Chapter Two

Theory of Demand and Supply

Introduction
Having learnt about the concept and meaning of economics as a subject and its nature, scope,
different systems and various other fundamentals in the previous chapter, we now resort to a
very important issue in economics. This is the issue of how free markets operate. In this
chapter we will forward our exploration and understanding of the vast field of economics by
focusing on two very powerful tools, namely, theory of demand and theory of supply.

The purpose of this chapter is to explain what demand and supply are and show how they
determine equilibrium price and quantity. We will also show how the concepts of demand and
supply reveal consumers‘ and producers‘ sensitivity to price change.

Chapter objectives
After covering this chapter, you will be able to:
 understand the concept of demand and the factors affecting it;
 explain the supply side of a market and the determinants of supply;

 understand how the market reaches equilibrium condition, and the possible
factors that could cause a change in equilibrium and
 explain the elasticity of demand and supply
2.1 Theory of demand

1. Are demand and want similar? Why?

2. Why can’t we purchase all that we need or we desire to have?
3. Can we say that, with a decrease in the price of a commodity, a consumer
normally buys more of it? Why?
4. Explain why demand curves always slope downwards from left to right. Are
there any exceptions to this?

Demand is one of the forces determining prices. The theory of demand is related to the
economic activities of consumers-consumption. Hence, the purpose of the theory of demand is
to determine the various factors that affect demand.

In our day-to-day life we use the word ‗demand‘ in a loose sense to mean a desire of a person
to purchase a commodity or service. But in economics it has a specific meaning, which is
different from what we use it in our day to day activities.
Demand implies more than a mere desire to purchase a commodity. It states that the consumer
must be willing and able to purchase the commodity, which he/she desires. His/her desire
should be backed by his/her purchasing power. A poor person is willing to buy a car; it has no
significance, since he/she has no ability to pay for it. On the other hand, if his/her desire to buy
the car is backed by the purchasing power then this constitutes demand. Demand, thus, means
the desire of the consumer for a commodity backed by purchasing power. These two factors
are essential. If a consumer is willing to buy but is not able to pay, his/her desire will not
become demand. Similarly, if the consumer has the ability to pay but is not willing to pay,
his/her desire will not be called demand.

More specifically, demand refers to various quantities of a commodity or service that a

consumer would purchase at a given time in a market at various prices, given other things
unchanged (ceteris paribus). The quantity demanded of a particular commodity depends on the
price of that commodity.

Law of demand: This is the principle of demand, which states that , price of a commodity and
its quantity demanded are inversely related i.e., as price of a commodity increases (decreases)
quantity demanded for that commodity decreases (increases), ceteris paribus.

2.1.1 Demand schedule (table), demand curve and demand function

The relationship that exists between price and the amount of a commodity purchased can be
represented by a table (schedule) or a curve or an equation.

Demand schedule can be constructed for any commodity if the list of prices and quantities
purchased at those prices are known. An individual demand schedule is a list of the various
quantities of a commodity, which an individual consumer purchases at various levels of prices
in the market. A demand schedule states the relationship between price and quantity demanded
in a table form.

Table 2.1 Individual household demand for orange per week

Combinations A B C D E

Price per kg 5 4 3 2 1

Quantity demand/week 5 7 9 11 13
Demand curve is a graphical representation of the relationship between different quantities of
a commodity demanded by an individual at different prices per time period.

Y
Price
5 A
4 B

3 C

2 D

1 E

0 X Quantity demanded
5 7 9 11 13

Figure 2.1: Individual demand curve

In the above diagram prices of oranges are given on ‗OY‘ axis and quantity demanded on
‗OX‘ axis. For example, when the price per kilogram is birr 1 the quantity demanded is 13
kilograms. From the above figure you may notice that as the price declines quantity demanded
increases and vice-versa.

Demand function is a mathematical relationship between price and quantity demanded, all
other things remaining the same. A typical demand function is given by:

Qd=f(P)

where Qd is quantity demanded and P is price of the commodity, in our case price of orange.

Example: Let the demand function be Q = a+ bP


b= Q (e.g. moving from point A to B on figure 2.1 above)

P
75
b= 2 , where b is the slope of the demand curve
45

Q = a-2P, to find a, substitute price either at point A or B.

7= a-2(4), a = 15

Therefore, Q=15-2P is the demand function for orange in the above numerical example.

Market Demand: The market demand schedule, curve or function is derived by horizontally
adding the quantity demanded for the product by all buyers at each price.
 Table 2.2: Individual and market demand for a commodity

Price Individual demand Market

Consumer-1 Consumer-2 Consumer-3 demand
8 0 0 0 0
5 3 5 1 9
3 5 7 2 14
0 7 9 4 20

The following graph depicts market demand curve at price equal to 3

Price Price Price Price

3 + 3 + 3 = 3

5 Q 7 Q 2 Q 14 Q

Consumer-1 Consumer - 2 Consumer - 3 Market Demand

Figure 2.2: Individual and Market demand curve

Numerical Example: Suppose the individual demand function of a product is given by: P=10 -
Q /2 and there are about 100 identical buyers in the market. Then the market demand function
is given by:

P= 10 - Q /2 ↔ Q /2 =10-P ↔ Q= 20 - 2P and Qm = (20 – 2P) 100 = 2000-200P

2.1.2 Determinants of demand

The demand for a product is influenced by many factors. Some of these factors are:
I. Price of the product
II. Taste or preference of consumers
III. Income of the consumers
IV. Price of related goods
V.Consumers expectation of income and price
VI. Number of buyers in the market
When we state the law of demand, we kept all the factors to remain constant except the price of
the good. A change in any of the above listed factors except the price of the good will change
the demand, while a change in the price, other factors remain constant will bring change in
quantity demanded. A change in demand will shift the demand curve from its original location.
For this reason those factors listed above other than price are called demand shifters. A change
in own price is only a movement along the same demand curve.

Changes in demand: a change in any determinant of demand—except for the good‘s price-
causes the demand curve to shift. We call this a change in demand. If buyers choose to
purchase more at any price, the demand curve shifts rightward—an increase in demand. If
buyers choose to purchase less at any price, the demand curve shifts leftward—a decrease in
demand.

When demand increases, demand

Price
curve shifts upward (D1) while a

1 decrease in demand shifts demand curve downwards

(D2).
2 D1

D0
D2
Quantity
Figure 2.3: Shift in demand curve

Now let us examine how each factor affect demand.

I. Taste or preference

When the taste of a consumer changes in favour of a good, her/his demand will increase and
the opposite is true.

II. Income of the consumer

Goods are classified into two categories depending on how a change in income affects their
demand. These are normal goods and inferior goods. Normal Goods are goods whose demand
increases as income increase, while inferior goods are those whose demand is inversely related
with income. In general, inferior goods are poor quality goods with relatively lower price and
buyers of such goods are expected to shift to better quality goods as their income increases.
However, the classification of goods into normal and inferior is subjective and it is usually
dependent on the socio-economic development of the nation.
III. Price of related goods

Two goods are said to be related if a change in the price of one good affects the demand for
another good.

There are two types of related goods. These are substitute and complimentary goods.
Substitute goods are goods which satisfy the same desire of the consumer. For example, tea
and coffee or Pepsi and Coca-Cola are substitute goods. If two goods are substitutes, then price
of one and the demand for the other are directly related. Complimentary goods, on the other
hand, are those goods which are jointly consumed. For example, car and fuel or tea and sugar
are considered as compliments. If two goods are complements, then price of one and the
demand for the other are inversely related.

IV. Consumer expectation of income and price

Higher price expectation will increase demand while a lower future price expectation will
decrease the demand for the good.

V. Number of buyer in the market

Since market demand is the horizontal sum of individual demand, an increase in the number of
buyers will increase demand while a decrease in the number of buyers will decrease demand.

2.1.3 Elasticity of demand

1. List some goods/commodities you think that increase in their prices will
not significantly decrease their quantity demanded.
2. Can you list some products for which increase in their prices will
significantly decrease/increase their quantity demanded?

In economics, the concept of elasticity is very crucial and is used to analyze the quantitative
relationship between price and quantity purchased or sold. Elasticity is a measure of
responsiveness of a dependent variable to changes in an independent variable. Accordingly, we
have the concepts of elasticity of demand and elasticity of supply.

Elasticity of demand refers to the degree of responsiveness of quantity demanded of a good to

a change in its price, or change in income, or change in prices of related goods. Commonly,
there are three kinds of demand elasticity: price elasticity, income elasticity, and cross
elasticity.
 i. Price Elasticity of Demand

Price elasticity of demand means degree of responsiveness of demand to change in price. It

indicates how consumers react to changes in price. The greater the reaction the greater will be
the elasticity, and the lesser the reaction, the smaller will be the elasticity. Price elasticity of
demand is a measure of how much the quantity demanded of a good responds to a change in
the price of that good, computed as the percentage change in quantity demanded divided by the
percentage change in price.

Demand for commodities like clothes, fruit etc. changes when there is even a small change in
their price, whereas demand for commodities which are basic necessities of life, like salt, food
grains etc., may not change even if price changes, or it may change, but not in proportion to the
change in price.

Price elasticity demand can be measured in two ways. These are point and arc elasticity.

a. Point Price Elasticity of Demand

This is calculated to find elasticity at a given point. The price elasticity of demand can be
determined by the following formula.

E p  Percentage change in quantity demanded  %Q d

d

percentage change in price %P

Q Q
where %Qd  1 0 X100 and
Q0

P  P
%P  1 0 X100
P0

Q Q
1 0
Q X100 Q Q P Q P
E P  0  1 0 . 0  . 0
Thus, d P P PP Q P Q
1 0 1 0 0 0
P X100
0

In this method, we take a straight-line demand curve joining the two axes, and measure the
elasticity between two points Qo and Q1 which are assumed to be intimately close to each
other.
ce

Y
ri
 ∆Q

In the diagram ‗RP‘ is the straight-line

R
demand curve, which connects both axes.
In the beginning at the price ON the
N quantity demanded is OM. Then the price

changes to ON1 and the new quantity

Q
o
demanded will be OM1. The symbol ‗∆P‘
∆
P represents the change in price while the
N
1 symbol ‗∆Q‘ shows the
change in quantity demanded.

O MM1 P Quantity
Figure 2.4: Point elasticity of demand

On a straight-line demand curve we can make use of this formula to find out the price
elasticity at any particular point. We can find out numerical elasticities also on different
points of the demand curve with the help of the above formula. It should be remembered
that the point elasticity of demand on a straight line is different at every point.

b. Arc price elasticity of demand

The main drawback of the point elasticity method is that it is applicable only when we
have information about even the slight changes in the price and the quantity demanded of
the commodity. But in practice, we do not acquire such information about minute
changes. We may possess demand schedules in which there are big gaps in price as well
as the quantity demanded. In such cases, there is an alternative method known as arc
method of elasticity measurement.

In arc price elasticity of demand, the midpoints of the old and the new values of both
price and quantity demanded are used. It measures a portion or a segment of the demand
curve between the two points. An arc is a portion of a curve line, hence, a portion or
segment of a demand curve.

The formula for measuring arc elasticity is given below.

Change in quantity demanded Change in price

Ed  
Original quantity plus new Original price plus
quantity demanded new price
Symbolically, the formula may be expressed thus:

E d  Q1  Q0  P1  P0
Qo  Q1 Po  P1
Here, Qo = Original quantity demanded
Q1 = New quantity demanded
Po = Original price
P1 = New price

We can take a numerical example to illustrate arc elasticity. Suppose that the price of a
commodity is Br. 5 and the quantity demanded at that price is 100 units of a commodity. Now
assume that the price of the commodity falls to Br. 4 and the quantity demanded rises to 110
units. In terms of the above formula, the value of the arc elasticity will be

110 100 4  5 = 10 1 9 = 3
Ed =   =-
100 110 4  5 21 9 2 7
0 1

Note that:
 Elasticity of demand is unit free because it is a ratio of percentage change.
 Elasticity of demand is usually a negative number because of the law of demand. If the price
elasticity of demand is positive the product is inferior.

i) I   1, demand is said to be elastic and the product is luxury product

f

0    1, demand is inelastic and the product is necessity

ii) I
f
  1, demand is unitary elastic.
iii) I
f   0, demand is said to be perfectly inelastic.

iv) I  , demand is said to be perfectly elastic.

f

v) I
f
Determinants of price Elasticity of Demand
The following factors make price elasticity of demand elastic or inelastic other than changes in
the price of the product.
i) The availability of substitutes: the more substitutes available for a product, the
more elastic will be the price elasticity of demand.
ii) Time: In the long- run, price elasticity of demand tends to be elastic. Because:
 More substitute goods could be produced.
 People tend to adjust their consumption pattern.
iii) The proportion of income consumers spend for a product:-the smaller the
proportion of income spent for a good, the less price elastic will be.
iv) The importance of the commodity in the consumers’ budget :

 Luxury goods tend to be more elastic, example: gold.
 
 Necessity goods tend to be less elastic example: Salt.
 ii. Income Elasticity of Demand

It is a measure of responsiveness of demand to change in income.

 I  %Qd  Q I
d
.
%I I Q

Point income elasticity of demand:

i) If  d
I  1, the good is luxury good.

ii) If  I  1( and positive), the good is necessity good,

d

iii) If  I  0, (negative), the good is inferior good.

d

 iii. Cross price Elasticity of Demand

Measures how much the demand for a product is affected by a change in price of another good.

%Qx Q Q P
 xy  = x 1 xo . y 0

%P P P Q
y y y x0
1 0

i) The cross – price elasticity of demand for substitute goods is positive.

ii) The cross – price elasticity of demand for complementary goods is negative.

iii) The cross – price elasticity of demand for unrelated goods is zero.

Example: Consider the following data which shows the changes in quantity demanded of good
X in response to changes in the price of good Y.

Unit price of Y Quantity demanded of X

10 1500
15 1000

Calculate the cross –price elasticity of demand between the two goods. What can you say about
the two goods?

Q P
x y 1000 1500  10  500 10
 xy   o    0.67
P Qx  1510  1500 5 1500
* .* .

y o

Therefore, the two goods are complements.

 2.2 Theory of supply

Supply indicates various quantities of a product that sellers (producers) are willing and able to
provide at different prices in a given period of time, other things remaining unchanged.

The law of supply: states that, ceteris paribus, as price of a product increase, quantity supplied
of the product increases, and as price decreases, quantity supplied decreases. It tells us there is
a positive relationship between price and quantity supplied.

2.2.1 Supply schedule, supply curve and supply function

A supply schedule is a tabular statement that states the different quantities of a commodity
offered for sale at different prices.

Table 2.3: an individual seller’s supply schedule for butter

Price ( birr per kg) 30 25 20 15 10

Quantity supplied kg/week 100 90 80 70 60

A supply curve conveys the same information as a supply schedule. But it shows the
information graphically rather than in a tabular form.

In this diagram the quantities of

Supply curve oranges are measured along X axis

and prices along Y axis. The supply
Price

curve slopes upward as we go from

the left to the right. This means, as
the price rises, more is offered for
sale and vice-versa.
Quantity

Figure 2.5 supply curve

The supply of a commodity can be briefly expressed in the following functional relationship:

S = f(P), where S is quantity supplied and P is price of the commodity.

Market supply: It is derived by horizontally adding the quantity supplied of the product by all
sellers at each price.
Table 2.4: Derivation of the market supply of good X

Price per Quantity Quantity supplied Quantity Market supply

unit supplied by by seller 2 supplied by per week
seller 1 seller 3

5 11 15 8 34

4 10.5 13 7 30.5

3 8 11.5 5.5 25

2 6 8.5 4 18.5

1 4 6 2 12

2.2.2 Determinants of supply

Apart from the change in price which causes a change in quantity demanded, the supply of a
particular product is determined by:

i) price of inputs ( cost of inputs)

ii) technology

iii) prices of related goods

iv) sellers‘ expectation of price of the product

v) taxes & subsidies

vi) number of sellers in the market

vii) weather, etc.

i) Effect of change in input price on supply of a product

An increase in the price of inputs such as labour, raw materials, capital, etc causes a decrease
in the supply of the product which is represented by a leftward shift of the supply curve.
Likewise, a decrease in input price causes an increase in supply.

ii) Effect of change in Technology

Technological advancement enables a firm to produce and supply more in the market. This
shifts the supply curve outward.

iii) Effect of change in weather condition

A change in weather condition will have an impact on the supply of a number of products,
especially agricultural products. For example, other things remain unchanged, good weather
condition boosts the supply of agricultural products. This shifts the supply curve of a given
agricultural product outward. Bad weather condition will have the opposite impact.

Activity: Discuss how supply is affected by the changes in prices of related goods, taxes
& subsidies, sellers’ expectations of future price of the product, and the number of
sellers in the market?

2.2.3 Elasticity of supply

It is the degree of responsiveness of the supply to change in price. It may be defined as the
percentage change in quantity supplied divided by the percentage change in price. As the case
with price elasticity of demand, we can measure the price elasticity of supply using point and
arc elasticity methods. However, a simple and most commonly used method is point method.

The point price elasticity of supply can be calculated as the ratio of proportionate change in
quantity supplied of a commodity to a given proportionate change in its price. Thus, the
formula for measuring price elasticity of supply is:

% ℎ
Q P Q P
= =   *
% ℎ
Q P P Q

Like elasticity of demand, price elasticity of supply can be elastic, inelastic, unitary elastic,
perfectly elastic or perfectly inelastic. The supply is elastic when a small change on price leads
to great change in supply. It is inelastic or less elastic when a great change in price induces
only a slight change in supply. If the supply is perfectly inelastic, it will be represented by a
vertical line shown as below. If supply is perfectly elastic it will be represented by a horizontal
straight line as in second diagram.
Price
Price

S
Infinite elasticity or
Perfectly
perfectly elastic
inelastic or
P S
zero elasticity

Supply
0 Supply O

Figure 2.6: Perfectly inelastic and perfectly elastic supply curves

 2.3 Market equilibrium

Having seen the demand and supply side of the market, now let‘s bring demand and supply
together so as to see how the market price of a product is determined. Market equilibrium
occurs when market demand equals market supply.

- At point ‗E‘ market

D S demand equals market supply (equilibrium point)

H J - P is the market
(P1)
equilibrium (market
(P) E clearing) price.
G F
- M is the market
(P2) equilibrium (market
clearing) quantity.
S D

Quantity
M

Figure 2.7: market equilibrium

In the above graph, any price greater than P will lead to market surplus. As the price of the
commodity increases, consumers demand less of the product. On the other hand, as the price of
increases, producers supply more of the good. Therefore, if price increases to P 1 the market
will have a surplus of HJ. If the price decreases to P 2 buyers demand to buy more and suppliers
prefer to decrease their supply leading to shortage in the market which is equal to GF.

Numerical example: Given market demand: Qd= 100-2P, and market supply: P =( Qs /2) + 10
a) Calculate the market equilibrium price and quantity
b) Determine, whether there is surplus or shortage at P= 25 and P= 35.

Solution:

a) At equilibrium, Qd= Qs

100 – 2P = 2P – 20

4P =120

P  30, and Q  40

b) Qd(at P = 25) = 100-2(25) =50 and Qs(at P = 25 ) = 2(25) -20 =30

Therefore, there is a shortage of: 50 -30 =20 units

Qd( at P=35) = 100-2(35) = 30 and Qs (at p = 35) = 2(35)-20 = 50, a surplus of 20 units
Effects of shift in demand and supply on equilibrium

Given demand and supply the equilibrium price and quantity are stable. However, when these
market forces change what will happen to the equilibrium price and quantity? Changes in
demand and supply bring about changes in the equilibrium price level and the equilibrium
quantity.

i) when demand changes and supply remains constant

Factors such as changes in income, tastes, and prices of related goods will lead to a change in
demand. The figure below shows the effects of a change in demand and the resultant
equilibrium price and quantity. DD is the demand curve and SS is the supply curve.
Price

S
D1
D
D2 E1
P1

P E
P2
E2 D1
D
D2
S
Quantity

M2 M M 1
Figure 2.8: The effect of change in demand on market equilibrium

DD and SS curves intersect at point E and the quantity demanded and supplied is OM at OP
equilibrium price. Given the supply, if the demand increases the demand curve will shift
upward to the right. Due to a change in demand, the demand curve D 1D1 intersects SS supply
curve at point E1. The equilibrium price increases from OP to OP 1 and the equilibrium quantity
from OM to OM1. On the other hand, if demand falls, the demand curve shifts downwards to
the left. Due to a change in demand, the curve D 2D2 intersects the supply curve SS at point E 2.
The equilibrium price decreases from OP to OP 2 and the equilibrium quantity decreases from
OM to OM2. Supply being given, a decrease in demand reduces both the equilibrium price and
the quantity and vice versa.
ii. When supply changes and demand remains constant
Changes in supply are brought by changes in technical knowledge and factor prices. The
following graph explains the effects of changes in supply.

S2
Price

D S
S1

E2
P2
P E
P1 E1

S2 S S
1 D
Quantity
M2 M M1
Figure 2.9: The effect of change in supply on market equilibrium

SS and DD intersect at point E, where supply and demand are equal at OM quantity at OP
equilibrium price. Given the demand, if the supply increases, the supply curve shifts to the
right (S1S1). The new supply curve, which intersects DD curve at E 1, reduces the equilibrium
price from OP to OP1 and increases the equilibrium quantity from OM to OM 1. On the
contrary, when the supply falls, the supply curve moves to the left (S 2S2) and intersects the DD
curve at point E2 raising the equilibrium price from OP to OP2 and reducing the equilibrium
quantity from OM to OM2.

III) Effects of combined changes in demand and supply

When both demand and supply increase, the quantity of the product will increase definitely.
But it is not certain whether the price will rise or fall. If an increase in demand is more than an
increase in supply, then the price goes up. On the other hand, if an increase in supply is more
than an increase in demand, the price falls but the quantity increases. If the increase in demand
and supply is same, then the price remains the same.

When demand and supply decline, the quantity decreases. But the change in price will depend
upon the relative fall in demand and supply. When the fall in demand is more than the fall in
supply, the price will decrease. On the other hand, when the fall in supply is more than the fall
in demand, the price will rise. If both demand and supply decline in the same ratio, there is no
change in the equilibrium price, but the quantity decreases.
 Activity: Considering the initial market equilibrium of figure 2.9 above, show the
new equilibrium
1. if there is an increase in supply and proportionate increase in demand
2. if the magnitude of an increment in demand is less than an increment
in supply
3. if demand and supply change in the opposite directions

Chapter summary
Demand for a commodity refers to the amount that will be purchased at a particular price
during a particular period of time. Price of the commodity, income of the consumer, prices of
related goods, consumer‘s tastes and preferences, consumers‘ expectations and number of
buyers are considered the main determinants of demand for a commodity. The law of demand
states that, other things remaining constant, the quantity demanded of a commodity increases
when its price falls and decreases when the price rises.

Supply refers to the quantity of a commodity which producers are willing to produce and offer
for sale at a particular price during a particular period of time. Price of a commodity, input
prices, prices of related products, techniques of production, policy of taxation and subsidy,
expectations of future prices, and the number of sellers are the main determinants of supply.
Law of supply states that other things remaining the same, the quantity of any commodity that
firms will produce and offer for sale rises with a rise in price and falls with a fall in price.

Market equilibrium refers to a situation in which quantity demanded of a commodity equals the
quantity supplied of a commodity.

Goods can be categorized as normal good (a good for which the demand increases with
increases in income), an inferior good (a good for which the demand tends to fall with an
increase in the income of the consumer), substitute goods(are those goods which satisfy the
same type of demand and can be used in place of one another), complementary goods( are
those goods which are used jointly or together), and giffen goods(whose demand falls with a
fall in their prices).

Elasticity of demand refers to the degree of responsiveness of quantity demanded of a

commodity to change in any of its determinants. There are three types of elasticity of demand:
Price elasticity of demand, income elasticity of demand and cross price elasticity of demand.
Price elasticity of demand is determined by availability of substitutes, nature of the commodity,
proportion of income spent and time.
 Chapter Three
Theory of Consumer Behavior
Introduction

In our day –to- day life, we buy different goods and services for consumption. As consumer,
we act to derive satisfaction by using goods and services. But, have ever thought of how your
mother or any other person whom you know decides to buy those consumption goods and
services? Consumer theory is based on what people like, so it begins with something that we
can‘t directly measure, but must infer. That is, consumer theory is based on the premise that we
can infer what people like from the choices they make.

Consumer behaviour can be best understood in three steps. First, by examining consumer‘s
preference, we need a practical way to describe how people prefer one good to another.
Second, we must take into account that consumers face budget constraints – they have limited
incomes that restrict the quantities of goods they can buy. Third, we will put consumer
preference and budget constraint together to determine consumer choice.

Chapter objectives

After successful completion of this chapter, you will be able to:

 explain consumer preferences and utility

 differentiate between cardinal and ordinal utility approach

 define indifference curve and discuss its properties

 derive and explain the budget line

 describe the equilibrium condition of a consumer

3.1 Consumer preferences

A consumer makes choices by comparing bundle of goods. Given any two consumption
bundles, the consumer either decides that one of the consumption bundles is strictly better than
the other, or decides that she is indifferent between the two bundles.

In order to tell whether one bundle is preferred to another, we see how the consumer behaves in choice situations
involving two bundles. If she always chooses X when Y is available, then it is natural to say that this consumer
prefers X to Y. We use the symbol ≻ to mean that one bundle is strictly preferred to another, so that X ≻Y should
be interpreted as saying that the consumer strictly prefers X to Y, in the sense that she definitely wants the X-
bundle rather than the Y-bundle. If the consumer is indifferent between two bundles of goods, we use the symbol
∼ and write X~Y. Indifference means that the consumer would be just as satisfied, according to her own preferences, consuming the bundle
X as she would be consuming bundle Y. If the consumer prefers or is indifferent between the two bundles we say that she weakly prefers X to
Y and write X ⪰ Y.

The relations of strict preference, weak preference, and indifference are not independent concepts; the relations are
themselves related. For example, if X ⪰ Y and Y ⪰ X, we can conclude that X ~Y. That is, if the consumer thinks that
X is at least as good as Y and that Y is at least as good as X, then she must be indifferent between the two bundles of
goods. Similarly, if X ⪰ Y but we know that it is not the case that X~ Y, we can conclude that X ≻Y. This just says that
if the consumer thinks that X is at least as good as Y, and she is not indifferent between the two bundles, then she thinks
that X is strictly better than Y.

3.2 The concept of utility

Economists use the term utility to describe the satisfaction or pleasure derived from the
consumption of a good or service. In other words, utility is the power of the product to satisfy
human wants. Given any two consumption bundles X and Y, the consumer definitely wants the
X-bundle than the Y-bundle if and only if the utility of X is better than the utility of Y.

Do you think that utility and usefulness are synonymous? Do two individuals always derive
equal satisfaction from consuming the same level of a product?

In defining utility, it is important to bear in mind the following points.

 ‗Utility’ and ‘Usefulness’ are not synonymous. For example, paintings by Picasso may be
useless functionally but offer great utility to art lovers. Hence, usefulness is product
centric whereas utility is consumer centric.

 Utility is subjective. The utility of a product will vary from person to person. That means,
the utility that two individuals derive from consuming the same level of a product may
not be the same. For example, non-smokers do not derive any utility from cigarettes.

 Utility can be different at different places and time. For example, the utility that we get
from drinking coffee early in the morning may be different from the utility we get during
lunch time.
 3.3 Approaches of measuring utility

How do you measure or compare the level of satisfaction (utility) that you obtain from goods and
services?

There are two major approaches to measure or compare consumer‘s utility: cardinal and
ordinal approaches. The cardinalist school postulated that utility can be measured objectively.
According to the ordinalist school, utility is not measurable in cardinal numbers rather the
consumer can rank or order the utility he derives from different goods and services.

3.3.1 The cardinal utility theory

According to the cardinal utility theory, utility is measurable by arbitrary unit of measurement
called utils in the form of 1, 2, 3 etc. For example, we may say that consumption of an orange
gives Bilen 10 utils and a banana gives her 8 utils, and so on. From this, we can assert that
Bilen gets more satisfaction from orange than from banana.

3.3.1.1 Assumptions of cardinal utility theory

The cardinal approach is based on the following major assumptions.

1. Rationality of consumers. The main objective of the consumer is to maximize his/her
satisfaction given his/her limited budget or income. Thus, in order to maximize his/her
satisfaction, the consumer has to be rational.

2. Utility is cardinally measurable. According to the cardinal approach, the utility or

satisfaction of each commodity is measurable. Utility is measured in subjective units
called utils.

3. Constant marginal utility of money. A given unit of money deserves the same value at any
time or place it is to be spent. A person at the start of the month where he has received
monthly salary gives equal value to 1 birr with what he may give it after three weeks or so.

4. Diminishing marginal utility (DMU). The utility derived from each successive units of a
commodity diminishes. In other words, the marginal utility of a commodity diminishes as
the consumer acquires larger quantities of it.

5. The 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 X 1X 2X n , the

total utility is given by TU = f ( X1 , X 2 ...... X n ).

 3.3.1.2 Total and marginal utility

Total Utility (TU) is the total satisfaction a consumer gets from consuming some specific
quantities of a commodity at a particular time. As the consumer consumes more of a good per
time period, his/her total utility increases. However, there is a saturation point for that
commodity beyond which the consumer will not be capable of enjoying any greater satisfaction
from it.

Marginal Utility (MU) is the extra satisfaction a consumer realizes from an additional unit of
the product. In other words, marginal utility is the change in total utility that results from the
consumption of one more unit of a product. Graphically, it is the slope of total utility.

Mathematically, marginal utility is:

TU
MU 
Q
where, TU is the change in total utility, and Q is the change in the amount of product
consumed.

To explain the relationship between TU and MU, let us consider the following hypothetical
example.

Table 3.1: Total and marginal utility

Quantity Total utility (TU) Marginal utility (MU)

0 0 -
1 10 10
2 18 8
3 24 6
4 28 4
5 30 2
6 30 0
7 28 -2

The total utility first increases, reaches the maximum (when the consumer consumes 6 units)
and then declines as the quantity consumed increases. On the other hand, the marginal utility
continuously declines (even becomes zero or negative) as quantity consumed increases.
Graphically, the above data can be depicted as follows.

TU

30

TU

18

0 2 6 Quantity Consumed

MU

Quantity Consumed
0 2 6

Figure 3.1: Total and marginal utility curves

As it can be observed from the above figure,

 When TU is increasing, MU is positive.
 When TU is maximized, MU is zero.
 When TU is decreasing, MU is negative.

3.3.1.3 Law of diminishing marginal utility (LDMU)

Is the utility you get from consumption of the first orange the same as the second or the third
orange?

The law of diminishing marginal utility states that as the quantity consumed of a commodity
increases per unit of time, the utility derived from each successive unit decreases, consumption
of all other commodities remaining constant. In other words, the extra satisfaction that a
consumer derives declines as he/she consumes more and more of the product in a given period
of time. This gives sense in that the first banana a person consumes gives him more marginal
utility than the second and the second banana also gives him higher marginal utility than the
third and so on (see figure 3.1).
The law of diminishing marginal utility is based on the following assumptions.
 The consumer is rational
 The consumer consumes identical or homogenous product. The commodity to be
consumed should have similar quality, color, design, etc.
 There is no time gap in consumption of the good
 The consumer taste/preferences remain unchanged

3.3.1.4 Equilibrium of a consumer

The objective of a rational consumer is to maximize total utility. As long as the additional unit
consumed brings a positive marginal utility, the consumer wants to consumer more of the
product because total utility increases. However, given his limited income and the price level
of goods and services, what combination of goods and services should he consume so as to get
the maximum total utility?

a) the case of one commodity

The equilibrium condition of a consumer that consumes a single good X occurs when the
marginal utility of X is equal to its market price.
MU P
X X

Proof
Given the utility function
Uf(X)

If the consumer buys commodity X, then his expenditure will be . The consumer
maximizes the difference between his utility and expenditure.
Max(U  Q P )
X X

The necessary condition for maximization is equating the derivative of a function to zero.
Thus,
dU  d (Q P )  0
X X
d d
Q X QX
dU  P  0  MU P
X X X
d
Q X
 MUX
A
C
PX

MUX
QX

Figure 3.2: Equilibrium condition of consumer with only one commodity

At any point above point C (like point A) where MUX > PX, it pays the consumer to consume
more. When MUX < PX (like point B), the consumer should consume less of X. At point C
where MUX = PX the consumer is at equilibrium.

b) the case of two or more commodities

For the case of two or more goods, the consumer‘s equilibrium is achieved when the marginal
utility per money spent is equal for each good purchased and his money income available for
the purchase of the goods is exhausted. That is,

= and + =M

where, M is the income of the consumer.

Example: Suppose Saron has 7 Birr to be spent on two goods: banana and bread. The unit
price of banana is 1 Birr and the unit price of a loaf of bread is 4 Birr. The total utility she
obtains from consumption of each good is given below.

Table 3.2: Utility schedule for two commodities

Income = 7 Birr, Price of banana = 1 Birr, Price of bread = 4 Birr

Banana Bread
Quantity TU MU MU/P Quantity TU MU MU/P
0 0 - - 0 0 - -
1 6 6 6 1 12 12 3
2 11 5 5 2 20 8 2
3 14 3 3 3 26 6 1.5
4 16 2 2 4 29 3 0.75
5 16 0 0 5 31 2 0.5
6 14 -2 -2 6 32 1 0.25
 Recall that utility is maximized when the condition of marginal utility of one commodity
divided by its market price is equal to the marginal utility of the other commodity divided by
its market price.
MU
1 
MU
 2

P1 P2

In table 3.2, there are two different combinations of the two goods where the MU of the last
birr spent on each commodity is equal. However, only one of the two combinations is
consistent with the prices of the goods and her income. Saron will be at equilibrium when she
consumes 3 units of banana and 1 loaf of bread. At this equilibrium,

i) MU1/P1 = MU2/P2
MU MU
banana
 bread
 3  12  3
P P 1 4
banana bread

ii) P1.Q1+ P2.Q2= M

(1*3) + (4*1) = 7

The total utility that Saron derives from this combination can be given by:
TU= TU1 + TU2
TU= 14 + 12
TU= 26

Given her fixed income and the price level of the two goods, no combination of the two goods
will give her higher TU than this level of utility.

Limitation of the cardinal approach

1. The assumption of cardinal utility is doubtful because utility may not be quantified. Utility
cannot be measured absolutely (objectively).
2. The assumption of constant MU of money is unrealistic because as income increases, the
marginal utility of money changes.

3.3.2 The ordinal utility theory

In the ordinal utility approach, it is not possible for consumers to express the utility of various
commodities they consume in absolute terms, like 1 util, 2 utils, or 3 utils but it is possible to
express the utility in relative terms. The consumers can rank commodities in the order of their
st nd rd
preferences as 1 , 2 , 3 and so on. Therefore, the consumer need not know in specific units
the utility of various commodities to make his choice. It suffices for him to be able to rank the
various baskets of goods according to the satisfaction that each bundle gives him.
 3.3.2.1 Assumptions of ordinal utility theory
The ordinal approach is based on the following assumptions.
 Consumers are rational - they maximize their satisfaction or utility given their income
and market prices.

 Utility is ordinal - utility is not absolutely (cardinally) measurable. Consumers are

required only to order or rank their preference for various bundles of commodities.
 Diminishing marginal rate of substitution: The marginal rate of substitution is the rate
at which a consumer is willing to substitute one commodity for another commodity so
that his total satisfaction remains the same. The rate at which one good can be substituted
for another in consumer‘s basket of goods diminishes as the consumer consumes more
and more of the good.
 The total utility of a consumer is measured by the amount (quantities) of all items he/she
consumes from his/her consumption basket.
 Consumer’s preferences are consistent. For example, if there are three goods in a given
consumer‘s basket, say, X, Y, Z and if he prefers X to Y and Y to Z, then the consumer is
expected to prefer X to Z. This property is known as axioms of transitivity.

The ordinal utility approach is explained with the help of indifference curves. Therefore, the
ordinal utility theory is also known as the indifference curve approach.

3.3.2.2 Indifference set, curve and map

Indifference set/ schedule is a combination of goods for which the consumer is indifferent. It
shows the various combinations of goods from which the consumer derives the same level of
satisfaction.

Consider a consumer who consumes two goods X and Y (table 3.3).

Table 3.3: Indifference schedule

Bundle (Combination) A B C D
Orange 1 2 4 7
Banana 10 6 3 1

In table 3.3 above, each combination of good X and Y gives the consumer equal level of total
utility. Thus, the individual is indifferent whether he consumes combination A, B, C or D.

Indifference curve: When the indifference set/schedule is expressed graphically, it is called an

indifference curve. An indifference curve shows different combinations of two goods which
yield the same utility (level of satisfaction) to the consumer. A set of indifference curves is
called indifference map.
a
 nana
10 A

Banana
B
6

C IC3
3
D IC2
1
IC1
Orange
1 2 4 7 Orange

i) Indifference curve ii) Indifference map

Figure 3.3: Indifference curve and indifference map

3.3.2.3 Properties of indifference curves

1. Indifference curves have negative slope (downward sloping to the right). Indifference
curves are negatively sloped because the consumption level of one commodity can be
increased only by reducing the consumption level of the other commodity. In other words, in
order to keep the utility of the consumer constant, as the quantity of one commodity is
increased the quantity of the other must be decreased.

2. Indifference curves are convex to the origin. This implies that the slope of an indifference
curve decreases (in absolute terms) as we move along the curve from the left downwards to
the right. The convexity of indifference curves is the reflection of the diminishing marginal
rate of substitution. This assumption implies that the commodities can substitute one another
at any point on an indifference curve but are not perfect substitutes.

3. A higher indifference curve is always preferred to a lower one. The further away from the
origin an indifferent curve lies, the higher the level of utility it denotes. Baskets of goods on a
higher indifference curve are preferred by the rational consumer because they contain more
of the two commodities than the lower ones.

4. Indifference curves never cross each other (cannot intersect). The assumptions of
consistency and transitivity will rule out the intersection of indifference curves. Figure 3.4
shows the violations of the assumptions of preferences due to the intersection of indifference
curves.
dY
oo
 B
IC2
C
A IC1

Good X
Figure 3.4: Intersection of indifference curves

In the above figure, the consumer prefers bundle B to bundle C. On the other hand, following
indifference curve 1 (IC1), the consumer is indifferent between bundle A and C, and along
indifference curve 2 (IC2) the consumer is indifferent between bundle A and B. According to the
principle of transitivity, this implies that the consumer is indifferent between bundle B and C
which is contradictory or inconsistent with the initial statement where the consumer prefers
bundle B to C. Therefore, indifference curves never cross each other.
22

3.3.2.4 Marginal rate of substitution (MRS)

Marginal rate of substitution is a rate at which consumers are willing to substitute one
commodity for another in such a way that the consumer remains on the same indifference curve.
It shows a consumer‘s willingness to substitute one good for another while he/she is indifferent
between the bundles.

Marginal rate of substitution of X for Y is defined as the number of units of commodity Y that
must be given up in exchange for an extra unit of commodity X so that the consumer maintains
the same level of satisfaction. Since one of the goods is scarified to obtain more of the other
good, the MRS is negative. Hence, usually we take the absolute value of the slope.
MR Number of units of Y given up Y
S X ,Y  
Number of units of X gained X
To understand the concept, consider the following indifference curve.
Good Y

30 A

20 B

12 C
8 D
IC

5 10 15 20 Good X

Figure 3.5: Indifference curve for two products X and Y

From the above graph, MRSX,Y associated with the movement from point A to B, point B to C
and point C to D is 2.0,1.6, and 0.8 respectively. That is, for the same increase in the
consumption of good X, the amount of good Y the consumer is willing to scarify diminishes.
This principle of marginal rate of substitution is reflected by the convex shape of the
indifference curve and is called diminishing marginal rate of substitution.

It is also possible to derive MRS using the concept of marginal utility. MR is related to
S X ,Y
MUX and MUY as follows.
M
MR
U
S X ,Y  X
M
U Y

Proof: Suppose the utility function for two commodities X and Y is defined as:
U  f ( X ,Y )

Since utility is constant along an indifference curve, the total differential of the utility
function will be zero.

U U
dU  dX  dY  0
X Y

MU dX  MU dY  0
X Y

M M   dX  MRSY ,
 Similarly, Y
U X dY U X dY
M  MRS X ,Y
X

M
U Y dX
U

Example: Suppose a consumer‘s utility function is given by U ( X ,Y )  X 4Y 2 . Find

MRSX,Y MU
MUY
U 3 2 U 4 MU X  4 X 3Y 2  2Y
MU  4XY and MU  2X Y Hence, MRS X ,Y 
X
X Y
Y M 2X Y
4
X
Y
U
3.3.2.5 The budget line or the price line

Do you think that the indifference curve discussed in the previous section tells us whether a
given combination of goods is affordable to the consumer? If no, what are the major
constraints to the consumer in maximizing his/her total utility?

Indifference curves only tell us about consumer preferences for any two goods but they cannot
show which combinations of the two goods will be bought. In reality, the consumer is
constrained by his/her income and prices of the two commodities. This constraint is often
presented with the help of the budget line.
The budget line is a set of the commodity bundles that can be purchased if the entire income is
spent. It is a graph which shows the various combinations of two goods that a consumer can
purchase given his/her limited income and the prices of the two goods.

In order to draw a budget line facing a consumer, we consider the following assumptions.
 There are only two goods bought in quantities, say, X and Y.
 Each consumer is confronted with market determined prices, PX and PY.

 The consumer has a known and fixed money income (M).

Assuming that the consumer spends all his/her income on the two goods (X and Y), we can
express the budget constraint as:
M  P X  PY Y
X

By rearranging the above equation, we can derive the following general equation of a budget
line.
Y  M  PX X
P P
Y Y

Graphically,

Good Y

M/PY

B
A

Good X
M/PX
Figure 3.6: The budget line
Note that:

 The slope of the budget line is given is by  PX (the ratio of the prices of the two goods).
P
Y

 Any combination of the two goods within the budget line (such as point A) or along the
budget line is attainable.
 Any combination of the two goods outside the budget line (such as point B) is
unattainable (unaffordable).
Example: A consumer has $100 to spend on two goods X and Y with prices $3 and $5
respectively. Derive the equation of the budget line and sketch the graph.

Solution: The equation of the budget line can be derived as follows.

P XPYM
X Y
Y
3X  5Y  100
5Y  100  3X 20

100 3
Y  X
5 5
Y  20  3
X5 X
33.3

When the consumer spends all of her income on good Y, we get the Y- intercept (0,20).
Similarly, when the consumer spends all of her income on good X, we obtain the X- intercept
(33.3,0). Using these two points we can sketch the graph of the budget line.

Recall that a budget is drawn for given prices and fixed consumer‘s income. Hence, the
changes in prices or income will affect the budget line.

Change in income: If the income of the consumer changes (keeping the prices of the
commodities unchanged), the budget line also shifts (changes). Increase in income causes an
upward/outward shift in the budget line that allows the consumer to buy more goods and
services and decreases in income causes a downward/inward shift in the budget line that leads
the consumer to buy less quantity of the two goods. It is important to note that the slope of the
budget line (the ratio of the two prices) does not change when income rises or falls.

Good Y

M/Py

Good X
M/Px

Figure 3.7: Effects of increase (right) and decrease (left) in income on the budget line
Change in prices: An equal increase in the prices of the two goods shifts the budget line
inward. Since the two goods become expensive, the consumer can purchase the lesser amount
of the two goods. An equal decrease in the prices of the two goods, one the other hand, shifts
the budget line out ward. Since the two goods become cheaper, the consumer can purchase the
more amounts of the two goods.

Good Y

M/Py

Good X
M/Px
Figure 3.8: Effect of proportionate increase (inward) and decrease (out ward) in the prices
of both goods

An increase or decrease in the price of one of the two goods, keeping the price of the other
good and income constant, changes the slope of the budget line by affecting only the intercept
of the commodity that records the change in the price. For instance, if the price of good X
decreases while both the price of good Y and consumer‘s income remain unchanged, the
horizontal intercept moves outward and makes the budget line flatter. The reverse is true if the
price of good X increases. On the other hand, if the price of good Y decreases while both the
price of good X and consumer‘s income remain unchanged, the vertical intercept moves
upward and makes the budget line steeper. The reverse is true for an increase in the price of
good Y.

Good Y

Good X
Figure 3.9: Effect of decrease in the price of only good X on the budget line
 3.3.2.6 Equilibrium of the consumer

The preferences of a consumer (what he/she wishes to purchase) are indicated by the
indifference curve. The budget line specifies different combinations of two goods (say X and
Y) the consumer can purchase with the limited income. Therefore, a rational consumer tries to
attain the highest possible indifference curve, given the budget line. This occurs at the point
where the indifference curve is tangent to the budget line so that the slope of the indifference
curve ( MRS ) is equal to the slope of the budget line (P / P ). In figure 3.10, the equilibrium
XY X Y

of the consumer is at point ‗E‘ where the budget line is tangent to the highest attainable
indifference curve (IC2).

Y* E
IC3

IC2
IC1

X
X*

Figure 3.10: Consumer equilibrium under indifference curve approach

Mathematically, consumer optimum (equilibrium) is attained at the point where:

Slope of indifference curve = Slope of the budget line
P
MR X

S 
XY
P
Y

 MU X  PX
MUY PY

Example: A consumer consuming two commodities X and Y has the utility function U ( X ,Y )
 XY  2X . The prices of the two commodities are 4 birr and 2 birr respectively. The consumer
has a total income of 60 birr to be spent on the two goods.

a) Find the utility maximizing quantities of good X and Y.

b) Find the MRS X ,Y at equilibrium.
 Solution
a) The budget constraint of the consumer is given by:
PX.X+ PY.Y = M
4X+2Y= 60 …………….…………. (i)

Moreover, at equilibrium
MU  P
X X
MU P
Y Y

Y2 4

X 2
Y2
2
X
Y  2X  2 ………….………… (ii)

Substituting equation (ii) into (i), we obtain Y  14 and X  8.

b) MRS MU  Y  2  14  2  2
X ,Y  X

MU Y X8

(At the equilibrium, MRS can also be calculated as the ratio of the prices of the two goods)
Chapter summary

A consumer makes choices by comparing bundle of goods. Given any two consumption
bundles, the consumer either decides that one of the consumption bundles is strictly better than
the other, or decides that he is indifferent between the two bundles. Economists use the term
utility to describe the satisfaction or pleasure derived from consumption of a good or service.
In other words, utility is the power of the product to satisfy human wants.

There are two approaches to measure or compare consumer‘s utility derived from consumption
of goods and services. These are cardinal and ordinal approaches. The cardinalist school
postulated that utility can be measured objectively. However, the assumption of cardinal utility
is doubtful because utility may not be quantified. Unlike the cardinal theory, the ordinal utility
theory says that utility cannot be measured in absolute terms but the consumer can rank or
order the utility he derives from different goods and goods.

The ordinal/indifference curve approach is based on the consumer‘s budget line and
indifference curves. An indifference curve shows all combinations of two goods which yield
the same total utility to a consumer and the budget line represents all combinations of two
products that the consumer can purchase, given product prices and his or her money income.
The consumer is in equilibrium (utility is maximized) at the point where the budget line is
tangent to the highest attainable indifference curve.

Suggested reading materials

 A. Koutsoyiannis, Modern Microeconomics, 2nd edition, 1979
 D.N.Dwivedi, 1997, Micro Economic Theory, 3rd edition., Vikas Publishing
 R. S. Pindyck and D. L. Rubinfeld, Microeconomics, 2nd edition,1992
th
 Varian, 2010, Intermediate Microeconomics: A Modern Approach, 8 edition
 C.L.Cole, Micro Economics: A Contemporary Approach.
 Ferguson & Gould‘s, 1989, Microeconomic Theory, 6th edition.
 E. Mansfield, 1988, Microeconomics: Theory and Applications
th
 Arnold, 2008, Microeconomics, 8 edition, International student edition