(6) Cardinal utility analysis does not split up the price affect into substitution and income effects: The third shortcoming of the cardinal utility analysis is that it does not distinguish between the income effect and the substitution effect of the price change. We know that when the price of a good falls, the consumer becomes better off than before, that is, a fall in price of a good brings about an increase in the real income of the consumer. In other words, if with the fall in price the consumer purchases the same quantity of the good as before, then he would be left with some income. With this income he would be in a position to purchase more of this good as well as other goods. This is the income effect of the fall in price on the quantity demanded of a good. Besides, when the price of a good falls, it becomes relatively cheaper than other goods and as a result the
consumer is induced to substitute that good for others. This results is increase in quantity demanded of that good. This is the substitution effect of the price change on the quantity demanded of the good. With the fall in price of a good, the quantity demanded of it rises because of income effect and substitution effect. But cardinal utility analysis does not make clear the distinction between the income and the substitution effects of the price change. In fact, Marshall and other exponents of marginal utility analysis ignored income effect of the price change by assuming the constancy of marginal utility of money. Thus, according to Tapas Majumdar, “the assumption of constant marginal utility of money obscured Marshall’s insight into the truly composite character of the unduly simplified price-demand relationship”. They explained the changes in demand as a result of change in the price of a good on the basis of substitution effect on it. Thus, marginal utility analysis does not tell us about how much quantity demanded increases due to income effect and how much due to substitution effect as a result of the fall in price of a good J R Hicks rightly remarks, “that distinction between income effect and substitution effect of a price change is accordingly left by the cardinal theory as an empty box which is crying out to be filled. In the same way, Tapas Majumdar says, “The efficiency and precision with which the Hicks-Allen approach can distinguish between the income and subsitutuion effects of a price change really leaves the cardinal argument in a very poor state indeed. (7) Marshall could not explain Giffen Paradox: By not visualizing the price effect as a combination of substitution and income effects and ignoring the income effect of the price change, Marshall could not explain the Giffen Paradox. He treated it merely as an exception to his law of demand. In contrast to it, indifference curve analysis has been able to explain satisfactorily the Giffen good case.
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- Fall '19