Income Effect Marginal Utilities

The concept of consumer s surplus is due to dupuit 1 but the important role of the income effect was not recognized until marshall 2 book 3 chapter vi.

Income effect marginal utilities. If the consumer s income increases his budget line will shift upwards remaining parallel to the original one. Income effect and substitution effect. Demand and marginal utility 14. To focus on this question we assume that the elasticity ρ of marginal utility with respect to income is constant.

Diminishing marginal utility of income and wealth suggests that as income increases individuals gain a correspondingly smaller increase in satisfaction and happiness. Effect of income change. Similarly if his income falls his budget line will shift downwards remaining parallel. 7 ignores income effect and substitution effect.

The law of equi marginal utility is based on the law of demand wherein the price and quantity demanded relationship is studied but it cannot segregate the income effect and substitution effect on account of change in the price of a commodity. A natural way to do this is to weight each person s change in income by his or her marginal utility of income. The marginal utility of income is the change in utility or satisfaction resulting from a change in an individual s income. Marshall essentially renders the income effect irrelevant by assuming constant marginal utility of income i e effectively quasilinear utility.

In layman s terms more money may not make you happy alfred marshall popularised concepts of diminishing marginal utility in his principles of economics 1890. However this is not explained by the marginal utility theory. Understanding happiness as a function of income and the marginal utility of income will shortcut your path toward how to build wealth in your 20s and freedom. Hicks vehemently criticized that the marginal utility theory failed to throw light on income effect and substitution effect.

Suppose that the consumer s income rises from 100 to 200.