2.

0 TOPIC TWO: CONSUMER THEORY

• Overview

The basic principles of microeconomics, Consumer behavior was introduced by laying a

strong foundation on the theory of demand on which premise the consumer behavior is
built upon. The consumer behavior is introduced as a utility maximizing behavior but
subject to consumer’s ability to purchase. A consumer is portrayed as an agent who
goes for the best that he/she can afford.
At the intermediate level, we describe more precisely what we mean by ‘best’ and
affordable’, In the first section, we will examine how to describe what a consumer can
afford; the next section will focus on the concept of how the consumer determines what
is best. We will then be able to undertake a detailed study of the implications of this
simple mode of consumer behavior.
(a) The Budget Constraint
The consumer can’t just choose any bundle he wants to choose. The bundle has to be
affordable. The budget constraint is the set of all bundles that use up the consumer’s
income, given the prices of the goods. Suppose that there is some set of goods from
which the consumer can choose. In real life there are many goods to consume but we
will consider two.
Let the consumer’s consumption of two bundles of goods (X1 X2), where X1 represents
the number of units of good 1 that the consumer chooses and X2 is the number of units
of good 2 that the consumer can choose.
Let P1 and P2 represent the unit prices for the two goods respectively; and M to
represent the amount of money the consumer has to spend.
The budget constraint of the consumer can be written as:
..............................................1
Where P1 X1 is expenditure for good 1 and P2X2 is expenditure on good 2
The budget constraint of the consumer requires that the amount of money spent on the
two good is not more than the total amount the consumer has to spend. The consumer’s
affordable consumption bundles are those that do not costs any more than M. The set of
affordable consumption bundles at prices P1, P2 and income M is called the budget set of
the consumer.
The set of bundles that cost exactly M is called the budget line.
..............................................2

These are the bundles of goods that are affordable at the given prices and income.
 X2

𝑝1
Slope =− 𝑝2

X1
The budget set consists of all bundles that are affordable at the given prices and income.
Suppose the consumer consumes zero quantity of good x1, what quantity of X2will be
available for the consumer to consume?
Express the equation 2 in terms of X2,
…………………………………… (3)

X 2 P
This is an equation for a straight line with a slope of =− 1
X 1 P2
(Negative) - . The slope of the budget line measures the rate at which the market is
willing to substitute good 1 for good 2
The slope of the budget line is also said to be an opportunity cost of consuming good 1.
In order to consume more of good1, one has to give up some consumption of good 2.
Giving up the opportunity of consume good 2 is the true economic cost of more of good
1 consumption, and that cost is measured by the slope of the budget line.
M
The vertical (x) intercept of , is the quantity of good X2 that the consumer would be
P2
able to buy if he spends all his money income (M) on X2, similarly, the horizontal (Y)
𝑀
intercept is , is equal to the quantity of good X1 that the consumer would be able to
𝑝1
buy if he spends all his money income (M) on X1

EXAMPLE 2.1
Suppose M = Ksh 5000, PX1 = Ksh 10 and PX2 = Ksh 5
i. Write the budget line equation
𝑀 = 𝑃1 𝑋1 + 𝑃2 𝑋2 , 5000 = 10𝑋1 + 5𝑋2
ii. What are intercepts of the equation:
𝑀 5000
The 𝑥1 intercept is 𝑃𝑋1
= 10
= 500
 The consumer would be able to buy 500 units of X2 if he spends all his money income (M) on
x1 and 1000 units of x2 if he spends all his income on x2.
𝑀 5000
𝑦 𝑖𝑛𝑡𝑒𝑟𝑐𝑒𝑝𝑡 = 𝑃𝑋 = 5
= 1000
2

What is the slope of the equation?

10
iii. The slope = − = − = −2
5

The slope of the budget line is the opportunity cost of consuming good a good. In order
to consume one more unit of good X2, the consumer has to give up 2 units of x1

iv. Illustrate the above budget line

X2
1000
Slope =−2

500 X1

Example 2
Suppose the Income of a person is 1200, He wants to spend his income on buying Chips and Sausage.
The price of a single unit of a sausage is 100, and that of a chips is 200.
With an aid of a diagram, illustrates the maximum number of both the goods that the consumer can
buy.
X2
6
chips Slope = −2

12 Sausages

(ii) Comment on the slope of the budget line

𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑠𝑎𝑢𝑠𝑎𝑔𝑒𝑠 𝑝1
𝑆𝑙𝑜𝑝𝑒 = − = 2.
𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑐ℎ𝑖𝑝𝑠 𝑝2
 The consumer has to trade off two units of sausages to consume one plate of chips. Thus, the
opportunity cost of one additional plate of chips is two units of sausages.

(b) Consumer Preferences

In the section above, we have used the budget constraint to show the consumers ability,
i.e “can afford” . In this section, we clarifying the economic concept of consumers
preference, i.e “best things”

The objects of consumer choice are consumption bundles. This is a complete list of the
goods and services that are involved in the choice problem faced by a consumer.

Suppose there are two consumption bundles, bundle one which contains goods ( X 1 X 2 )
and bundle two which contains (Y1Y2 ) . The consumer can rank them as to their
desirability. That is, the consumer can determine that one of the bundles is strictly
better than the other, or decide that she is indifferent between the two bundles.

Assumptions /Axioms of Preferences

i. Completeness: This means that a consumer is able to rank any two bundles. In other
words, for any two bundles for example A has (𝑋1 𝑋2) and B has(𝑌1 𝑌2 ) the consumer
is able to tell that he prefers A to B, or prefers B to A, or likes both A and B in the
same manner (indifferent). i.e ( X 1 X 2 )  (Y1Y2 ) or (Y1Y2 )  ( X 1 X 2 ) or (𝑋1 𝑋2 ∼ 𝑌1 𝑌2 ).
This property implies that the consumer can make a choice.
ii. Reflexive: We assume that any bundle is at least as good as itself
(X1 X 2 )  (X1 X 2 )
iii. Transitive: This means that if a consumer prefers bundle A to bundle B and the
consumer prefers bundle B to bundle C, then the consumer must prefer bundle A to
bundle C. i.e ( X 1 X 2 )  (Y1Y2 ) and (Y1Y2 )  (Z1 Z 2 ) then (𝑋1 𝑋2 ≿ 𝑍1 , 𝑍2 )
For example, if a consumer prefers Oranges to Mangos but like Mangos are better
than Lemon then I must like oranges more than Lemons
Geometrically, this property imply that indifference curves cannot cross.
iv. Monotonicity/ Non satiation :More is preferred to less, The consumer will prefer to
consume more and more of the goods, none of the good is a “bad” such as pollution
Geometrically, this means two things. First, higher indifference curves (containing more
of both goods) are preferred to lower indifference curves. Second, indifference curves
slope downwards – the consumer likes good X, and is willing to give up some good Y
in order to obtain more.
v. Convexity. This is a way of saying that preferences satisfy the law of diminishing
marginal rate of substitution. Geometrically, this means that indifference curves are
convex to the origin. The MRS is high initially and then falls as the consumer obtains
more of good X.
Preferences that are complete and transitive are called rational. Without rational
preferences, it is impossible to do much of anything. Preferences that are complete,
transitive, continuous, monotonic and convex are called well-behaved.

❖ Indifference curves
The whole theory of consumer choice can be formulated in terms of preferences that
satisfy the axioms above. However, it is convenient to describe preferences graphically
using indifference curves.
An indifference curve: is a collection of all commodity bundles which provide the consumer
with the same level of utility. The indifference curve is so named because the consumer would
be indifferent between choosing any one of these commodity bundles.
Consider a consumer’s consumption of goods 1 and 2

If (X1 X2) is a certain consumption bundle, the consumption bundle in the shaded region
is weakly preferred to (X1 X2). It is called the weakly preferred set. The bundles on the
boundary of this set for which the consumer is just different to (X1 X2) from the
indifference curve. It consists of all bundles of goods that leave consume indifferent to
the given bundle.
• Features of indifference curves
⎯ Indifference curves can never cross
⎯ Higher indifference curve indicates higher utility
⎯ Indifference curves are downward sloping
⎯ indifference curves are convex to the origin

• Shapes of Indifferent Curves

It has been assumed that for normal goods, the indifference curves are convex to the
origin. If no further assumptions about preferences are made, ICs can take very
peculiar shapes,

1. Perfect Substitutes
Two goods are perfect substitutes if the consumer is willing to substitute one good for
the other at a constant rate. The simplest care of perfect substitutes occurs when the
consumer is willing to substitute the goods on alone to one basis. ICs for such a
consumer are all parallel straight lines.

Linear ICs, Perfect Substitution

2. Perfect Complements
Perfect complements are goods that are always consumed together in fixed proportions,
e.g shoes (left and right). The ICs L shaped. With the vertex of the L occurring where
the number of one good equals the number of the other good
 3. Bad goods
A bad is a commodity that the consumer doesn’t like. Suppose that the two
commodities are meat and pepper, the consumer loves meat but dislike pepper. But
suppose there is some trade of possible between meat and pepper i.e. there would be
some amount of meat in samosa that could compensate the consumer for having to
consume a given amount of pepper, If more pepper is given in the samosa, more meat
has to be given to compensate for having to put up with the pepper. Thus this
consumer will have indifference curves that slope up and to the right.
 4. Neutral Goods
A good is a neutral good if the consumer doesn’t care about it one way or the other.
Suppose in the above case the consumer is just neutral about pepper (X2). The IC would
be vertical lines as depicted below. The consumer only cares about the amount of X1
and doesn’t care at all about how much of X2 he/she has. The more of X1 the better but
adding more X2 doesn’t affect him.

5. Imperfect Substitutes
If the rate at which one good is substituted for another is not constant, but
diminishing, then the two goods are imperfect substitutes. As more and note of one
good is given up successively larger units of the other good are consumer to
compensate the consumer for the loss. Such goods will have indifference curves that
are rounded, i.e. The ICs are strictly convex.
 X2

X1
❖ Revision Question:
1) A consumer has an income of 15000 shillings, and consume only two types of goods X and
Y, given the price of good x is 500 and the price of good Y is 300.
a) Write the budget equation
b) Sketch the consumer’s budget line
c) What is the opportunity cost
2) Discuss the Properties of indifference curves
3) Using preference relations, explain the assumptions of preference
4) Suppose that a consumer has the following utility function: 𝑈 (𝑋, 𝑌) = 5𝑋 0.5 + 𝑌
(a) Graph the indifference curve
(b) Generated by the utility function when U = 100.

SOLUTION

1. A consumer has an income of 15000 shillings, and consume only two types of goods X and
Y, given the price of good x is 500 and the price of good Y is 300.
a) Write the budget equation
𝑀 = 𝑋. 𝑃𝑥 + 𝑌. 𝑃𝑦
15000 = 500𝑋 + 300𝑌
150 = 5𝑋 + 3𝑌
b) Sketch the consumer’s budget line

50

30
 c) The opportunity cost.
150 = 5𝑋 + 3𝑌
5 150 3𝑌
𝑋= −
5 5 5
𝑋 = 30 − 0.6𝑌
The consumer must give up 0.6 units of good Y to consume one extra unit of good X
2) Discuss the Properties of indifference curves
i. Indifference curves can never cross
ii. Higher indifference curve indicates higher utility
iii. Indifference curves are downward sloping
iv. indifference curves are convex to the origin
3) Assumptions /Axioms of Preferences

i. Completeness: consumer is able to rank any two bundles.

for any two bundles (X1X2) , (Y1Y2) . ( X 1 X 2 )  (Y1Y2 ) or (Y1Y2 )  ( X 1 X 2 ) or 𝑋2 𝑋1 ~𝑌1 𝑌2
ii. Reflexive: We assume that any bundle is at least as good as itself
(X1 X 2 )  (X1 X 2 )
iii. Transitive: This means that if a consumer prefers bundle A to bundle B and the consumer
prefers bundle B to bundle C, then the consumer must prefer bundle A to bundle C. i.e
( X 1 X 2 )  (Y1Y2 ) and (Y1Y2 )  (Z1Z 2 ) then 𝑋1𝑋2~𝑍1𝑍2
iv. Monotonicity/ Non satiation :More is preferred to less, The consumer will prefer to
consume more and more of the goods, none of the good is a “bad”
v. Convexity. This is a way of saying that preferences satisfy the law of diminishing marginal
rate of substitution. They are convex to the origin
QUESTION 3

5X 0.5 + Y = 100

Y = 100 – 5X 0.5

When x = 0, the intercept of y= 100

When y = 0, the intercept of 5X 0.5 = 100

X 0.5 = 20, X= 400

❖ The Marginal Rate of Substitution
The slope of the IC is known as the MRS. It measures the rate at which the consumer is
willing to substitute one good for another.
𝛥𝑥2
𝛥𝑥1
Suppose that we take a little of good 1; ΔX1 away from the consumer. Then we give
him Δ X2 an amount i.e. sufficient to put him back on his/her IC, so that he is as well
off after this substitution of X2 for X1 as he was before.

The rate is the consumer willingness to substitute good 1 for good 2 and is called MRS.
Suppose that the consumer has well behaved preferences, i.e., preferences which are
monotonic and convex, and currently consuming some bundle (X X ).
1 2

The consumer is now offered a trade off to exchange good X1 for X2 or good X2 for XI
in any amount at a “rate of exchange” of E. i.e. If the consumer gives up ΔX1 units of
good X1 he can get EΔX1 units of good X2 in exchange or conversely, if he gives up
Δ X2, units of good 2, he can get units of good 1.
x 2
MRS = =E
x1
x 2 = Ex1
x 2
x1 = −
E
ΔX2 is called the marginal utility of X2 written as MUx2 and can be found by
differentiating the utility function with respect to X2.
ΔX1 is called the marginal utility of X1 and is written as MUx1 and can be found by
differentiating the utility function with respect to X1
𝛿𝑢
𝑥2 = MUx2 = = 𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑢𝑡𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝑔𝑜𝑜𝑑 𝑋2
𝛿𝑋2

𝛿𝑢
𝑥1 = MUx2 = = 𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑢𝑡𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝑔𝑜𝑜𝑑1
𝛿𝑥1
To find the marginal rate of substitution (MRS), the marginal utilities are divide

𝑚𝑢𝑥1
𝑚𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑠𝑢𝑏𝑠𝑡𝑖𝑡𝑢𝑡𝑖𝑜𝑛 𝑜𝑓 𝑔𝑜𝑜𝑑 1 𝑡𝑜 𝑔𝑜𝑜𝑑 2 = 𝑀𝑅𝑆𝑥1, 𝑥2 =
𝑚𝑢𝑥2

𝑥2 𝑀𝑈𝑥2
= = 𝑀𝑈𝑥2,𝑋1
𝑥1 𝑀𝑈𝑥1
Example 1

a) A consumer’s utility function is given as 𝑈 = 𝑋 0.2 𝑦 0.4 , calculate the Marginal rate of
substitution (5 marks)
𝑀𝑈𝑥
𝑀𝑅𝑆𝑥𝑦 = 𝑀𝑈
𝑦
𝜕𝑈
𝑀𝑈𝑥 = = 0.2 𝑋 −0.8 𝑌 0.4
𝜕𝑥
𝜕𝑈
𝑀𝑈𝑌 = = 0.4 𝑋 0.2 𝑌 −0.6
𝜕𝑦
𝑀𝑈𝑥 0.2 𝑋 −0.8 𝑌 0.4
𝑀𝑅𝑆𝑥𝑦 = 𝑀𝑈 = 0.4 𝑋 0.2 𝑌 −0.6
𝑦
𝑀𝑈𝑥 0.2𝑌 0.4 .𝑌 0.6
𝑀𝑅𝑆𝑥𝑦 = 𝑀𝑈 = 0.4 𝑋 0.2 .
𝑦 𝑋 0.8
0.2 𝑌 (0.4+0.6)
𝑀𝑅𝑆𝑥𝑦 = 0.4 𝑋 (0.2+0.8)
0.2𝑌
𝑀𝑅𝑆𝑥𝑦 = 0.4 X
Example 2
Given the following utility function 𝑢(𝑥𝑦) = 𝑥 𝑎 𝑦 𝑏 find the MRSXY

𝑀𝑈𝑥 𝜕𝑈 𝜕𝑈
𝑀𝑅𝑆𝑥𝑦 = 𝑀𝑈 to find the 𝑀𝑈𝑥 = and 𝑀𝑈𝑦 =
𝑦 𝜕𝑥 𝜕𝑦

𝑀𝑈𝑥 = 𝑎𝑥 𝑎−1 𝑦 𝑏

𝑀𝑈𝑥 = 𝑏𝑥 𝑎 𝑦 𝑏−1
𝑎𝑥 𝑎−1 𝑦 𝑏
𝑀𝑅𝑆𝑥𝑦 = 𝑏𝑥 𝑎 𝑦 𝑏−1

𝑎 𝑥𝑎−1 𝑦 𝑏
𝑀𝑅𝑆𝑥𝑦 = 𝑏 𝑥𝑎 𝑦 𝑏−1

𝑎 𝑥 −1
𝑀𝑅𝑆𝑥𝑦 = −1
𝑏 𝑦
𝑎𝑦
𝑀𝑅𝑆𝑥𝑦 = 𝑏𝑥

1) Discussion question : given a utility function 𝑈 = (𝑥 0.5 𝑦 0.5 ) , find the mrs
of the function
Geometrically, we ,are offering the consumer an opportunity to move to any point
along a line with a slope E that passes through X1 X2 as depicted.

Moving up and to the left from X1 to X2 involves exchange of good I for good 2 and
moving down to the right involves exchanging good 2 for good 1. In either movement
the exchange rate is E. Since exchange always involves giving up one good in exchange
for another, the exchange rate E corresponds to slope at E. The point of tangency
between the budget line and the indifference curve is referred to as the consumer
equilibrium.
• Behavior of the marginal Rate of substitution
Perfect substitute’s indifference curves are characterized by the fact that the MRS is
constant at –1.
The neutral case is characterized by the fact that the MRS is everywhere infinite . The
preference for perfect complements are characterized by the fact that the MRS is either
or infinite and nothing is between.
The assumption of monotonicity implies that ICs must have a negative slope, so the
MRS always involves reducing the consumption of one good in order to get mote of
another for monotonic preferences.
The case of convex ICs exhibits yet another kind of behavoiur for the MRS. For Convex
ICs, the MRS decreases as more of X1 is consumer. Thus the IC exhibits a diminishing
Mrs. Convexity of ICs implies that the more of a good consumed, the more willing is a
consumer is to give some of it u- in exchange for the other goods. This seems very
natural for a consumer and hence convexity if ICs becomes both necessary and
sufficient conditions for consumer equilibrium besides just having a point of tangency
between the consumer’s budget line and the IC.

❖ Utility
The theory of consumer behavior has been formulated with an objective of utility
maximization. Utility refers to the ability of a good to satisfy the consumer’s needs.
There are two main approaches to the study of utility cardinal and ordinal approaches.

• The Utility Function

A utility function is a way of assigning a number to every possible consumption bundle
such that more preferred bundles get assigned larger numbers than less preferred
bundles. A utility function is a way of to label indifference curves. Since every bundle of
an IC must have the same utility, a utility function is a way to assign number to the
different indifference curves in a way that higher ICs get assigned larger numbers. As
long as ICs containing more preferred bundles get a larger label than indifference
curves containing less preferred bundles, the labeling will represent the different
preferences.
However, not all kinds of preferences can be represented by a utility function for
example, suppose a consumer had intransitive preferences so that A > B > C > A. Then a
utility function for these preferences would have to consist of numbers U(A), U(B) and
U(C) such that U(A) >U(B) > U (C) > U(A), which is impossible.

• Approaches of utility

There are two approaches to the problem of comparison of utility; - Cardinalist

Approach and the Ordinalist Approach .

(a) Cardinal Utility Theory

The Cardinalist school of thought postulates that utility is measurable. Various

suggestions have been put forward for the measurement of utility. Under certainty
i.e. complete knowledge of the market conditions and income over the planning
period, some economist have suggested that utility can be measured in monetary
terms, by the amount of money the consumer is willing to sacrifice for an additional
unit of the commodity. Others have suggested the measurement of utility using
subjective units called utils.

Assumptions

a) Rationality: The consumer is assumed to be rational. i.e. he aims to maximize

his utility subject to the budget constrain

b) Cardinality: That the utility of each commodity is measurable. Utility is a

cardinal concept; the most convenient way of measurement is monetary terms.
This is the amount of money that the consumer is willing to pay for an additional
unit of a commodity.

c) Constant Marginal Utility of Money: money must measure the same amount of
utility under all circumstances. The utility derived from each unit of money
remains constant. if marginal utility of money changes as income increases (or
decreases) the measuring rod for utility becomes like an elastic ruler, hence
becoming inappropriate for measurement.

d) Diminishing Marginal Utility: The utility gained from successive units of a

commodity diminishes. i.e. the marginal utility of a commodity diminishes as the
 consumer acquires larger quantities of it. This is the axiom of diminishing
marginal utility.

e) Utility is Additive: Total utility of a basket of goods depends on the quantities of

the individual commodities. If there are n commodities in the bundle with
quantities x1, x2, x3,……….,xn the total utility is

U = f ( x1 , x 2 , x3 .......... ... x n )

❖ Concept of Total utility and Marginal Utility

Total utility is the sum of utility derived from the consumption of each unit of a good. It
can be measured in utils and in monetary terms.

𝑇𝑈 = 𝑈1 + 𝑈2 + 𝑈3 … . . 𝑈𝑛

Marginal utility is the utility derived from the last unit consumed. More precisely,
Marginal utility is the change in the total utility due to an additional unit consumed.
𝑇𝑈
𝑀𝑈 = or 𝑀𝑈 = 𝑇𝑈𝑛 – 𝑇𝑈𝑛 − 1
𝑄

Quanty in units Total utility (utils) Marginal utility (MU)

1 0 -

2 40 40

3 70 30

4 90 20

5 100 10

6 100 0

90 -10
From the table above, initially, the total utility increases as the consumer take a good,
but as he consume more of a good, it increases but at a diminishing rate, as in we can
see from the table and from the figure that initially the total utility increases to 40 and
then to 70 to 90 to 100 but the marginal utility first increases by 40 and then by 30 (TUn –
TUn-1; 70-40=30) then by 20 and then by just 10.

However, when the total utility reaches its maximum, i.e. at 100, then it starts falling as
the consumer increases his consumption; correspondingly, the marginal utility becomes
zero and then negative.

Note that the point where the total utility reaches its maximum is the point where the
marginal utility becomes zero. Thereafter when the consumer increases his
consumption of the goods again, then total utility decreases, and marginal utility goes
negative.

Thus we can conclude that there exists the following relationship between total utility
and marginal utility:

• Total utility increases initially at an increasing rate first, and marginal utility also
increases.
• Thereafter total utility increases at a diminishing rate, and marginal utility
diminishes.
• When total utility reaches its maximum, marginal utility becomes zero.
• When more of the units of the good is consumed even after achieving the highest
level of total utility, then the total utility decreases and correspondingly, marginal
utility becomes negative.
❖ Equilibrium of the consumer

Let’s begin with the simple model of a single commodity x. the consumer can either buy
x or retain his money income Y. under this conditions the consumer is in equilibrium
when the marginal utility of x is equated to its market price (Px). Symbolically this can
be represented as

MU X = PX

If the marginal utility of X is greater than its price, the consumer can increase his
welfare by purchasing more units of x. similarly if the marginal utility of x is less than
its price the consumer can increase his total satisfaction by cutting down the quantity of
x and keeping more of his income unspent. Therefore, he attains the maximization of
his utility when MUx = Px

if there are more commodities, the condition for the equilibrium of the consumer is the
equality of the ratios of the marginal utilities of the individual commodities to their
MU X MU Y MU n
prices. i,e;- = = .......... .........
PX PY Pn

Mathematical derivation of the equilibrium of the consumer

The utility function is given as;- U = f (q x )

Where utility is measured in monetary units. If the consumer buys q x his expenditure is
qxpx. Presumably the consumer seeks to maximize the difference between his utility and
his expenditure U − PX q x

The necessary condition for a maximum is that the partial derivative of the function
with respect with to qx be equal to zero. Thus

U  ( p x q x )
− =0
q x q x

Rearranging we obtain

U
= p x or MU X = PX
q x

The utility derived from spending an additional unit of money must be the same for all
commodities. If the consumer derives greater utility from any one commodity, he can
increase his welfare by spending more on that commodity and less on the others, until
the above equilibrium condition is fulfilled.

• Derivation of the consumer demand curve

The derivation of consumer demand curve is based on the axiom of diminishing

marginal utility. The marginal utility of a commodity x may be depicted by a line with a
negative slope (see figure 3(b)). Geometrically the marginal utility of x is the slope of the
total utility function U=f(qx). The total utility increases but at a decreasing rate, up to
quantity x, and the starts declining (fig 3(a)). Accordingly the marginal utility of x
declines continuously, and becomes negative beyond quantity x. if the marginal utility
is measured in monetary units the demand curve for commodity x is identical to the
positive segment of the marginal utility curve. At x1 the marginal utility is MU1 which is
equal to P1. Similarly at X2 the marginal utility is MU2 which is also equal to P2. Hence
at P2 the consumer will buy X2, and so on. The negative section of the MU curve does
not form part of the demand curve since negative values does not make sense in
economics.
Weaknesses of the Cardinal Utility Theory

There are three major weaknesses of the cardinal utility theory these are;-

a) The assumption of cardinality is doubtful, in that utility derived from the various
commodities cannot be measured objectively.

b) The assumption of constant utility of money is also unrealistic, as income increases

the marginal utility of money changes. Therefore making money to be a poor
measuring rod of utility.

c) And lastly the axiom of diminishing marginal utility is just a psychological law
which is must be taken for granted.

❖ The Ordinalist school postulated that utility is not measurable, but is an ordinal
magnitude. That the consumer needs not to know in specific units the utility of
various commodities to make his choice. It is sufficient for him/her to be able to
rank the various baskets of goods, according to the satisfaction that each bundle
gives him. He should be able to determine the order of preference among the
different goods. The main ordinal approach theories are the indifference curve and
revealed preference theories.

The indifference-curves theory

Assumptions

a) Rationality the consumer is assumed to be rational, that is he aims at

maximization of his utility, given his income and market prices. it is assumed he
has full knowledge of all the relevant information

b) Utility is ordinal. It is taken as axiomatically true that the consumer can rank his
preferences (that is ordering the various baskets of goods) according to
satisfaction of each basket. He needs not to know precisely the amount of
satisfaction. It is sufficient that he expresses his preference for the various bundles
of commodities.

c) Diminishing marginal rate of substitution. Preferences are ranked in terms of

indifference curves, which are assumed to be convex to the origin. This implies
that the slope of the indifference curves increases. The slope of the indifference
curve is called the marginal rate of substitution of the commodities. The
indifference curve theory is based, thus on the axiom of diminishing rate of
substitution
 d) The total utility of the consumer depends on the quantities of the commodities
consumed. That is U = f (q1 , q2 .......... q x , q y ,......... .......... .qn )

e) Consistency and transitivity of choice. It is assumed that the consumer is

consistent in his choice, in that if in one period he chooses bundle A over B, he
will not choose B over A in another period if both bundles are available to him.
The consistency assumption may be symbolically written as;- ifA  B, thenB  A

Similarly it is assumed that the consumer’s choices are characterized by

transitivity; if bundle A is preferred to B, and B is preferred to C then bundle A is
preferred to C. this can be represented as

If A>B and B>C the A>C

Derivation of the equilibrium of the consumer

The consumer is in equilibrium when he maximizes his utility, given his income and the
market prices. Two conditions must be fulfilled for the consumer to be in equilibrium.

The first condition is that the marginal rate of substitution be equal to the ratio of
commodity prices

MU x Px
MRS x, y = =
MU y Py

This is the necessary but not sufficient condition for equilibrium.

The second condition is that the indifference curves be convex to the origin. This
condition is fulfilled by the axiom of diminishing MRS x,y, which states that the slope of
the indifference curve decreases (in absolute term) as we move along the curve from left
to right

Graphical presentation of the equilibrium of the consumer

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 (point e)
At the point of tangency the slopes of the budget line (Px/Py) and of indifference curve
(MRSx,y = MUx/MUy) are equal:

MU x Px
=
MU y PY

Thus the first order condition is denoted by the point of tangency of the two relevant
curves. The second order condition is implied by the convex shape of the indifference
curves. The consumer maximizes his utility by buying x* and y* of the two
commodities.

Mathematical derivation of the equilibrium

Given the market prices and his income, the consumer aims at the maximization of his
utility. Assume that there are n commodities available to the consumer, with given
market prices P1, P2,……….Pn) the consumer has money income (Y), which he spends on
the available commodities.

Formally the problem can be stated as follows

Maximize U = f (q1 , q2, .......... .....qn )

n
Subject to q p
i =1
i i = q1 p1 + q2 p2 + .......... ....... + qn pn = Y
We use the Lagrangian multiplies method for the solution of this constrained
maximization

The steps involved in this method may be outlined as follows

i) Rewrite the constraint in the form

q1 p1 + q 2 p 2 + .......... ..... + q n p n − Y = 0

ii) Multiply the constraint by a constant λ, which is the Lagrangian multiplier

 (q1 p1 + q 2 p 2 + .......... . + q n p n − Y ) = 0

iii) Subtract the above constraint from the utility function and obtain the
composite function

 = U −  (q1 p1 + q 2 p 2 + ........ + q n p n − Y )

It can be shown that maximization of the composite function implies maximization of

the utility function.

The first order condition for the maximization of a function is that its partial derivatives
be equal to zero. Differentiating ϕ with respect to q1, q2……...…qn, and λ and equating to
zero we obtain

 U
= −  ( p1 ) = 0
q1 q1
 U
= −  ( P2 ) = 0
q 2 q 2
.
.
.
 U
= −  ( Pn ) = 0
q n q n

= −( q1 p1 + q 2 p 2 + ........ + q n p n − Y ) = 0

From this equations we obtain
 U = P1
q1
U = P2
q 2
.
.
.
U = Pn
q n
U U U
But = MU1 , = MU 2 , ………………. = MU n
q1 q 2 q n

Substituting and solving for λ we find

MU 1 MU 2 MU n
= = = .......... ...
P1 P2 Pn

Alternatively, we may divide the preceding equation corresponding to commodity x, by

the equation which refers to commodity y and obtain

MU x Px
= = MRS x, y
MU y Py

We observe that the equilibrium conditions are identical in cardinalist approach and in
the indifference curves approach. In both we have

MU 1 MU 2 MU x MU y MU n
= = .......... .. = = = .......... ...... =
P1 P2 Px Py Pn

Thus, although in the indifference curve approach cardinality of utility is not required,
the MRS requires knowledge of the ratio of the marginal utilities, given that the first
order condition for any two commodities may be written as

MU x Px
= = MRS x, y
MU y Py

Hence the concept of marginal utility is implicit in the definition of the slope of the
indifference curves, although its measurement is not required by this approach. What is
needed is diminishing marginal rate of substitution, which of course does not require
diminishing marginal utilities of the commodities involved in the utility function.

Derivation of the Demand Curve Using the Indifference Curve Approach

Graphical derivation of the demand curve As the price of a commodity, for example x,
falls the budget line of the consumer shifts to the right, from its initial position (AB) to a
new position (AB’) due to increase in the purchasing power of the consumer. With the
more purchasing power in his possession the consumer can buy more x and y. The
point of equilibrium will shift to the right of the original equilibrium (for normal goods)
showing that as price falls more of the commodity will be bought. If the price of
commodity x falls continuously and join the points of tangency of successive budget
lines and the highest possible indifference curves we obtain price consumption curve.
For which we derive the demand curve for commodity x. At point E1 the consumer
buys x1 at price P1. At point e2 the price P2 is lower than P1 and the quantity demanded
increases to x2 and so on. When we plot this we obtain the demand curve of commodity
x
The demand curve for normal commodities will always have a negative slope, denoting
the law of demand. In the indifference curve approach the law of demand is derived
from the what is known as the Slutsky’s theory which states that the substitution effect
of a price change is always negative ( relative to price, if the price increases, the
quantity demanded decreases and vice versa)
We observed that a fall in the price of x from p1to p2 resulted in an increase in the
quantity demanded from x1 to x2. This is the total price effect which may be split into
two separate effects, Substitution effect and income effect.
Substitution effect is the increase in the quantity bought as the price of the commodity
falls after adjusting income so as to keep the real purchasing power of the consumer the
same as before. This adjustment in income is called compensating variation and is
shown graphically by a parallel shift of the new budget line until it becomes tangent to
the initial indifference curve. The purpose of compensating variation is to allow the
consumer to remain on the same level of satisfaction as before the price change. The
compensated budget line will be tangent to the original indifference curve Ic1 at e2 to the
right of the original tangency e1 because this line is parallel to the new budget line
which is less steep than the original one when the price of x falls this is the substitution
effect of a price change. The consumer buys more of commodity x now that now that it
is cheaper, substituting y for x.
However the compensating variation only isolates the substitution effect but does not
take into account of the new equilibrium obtained E3 define from the higher
indifference curve Ic3. The consumer has in fact a higher purchasing power and if the
commodity is a normal good he will spend his increased real income on x thus moving
from x2 to x3. This is the Income effect of a price change.
The income effect of a price change is negative for normal goods and it reinforces the
negative substitution effect. If however the commodity is inferior, the income effect of
the price change will be positive as the purchasing power increases, less of x will be
bought and still the negative substitution effect off sets the positive income effect,
therefore the total price effect will be negative. Hence the negative substitution effect is
sufficient to explain the law of demand.
When the income effect is positive and strong against the substitution effect that the law
of demand does not hold hence the case of Giffen goods which are inferior and have a
positive demand curve
Consumer Equilibrium
This section concentrates with putting together the budget line and the theory of preference in
order to examine the optimal choice of consumers. We have noted that the economic model of
consumer choice is that consumers choose the best bundle they can afford, i.e. the consumers
choose the most preferred bundle from their budget set.
Suppose the budget set and the well behaved consumer preferences are drawn on the same
diagram as:
X2

The consumer
equilibrium

X 2*

X 1* X1

The bundle of goods that is associated with the highest indifference curve and is affordable is
(X *
)
X 2* . Any bundle above this one is unaffordable, such a bundle that appears on a point of
1

tangency between the consumers optimal choice and also referred to as the consumer’s
equilibrium choice. The point of tangency is called the consumer equilibrium point. Since a
solution as is represented above is an interior solution, where the consumers optimal choice
involves both goods. A situation where optimal consumption involves consuming 0 units of one
good and some units of another is called a boundary solution/optimum. For example:
X2

IC

Budget line

0 X 1* X1

Boundary optimum: The optimum consumption involves consuming 0 units of good 2 and the
indifference curve is not tangent to the budget line.
The tangency condition is only a necessary condition to have as optimal choice but not a
sufficient condition. However, there is one important case where it is sufficient, the case of
convex preferences. In the case of convex preferences, any point that satisfies the tangency
condition must be an optimal point.
Generally there may be more than one optimal bundle that satisfies the MRS condition as show
below:
X2

Optimal bundle

Non − optimal bundle

•
•

0 X1

In such a case, there are three tangencies but only two optimal points, so the tangency condition
is necessary but not sufficient. However, again convexity implies a restriction. If the
indifference curves are strictly convex, then there will be only one optimal choice in each budget
line.
Recall that the marginal rate of substitution is the rate of exchange at which the consumer is just
willing to stay put. On the other hand, the market is offering a rate of exchange to the consumer
P
of − 1 (the slope of the budget line).
P2

If the consumer is at a consumption bundle where he/she is willing to stay put, it must be one
where the MRS is equal to this rate of exchange.

P1
MRS = −
P2

MU1 MU 2
=
P1 P2

Hence

MU 1 P
MRS = − =− 1
MU 2 P2

Or simply
MU1 P1
= consumer equilibrium condition
MU 2 P2

The equilibrium point (optimal choice) has this characteristic that the slope of the IC (MRS) is
equal to the slope of the budget line. The consumer’s choice model can be used to find the
optimal choices for other preferences. Some examples include:
1. Perfect Substitutes
Recall that perfect substitutes have linear indifference curves, just similar to a budget line. If
P2  P1 , then the slope of the budget line is flatter than the slope of the indifference curves.
In such a case, the optimal bundle is where the consumer spends all income on good 1.

If P1  P2 , then the consumer purchases only good 2. If P1 = P2 , there is a whole range of

optimal choices and any amounts of goods 1 and 2 that satisfies the budget constraint is
optimal.
The graph below illustrates an optimal choice with perfect substitutes which provide a
boundary solution.

X2

Indifference curve

Budget line

Optimal choise

M X1
X 1* =
P1

In summary
 M
 P if P1  P2
 1
 M
X 1 = any number between 0 and if P1 = P2
 P1
0 if P1  P2



2. Perfect Complements
In this case, the optimal choice must always lie on the diagonal, where the consumer is
purchasing equal amounts of both goods, no matter what prices are. The optimal choice
can be illustrated as:

X2

Indiffrence curves

Optimal choice

X 2*
Budget line

0 X 1* X1

3. Concave preferences
 X2

Indifference curve

Non optimal choice

Budget line
X

Optimal choice

Z X1

The optimal choice is always going to be a boundary choice/solution such as bundle z.

The optimal choice is the boundary point z, not the interior tangency point X because Z
lies on a higher indifference curve.
The Consumer Demand Functions
The consumer’s demand functions give the optimal amounts of each of the goods as a function of
the prices and income faced by the consumer. The demand function are written a
X1 = X1 (P1P2 M )

X 2 = X 2 (P1P2 M )

In elementary microeconomics, a clear distinction is made between the normal, inferior and
giffen goods.When the consumer income changes, the optimal choice for the goods changes
yielding an income expansion path. The income consumption path is used to derive an Engel
curve. On the other hand, a change in price also changes the optimal choice of the consumer
yielding a price offer curve which is used to derive the demand curve.
In this level we give it a mathematical approach where we seek to determine the demand
functions for the optimal choice bundle of the consumer.
The consumer problem is stated as:
 MaxU ( X 1 X 2 ).......... .......... .......... .......... ...(i )
st
P1 X 1 + P2 X 2 = M .......... .......... .......... ........ (ii )

Introducing a langrangian multiplier and converting (1) and (2) into a composite function we
have:

L = U ( X 1 X 2 ) −  (P1 X 1 + P2 X 2 − M ) = 0

Obtaining the first order conditions,

L U
= − P1 = 0.......... .......... .......... .......... .....(iii)
X 1 X 1

L U
= − P2 = 0.......... .......... .......... .......... .....(iv)
X 2 X 2

L
= P1 X 1 + P2 X 2 − M = 0.......... .......... .......... ....(v )


Re- writing equations (4) and (5) and dividing them yields:

U
X 1 P
= 1
U P2
X 2
MU X 1 P1
=
MU X 2 P2

This is a similar concept to what was earlier called the consumer equilibrium condition. It
corresponds to a point of tangency between an indifference curve and the budget line from the
graphical approach discussed in the previous sections.
Solving equations (iii), (iv) and (v) above simultaneously, we obtain the demand functions for
the optimal choice bundle. This is best demonstrated using a specific consumer preference and
in this case the Cobb-Douglas preference.
Suppose a utility function is specified as

U ( X 1 X 2 ) = X 1 X 2

The consumer problem is stated as

MaxU = X 1 X 2
st
P1 X 1 + P2 X 2 = M

L = X 1 X 2 −  (P1 X 2 + P2 X 2 − M )
L
= X 1 −1 X 2 − P1 = 0.......... .......... ...(i )
X 1
L
= X 1 X 2 −1 − P2 = 0.......... .......... .....(ii )
X 2
L
= P1 X 1 + P2 X 2 − M = 0.......... .......... .....(iii )


Re-writing and dividing equation 1 and 2 above we obtain

X 1 −1 X 2 P1
=
X 1 X 2 −1 P2
P1
X 1 −1− X 2 −(  −1) =
P2
X 2 P1
=
X 1 P2

Such that

P1 
X2 = X 1 .......... .......... .......... .....(iv )
P2 
 P2 X 2
X1 = .......... .......... .......... ......(v )
 P1

Equation (4) and (5) represent the income expansion paths or the income offer curve.
Substituting equation (4) and (5) into equation (3) one at a time we obtain.
P1 X 1 + P2 X 2 = M
  P1 X 1 
P1 X 1 + P2   = M
  P 2 


P1 X 1 + P1 X 1 = M

 
1 +  P1 X 1 = M
 
 +  
  P1 X 1 = M
  
M
X1 =
 
1 +  P1
 

M
X 1* =
 +
P1

 M
X 1* = demand function for X 1
 +  P1
 M
X 2* = demand funtion for X 2
 +  P2

X 1* and X 2* are referred to as the Marshallian demand function that represents the optimal
choice bundle X 1* X 2* . They provide the solution to the consumer utility maximising problem.

Given the market prices and the income level for a consumer then the functions describe the
exact amount of both goods that the consumer would have to consume so as to maximise utility.
Revealed Preference
We have seen how we can use information about the consumer’s preferences and the budget
constraints to determine his/her demand. However, in real life, preferences are not directly
observable. We discover people’s preferences from observing their behaviour. The revealed
preference theory shows how we can use information about the consumers demand to discover
information about his/her preferences.

The theory adopts a maintained hypothesis that the consumers preferences are stable over the
time period for which his/her behaviour is observed-whether they may be or are known to be
strictly convex. Thus there will be a unique demanded bundle at each budget.
Consider the figure below, where we have depicted a consumer’s demanded bundle ( X 1 X 2 ) and
another arbitrary bundle (Y1Y2 ) i.e. beneath the consumer’s budget line.

good 2

• X1 X 2

• Y1Y2

good 1

Bundle (Y1Y2 ) is certainly an affordable purchase at the given budget. The consumer could have
bought it if he/she wanted to and even had money left over. Since ( X 1 X 2 ) is the optimal bundle
it must be better than anything else that the consumer could afford. Hence it must be better than
(Y1Y2 ) or any other bundle on or beneath the budget line.
Let ( X 1 X 2 ) be the bundle purchased at prices (P1 P1 ) when the consumer has income M. Since
(Y1Y2 ) is affordable at these prices and income, then:
P1Y1 + P2Y2  M

Since X1X2 is actually bought at the given budget, then

P1Y1 + P2Y2 = M

Putting these two equations together

P1Y1 + P2Y2  P1Y1 + P2Y2

If the above inequality is satisfied and (Y1Y2 ) is actually a different bundle from ( X 1 X 2 ), then
( X 1 X 2 ) is said to be directly revealed preferred to (Y1Y2 ) . This revealed preference is a relation
that holds between the bundle that is actually demanded at some budget and the bundles that
could have been demanded at that budget. The principle of revealed preference is therefore stated
as:-

Let ( X 1 X 2 ) be the chosen bundle when prices are (P1 P2 ) and let (Y1Y2 ) be some other bundle
such that:

P1Y1 + P2Y2  P1Y1 + P2Y2 . Then if the consumer is choosing the most preferred bundle, he can
afford, we must have ( X 1 X 2 )  (Y1Y2 ) .

Suppose further that (Y1Y2 ) is a demanded bundle at prices (q1q 2 ) and that (Y1Y2 ) is itself revealed
preferred to some other bundle Z1 Z 2 . That is:

q1 y1 + q2 y 2  q1 z1 + q1 z 2 .

Then ( X 1 X 2 )  (Y1Y2 ) and (Y1Y1 )  (Z1 Z 2 ) . From the transitivity assumption, we can conclude
that ( X 1 X 2 )  (Z1 Z 2 ) .

This is illustrated:

good 2

• X1 X 2
•
Y1Y2 budgetlines

• Z1 Z 2
good 1

Revealed preference and transitivity assumption tell us that ( X 1 X 2 ) must be better than (Z1 Z 2 )
for the consumer who made the illustrated choices. In this case ( X 1 X 2 ) is said to be indirectly
revealed proffered to (Z1 Z 2 ) . The chain of direct comparisons can be of any length such that if
bundle A is directly revealed to B, and B to C, C to D… all the way to Z, then bundle A is still
indirectly revealed to Z.
If a bundle is either directly or indirectly revealed preferred to another bundle, we will say that
the first bundle is revealed preferred to the second.
From the figure below, since ( X 1 X 2 ) is revealed preferred, either directly, to all of the bundles
below (shaded area) either budget lines, ( X 1 X 2 ) is in fact preferred to those bundles by the
consumer. That is, the true indifference curve through ( X 1 X 2 ), whatever it is, must lie above
the shaded region. It therefore also follows that, the true indifference curve through (Y1Y2 ) must
lie above the flatter budget line.
The Weak Axiom of Revealed Preference
We have so far supposed that the consumer has preferences and that he/she is always choosing
the best bundle of goods affordable. If the consumer is not behaving this way, the estimates of
the indifference curves that we have constructed are meaningless.
Consider:

good 2

•
X1 X 2 budgetlines

• Y1Y2

good 1

According to the logic of revealed preference, the diagram allows us to conclude two things.

(i) ( X 1 X 2 ) is preferred to (Y1Y2 ) and

(ii) (Y1Y2 ) is preferred to ( X 1 X 2 )
That is, the consumer has apparently chosen ( X 1 X 2 ) when he/she could have chosen (Y1Y2 )
indicating that ( X 1 X 2 ) was preferred to (Y1Y2 ) indicating that ( X 1 X 2 ) was preferred to (Y1Y2 )
but then he/she indicating the opposite. This situation is absurd and violates the weak Axiom of
Revealed Preference
Clearly this consumer cannot be a maximizing consumer. Either the consumer is not choosing
the best bundle he/she can afford or there is some other aspect of the choice problem that has
changed that we have not observed. Perhaps the consumer’s tastes or some other aspect of
his/her economic environment have changed. If consumers are choosing the best bundles that
are affordable, but not chosen must be worse than what is chosen. Economists have therefore
formulated this simple point in a basic axiom of consumer theory referred to as the weak axiom
of revealed preference (WARP) it states that ‘if ( X 1 X 2 ) is directly revealed preferred to (Y1Y2 )
and the two bundles are not the same, then it cannot happen that (Y1Y2 ) is directly revealed
preferred to ( X 1 X 2 ).

In other words, if a bundle ( X 1 X 2 )is purchased at prices (P1 P2 ) and a different bundle (Y1Y2 ) is
purchased at prices q1 q 2 then if.

P1 X 1 + P2 X 2  P1Y1 + P2Y2

It must not be the case that

q1Y1 + q2Y2  q1 X 1 + q2 X 2

That is, if the Y bundle is affordable when the x-bundle is purchased, then when the Y-bundle is
purchased, the X bundle must not be affordable.
The consumer in (immediate diagram) has violated the WARP and therefore this consumer’s
behaviour could not have been maximizing behaviour. There is no set of indifference curves that
could make both bundles maximizing bundles.
On the other hand, a consumer who satisfies WARP is said to have a maximizing or optimal
behaviour and for such, it is possible to find indifference curves for which his/her behaviour is
optimal. One possible choice of indifference curves is illustrated below.

Good 2

• X1 X 2
Budget lines

• X1 X 2

Good 1
The Strong Axiom of Revealed Preference
The weak axiom of revealed preference requires that if X is directly revealed preferred to Y, then
we should never observe Y being directly revealed to X. The strong axiom of revealed
preference requires that the same sort of condition hold for indirect revealed preference. The
strong Axiom of Revealed Preference. The strong Axiom of Revealed Preference (SARP) states
that:

If ( X 1 X 2 ) is revealed preferred to (Y1Y2 ) either directly or indirectly and (Y1Y2 ) is different from
( X 1 X 2 ) is revealed preferred to (Y1Y2 ) .
It is therefore clear that if the observed behaviour is optimizing behaviour, then it must satisfy
the strong axiom. For if the consumer is optimizing and ( X 1 X 2 ) is revealed preferred to, either
directly or indirectly, then it must be the case that ( X 1 X 2 ) > (Y1Y2 ) . Therefore, having ( X 1 X 2 )
revealed preferred to (Y1Y2 ) and (Y1Y2 ) revealed preferred to ( X 1 X 2 ) would imply that ( X 1 X 2 )>
(Y1Y2 ) and (Y1Y2 ) > ( X 1 X 2 ), which is a contradiction. We can conclude that either the consumer
must not be optimizing or some other aspect of the consumer’s environment such as tastes, other
prices etc. must have changed.
While WARP is a necessary condition for optimizing behaviour, SARP is both necessary and
sufficient in the sense that, if the observed choices satisfy SARP, we can always find well
behaved preferences that could have generated the observed choices. It ensures both consistency
and transitivity of consumer preferences.

NOTE

The weak axiom of revealed preference requires that if X is directly revealed preferred to Y,
then we should never observe Y being directly revealed to X. The strong axiom of revealed
preference requires that the same sort of condition hold for indirect revealed preference. The
strong Axiom of Revealed Preference. The strong Axiom of Revealed Preference(SARP)
states that If ( X 1 X 2 ) is revealed preferred to (Y1Y2 ) either directly or indirectly and (Y1Y2 ) is

different from ( X 1 X 2 ) is revealed preferred to (Y1Y2 ) .

 THE SLUTSKY EQUATION
Economists are concerned with how consumer’s behaviour changes in response to changes in the
economic environment. So far, the prices of the goods and the income are the common variables
in the consumer economic environment.
In previous lessons we had an exposure of how the optimal choice by a consumer changes due
to changes in both prices and income. In this case, we consider a detailed analysis of how a
consumer’s choice of a good responds to changes in its price.
When the price of a good changes, there are two types of effects, the rate at which one can
exchange one good for another changes, and the total purchasing power of income changes.
These two causes’ changes in the consumer demand for the goods.
The change in demand due to the change in the rate of exchange between the goods is called the
substitution effect. While the change in demand due to changes in the purchasing power is
called income effect. To give a more precise definition, let us consider the two effects separately
and in details.
The substitution effect
To capture the SE, we let the relative prices to change due to a price change and adjust money
income so as to hold pursing power constant.
Using the following diagram:
Good 2

M
P2

Original BL

Original choice

Final choice
X1
Pivoted BL

Final Budgetline
Pivot Shift
0 X1 M Good 1
P1

Suppose the price of good 1 falls, this means that the budget line rotates around the vertical
M
intercept and becomes flatter. This movement of the budget line can be broken into two
P2
steps:
1. Pivot the budget line around the original demanded bundle and then,
2. Shift the pivoted line out to the new demanded bundle.

The pivot is a movement where the slope of the budget line changes while its purchasing power
remains constant, while a shift is a movement where the slope of the BL remains constant while
the purchasing power changes.
These two movements give a convenient way to decompose the change in demand into two
places. This decomposition is only hypothetical and the consumer simply observes a change in
price and chooses a new bundle of goods in response. In analysing how the consumer’s choice
changes it is useful to think of the budget line changing in two stages (i) pivot and (ii) shift.
Considering the pivot, the pivoted budget line has the same slope and thus the same relative
prices as the final budget line. However, the money income associated with this budget line is
different since the vertical intercept are different.
Since the original consumption bundle ( X 1 X 2 ) lies on the pivoted BL, that consumption is just
affordable. In this sense, the purchasing power of the consumer has remained constant in the
sense that the original bundle of goods is just affordable at the new pivoted line. That is after the
price of good 1 falls, income must have been adjusted so as to make the original bundle just
affordable at a change in relative prices.
Suppose the original prices for goods 1 and 2 are P1 and P2 respectively and M is the original
income. Let M1 be the amount of money income that will just make the original consumption
bundle affordable this will be the amount of money income associated with the pivoted budget
line.

Since ( X 1 X 2 ) is affordable at both (P1 P2 M ) and (P1 ' P2 M )

Where P1 is the new fallen price of good 1, then we have

M ' = P1' X 1 + P2 X 2
M = P1 X 1 + P2 X 2

Subtracting the two equations

(
M '− M = X 1 P1' − P1 )
That is, the change in money income necessary to make the old bundle affordable at the new
price is just the original amount of consumption of good 1 times the change in prices.

Let P1 = P1' − P1 . Represent the change in price.

M = M '− M . Represent the change in income necessary to make the old bundle just
affordable.
Then:

M = X 1P1

NOTE: The change in income and the changes in price will always move in the same direction:
if the price goes up, then we have to raise income to keep the same bundle affordable.

Although ( X 1 X 2 ) is still affordable, it is not generally the optimal purchase at the pivoted
budget line. The optimal purchase on the pivoted budget line is
Good 2

•X

•Z
•Y

Pivot Shift
SE Good 1
IE

Bundle Y is the optimal one, when we change the price and adjust income so as to keep the old
bundle of goods just affordable. The movement from X and Y is known as SE. It indicates how
the consumer substitutes one good for the other, when the price changes while adjusting income
to retain the consumer’s purchasing power.

More precisely, the SE X 1 is the change in the demand for good 1, when the price of good 1
changes to P1 ' from P1 and at the same time, money income changes from M to M '

( )
X 1S = X 1 P1' M ' − X 1 (P1 M )

The SE is sometimes called the change in compensated demand. The idea is that the consumer is
being compensated for a price change by having his/her income adjusted accordingly, if the price
rises “compensation” is done by giving the consumer some more income to make the same
amount of a good affordable at a higher price and vice versa.

For example:
Mathematically
Suppose that the consumer has a demand function for good x of the form.
 M
X = 10 +
10P

Let his original income be Kshs.120 per day and let the price of good X be Ksh.3 per unit. Thus
the demand for good X per day is:

X (P, M ) = X (3,20) = 10 +
120
= 14 units per day
10(3)

Suppose the price of good X falls to Ksh.2 per unit. His new demand at his new price would be

X (P' , M ) = X (2,120) = 10 +
120
= 16 units per day
10(2)

The total change in demand is increased by 2 units of good X per day. In order to calculate the
SE, we must first calculate by now much income would have to change in order to make the
original demand of 14 units just affordable when the price is Ksh.2 per unit.
Recall that:

M = X 1 P1
= 14(2 − 3)
= −14
The level of income necessary to keep purchasing power constant is:
M ' = M + M
= 120 − 14
= 106 shillings

The consumer demand at the new price of Kshs.2 and the new income level of Ksh. 106 is.

( )
X P1' M ' = X (2,106) = 10 +
106
10(2)
= 15.3

Thus the SE is

( )
X 1S = X P1' M ' − X (P1 M )

The Income Effect

We have so far considered the pivot of the budget line, the second stage of the price adjustment
is the shift movement.
A parallel shift of the budget line is the movement that occurs when income changes while
relative prices remain constant. Thus the second stage of the price adjustment is called the
income effect. It is a change of the consumers income from M1 back to M1 keeping the prices
constant at (P1 ' P2 ) . In the last diagram this change moves from the point Y to Z. It is natural to
call this last movement the income effect since all we are doing is changing income while
keeping the prices fixed at the new prices.

Precisely, the income effect X 1n is the change in the demand for good 1 when the income
changes from M ' to M holding the price of good 1 fixed at P1'

( ) (
X 1n = X 1 P1' M − X 1 P1' M ' )
Recall from EET 100, that income effect of a price change can operate either way. It will tend to
increase or decrease the demand for good 1 depending on whether good 1 is Normal or Inferior.
When the price of a good decreases the income also decreases in order to keep purchasing power
constant. If the good is normal, then this decrease in income will lead to a decrease in demand.
If the good is inferior, then the decrease in income will lead to an increase in demand.
For example

( )
X P1' M = X (2,120) = 16
X (P M ') = X (2,106) = 15.3
1
'

Thus

X 1n = X 1 (2,120) − X 1 (2,106)
= 16 − 15.3
= 0.7

Since the demand for good X here increases when income increases, then good X is normal.
The Sign of the Substitution Effect
Consider (last diagram ) where the amount of good 1 consumed is less that at the bundle X and Y
were both affordable at the old prices (P1 P2 ) but they were not purchased. Instead, the bundle x
was purchased. If the consumer is always choosing the best bundle he/she can afford, then X
must be preferred to all of the bundles on the part of the pivoted budgetline that lies inside the
original budget set.
That is, the optimal choice on the pivoted budgetline must not be one of the bundles that has
underneath the original budgetline. The optimal choice on the pivoted line would have to be
either X or some point to the right of X. But this means that the new optimal choice must
involve consuming at least as much as good 1 as originally just as we wanted to show. In the
(diag.) the optimal choice at the pivoted budgetline is the bundle Y, which certainly involves
consuming more of good 1 than at the original consumption point X.
The substitution effect always moves opposite to the price movement. It is said to be always
negative, since the change in demand due to the SE is opposite to the change in price. If the
price increases, the demand for the good due to the SE decreases.
The Total Change

The total change in demand is X 1 , is the change in demand due to the change in price, holding
income constant:

( )
X 1 = X 1 P1' M − X 1 (P1 M )

We have already seen that, this total change can be split into two effects, the substitution effect
and X 1S and the income effect X 1n

That is

X 1 = X 1S + X 1N

Hence

( )  ( )   ( ) (
X 1 P1' M − X 1 (P1 M ) = X 1 P1' M − X 1 (P1 M ) + X 1 P1' M − X 1 P1' M ' )
These equations say that the total change in demand equals the substitution effect plus the
income effect. This equation is called the Slutsky’s identity. It is true for all values of P1 P1' , M
and M ' . The first and the fourth terms on the RHS cancel out, so the RHS is identically equal to
the LHS.
Use of the Slutsky’s Equation
The Slutsky’s identity is not just the algebraic identity. The content comes in the interpretation
of the two terms on the RHS, the substitution effect and the income effect. In particular, the
signs of the income and substitution effect can be used to determine the sign of the total effect,
which in turn reveals the type of a good in question. That is, the total effect reveals whether a
good is normal, inferior or giffen.
When the SE must always be negative (opposite to the change in price) the income effect can go
either way thus, the total effect maybe positive or negative.
i) Normal Good

If a good is normal, the substitution effect and the income effect work in the same direction. An
increase in the price will mean that demand will go down due to the SE. If the price goes up, i.e.
a decrease in income, which for a normal good means a decrease demand. Both effects reinforce
each other. In terms of our notations, the change in demand due to a price increase means that

X 1 = X 1S + X 1n
− − −

ii) Inferior good

On the other hand, if we have an inferior good, the income effect is positive. A fall in price for
example is like an increase in income. an increase in income would reduce the demand for an
inferior good.

X 1 = X 1S + X 1n
− − +

However, the second term on the RHS – the income effect – the first term of the right hand side.
The total change is therefore negative. This would mean that a fall in price results to an increase
in demand.
iii) Giffen good,

For a giffen good, the second term on the RHS – income effect is positive but large enough that
the total change could be positive. This would mean that a fall in price would result to a fall in
demand.

X 1 = X 1S + X 1n
+ − +

A fall in price and increased the consumer purchasing power such that, the consumer has reduced
his/her consumption of the inferior good. The slutsky’s identity shows that his kind of perverse
effect can only occur for inferior goods. If the good is normal, then the income and substtituion
effect reinforce each other, so that the total change in demand is always in the ‘right’ directions.
Thus a giffen good must be inferior. But an inferior good is not necessarily a giffen good. The
income effect not only has to be large enough of the ‘wrong’ sign it also has to be large enough
to outweigh the right sign of the substitution effect. This is why giffen goods are so rarely
observed in real life; they would not only have to be inferior goods, but they would have to be
too inferior.
Income and Substitution Effects for Other Preferences.
A similar analysis could be done for other preferences. A similar analysis could be done for
particular kinds of preferences and decompose the demand changes.
a) perfect compliments:- The slutsky decomposition is shown below:
 X2

Indiffrence curves

Original
budget line
Final budget line

 Shift
X1
Pivot Income effect = total effect

When the budgetline pivots around the chosen bundles the optimal choice at the new budgetline
is the same as at the original one – this means that the substitution effect is zero. The change in
demand is entirel due to the income effect.
b) Perfect substitutes
In this case, when the budgetline tilts, the demand bundle moves from the vertical axis to the
horizontal axis. There is no shifting and the entire change in demand is due to the substitution
effect. This is show as:
 X2

Indiffrence curves

Final budget line

Original
choice Final choice

Original
budget line
X1

THE HICKS SUBSTITUTION EFFECT

The substitution effect is the name that economists give to the change in demand when prices
change but a consumer’s purchasing power is held constant, so that the original bundle remains
affordable. This definition is called the slutsky’s substitution effect.
Suppose that instead of pivoting the budget line around the original consumption bundle, the
budget line is rolled around the indifference curve through the original consumption bundle as
shown.
 X2

Indiffrence curve

Final budget line

Original choice

Original budget Final choice

0 SE IE X1

The budgetline is pivoted around the indifference curve rather than around the original choice
i.e., the consumers purchasing power will no longer be sufficient to purchase his/her original
bundle of goods, but will be sufficient to purchase a bund that is just indifferent to his/her
original bundle.
Thus the substitution effect keeps the utility level constant rather than keeping the purchasing
power constant. This SE is called the Hicks SE.
The Slutsky substitution effect gives the consumer just enough money to get back his/her
original level of consumption while the Hicks SE gives the consumer just enough money to get
back to his/her original difference curve.
Despite the difference in definition, it turns out that the Hicks SE must be negative in the sense
that it is a direction opposite that of the price change just like the Slutsky SE.
Summary

The substitution effect involves the substitution of good x1 for good x2 or vice-versa
due to a change in relative prices of the two goods.
The income effect results from an increase or decrease in the consumer’s real income
or purchasing power as a result of the price change.
The sum of these two effects is called the price effect.

NOTE

A parallel shift of the budgetline is the movement that occurs when income changes
while relative prices remain constant. Thus the second stage of the price adjustment is
called the income effect.
The Slutsky substitution effect gives the consumer just enough money to get back
his/her original level of consumption while the Hicks SE gives the consumer just
enough money to get back to his/her original difference curve.