Chapter - 9
Demand Theory
(Hicks & Samuelson)
The most widely used book of Hicks is Value and Capital. His book uses the General Equilibrium approach of Walras and Pareto and it continues their tradition. He re-discovers the indifference curve technique earlier used by Edgeworth and Pareto. He uses this tool of Indifference curve to explain the theory of Demand. Dispensing with the Cardinal Utility concept, Hicks uses the ordinal concept of Ranking based on Indifference curves.
Marshall assumed that a Consumer gets satisfaction from his consumption of goods and his satisfaction is measurable in terms of so many ‘Utils’ of satisfaction. This satisfaction is the feeling by the consumer and it is introspective. According to Marshall, a Consumer tries to maximize his utility and he spends his money in such a way so that every Rupee spent on commodity X and Y should yield equal extra satisfaction, when consumed. Then only his utility will be maximized. Any change from this position will result in less satisfaction, the gain in utility in buying, say, more of ‘X’ will be less than the loss of Utility in buying less of ‘Y’. This follows from the principle of Diminishing marginal utility which states each successive units of consumption yields diminishing extra satisfaction. Marshall’s argument leads to the conclusion that marginal utilities of commodities must be proportional to their prices. Marshall assumes that the marginal utility of money is constant. Therefore, the marginal utility of a commodity and its price is a constant ratio. If the price falls, the marginal utility must be reduced too. But by the law of diminishing marginal utility, this implies an increase in the amount demanded and consumed. A fall in Price therefore increases the amount demanded.
A fall in the Price of a commodity actually affects the demand for the commodity in two different ways. On the one hand, it makes the Consumer better off, it raises his real income and this may be termed the Income effect, on the other hand, it changes relative Prices, and therefore, apart from changes in real Income, there will be a tendency to substitute the commodity whose Price has fallen for other commodities. This is the substitution effect. The total effect on demand is the sum of these two tendencies. Marshall neglected the Income effect while Hicks considered them both in his Theory. The Income effect added to the Substitution effect gives the Price effect on Demand.
For explaining the Theory of Demand, Hicks uses Indifference Curves. Points on an Indifference Curve represent different combinations of two commodities giving the same level of satisfaction (not the absolute amount). The slope of an indifference curve represent the ratio of marginal utilities of the two commodities and it is the rate of substitution in Consumption. The slope of a Budget line indicates the ratio of Prices of the two commodities and it represents the rate of substitution in purchase. The tangency between the Price line and the Indifference curve is the expression in terms of Indifference curves, of the proportionality between marginal Utilities and Prices.
Using the tool of Indifference curves, Hicks shows the Price effect on Demand, consisting of the Income effect and the substitution effect.
In the case of Normal goods, the Income effect is positive. Only in the case of Inferior goods, Income effect is negative. Even if the income effect is negative, it may be small and substitution effect will out-weigh the Income effect. The demand curve for a commodity must slope down wards, more being consumed when price falls. The only exception to the Law of Demand is the famous Giffin Paradox where the Income effect is negative and large.
Samuelson was a great general economist who made significant contributions to many areas and fields of Economics such as Macro-economic theory, Public finance, Trade, Finance and Consumer behaviour.
We consider here, Samuelson’s contributions relating to Demand theory. His fundamental Theorem of Consumption states that the demand for a commodity always changes in the same directions as that of a change in the income of consumer; positively sloped income curves always imply negatively inclined demand curves. He avoids any reference to cardinal utility and satisfaction, abandons Hicksian Indifference curves while stating his Law of demand. Based on consistence axioms of Consumer behaviour, Samuelson deduces the Law of Demand, using the Revealed Preference approach. His fundamental Theorem of Consumption states that “any good that is known always to increase in demand when money income alone rises, must definitely shrink in demand when its price alone rises”. Samuelson argued that observed consumer spending reveals the consumers’ preferences of goods. His theory of Revealed Preference to demand is termed as Behavioristic Ordinalism.