HSBC: INTERMEDIATE MICROECONOMICS

LECTURE 2

WEEK TOPIC HOURS CONTENT

- Consumer preferences and the concept of
utility and consumer Choice
- Consumer preferences
- Assumptions about preferences
- Indifference curves
- Examples of preferences
- Well behaved preferences
2 2 4hrs - The Marginal rate of substitution
- Cardinal utility
- Constructing a utility function
- Examples of utility functions
- Marginal utility and MRS
- Optimal choice and the langrage method
- Consumer demand
- Examples of optimal choices

1.0 CONSUMER DEMAND THEORY/ CONSUMER BEHAVIOR

Consumer behavior theory is main objective is concerned with how consumers

make decisions about consumption given commodity price and their limited

income so as to maximize utility.

Objective is to maximize utility subject to constraints

1) Price of commodities

2) income of the consumers

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WHO IS A CONSUMER?

A consumer is a decision making unit within the economy about consumption.

PRINCIPLES OF CONSUMERS DEMAND THEORY

(a) Limited income (scarcity) necessitates choice.

(b) Consumers make decisions purposely. That is consumers are careful shoppers

(c) One good or service can be substituted for another.

(d) Consumers make decisions without perfect information.

(e) The law of diminishing marginal utility applies to consumer behavior- As a

consumer successively consumes one unit of a good, the additional satisfaction

(marginal utility), starts to decline after some time period.

THEORIES OF CONSUMER BEHAVIOR

a) Cardinal/Neo-classical utility theory

The theory holds that utility derived from consumption of a good or service is

measurable subjectively using cardinal numbers (e.g. 1, 2, 3 …) by units of

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measurements called utils. For example if a consumer imagines that a mango has

8 utils and an apple has 4 utils, it implies that the utility of a mango is twice the

utility of apple.

Consumer equilibrium

Analyses of consumer equilibrium entails answering the question ‘‘how does a

consumer allocates his/her money income among the various goods and services

he/she consumes to maximize utility?’’. (Consumer can exhaust his / her income

(Langrange multiplier) OR Not exhaust his or her income(Kuhn-Tucker approach)

The cardinal utility approach to consumer’s equilibrium is based on the following

assumption,

 Consumer is assumed to be rational

 Limited money income

 Consumer has given preferences for the goods under consideration

 Consumer possesses perfect knowledge of obtainable utilities

 Utility of each product is measurable in cardinal numbers.

 Diminishing Marginal Utility applies to consumer behavior.

 Marginal utility of money is constant

 Units of commodities are homogeneous

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 Commodities are divisible

 Utility is additive.

Consumer Equilibrium-The General Case (Several Commodity Case)

Suppose a consumer consumes only two commodities X1 and X2

The corresponding utility function is,

Maximise U=f ( X 1 X 2 ) ……………………………………………. {1}

To buy these commodities, the consumer will pay prices P 1 and P2 for X1 and X2

respectively hence the corresponding total expenditure (money income of the

consumer).

P1 X 1 +P 2 X 2 =E ……………………………………………. {2}

Since the consumer has a limited income he or she can either spend less or equal

to income (E ≤ M) where. E = Expenditure; M= Money Income

That is,

P1 X 1 +P 2 X 2 ≤M …………………………………………….. {3}

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But since the consumer is assumed to be rational, he will spend the entire income

hence,

P1 X 1 +P 2 X 2 =M ……………………………………………… {4}

From {2} and {4},

E=M ……………………………………………………..… {5}

For each unit of X1the consumer buys, his utility increases by MU X 1 (Marginal

utility of X1= dTU/dX1)) .The same applies to X2.

To maximize utility,

If MU X 1<P1 , the consumer will reduce the quantity of X 1 consumed. Due to the

law of diminishing MU as quantity of X1 decreases MUX1 increases until MU X 1=P1

If MU X 1>P1 , the consumer will increase the quantity of X 1 consumed. Due to the

law of diminishing MU as quantity of X1 increases MUX1 decreases until MU X 1=P1

Thus when MU X 1=P1 , the consumer will be indifferent and is said to be in

equilibrium.

The same can be said for X2. That is the consumer will be in equilibrium when,

MU X 2 =P2 or

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MU X 2
=1
P2

MU X 1 MU X 2
=1 =1
Since P1 and P2 hence 1=1 .Thus,

MU X 1 MU X 2
=
P1 P2

Or

MU X 1 MU X 2
=
P1 P2

Cross multiply

MU X 1 P2=MU X 2 P1

Divide both sides by MUX2 and P2

MU X 1 P1
=
MU X 2 P2 ……………………………………………..{6}

MU X 1
=MRS
MU X 2

P1
=Slopeofbudgetline
P2

This is the condition for consumer equilibrium when consuming two commodities.

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Since a consumer does not consume only two commodities but several

commodities. The above condition for consumer equilibrium can be extended to a

n-general case,

MU X 1 MU X 2 MU X 3 MU Xn
= = =.. .. . .. .. . .. .. .=
P1 P2 P3 Pn

Or

MU X 1 P1 MU X 2 P2 MU Xn−1 Pn−1
= = = =. .. .. . .. .. .. . . =
MU X 2 P2 MU X 3 P3 MU Xn Pn ……………………………… {7}

Equations {6} and {7} give the necessary condition for consumer equilibrium. In

equilibrium it sufficient that the total expenditure on commodities consumed be

equal to income. That is,

P1 X 1 +P 2 X 2 =M

Or

P1 X 1 +P 2 X 2 +P 3 X 3 +.. .. . .. ..+Pn X n =M

This is the sufficient condition for consumer equilibrium.

Example

Consider the table below showing Total Utility for commodities X1 and X2

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Q TUX1 TUX2

1 16 21

2 30 40

3 42 55

4 52 67

5 60 76

6 65 82

If the prices for X1 and X2 are for P1 = 2 and P2 = 3 respectively and consumer’s

income (M) = 17( P1 X 1 +P 2 X 2 =M )= 2 X 1 +3 X 2 =17 . We can compute that level of

consumption of X1 and X2 that will yield maximum equilibrium and maximum Total

MU X 1 P1
=
Utility as follows, How do we choose? We apply MU X 2 P2 ; We also get Mux1

and Mux2; dTux1/dx1

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 Q TUX1 TUX2 MUX1 MUX2 MU X 1 MU X 2
P1 P2

1 16 21 (16- 0)/ (1-0) = (21- 0)/(1-0) = 21 8 7

16

2 30 40 (30-16 )/(2-1)=14 (40-21)/(2-1)= 19 7 6.3

3 42 55 42- 30=12 55-40= 15 6 5

4 52 67 52- 42=10 67-55= 12 5 4

5 60 76 60-52= 8 76-67= 9 4 3

6 65 82 65-60=5 82-76=6 2.5 2

P1 = 2

P2 = 3

M = 17

At equilibrium, the first condition is to have

MU X 1 MU X 2
=
P1 P2

and

P1 X 1 +P 2 X 2 =M

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The second condition 2 X 1 +3 X 2 =17 must be satisfied by the choices

1) X1=2; X2=1

2) X1=4; X2=3

3) X1=5; X2=4

Thus, 2(2) + 3(1) = 7

2(4) +3(3) =17

2(5) +3(4) =22

Thus, the consumer will be in equilibrium when consuming 4 units of X1 and 3

units of X2.

TU=TUX1 + TUX2 =52+55 =107

Derivation of consumer’s demand function

i. Marshallian Demand function/ The ordinary demand functions

The demand function is a mathematical representation between quantity

xi( pi)
demanded and price. Q=f(P) = this is direct demand function or P=f(Q)

this is an indirect demand function.

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A consumer’s ordinary demand function expresses the quantity demanded of a

x i ( p i m)
product as a function of prices and income. .

It is derived from utility maximizing problem.

example

u ( x 1 , x 2 )=x 1 x 2
Suppose the utility function is where x 1 and x 2 are two

goods. Let p1 and p2 represent the prices of the two goods respectively. Let M

represent the consumer’s income.

The consumer seeks to maximize utility subject to the budget constraint.

max u= x1 x 2
st
p1 x 1 + p2 x 2= M

Using the langrange we combine (Adding) the objective

function and the constraint into one function called the langrange as

follows. The constraint function can be written on one side of the

equation and thereafter combined with the objective as follows

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 1. We can combine the constraint to the left side of equation or

the right side of the equation as follows

a) To the right ……..=Z(M-P1x1-P2X2)

b) To the left……… Z(P1x1+P2X2 –M)=

2. To combine with the objective function the 1 st option is

added to the objective function and the 2nd option is

substracted from the objective function.

3. In our case we have used the second option and our

combined function becomes L =x1x2- Z(P1x1+P2X2 –M).

Alternatively we can use the first option, and our combined

function will be

L =x1x2 + Z(M-P1x1-P2X2).

The combined function(s) in step 3 above is reffered to as

the langrange function.

The langrange are used to allocate resources, in this case qty

(consumer demand qty) for the economic problem. This is

done by getting the FOC for the decision variables which in

this particular case will be X 1, X2 and the Z, always equated

to 0 to signify the maximum or minimum points before

inflexion (change of direction).

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 After identifying the peak of the curves/ problems, then we

can proceed and solve the choice problem using elimination

and substitution or matrix algebra.

L=x 1 x 2− λ ( p1 x 1 + p2 x 2−M )
∂L
=x − λp1 =0 .. .. . .. .(i)
∂ x1 2
∂L
=x − λp2 =0 .. .. . .. .. . ..(ii )
∂ x2 1
∂L
=p 1 x1 +p 2 x 2−M =0 .. .. .. . .. .(iii)
∂λ

Demonstration of ……(i)

L =x1x2- (P1x1+P2X2 –M).

L =x1x2- 𝞴 P1x1- 𝞴 P2X2 + 𝞴 M.

dL/d x1 = x2- 𝞴 P1=0

dL/d x2 = x1- 𝞴 P2=0

dL/d 𝞴 = P1x1+P2X2 –M =0

matrix

X1 X2 𝞴 Output

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 0 1 -P1 0

1 0 -P2 0

P1 P2 0 M

( )( ) ( )
0 1 −P 1 X 1 0
1 0 −P 2 X 2 = 0
P1 P2 0 λ M

Solve using cramers’ rule

Alternatively using elimination and substitution

Dividing the first two equations

x2 p1
=
x1 p2
p2 x 2
x 1=
p1
p1 x 1
x 2=
p2

Substituting this into equation (iii)

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 p1
( )
p 2 x2
p1
+ p2 x 2 =m

2 p 2 x 2 =m
¿ m
x 2=
2 p2

( )
p1 x1
p1 x 1 + p2 =m
p2
2 p1 x 1 =m
¿ m
x 1=
2 p1

¿ ¿
x 1 andx 2 are the ordinary or Marshallian demand functions and we could verify

that by showing that their slopes are negative;

∂ x2 −m
= 2
∂ p2 2 p2
∂ x 1 −m
= 2
i.e. ∂ p1 2 p1

(b) Ordinal utility theory (indifference curve approach).

All that matter about Utility as far as choice behavior is concerned is whether one

bundle has higher Utility than another, how much Utility does not matter.

Ordinal utility is an expression of the consumer preferences for one commodity

over another or for one basket over another and not the quantity or numerical

value.

The theory uses indifference curve to analyze the consumer behavior.

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Assumptions of Ordinal Utility Theory

 Consumer rationality

 The consumer possesses complete information about the prices of the

commodities in the market.

 The consumer’s tastes, habits and income remain the same throughout the

analysis

 Utility is Ordinal. The Ordinal Utility approach is based on the fact that the utility of a
commodity cannot be measured in absolute quantity, but however, it will be possible for

a consumer to tell subjectively whether the commodity derives more or less or equal

satisfaction when compared to another.

 The consumer arranges the two goods in a scale of preference.

 Consumer’s preference and indifference are transitive. Transitivity of

preferences means that if combination C is preferred to combination B and

combination B is preferred to combination A, then Combination C is preferred to

combination A.

 Consumer’s choices are consistent. This is derived from behavioral

consistency, which refers to people's tendency to behave in a manner that matches their

past decisions or behaviors

 Non-satiety. Non satiety means consumer is not at maximum utility level

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Indifference curves

It’s a locus of points showing different combinations of two commodities say X

and Y which yields the same level of utility or satisfaction/ at which the consumer

is indifferent

Properties/Characteristics of Indifference Curves

 Each indifference curve represents a given level of utility/satisfaction

 They are downwards sloping from left to right.

 They are convex to the origin. that is, they lie above any tangent to the curve

 They do not intersect/cross nor are they tangent to one another. If they

intersect, then they violate the principle of transitivity of preferences.

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 Higher IC represents higher level of satisfaction than a lower IC.

 ICs are everywhere dense.

 Indifference curves cannot touch either of the axes.

 They do not cut any of the axes.

 The numbers Ic0 , IC 1, IC 2 , .. . .IC n given to indifference curves are arbitrary. Any

number can be given to indifference curves. The numbers can be in the ascending

of 1, 2, 3,….. or descending order of …3, 2, 1, 0

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 In reality indifference curves are like bangles. However, their effective region

is where they are downwards sloping convex to the origin.

MARGINAL RATE OF COMMODITY SUBSTITUTION (MRCS)/MARGINAL RATES OF

SUBSTITUTION (MRS)

MRCS refers to the rate at which the consumer is just willing to substitute one

commodity for another but leave utility constant.

MRCS/MRS is equal to the negative slope of indifference curve.

A marginal rate of commodity of substitution of say X for Y is given by MRCS XY

which reads as, MRCS of X for Y and shows the number of units of Y that must be

given up to obtain a unit for X. (Downwards movement along the IC)

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Suppose a consumer utility function U=U (X, Y). Let the consumer substitute X for

Y such that TU remains the same.

When the consumer sacrifices some units of Y His/her stock of Y decreases by ΔY

and loses part of his total utility equal to −ΔY ×MU Y .

On the other hand, the consumer’s stock of X increases by ΔX and gains total

utility equal to + ΔX ×MU X . TU will remain the same only when,

−ΔY ×MU Y = + ΔX ×MU X

Or

ΔY MU X
− =
ΔX MU Y

ΔY
−
ΔX = slope of IC which gives the MRCSXY (Use X in place of Y)

Conversely,

ΔX MU Y
− =
ΔY MU X

ΔX
−
ΔY = slope of IC which gives the MRCSYX (Use Y in place of X)

MRS diminishes/decreases as we move along the IC.

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At point A,

ΔY ΔY
MRS XY = = =¿
 ΔX 0

ΔX 0
MRSYX = = =0
 ΔY ΔY

At point B,

ΔY 0
MRS XY = = =0
 ΔX ΔX

ΔX ΔX
MRSYX = = =¿
 ΔY 0

This shows that MRSXY decreases from infinity at point A to zero at point B while

MRSYX decreases from infinity at point B to zero at point A.

There is however exceptions to this law. The law is not applicable in case of

perfect substitutes and perfect complements

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 ΔX
MRS XY = =1
For perfect substitutes, ΔY =ΔX hence ΔY

In case of perfect complements, ICs are ∟shaped and MRS XY is always equal to

zero.

THE BUDGET CONSTRAINT

Given the consumption of bundle (X, Y) and prices (P 1, P2) for X and Y respectively,

consumer’s budget constraint can be written as:

P1 . X +P2 .Y ≤M

The set of affordable consumption bundles at prices P 1 & P2 and income M is

known as the consumer’s budget set ( P1 . X + P2 . Y ≤M ) .

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Since more is preferred to less the consumer will exhaust his or her budget hence

P1X+P2Y =M

This is a set of affordable consumption bundle which exhausts the consumer’s

budget/that costs exactly the level of income and forms the budget line.

Given, P1 . X +P2 .Y =M

P1
−
The slope of the budget line is given by the ratio of prices i.e. P2

CHANGES IN BUDGET LINE

1. Changes in consumers income (M)

If M increases by δ the new budget line is,

P1 . X +P2 .Y =M+δ

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 P1
−
Slope of the new budget line is, P2

Conversely, if income decreases by the same amount, the new budget line is,

P1 . X +P2 .Y =M−δ

This will shift the budget line to the left and leave the slope of the new budget

line unchanged.

2. Changes in price

a. Changes in price of one of the commodities leaving price of the other

commodity

If P1 increases by λ , the new budget line is,

( P1 +λ ). X +P 2 .Y =M

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Slope of the new budget line,

M ( P1 + λ )
Y= − X
P2 P2

( P 1 + λ ) P1
>
P2 P2 .

Conversely, if P1 decreases by the same amount, the new budget line is,

( P1− λ). X +P2 . Y =M

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The slope of the new budget line,

M ( P1 −λ )
Y= − X
P2 P2

( P1− λ) P 1
<
P2 P2 .

b. Changes in price of the two commodities by the same proportion

This will shift the budget line inwards for an increase in prices and outwards for a

decrease in prices

If P1 and P2 increase by t times, the new budget line is,

tP 1 . X +tP 2 . Y =M

t ( P1 . X + P2 . Y ) =M

M
P1 . X +P2 .Y =
t

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 P1
−
Slope of the new budget line, P2 .

Conversely, if prices reduce by the same amount, this will have the opposite

effect

3. Changes in price of the two commodities and Income by the same proportion

If P1, P2 and M increase by t times, the new budget line is,

tP 1 . X +tP 2 . Y =tM

tP 1 . X +tP 2 .Y =tM
t

P1 . X +P2 .Y =M

Conversely if P1, P2 and M decrease by t times, the new budget line is

P1 . X +P2 . Y M
=
t t

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( P 1 . X + P 2 .Y
t ) ( )
t=
M
t
t

P1 . X +P2 .Y =M

4. Government Policy

a. Tax

i. Quantity tax- The imposition of quantity tax of say t on good X will increase its

price from P1 to P1 +t.

P1 . X +P2 .Y =M

( P1+t ) X + P2 . Y =M

Slope of the new budget line is,

P1 +t
−
Thus the slope is, P2

ii. Value/ad-valorem Tax

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If good X is subjected to value tax (VAT) of β %, the price facing the consumer will

be,

P1 +βP1

P1 . X +P2 .Y =M

( P1 + βp 1 ) X + P2 . Y =M

Slope of the new budget line,

P1 +P1 β
−
Thus the slope is, P2

iii. Lump sum tax- If lump sum tax of say μ is imposed on good X, the consumer

pay an amount equal to μ from his/her income as tax. This shift the budget line

inwards

P1 . X +P2 .Y =M

P1 . X +P2 .Y =M−μ

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 P1
−
Slope of the new budget line is, P2

b. Subsidy

i. Quantity subsidy –

If quantity subsidy of say, σ is imposed on X, P1 changes to P1−σ . The new budget

line is,

( P1−σ ) X +P2 . Y =M

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ii. Value/ad-valorem Subsidy –If commodity X is subsidized at the rate of π , its

price will change to P1−πP1

The new budget line is,

( P1−πP1 ) X +P2 . Y =M

P1 −P1 π
−
Slope of the new budget line is, P2 .

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iii. Lump sum subsidy –If good X is subjected to a lump sum subsidy of an amount

equal to ω , the new budget line is,

P1 . X +P2 .Y =M+ω .

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CONSUMER EQUILIBRIUM (OPTIMAL CHOICE)

(a) Graphical analysis

A Consumer is in equilibrium when maximizing utility given market commodity

prices and income.

This is achieved where the budget line is tangent to the highest possible

ΔY MU X P1
− = =MRS X , Y =−
indifference curve. That is, at the optimal choice, ΔX MU Y P2

At equilibrium point E the consumer consumes Y 0 of Y and X0 of X and yields

maximum utility possible given commodity prices and consumer’s income.

The optimal choice of (X0Y0) at the set prices (P1P2) and income (M) is called

consumer’s demanded bundle.

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The tangency condition however does not hold at all cases at an optimal choice.

What is true at the optimal point is that indifference curve does not intersect the

budget line.

There are exceptional cases e.g. where two commodities are perfect implement.

The tangency condition of consumer equilibrium is a necessary but not a sufficient

condition. Consider the following case where tangency condition is satisfied,

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To ensure that there is only one optimal choice on each budget line, IC must be

strictly convex to the origin.

(b) mathematical/formal analysis

Consider a consumer consuming commodities X and Y whose utility function is

given by,

U ( XY )=XY

The prices of X and Y are P1 and P2 respectively and income M.

In equilibrium IC is tangent to the budget line hence their slope are equal

ΔU dU
MU X = = =Y
ΔX dX

Conversely,

ΔU dU
MU Y = = =X
ΔY dY

MU X Y P1
= =
MU Y X P2

If P1 and P2 equals 20 and 40 respectively and M=800

Y 20 1
= =
X 40 2

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2Y =X
X =2Y
OR
1
Y= X
2 ………………….………………………………………………. {1}

But,

P1 . X +P2 .Y =M

20 X +40Y =800 ………………………………………………………… {2}

From {1} and {2},

20 X +40Y =800

20(2 Y )+40 Y =800

40 Y +40Y =800

80 Y =800

Y =10 …………………………………………………………………….. {3}

Substituting {3} into {2},

X =20 ………………………………………………………………… {4}

Total utility,

U ( XY )=XY

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U ( XY )=20(10 )=200

OPTIMAL CHOICE AND DEMAND

1. Effects of changes in price

If X is giffen good,

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2. The effect of changes in income

If good Y is a normal good while good X is an inferior good

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ENGELS CURVE

Since the quantity demanded of X increases as income increases, commodity X is

a normal good.

Derivation of Engel’s curve from ICC

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If good X is an inferior good, the Engel’s curve will slope downwards.

DEMAND FUNCTION

Demand function depends on both prices and income.

X =( P1 P2 M )
Demand function for good X

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Y =( P 1 P 2 M )
Demand function for good Y

Different preferences will lead to different demand functions.

Examples

a. Perfect substitutes

If P2 >P1 the optimal bundle is where the consume spends all his/her income on

good X

Thus,

M
X=
P1 [Demand function for X when P2 >P1 ]

M
Y=
Conversely if P2 <P1 , P2 [Demand function for Y when P2 <P1 ]

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If P2 =P 1 , the optimal bundle is any amount of X and/or Y that satisfies the budget

constraint, P1 . X +P2 .Y =M

b. Perfect complements

P1 . X +P2 .Y =M

Let the amount of X and Y the consumer purchase/buys be X *

¿ ¿
P1 . X + P2 . X =M

The optimal choice of X and Y is thus,

¿
X ( P 1 + P2 ) =M

¿ M
X=
P 1 +P2

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DERIVATION OF DEMAND CURVE

a.Ordinary / uncompensated demand curve.

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This analysis assumes that

D X=( P1 P2 M )

b. Compensated/Hicksian demand curve

They are derived based on the concept of compensation i.e. following any

change in price, the consumer’s income is adjusted. There are two types of

compensations,

(i) Hicksian compensation: - it assumes that after the price change, the

consumer’s income is adjusted so as to retain the same level of

satisfaction. (remains on the same indifference curve)

(ii) Slutskys compensation: - after a price change, the consumers income is

adjusted so that the initial consumption bundle is still affordable.

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 The compensated demand functions are derived from an expenditure

minimization problem and the quantity demanded is expressed as a function of

prices and utility. i.e. given the same information, the consumer seeks to;

min p1 x 1+ p2 x 2
st
U=x 1 x 2
L= p1 x 1 + p2 x 2 −λ ( U −x 1 x 2 )
∂L
= p +λx =0.. . .. .. ... . (i )
∂ x1 1 2
∂L
= p + λx =0. .. .. . .... .(ii)
∂ x2 2 1
∂L
=U−x 1 x 2=0.. .. .. ...... .(iii)
∂λ

Dividing the first two equations;

p1 λx 2
=
p2 λx 2
p1 x 2
=
p2 x 1
p x
x 1= 2 2
p1
p1 x 1
x 2=
p2

Substituting into equation (iii)

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U=x 1
( )
p 1 x1
p2
p1 2
U= x
p2 1
p Hicksian compensated demand function ¿
x 21= 2 U
p1

x1 =

¿
¿

√ }
p2 U
p1
¿¿

We can therefore say that the hicksian demand is derived on the assumption that

price of the other good and utility is held constant.

h X =( P1 P2 U )

SUBSTITUTION AND INCOME EFFECT OF PRICE CHANGE (SLUTSKY EQUATION)

Changes in price of a good has two sorts of effects,

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a. The rate of exchange of one good for other changes. For example if X becomes

cheaper, more of it and less of Y is bought (Substitution effect)

b. Purchasing power/real income changes e.g. if X becomes cheaper, a given

money income can now buy more of both X and Y than before (Income effect)

GRAPHICAL ANALYSIS OF SLUTSKY EQUATION

a. Substitution effect

Let price of X decreases and adjust money income so as to hold purchasing power

constant.

As a result of the decrease in price of X, the budget line rotates around the

original demanded bundle (X1Y1).

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The increase in real income due to decrease in price of X is compensated by

reducing money income so that the consumer remains on the same IC.

b. Income effect

Let price of X decrease and allow purchasing power to vary.

The movement from E1 to E3 is the income effect. The consumer is at equilibrium

at E3.

In this case, good X is a normal good.

If good X is an inferior good,

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Substitution effect=x1x0=Positive

Income effect=x2x1=negative

Total price effect=x2x0=Positive

If good X is a Giffen good,

Substitution effect=x1x0=Positive

Income effect=x2x1=negative

Total price effect=x2x0=Negative

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 s n
ΔX =ΔX + ΔX

X 2 −X 0=( X 1 −X 0 ) + ( X 2 −X 1 )

X 2 −X 0= X 1 −X 0 + X 2 −X 1

X 2 −X 0=− X 0 + X 2

X 2 −X 0= X 2 −X 0

FORMAL/MATHEMATICAL ANALYSIS OF SLUTSKY EQUATION

To keep (X0Y0) just affordable, money income (M) must be adjusted

Let,

1
M =Income that will just let the original consumption bundle affordable

Since (X0Y0) is affordable at both ( P1 P2 M ) and ( P1 P2 M ) , we have,

1 1

1 1
M =P1 X 0 +P2 Y 0 …………………………. {1}

M=P1 X 0 +P2 Y 0 ……………………………. {2}

The necessary change in money income so that the original bundle (X 1Y1) is just

affordable is given by,

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{1}− {2}

M 1−M =P 11 X 0 −P1 X 0

M 1−M =X 0 (P 11−P1 )

ΔM =Δ PX 0 ……………………………. {3}.

ΔM and ΔP Must always move in the same direction

NUMERICAL EXAMPLE

Suppose the consumer is consuming 200 units a week at Sh50 per unit.

If price increases by 10, by how much will money income change to make the

original bundle just affordable?

Hint

ΔM =Δ PX 0

X 1 =2000

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ΔP=60−50=10

ΔM =10(2000)=20 , 000

SUBSTITUTION EFFECT ( ΔX )
S

The substitution effect ( ΔX ) is the change in demand for good X when its price
S

changes with real income and price of the other commodity held constant.

ΔX S =X 1 ( P11 M 1 )−X ( P1 M )

Numerical Example II

Suppose the consumer demand for good X is,

M
X =10+
10 P 1

If M=120 and P1=3

120
X =10+
10(3)

120
X =10+ =10+4=14
30 Demand for X at X ( P1 M )

1 1
If P1 falls to 2 i.e. P1=2 , demand at P1 will be

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 M
X 1 =10+
10 P1

120 120
X 1 =10+ =10+ =10+6=16
Demand for X at X ( P 1 M )
1 1 1
10(2 ) 20

The change in money income necessary to make the original bundle just

affordable when price decreases to 2 is,

ΔM =Δ PX 1

ΔM =( 2−3 ) 14=−1(14 )=−14

Thus the level of income necessary to keep real/purchasing power constant is,

1
M =120+(−14 )=120−14=106

1
The consumer demand for X at price P1 and income M is,
1

X 1 ( P 11 M 1 )=X ( 2, 106 )

1
M
X 1 =10+
10 P11

106
X 1 =10+ =10+5 . 3=15 . 3
.Demand for X at X ( P 1 M )=X ( 2, 106 )
1 1 1
10(2 )

But,

ΔX S =X 1 ( P11 M 1 )−X ( P1 M )

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ΔX S =15 .3−14=1 .3 [Substitution effect]

Income Effect

Income effect is the change in the demand for good X when income changes from
1
M to M holding price P1 constant.
1

ΔX n= X 1 ( P11 M )−X 1 ( P11 M 1 )

120
X 1 ( P 11 M )= X 1 ( 2, 120 )=10+ =10+6=16
10(2)

106
X 1 ( P 11 M 1 )=X 1 ( 2 ,106 )=10+ =10+5 . 3=15 . 3
10(2 )

Thus,

ΔX n= X 1 ( P11 M )−X 1 ( P11 M 1 )

ΔX n=16−15 . 3=0 . 7>0

TOTAL CHANGE IN DEMAND

The total change in demand for a good is the change in demand due to the

change in its own price holding money income constant.

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ΔX =X 1 ( P11 M )− X ( P1 M )
…………………………………… {1}

The change in demand above is broken into,

S n
ΔX =ΔX + ΔX

1
ΔX =X 1 ( P11 M )− X ( P1 M )=[⏟
X 1 ( P11 M 1 )−X ( P1 M )] +[⏟
X ( P 11 M )− X 1 ( P 11 M 1 ) ]
ΔX S ΔX n ……………………..

{2}

2=1 .3+0 .7

Equation {2} Is called Slutsky Equation/Identity. It can be re-written as follows,

ΔX =X 1 ( P11 M ) − X ( P1 M )=X 1 ( P11 M 1 )−X ( P1 M )+ X 1 ( P11 M )− X 1 ( P11 M 1 )

X 1 ( P 11 M )− X ( P 1 M ) =−X (P1 M )+ X 1 ( P11 M )

X 1 ( P 11 M ) − X ( P 1 M ) =X 1 ( P11 M )− X ( P1 M )
………………………………………….. {3}

16−14=16−14

Equation {3} is the Slutsky Identity.

GOODS, BADS AND NEUTERS

i. Goods

‘Goods’ are goods and services which yields satisfaction.

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ii. Bads

These are commodities, which yield disutility

Most ‘bads’ are however associated with ‘goods’. ‘Goods’ turn ‘bads’ beyond a

certain level of consumption.

iii. Neuters

Are commodities that yield neither utility nor disutility to the consumers

INDIFFERENCE MAPS FOR ‘GOODS’, ‘BADS’ AND NEUTERE

Consumers have to make their consumption basket/bundle of,

i. ‘Goods’ and ‘Goods’

ii. ‘Goods’ and ‘Bads’

iii. ‘Goods’ and Neuter

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a. Indifference map for a ‘Good’ and a ‘Bad’

More of a ‘Good’ is always preferred to less of it and less of ‘Bad’ is preferred to

more of it.

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Since ‘Bads’ are often inseparable from ‘Goods’ if the society wants to have more

of such goods, it will have to accept more of ‘Bads’ as well.

b. Indifference map for a ‘Good’ and a Neuter

c) Revealed preference theory

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The theory assumes that consumer preferences are known and are strictly

convex. Thus, there is a unique demanded bundle at each budget.

Suppose (X0Y0) is the optimal bundle. Bundle (X1Y1) is affordable at the given

budget.

Since (X0Y0) is the optimal bundle, it must be better than anything else that the

consumer could afford yet not bought.

In particular, (X0Y0) is better that (X1Y1). The same applies to any bundle

underneath the budget line other than the demanded bundle.

Let (X0Y0) be the bundle purchased at prices (P1P2) when consumer income is M.

To say (X1Y1) is affordable at those prices and income, it simply means that (X 1Y1)

satisfies the budget constraint,

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P1 X 1 +P 2 Y 1≤M …………………………………… {1}

Since (X0Y0) is actually bought it must satisfy,

P1 X 0 +P2 Y 0 =M ……………………………………….. {2}

The fact that (X1Y1) is affordable at the budget, ( P1 P 2 M ) means that,

P1 X 0 +P2 Y 0 >P1 X 1 +P2 Y 1 …………………………………………. {3}

If {3} is satisfied and (X 0Y0) is different from (X1Y1), then (X0Y0) is directly revealed

preferred to (X1Y1).

To say that (X0Y0) is revealed preferred to (X1Y1), it means that (X0Y0) is chosen

when (X1Y1) could have been chosen.

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