2.

Monotonic transformation is a way of transforming a set of numbers into another set that
preserves the order of the original set, it is a function mapping real numbers into real numbers,
which satisfies the property, that if x>y, then f(x)>f(y), simply it is a strictly increasing function.

Applying a monotonic transformation to a utility function representing a preference relation

simply creates another utility function representing the same preference utility of utility,
basically what this means is that when monotonic transformation of utility is applied the
marginal rate of substitution does not change here is why.

Marginal rate of substitution does not change when a transformation of utility function is
undertaking by any positive monotonic transformation, this will be presented through a concept,
by an example

U (X, Y)=X0.4 Y0.6

Computing marginal rate of substitution

For U (X) and U (Y), marginal rate of substitution is the

Ration of marginal utility.

MRS=UxUy

Computing for marginal derivative

=0.4( ) 0.6

0.6( ) 0.4

V (X, Y)=2 LOGx +3 LOGv

MRS=

Computing for marginal utilities

MRS= =

Simplification

So basically the expression of the marginal rate of substitution is equal to the second function,
different utility functions can give you the exact same preference, the two functions can be
related to express one as the function of the other;

V (x,y) = LOGx2 +LOGv3

=LOG (x2 y3) = LOG ((x25 y3|5)) =

LOG ((v (x, y5))

V (X, Y) = 5 LOG (U(X,Y))

These two utility functions are directly related to one another and not only are they directly
related but if the derivative of (5 log (v(x,y)), is being applied to the utility function of

U (x, y)=x0.4 y0.6 , a positive derivative will be obtained, this is why generally it is the case
consider a general argument for why , the marginal rate of substitution *************** $$$$$
$$$$, where the same for the utility function of V(X,Y) U(X,Y)

V (x, y)=g(u(x,y)), suppose there is a utility function of U(x,y), it is then transformed by

applying an increasing function G,G has a positive derivative no matter what value it is applied
in this =g(U(x,y)), and the result is this new utility function of V (x,y), given this setup the
marginal rate of substitution for this V(x,y) =

MRS=VxVy

here the marginal utility can be computed simply by taking the derivative of the outside
function(g(u(x,y))) and multiply it by the derivative of the inside function

MRS=VxVy=g1(u(x,y)) .Ux g1(u(x,y)) .Ux

this is an expression of the marginal rate of substitution using the utility function V(X,Y)

MRS=VxVy=g1(u (x,y)) .Ux g1(u(x,y)) .Ux(This derivative can be cancelled out as long as they
are positive)

Which means it can be divided through by g1 which will be

MRS=VxVy=g1(u (x,y)) .Ux g1(u(x,y)) .Ux= UxUy

The marginal rate of substitution are the same for the utility function U(x,y) and any increasing
transformation of u(X,Y), so if the utilities are to be transformed to some other utility function
using some increasing function , the marginal rate of substitution will not be changed because the
marginal rate of substitution will not be changed at any point , the preferences that where
describing using transformed utility function are no different , so when we have this
transformation of cobb Douglass utility function

=V (x, y)= 5 log (u(x,y)

Transforming it by log and multiplying it by 5that did not change what was computed for the
marginal rate of substitution.

Subtracting or adding a number of “units” from a utility function does not change the ordering of
the preferences. It makes the utility level shift up or down by some constant number of units.
Multiplying a utility function by any positive number is also simple. This change multiplies the
number of units of utility by that positive number without changing their order. The same goes
for exponents as long as the application of the same positive exponent is done to the whole utility
function, we just increase or decrease the number of units by that exponent with- out changing
the order.

“the preference and indifference curve order remains the same with a positive monotonic
transformation of utility function this is true for any monotonic transformation including
multiplying a utility function by a positive constant or raising the function to the power of some
positive constant”

All this is basically a demonstration of why a monotonic transformation of a utility function

does not affect or change the marginal rate of substitution.

Indifference Curves between: Goods, Bads

and Neuters (with curve diagram)
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If a commodity is ‘good’, then more of it is preferred to less of it. Indifference curves

between two commodities which are “goods” slope downward and are convex to the origin.

However, when for a consumer a commodity is a bad’ that is undesirable object, the more
of it will lower his satisfaction.

Thus, if a commodity which is bad’ less IS preferable to more. Pollution, risk, tenacious
work, and illness are some examples of bads. In the case of bads, indifference curves are of
different shape. Suppose a bad (for example, pollution) is represented on the X-axis and a
commodity which is “good” is represented on the y-axis, then the indifference curve will be
sloping upward (that is, will have a positive slope) as displayed in Figure 8.9.

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This is because in this case a movement towards the right along an indifference curve
implies more of pollution which will reduce consumer’s satisfaction and, therefore in order
to keep his level of satisfaction constant, the quantity of a commodity which is good such as
clothing will have to be increased. The direction of preference in this case is upward and to
the left.

An important application of indifference curve analysis in recent years relates to the

problem of portfolio selection. Portfolio selection by an individual means his choice of a
particular distribution of his wealth among several assets such as equity shares debentures
real estate, etc. These different assets yield different rates of return and involve varying
degree of riskiness.

In the analysis of portfolio selection, the average or mean return from a portfolio enters as
a “good” or a desired object, whereas degree of risk involved enters as a bad or an
undesired object. In Figure 8.10 we depict indifference curves of an investor who wants or
prefers high average return and low risk. The higher the average return, the higher the
satisfaction of the investor; and higher the degree of risk involved in a portfolio, the lower
the satisfaction of the investor.

Therefore, in this case also, the indifference curve between riskiness (i.e., bad) and rate of
return (i.e., a good) slopes upward. This is because as we move rightward satisfaction
declines due to greater risk and to compensate for the decline in satisfaction due to greater
risk and to keep the level of satisfaction constant, rate of return (i.e., good’) has to be
increased. It may be noted that direction of preference in this case also will be northward
and westward as indicated in the diagram.
Neuter:

A commodity can be neuter (or a neutral good) in which case the consumer does not
care whether he has more or less of that commodity. That is, more or less of a neuter
does not affect his satisfaction in any way. If a commodity X is a neuter good and Y a
normal good, then indifference curves will be horizontal lines as depicted in Figure
8.11 and the direction of preference will be upward to the north indicating thereby
that the higher level of indifference curve will mean higher level of satisfaction
because upward movement will mean a ‘good’ commodity is increasing, the quantity
of a neuter good remaining the same.
On the other hand, if commodity Y is neuter, while commodity X is good or normal, then
indifference curves will be vertical straight lines as depicted in Figure 8.12. The direction of
preference in this case will be towards the east (i.e. rightward).

Satiation and Point of Bliss:

Our observations in the real world tell us that a commodity can be good only up to a point
called the point of satiation and becomes bad for a consumer if he is forced to increase his
consumption beyond that point. There is a combination or bundle of the commodities
which contains the optimal or most preferred quantities of the commodities for a consumer
and any increase in the quantity of each of them beyond that best or optimal quantity will
make the consumer worse off (that is, reduce his satisfaction), quantities of other
commodities remaining the same. Too much of everything is bad.
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Therefore, commodity X becomes bad beyond the quantity X 1 and commodity Y becomes
bad beyond the quantity Y1. Two goods case is represented in Figure 8.13 where the
circular indifference curves between the two commodities X and Y are drawn. Suppose X 1
and Y1 are the quantities of two commodities which the consumer considers as the best or
optimal quantities beyond which the two commodities become bad.

Point S represents these most preferred quantities of the two commodities and is therefore
the point of satiation or bliss. In zone 1, the portions of indifference curves between the
two commodities have negative slope and, therefore, the two commodities are good in this
zone.

Let us now consider point A in zone 2 which contains more of Y than regarded optimal or best
by our consumer. Therefore, in order to keep his satisfaction constant, he has to be compensated
by increase in the quantity of X (Note that in zone 2 the quantity of X remains less than X and
increase in its quantity is desirable and adds to his satisfaction. In zone 2, indifference curves
have positive slope and here while commodity X is too little, the commodity Y is too much.

Therefore, in zone 2, the commodity y becomes bad while the commodity X remains good. It
may be further noted that as the consumer moves toward the point S or his indifference curves
approach closer to this point, his satisfaction is increasing and at point S of satiation his
satisfaction is maximum. Satiation point S is also called the point of bliss.

Now, consider point R on indifference curve IC1 in zone 3 in which indifference curves have also
negative slope. As the consumer moves from point R to S, the quantities of both the commodities
decrease but he reaches nearer to the point S of his satiation or bliss. In this case both the
commodities are bad. The sum and substance of the whole matter is that as a consumer moves
nearer to his most preferred combination S, his satisfaction increases.

In zone 4, whereas the commodity X is more than the desirable quantity X1, the quantity of
commodity Y is less than its optimal quantity. Indifference curves in this region are positively
sloping indicating that, commodity X being bad in this region increase in its quantity has to be
compensated by the increase in the quantity of Y which is desirable in this region to keep the
level of consumer’s satisfaction constant.

It follows from above that a consumer has some optimal or most preferred combination of
commodities and closer he is to that combination, the better off he is. The combinations of two
commodities, say chocolate and ice cream, which are nearer to the point of satiation or bliss
point, lie on higher indifference curves and the combinations lying further away from the
satiation point, would lie on lower indifference curves. There will be some optimal combination
of chocolate and ice cream which a consumer would like to eat per week. Consumers would not
voluntarily like to consume too much of them, that is, more than what they want.

Thus, the interesting and relevant region for consumer’s choice of commodities is where he has
less than optimal quantities of both these commodities. In Figure 8.13 this region is represented
by zone 1 in which the consumer has less of the two goods than he wants and therefore increase
in the quantities of the two goods in this region will cause increase in his satisfaction and will
move him nearer to the point of satiation.

3The Substitution and Income

Affects from the Price Effect
(Inferior and Giffen Goods)
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The Substitution and Income Affects from the Price Effect

(Inferior and Giffen Goods)!
We saw that a fall in the price of good X, given the price of Y, increases
its demand. This is the price effect which has dual effects: a
substitution effect and an income effect. The substitution effect relates
to the increase in the quantity demanded of X when its price falls
while keeping the real income of the consumer constant.
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The consumer substitutes the cheaper good X for the relatively dearer
good Y. The income effect is the increase in the quantity demanded of
X when the real income of the consumer increases as a result of fall in
the price of X while the price of Y is held constant. There are two
methods of separating these two effects from the price effect, the
Hicksian method and the Slut-sky method which are explained below.

Hicks has separated the substitution effect and the income effect from
the price effect through compensating variation in income by changing
the relative price of a good while keeping the real income of the
consumer constant.

Suppose initially the consumer is in equilibrium at point R on the

budget line PQ where the indifference curve I1 is tangent to it at point
R in Figure 12.19. Let the price of good X fall. As a result, his budget
line rotates outward to PQ1 where the consumer is in equilibrium at
point T on the higher indifference curve I2. The movement from R to T
or В to E on the horizontal axis is the price effect of the fall in the price
of X. With the fall in the price of X, the consumer’s real income
increases. To make the compensating variation in income in order to
isolate the substitution effect, the consumer’s money income is
reduced equivalent to PM of Y or Q1N of X by drawing the budget line
MN parallel to PQ1 so that it is tangent to the
original indifference curve l1 at point H.
The movement from the R to H on the 11 curve is the substitution
effect whereby the consumer increases his purchases of X from В to D
on the horizontal axis by substituting X for К because it is cheaper. It
may be noted that when there is a fall (or rise) in the price of good X,
the substitution effect always leads to an increase (or decrease) in its
quantity demanded. Thus the relation between price and quantity
demanded being inverse, the substitution effect of a price change is
always negative, real income being held constant. This is known as the
Slut-sky Theorem, named after Slut-sky who first stated it in relation
to the Law of Demand.
To isolate the income effect from the price effect, return the income
which was taken away from the consumer so that he goes back to the
budget line PQ1 and is again in equilibrium at point T on the curve I2.
The movement from point H on the lower indifference curve I 1 to point
T on the high indifference curve I2 is the income effect of the fall in the
price of good X. By the method of compensating variation in income,
the real income of the consumer has increased as a result of the fall in
the price of X. The consumer purchases more of this cheaper good X
thus moving on the horizontal axis from D to E. This is the income
effect of the fall in the price of a normal good X The income effect with
respect to the price change for a normal good is negative.
In the above case, the fall in the price of good X has increased the
quantity demanded by DE via the increase in the real income of the
consumer. Thus the negative income effect DE of the fall in the price of
good X strengthens the negative substitution effect BD for the normal
good so that the total price effect BE is also negative, that is, a fall in
the price of good X has led, on both counts, to the increase in its
quantity demanded by BE. This can be written in the form of the Slut-
sky equation thus:

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Price Effect (-) BE-(-) BD (Substitution Effect + (-) DE (Income

Effect).

Substitution and Income Effects for an Inferior Good:

If X is an inferior good, the income effect of a fall in the price of X will
be positive because as the real income of the consumer increases, less
quantity of X will be demanded. This is so because price and quantity
demanded move in the same direction On the other hand, the negative
substitution effect will increase the quantity demanded of X.

The negative substitution effect is stronger than the positive income

effect in the case of inferior goods so that the total price effect is
negative. It means that when the price of the inferior good falls, the
consumer purchases more of it due to compensating variation in
income. The case of X as an inferior good is illustrated Figure 15.20.
Initially, the consumer is in equilibrium at point R where the budget
line PQ is tangent to the curve I1. With the fall in the price of X, he
moves to point T on the budget line PQ1, at the higher indifference
curve His movement from R to Tor from В to E on the horizontal axis
is the price effect. By compensating variation in income, he is in
equilibrium at point H on the new budget line MN along the original
curve I1.
The movements from R to H on the I1 curve are the substitution effect
measured horizontally by BD of X. To isolate the income effect, return
the increased real income to the consumer which was taken from him
so that he is again at point T of the tangency of PQ; line and the curve
l2. The movement from H to T is the income effect of the fall in the
price of X and is measured by DE.
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This income effect is positive because the fall in the price of the
inferior good X leads, via compensating variation in income, to the
decrease in its quantity demanded by DE. When the relation between
price and quantity demanded is direct via compensating variation in
income, the income effect is always positive.

In the case of an inferior good, the negative substitution effect is

greater than the positive income effect so that the total price effect is
negative. Thus the price effect (-) BE = (-) BD (substitution effect) +
DE (income effect). In other words, the overall price move from R to T
which comprises both the income and substitution effects has led to
the increase in the quantity demanded by BE after the fall in the price
of X. This establishes the downward sloping demand curve even in the
case of an inferior good.

Substitution and Income Effects for a Giffen Good:

A strongly inferior good is a Giffen good, after Sir Robert Giffen who
found that potatoes were an indispensable food item for the poor
peasants of Ireland. He observed that in the famine of 1848, a rise in
the price of potatoes led to an increase in their quantity demanded.
Thereafter, a fall in the price led to a reduction in their quantity
demanded.

This direct relation between price an quantity demanded in relation to

essential food items is called the Giffen paradox. The reason for such a
paradoxical tendency is that when the price of some food articles like
bread of mass consumption rises, this is tantamount to a fall in the
real income of the consumers who reduce their expenses on more
expensive food items, as a result the demand for the bread increases.
Similarly, a fall in the price of bread raises the real income of
consumers who substitute expensive food item for bread thereby
reducing the demand of bread.

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In the case of a Giffen good, the positive income effect is stronger than
the negative substitution effect so that the consumer buys less of it
when its price falls. This is illustrated in Figure 12.21. Suppose X is a
Giffen good and the initial equilibrium point is R where the budget
line PQ is tangent to the indifference curve l1. Now the price of X falls
and the consumer moves to point T of the tangency between the
budget line PQ: and the curve I2. His movement from point R to T is
the price effect whereby he reduces his consumption of X by BE.

To isolate the substitution effect, the increased real income due the fall
in the price of X is withdrawn from the consumer by drawling the
budget line MN parallel PQ1 and tangent to the original curve I1 at
point H. As a result, he moves from point R to H along the l 1 curve.
This is the negative substitution effect which leads him to buy BD
more of X with the fall in its price, real income being constant. To
isolate the income effect, when the income that was taken away from
the consumer is returned to him, he moves from point H to T so that
he reduces the consumption of X by a very large quantity DE. This is
the positive income effect because with the fall in the price of the
Giffen good X, its quantity demanded is reduced by DE via
compensating variation in income. In other words, it is positive with
respect to price change, that is, the fall in the price of good X leads, via
the income effect, to a decrease to the quantity demanded.
Thus in the case of a Giffen good, the positive income effect is stronger
than the negative substitution effect so that the total price effect is
positive. That is why, the demand curve for a Giffen good has positive
slope from left to right upwards. Thus the price effect BE= DE (income
effect) + (-) BD (substitution effect).

According to Hicks, a giffen good must satisfy the following

conditions: (i) the consumer must spend a large part of his income on
it; (ii) it must be an inferior good with strong income effect; and (iii)
the substitution effect must be weak. But Giffen goods are very rare
which may satisfy these condit
4. If a commodity is ‘good’, then more of it is preferred to less of it.
Indifference curves between two commodities which are “goods” slope
downward and are convex to the origin.

However, when for a consumer a commodity is a bad’ that is

undesirable object, the more of it will lower his satisfaction.

Thus, if a commodity which is bad’ less IS preferable to more.

Pollution, risk, tenacious work, and illness are some examples of bads.
In the case of bads, indifference curves are of different shape. Suppose
a bad (for example, pollution) is represented on the X-axis and a
commodity which is “good” is represented on the y-axis, then the
indifference curve will be sloping upward (that is, will have a
positiveThis is because in this case a movement towards the right
along an indifference curve implies more of pollution which will
reduce consumer’s satisfaction and, therefore in order to keep his level
of satisfaction constant, the quantity of a commodity which is good
such as clothing will have to be increased. The direction of preference
in this case is upward and to the left.

An important application of indifference curve analysis in recent years

relates to the problem of portfolio selection. Portfolio selection by an
individual means his choice of a particular distribution of his wealth
among several assets such as equity shares debentures real estate, etc.
These different assets yield different rates of return and involve
varying degree of riskiness.

In the analysis of portfolio selection, the average or mean return from

a portfolio enters as a “good” or a desired object, whereas degree of
risk involved enters as a bad or an undesired object. In Figure 8.10 we
depict indifference curves of an investor who wants or prefers high
average return and low risk. The higher the average return, the higher
the satisfaction of the investor; and higher the degree of risk involved
in a portfolio, the lower the satisfaction of the investor. Therefore, in
this case also, the indifference curve between riskiness (i.e., bad) and
rate of return (i.e., a good) slopes upward. This is because as we move
rightward satisfaction declines due to greater risk and to compensate
for the decline in satisfaction due to greater risk and to keep the level
of satisfaction constant, rate of return (i.e., good’) has to be increased.
It may be noted that direction of preference in this case also will be
northward and westward as indicated in the diagram.