OXA units of good X and e1XA units of good Y. Note
�
that the coordinate of X intercept at the point B is �� , 0�, and that of Y
�
�
intercept at the point A is �0, � �. Now government imposes a quantity tax
�
of Rs. t per unit on good X, so the post tax price of commodity X is (PX + t)
with PY being the price of commodity Y remaining unchanged. This causes
the budget line to pivot leftwards from AB to AC. AC is defined by the
equation
(PX + t) X + PYY = M (16)
The new equilibrium is established at e2 where the budget line AC is tangent
to IC1. The consumer is consuming OXB units of good X and e2XB units of
good Y. The government is able to collect tax revenue R, equal to tXB. At
equilibrium e2, we know
(PX + t)XB + PY (e2XB) = M (17)
As a policy option, if the government had imposed an income tax equal to
tXB, then the original budget constraint AB would have shifted parallel
leftwards to FG, passing through point e2. FG passes through e2 because
R = tXB (18)
Income after tax = M − tXB
35
Consumer Theory
Therefore, equation of the new budget line becomes, PXX + PYY = M − tXB,
�
which has a slope of – �� and will pass through (XB, e2XB) as it will be a
�
transformed form of Equation (17)⇒ PXXB + PY(e2XB) = M − tXB with an
income tax, equilibrium is established at e3 when the budget line FG is
tangent to IC2.
Now comparing a quantity tax with an income tax we find that the
consumer is better off with an income tax. This is because with an income
tax, consumer attained an equilibrium point e3 on IC2 and with a quantity tax
he attained an equilibrium point e2 on IC1, and as you may notice, IC2
provides a higher level of satisfaction than IC1.
Check Your Progress 2
1) In a two-good world (x1, x2) with prices (p1, p2), assume that a consumer
has a utility function U = x11/2.x21/2 with a budget constraint p1x1 + p2x2 =
M. Initially, price of good x1 is Rs. 2 and of good x2 is Rs. 8. The income
of the consumer is Rs. 400.
a) Let the government impose a quantity tax of Rs. 2 per unit on
good x1. What happens to the optimal consumption bundles and
find the amount of tax collected.
……………………………………………………………………………………………………..
……………………………………………………………………………………………………..
……………………………………………………………………………………………………..
……………………………………………………………………………………………………..
b) Suppose the government replaces the quantity tax by an
equivalent income tax. Find the optimal consumption bundle. Is
the consumer better or worse off compared to the quantity tax
situation.
……………………………………………………………………………………………………..
……………………………………………………………………………………………………..
……………………………………………………………………………………………………..
2) Priya spends all her income of Rs. 5000 on food (F) and clothing (C). The
price of food is Rs. 250 and that of cloth is Rs.100 and her monthly
consumption of food is 10 units and that of clothing is 25 units. MRSFC =
��
��
. Is she in equilibrium with this consumption, which commodity she
will substitute for the other to reach equilibrium position?
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
……………………………………………………………………………………………………………….
36 ……………………………………………………………………………………………………………….
 Consumer’s
2.5 CONSUMER’S EQUILIBRIUM WITH CHANGE IN Equilibrium
PRICE
In this section, we shall study the impact on consumer equilibrium when
price of one of the goods changes. Considering a 2-good model, when price
of one good, let say good X changes, this brings change in the price of good
X (i.e., PX) relative to good Y, and also in the real income of the consumer.
The overall change in quantity demanded of good X due to a change in its
price, ceteris paribus, is called the price effect. This change can be further
broken down into two components:
a) Substitution effect: Substitution implies a movement away from the
relatively expensive good. Controlling for the change in real income,
substitution effect captures the effect of change in the relative price
ratio on the quantity demanded of the good whose price has changed.
b) Income effect, on the other hand measures the effect of change in the
real income on the quantity demanded of the good whose price has
changed.
This decomposition of the price effect into substitution and income effect
can be done by way of two approaches:
i) Slutsky’s approach
ii) Hicksian approach

2.5.1 Slutsky’s Approach

We shall use Slutsky’s method to break the price effect into income effect
and substitution effect for good X wherein
Case 1 Good X is a normal good
Case 2 Good X is an inferior good
Case 3 Good X is a giffen good
We make the following assumptions for all the three cases:
1) The consumer is consuming two goods; good X and good Y.
2) The initial nominal income of the consumer is given by M.
3) The initial prices of the two goods are PX and PY.
4) All income is spent on the two goods and no part of the income is
saved.
5) The initial budget line faced by the consumer is given by AB.
6) The consumer is initially in equilibrium at e1, where the budget line AB is
tangent to IC1.
Case 1: Good X1 is a normal good.

37
Consumer Theory

Fig. 2.3: Decomposition of Price effect into Substitution effect and Income effect in case
of Normal Good using Slutsky’s approach

Consider Fig. 2.3, where budget line AB is tangent to IC1 and initial
equilibrium is given by e1, with consumer consuming OXA units of good X.
Let the price of good X fall from PX to PX', ceteris paribus. This causes the
budget line to pivot from AB to AC. The new equilibrium is established at e2
where the budget line AC is tangent to IC3. The consumer now purchases
OXB units of good X. The total change in demand for good X is given by, ∆X =
(OXB – OXA). This represents the magnitude of the price effect, which can be
broken down into Substitution and the Income effect.
We know that when price of good X falls, the real purchasing power of the
� �
consumer rises �� < � � �. To eliminate this increase in real purchasing
� �
power, the money income of the consumer is reduced temporarily (say by
taxation) by such an amount that the consumer is just able to afford his
�� �
original preferred bundle (defined by e1), at the new price ratio ��
. That is,
allowing only for the change in the relative price ratio, while the real
purchasing power is held constant. This is graphically achieved by
introducing an income compensated budget line FG [defined by parameters
(PX', PY, M')] parallel to AC and passing through e1 (the original preferred
bundle).
The consumer now attains equilibrium at point e3 where FG is tangent to IC2.
The movement from e1 to e3 shows that the consumer increased his
demand for good X from OXA to OXC as good X became relatively cheaper to
good Y. Therefore, OXC – OXA defines the substitution effect resulting from a
change in the price of good X relative to good Y, with real income remaining
constant.
To study the income effect, we now restore the money income of the
consumer that was taken away. This is graphically achieved by shifting the
budget line from FG to AC. The consumer moves from e3 on IC2 to e2 on IC3.
38 Consumer increases his consumption of good X from OXC to OXB. This
increase in quantity demanded (OXB – OXC) measures the magnitude of the Consumer’s
income effect. Equilibrium

We are now in a position to explain symbolically how the price effect is split
into income and substitution effect.
1) OXA is calculated with parameters (PX, PY, M)
2) OXB is calculated with parameters (PX’, PY, M)
3) OXC is calculated with parameters (PX’, PY, M’)
Now, how to determine M’?
We know that point e1 lies on two budget lines, AB and FG. There, the
consumption bundle of good X and Y, given by (OXA, e1XA) is the same for
two budget lines AB and FG. Thus (OXA, e1XA) is affordable at (PX, PY, M) and
(PX', PY, M'). That is, e1 on AB shall satisfy the following equation
P X X + PY Y = M (19)
and e1 on FG shall satisfy the following equation
PX'X + PY Y = M' (20)
Subtracting Equation (19) from Equation (20) i.e. [(20) – (19)], we get
M' – M = PX' X – PX X
M' – M = X (PX' – PX)
In simple words,
(New money income – original money income) = [(original quantity of good
X demanded) multiplied by (new price – old price)]
Or ∆M = X∆P�
Remember:
∆M and ∆P will always move in the same direction.
• If the price of a good falls, we shall need to reduce money income to
keep the original bundle affordable at the new price ratio.
• If the price of a good rises, we shall need to increase money income of
the consumer to keep the original bundle affordable, at the new price
ratio.
Let us now symbolically represent the price effect (PE) as the sum of income
effect (IE) and substitution effect (SE):
PE = SE + IE
∆X = ∆XS + ∆XN
where, ∆X = Total price effect
∆XS = the substitution effect
∆XN = the income effect
Now, ∆X = X (PX’, PY, M) – X (PX, PY, M)
∆XS = X (PX ’, PY, M’) – X (PX, PY, M)
∆XN = X (PX ’, PY, M) – X (PX ’, PY, M’)
39
Consumer Theory
We have ∆X = ∆XS + ∆XN
X (PX’, PY, M) – X (PX, PY, M) = [X (PX ’, PY, M’) – X (PX, PY, M)] +
[X (PX ’, PY, M) – X (PX ’, PY, M’)]
The above equation is referred as the Slutsky’s Identity. The above equation
is an identity because the left hand side is equal to the right hand side as the
first and the fourth terms on the right side cancel out.
Case 2: Good X is an inferior good
In case of an inferior good, increase in income of the consumer causes fall in
the demand of that good. Good X is assumed to an inferior good. The initial
equilibrium of the consumer is given by point e1 on budget line AB, where
AB is tangent to IC1, with consumer consuming OXA units of good X. (Refer
Fig. 2.4)

J
e2
Good Y (Normal)

e1
IC3
e3
S.E

IC1 IC2
P.E I.E
O XA XB XC B K C
Good X (Inferior)

Fig. 2.4: Decomposition of Price effect into substitution effect and Income effect in case of
an Inferior Good using Slutsky’s approach

Let price of the inferior good X falls from PX to PX'. This causes the budget
line to pivot from AB to AC. Consumer reaches new equilibrium at e2,
purchasing OXB units of goods X. The total change in demand of good X, ∆X
= (OXB – OXA) gives the magnitude of the price effect (notice that the law of
demand holds true for an inferior good X).
Like we did in case of normal good, to cancel the income effect, we
introduce an income compensated budget line JK parallel to AC (reflecting
the new price ratio), by withdrawing some income of the consumer, so that
the consumer can buy the original commodity bundle at the new price
(hence JK is passing through e1). At new equilibrium e3, given by the
tangency of JK and IC2, consumer purchases OXC units of good X. Movement
from e1 to e3 shows that the consumer increased his demand for the inferior
good X from OXA to OXC by substituting the dearer commodity Y for the
cheaper commodity X giving the magnitude of the substitution effect as OXC
– OXA. On restoring the money income of the consumer, equilibrium moves
from e3 on IC2 to e2 on IC3. The consumer decreases his consumption of
40
good X from OXC to OXB under the income effect as good X is an inferior Consumer’s
good. Equilibrium

You will notice that while the substitution effect causes an increase in
quantity demanded (from OXA to OXC), the income effect causes a decrease
in the quantity demanded (from OXC to OXB). You can further see that the
strength of the substitution effect is relatively stronger than the strength of
the income effect. The final result (of price effect) from the sum of the
substitution effect and income effect is that there is still rise in quantity
demanded (OXA to OXB) for the inferior good X when its prices have
decreased from PX to PX'. Thus, the law of demand operates even in case of
inferior goods.
Case 3: Good X is a Giffen good
It was observed by Sir Robert Giffen, a British economist of the 19th century,
that as the price of bread rose in England, many low paid workers began to
purchase more bread. This observation was contrary to the law of demand.
A good which behave contrary to the law of demand is known as a “Giffen-
type” good and the phenomenon as “Giffen’s Paradox”. The cardinal utility
analysis could not explain this “Giffen’s Paradox”, as it did not treat the price
effect as a combination of substitution and income effect. It completely
ignored the income effect of a price change, by assuming constant marginal
utility of money. Indifference curve analysis has been successful in
overcoming this limitation of cardinal utility analysis. It has been able to
resolve the “Giffen’s paradox”. Even in case of a “Giffen” good, the
substitution effect causes an increase in quantity demanded for a fall in
price of the Giffen good, but simultaneously the income effect acts to
reduce the quantity demanded as all Giffen goods are inferior goods.
However in this case, the dominance of income effect over the substitution
effect makes the price effect positive (fall in price of good X is accompanied
by rise in quantity demanded) leading to the violation of law of demand.
This is explained with the help of Fig. 2.5 below. Let us assume that good X is
a Giffen good. The consumer is initially in equilibrium at point e1, purchasing
OXA units of good X.

A
e2
Good Y (Normal)

M IC3

e1 e3
P.E S.E IC2
I.E IC1
O XB XA XC B N C
Good X (Giffen)

Fig. 2.5: Decomposition of Price effect into substitution effect and Income effect in case of
a Giffen Good using Slutsky’s approach 41
Consumer Theory
With a fall in price of good X (which is a Giffen good), the budget line pivots
from AB to AC, with consumer reaching equilibrium at e2. The consumer
now demands a lower quantity of good X, although he/she is on a higher
indifference curve. The quantity decreases by (OXB – OXA), giving the price
effect.
Now, using the same methodology of separating substitution effect from
income effect, we draw income compensated budget line MN parallel to AC,
passing through e1. The new equilibrium is established at point e3 on IC2,
with consumption of good X increased to OXC. The increase in quantity
demanded (OXC – OXA) defines the substitution effect. To study the income
effect, the money income that was taken away from the consumer is
restored. The consumer moves from point e3 on IC2 to e2 on IC3. The
consumer reduces his consumption from OXC to OXB because Giffen good X
is an inferior good. The decrease in quantity demanded (OXC – OXB)
measures the income effect.
While the substitution effect caused an increase in quantity demanded for a
fall in price, the income effect caused a substantial decrease in quantity
demanded. In case of a Giffen good, the strength of the income effect is so
strong that it outweighs the substitution effect, causing a decrease in
quantity demanded from OXA to OXB, with a fall in price of good X. Thus, the
“Giffen’s paradox” is a strong exception to the law of demand.

2.5.2 Hicksian Approach

In Slutsky’s approach, substitution effect is given by the change in demand
of the good whose price changes, holding constant consumer’s real income.
This we measured by constructing an income compensated budget line (by
introducing a compensated change in income of the consumer opposite to
the change in price) parallel to the pivoted budget line after the price
change, reflecting new price ratio but compensated income and passing
through the original equilibrium bundle.
Hicksian approach, on the other hand, involves measurement of the
substitution effect as the change in the demand of the good whose price has
changed, holding utility constant. Now, this will involve constructing the
income compensated new budget line reflecting new price ratio, parallel to
the pivoted budget line and tangent to the original indifference curve. This is
the point of difference between the Slutsky’s and the Hicksian approach,
while the former requires keeping constant the initial purchasing power (so
that the consumer can buy the initial commodity bundle at the new price),
the latter involves keeping constant the original utility level (so that the
consumer can attain the initial utility level at the new price), but both the
approaches involve altering the money income of the consumer after the
price change to separate substitution effect from the income effect. Let us
graphically present the Hicksian approach (refer Fig. 2.6).
We assume the same case-I that we did under Slutsky’s approach in Fig. 2.3.
Consumer’s initial equilibrium is given by e1, where budget line AB is tangent
to IC1, with consumer consuming OXA units of good X. Let the price of good X
42 fall from PX to PX’, ceteris paribus. This causes the budget line to pivot from
AB to AC. At new equilibrium e2 consumer consumes OXB units of good X. Consumer’s
The total change in demand for good X is given by, ∆X = (OXB – OXA). This Equilibrium

represents the magnitude of the price effect.

Now as per Hicksian approach, substitution effect is separated from the
income effect by drawing income compensated budget line JK parallel to AC,
but tangent to the original indifference curve, IC1 (Refer Fig. 2.6). That is,
after the fall in the price of good X, money income is reduced to the extent
that consumer can afford the previous utility level. Equilibrium e2, given by
the tangency of JK and IC1, marks the change in demand of good X resulting
from change in the price ratio, keeping constant the utility level. Thus,
substitution effect is given by OXC – OXA. The remaining change in the
quantity demanded of good X from OXC to OXB account for the income
effect.

e1 e2
Good Y

e3
IC2
S.E I.E
IC1
P.E
A
O X XC XB B K C
Good X

Fig. 2.6: Decomposition of Price effect into substitution effect and Income effect in case of
a Normal good using Hicksian approach

The other cases, of that of an inferior good and a Giffen good, can be
similarly analysed.

2.5.3 Estimation of Substitution and Income Effect through

Slutsky’s and Hicksian Approach
Consider two goods, X and Y, priced at PX and PY. Let M be the income of the
consumer. Initial demand for both the goods will be a function of (Px, PY, M),
given by
XO (PX, PY, M) for good X and YO (PX, PY, M) for good Y
Now let price of good X fall from PX to PX’. Final demand for the both the
goods will be a function of (PX’, PY, M), given by, XF (PX’, PY, M) for good X
and YF (PX’, PY, M) for good Y. Now, price effect equals, XF (PX’, PY, M) – XO
(PX, PY, M). This can be further separated into substitution and income effect
by Slutsky’s and Hicksian approach.

43
Consumer Theory
i) Slutsky’s Approach
This approach involves finding out the intermediate demand for good X
� ’
at the new price ratio �� , keeping constant the original purchasing
�
power or the real income of the consumer. Let Ms be the altered money
income spending which consumer can consume the original bundle of
both the goods i.e., (XO, YO) after PX changes to PX’. That is, we have
M s = P X’ X O + P Y Y O
This represents equation of the income compensated budget line,
which we draw parallel to the pivoted budget line, after passing through
the original consumption bundle. Now, optimal consumption of good X
on this new budget line will be a function of (PX’, PY, Ms), let us denote it
by, XS (PX’, PY, Ms), with Ms itself given by (PX’, PY, XO, YO), we can also
write XS (PX’, PY, XO, YO).
Now, Substitution effect = XS – XO
and Income effect = XF – XS
ii) Hicksian Approach
The sole difference between the Slutsky’s and Hicksian approach is the
estimation of the intermediate demand. Hicksian approach involves
finding out the intermediate demand for good X at the new price ratio
�� ’
�
, keeping constant the original utility level of the consumer. Let Mh be
�
the altered money income spending which consumer can attain the
original utility level (let say UO) after PX changes to PX’. That is, we have
UO = U [X(PX’, PY, Mh), Y(PX’, PY, Mh)]
where utility function is given by U(X, Y), with X and Y themselves being
a function of (PX’, PY, Mh). The optimal demand for good X associated
with income Mh is given by Xh (PX’, PY, Mh), where Mh itself is a function
of (PX’, PY, UO), thus we can write Xh (PX’, PY, UO).
Now, Substitution effect = Xh – XO
and Income effect = XF – Xh
Example
Suppose consumer ‘A’ has utility function of the form U (x1, x2) = x1x2. Let
price of good x1 be P1 = Rs. 2 and good x2 be P2 = Re 1. Now let price of x1
falls from Rs. 2 to Re 1. A’s income is Rs. 40/day. Answer the following:
a) Before the price change what was A’s consumption bundle?
b) After the price change, if A’s income had changed, so that he could
afford old bundle exactly, what would A’s income be? What is the
consumption bundle with new income and price?
c) Break up the price effect into substitution effect and income effect.

44
Solution Consumer’s
Equilibrium
�
a) Using the equilibrium condition �� = MRS12, we can determine A’s
�
consumption function before the price change.
��
��� � � � � �
We have MRS12 = �� = �� and �� = �, for equilibrium, �� = �
⟹ x2 = 2x1
� � �
���
(21)
Using Equation (21) and the budget constraint, given by 40 = 2x1 + x2,
we get x10 = 10, x20 = 20.
b) Going by the Slutsky’s approach, income required to exactly afford
original bundle would be given by, Ms = p1’x10 + p2x20, where p1’= 1, x10 =
10, p2 = 1, x20 = 20. Thus, we get Ms = 30.
��
Using equilibrium condition, ��
= 1 ⟹ x2 = x1 and the new budget
constraint given by 30 = x1 + x2, we get the consumption levels with new
income (Ms = 30) and price (p1’= 1), given by x1S = 15 and x2 S = 15.
c) Now, in order to break up price effect into substitution effect and
income effect, we need to derive demand for good x1 after its price
changes, keeping constant all the other parameters. Using equilibrium
� � ’ �
condition �� = �� ⟹ �� = 1 ⟹ x2 = x1 and pivoted budget line
� � �
equation, 40 = x1 + x2, we get x1’= 20 and x2’ = 20.
Now, Substitution effect = x1s – x10 = 15 – 10 = 5
and Income effect = x1’ – x1s = 20 – 15 = 5

2.6 CONSUMER’S EQUILIBRIUM UNDER SPECIAL

CIRCUMSTANCES
2.6.1 Perfect Complements
We now consider a case where good X and good Y are always consumed
together in a fixed proportion. Thus, good X and good Y are perfect
complements.

Fig. 2.7
45
Consumer Theory
In Fig. 2.7, the consumer is initially in equilibrium at point e1 where the
budget line AB is tangent to the L-shaped IC1. The consumer is initially
consuming OXA units of good X and e1XA units of good Y. The budget line is
defined by parameters (PX, PY, M).
Let the price of good X fall from PX to PX', ceteris paribus. This causes the
budget line to pivot rightwards from AB to AC. The new equilibrium is
established at point e2 where the budget line AC becomes tangential to IC2.
The consumer now consumes OXB units of good X and e2XB units of good Y.
The change in quantity demanded of good X due to a change in its price is
the magnitude of the price effect which equals OXB – OXA.
We now break up the price effect into substitution and income effect. We
first cancel the income effect by reducing the nominal income of the
consumer from M to M' such that the real purchasing power is held
constant and the original preferred bundle e1 is just affordable. This is
graphically achieved by shifting the budget line AC parallel downwards to FG
till it passes through e1. The new equilibrium is once again established at e1
when FG is tangent to IC1. This means that the magnitude of the substitution
effect is zero. Intuitively, we can say that the substitution effect is zero as
good X and good Y are perfect complements and there is no possibility of
substitution of one good by the other complementary good.
We now restore the money income of the consumer that had earlier been
taken away to measure the magnitude of the income effect. This is
graphically achieved by shifting the budget line from FG to AC. The
equilibrium is established at e2 on IC2. The change in demand due to the
income effect is OXB – OXA. Therefore, the entire price effect is equal to the
income effect (because substitution effect is zero). Thus, in case of perfect
compliments, price effect equals income effect and substitution effect
equals zero.

2.6.2 Perfect Substitutes

Let good X and good Y be perfect substitutes with MRSXY = 1 (in absolute
terms). This implies that one unit of X can be equally well replaced by one
unit of Y or vice-versa. This further implies that the indifference curves shall
be linear (making a 45o angle with the axes).

46 Fig. 2.8
In Fig. 2.8, let PX be greater than PY initially. This implies that the budget line Consumer’s
(drawn as AB) shall be steeper than the indifference curves (IC1, IC2 etc) Equilibrium

because if PX > PY, then slope of AB, given by PX/PY > slope of IC’s (which
equals 1). The consumer shall initially be in equilibrium at point A = e1 (on
the y-axis) only consuming good Y. (Intuitively, the consumer shall not
purchase any units of X as X and Y are perfect substitutes and the price of
good X is greater than price of good Y).
Now let price of good X fall from PX to PX' such that PX' falls below PY. This
causes the budget line to pivot from AB to AC. As you may notice, new
budget line AC is now flatter than the indifference curves, because if PX' < PY,
then PX'/PY (slope of AC) < 1 (slope of IC's). New equilibrium is established at
point C = e2. The consumer now purchases only good X and zero units of
good Y. This is because PX' < PY and X and Y are perfect substitutes. The
consumer was initially purchasing zero units of good X and after the price
change the consumer purchases OC units of good X. Therefore, the total
change in demand for good X due to the change in price is OC. OC is
therefore the magnitude of the price effect (PE) = e2 – e1 = OC – 0 = OC.
In order to decompose the price effect into substitution effect and income
effect we first eliminate the income effect. This would be attained
graphically by shifting the budget line parallel downwards till the original
bundle (in this case point A) is just affordable. Since point A lies on AC we
cannot shift the budget line parallel downwards. This implies that income
effect shall be zero. As the budget line after cancelling the income effect
stays at AC, the magnitude of the substitution effect is OC, which is also
equal to the price effect. In case of perfect substitutes, the total change in
demand is due to the substitution effect and income effect is zero.

2.6.3 Quasi Linear Preferences

Let the consumer face quasi linear preferences and his utility function is
defined by U(X, Y) = V(X) + Y. The indifference curve map faced by the
consumer is drawn in the Fig. 2.9 below.

Fig. 2.9

47
Consumer Theory
The budget line AB is defined by parameters (PX, PY, M). The consumer is
initially in equilibrium at e1 when the budget line AB is tangent to IC1. The
consumer is initially consuming OXA units of good X and e1XA unit of good Y.
Let price of good X fall from PX to PX', ceteris paribus. This causes the budget
line to pivot from AB to AC. The new equilibrium is established at e2 where
AC is tangent to IC3. The consumer, after the price change, is consuming OXB
units of good X and e2XB units of good Y. The total change in demand for
good X is OXB – OXA (which is the magnitude of the price effect) resulting
from the price change.
We now break up the price effect into income and substitution effects using
Slutsky’s method. We first eliminate the income effect by reducing the
money income of the consumer to an extent that the consumer is just able
to afford the original preferred bundle at the new price ratio. This is
graphically achieved by shifting the budget line parallel downwards from AC
to FG, with FG passing through point e1 (ensuring that the original preferred
bundle is still affordable). The new equilibrium is established vertically
below e2 at e3. This is because each indifference curve is a vertical translate
of the original indifference curve, and with the budget line also shifting
parallel downwards, there is no option but for the new equilibrium to be
established at e3 on IC2.
Having eliminated the income effect, the consumer now consumes OXB units
of good X and e3XB units of good Y. Therefore, the magnitude of the
substitution effect is OXB – OXA. We now restore the money income to
measure the magnitude of income effect. This is graphically achieved by
shifting the budget line from FG to AC. The consumer moves from e3 on IC2
to e2 on IC3. There is no change in the consumption of good X. Therefore,
the magnitude of income effect of the price change on good X is zero. The
entire magnitude of the price effect is the substitution effect. Thus, in case
of quasilinear preferences, price effect equals substitution effect and
income effect is zero.
Check Your Progress 3
1) Consider a consumer with the utility function given by, U (X, Y) = XY,
where X and Y represent the two goods of consumption, priced at Px
and PY, respectively. Assuming income of this consumer to be Rs. 120,
Px = Rs. 3 and PY = Re. 1.
a) Find the equilibrium quantities of consumption of both the goods.
b) Suppose price of good X fall to Rs. 2.5, what will be the impact on
consumption quantities of both the goods?
c) Estimate the price effect of the price fall on consumption of good X.
d) Decompose the price effect into substitution and income effect for good X.
……………………………………………………………………………………………………….
……………………………………………………………………………………………………….
2) A spends all his income on x1 and x2. According to him, x1 and x2 are
perfect substitutes. Given, P1 = Rs. 4, P2 = Rs. 5, answer the following:
48
 a) Suppose price of x1 falls to Rs. 3, will its quantity demanded Consumer’s
increase? Why? Equilibrium

b) Now suppose P2 falls to Rs. 3 and P1 does not change. What

happens to its quantity demanded and why? Represent the
situation graphically.
……………………………………………………………………………………………………….
……………………………………………………………………………………………………….
……………………………………………………………………………………………………….
……………………………………………………………………………………………………….
……………………………………………………………………………………………………….
3) Two goods are perfect complements. If price of one good changes, what
part of change in demand is due to income effect (IE) and what part is
due to substitution effect (SE)?
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………
………………………………………………………………………………………………………………

2.7 LET US SUM UP

The theory of consumer choice is designed to explain how and why
consumers purchase the combination of goods and services they do. The
theory emphasises on two factors: the consumer’s budget line, which shows
the market baskets that can be bought; and the consumer’s preferences,
which indicate the subjective ranking of different market baskets. The effect
of a price change on the quantity demanded of a good can be broken into
two parts: a substitution effect, in which the level of real income remains
constant while price changes, and an income effect, in which the price
remains constant while the level of real income changes. Because the
income effect can be positive or negative, a price change can have a small or
a large effect on quantity demanded. In the unusual case of a so-called
Giffen good, the quantity demanded may move in the same direction as the
price change thereby generating an upward-sloping individual demand
curve.
We began by explaining the theory of consumer’s behaviour, i.e., the
explanation of how consumers allocate incomes to purchase different goods
and services. Further, we explained using indifference curve analysis that
the consumer shall be better off under an income tax vis-à-vis a commodity
tax, given the assumption that the revenue collected from both types of
taxes is the same for the government. The discussion ended on splitting up
price effect into income effect and substitution effect using Slutsky’s and
Hicksian methods. 49
Consumer Theory
2.8 REFERENCES
1) Hal R. Varian. Intermediate Microeconomics: A Modern Approach;
Eighth Edition.
2) Robert S. Pindyck, Daniel L. Rubinfeld and Prem L. Mehta.
Microeconomics, Pearson; Seventh Edition.
3) Alpha C. Chiang and Kevin Wainwright. Fundamental Methods of
Mathematical Economics; Fourth Edition.
4) Dr. H.L Ahuja. Advanced Economic Theory: Microeconomic Analysis;
Revised Edition.
5) A. Koutsoyiannis. Modern Microeconomics, Second Edition.

2.9 ANSWERS OR HINTS TO CHECK YOUR PROGRESS

EXERCISES
Check Your Progress 1
1) a) x2 = 14 units
�� �� �� �� ��
b) MRSx1x2 = ��� ; MRS (9, 20) = = �
; MRS (9, 10) = = �
� √� √�
Therefore, MRS is indifferent of the value of x2.

2) x = 15, y = 10
Lagrangian expression for the given problem will be
L = x3/4y1/4 + λ (120 – 6x – 3y)
� ��� ��
� �� � ��
Equation condition will be �
� �� ��� = ��
� �� �
�

Check Your Progress 2

1) a) Given: U = x11/2 x21/2
Post tax optimal bundle: (50, 25)
Amount of tax collected = Rs 100
Hint: At the optimum consumption bundle,
�
MRS �� �� = ��
�

Taking the log transformation of the utility function, we get, V = ln (U)

� �
V = � ln x� + �
ln x�
� � � �
MV1 = � × ��
and MV2 = � × ��

��� ��
Now, ���
= ��
� �
× �� �� �� �� ��
� ��
� � = ⇒ = ⇒ x� =
× �� �� �� ��
� ��

50 On solving we will get pre tax bundle (x1*, x2*) = (100, 25)
 Now, the government imposes a quantity tax of Rs. 2 per unit on good x1 Consumer’s
��� Equilibrium
Now P1 = 4, ∴ x 1* = �×�
= 50 ∴ Post tax bundle (50, 25)
The amount of tax collected = 2 × 50 = Rs 100
b) New Bundle: (75, 18.75) consumer is better off
Hint: Income tax = 100
M = 400 – 100 = 300
��� ���
x1* = � × � = 75 , x2* = � × � = 18.75

Original bundle Quantity tax bundle Income tax bundle

(100, 25) (50, 25) (75, 18.75)

Original utility U0 = (100)1/2 (25)1/2 = 10 × 5 = 50

Utility after quantity tax U1 = (50)1/2 (25)1/2 = 7.07 × 5 = 35.35
Utility after income tax U2 = (75)1/2 (18.75)1/2 = 8.66 × 4.33 = 37.49
∴ U2 > U1 , meaning that the consumer is better off under income tax
compared to the quantity tax situation.
2) Given, MRSFC = 1
� ���
Also, �� = ��� = 2.5
�
�� �
⟹ ����� < ��
But for equilibrium, �� = �����
�

Therefore, presently she is not in equilibrium position. Now, since in the

market with the given prices of the two goods, she can exchange 1 unit
of F for 2.5 units of C while she is willing to forego 1 unit of F for 1 unit
of C to keep her satisfaction constant, she will be increasing her
satisfaction by consuming less of food and substituting C for it. This is
because with loss of 1 unit of food she will be having extra 2.5 units of
C, while only one unit of C is sufficient to compensate her for the loss of
1 unit of F.
Check Your Progress 3
1) a) X0 = 20 and Y0 = 20
�
Hint: We use the equilibrium condition, �� = MRSXY, where PX = 3, PY
�
�
= 1, MRS = � and the budget line equation, 120 = 3X + Y to arrive at
X0 = 20 and Y0 = 60 (original bundle).
b) X’ = 24 and Y’ = 60
� �� ’
Hint: We use the equilibrium condition, � = ��
, where P X′ = 2.5, PY
= 1 and the budget line equation, 120 = 2.5X + Y to arrive at X’ = 24
and Y’ = 60 (final bundle).
c) Price effect = X’ – X0 = 24 – 20 = 4
d) Substitution effect = 2 and Income effect = 2
51
Consumer Theory
2) a) Yes. It is given that x1 and x2 are perfect substitutes for A. x1 is
cheaper. So A would consume only x1. When price of x1 falls
further to Rs. 3 and with same money income he would be able to
buy more of x1. Hence, A starts to consume more of x1. It is due to
income effect.
b) Refer Sub-section 2.6.2 and draw
Hint: As P2 falls to Rs. 3 and x1 and x2 being perfect substitute, A
will spend his entire income to buy x2 as P2 < P1.
New budget line: 4x1 + 3x2 = 120
When x2 = 0, x1 = 30 and x1 = 0, x2 = 40. Hence, New equilibrium
bundle is (0, 40)
3) In this case entire change is due to income effect. So, PE = IE and SE=0.

52