MICROECONOMICS I

ECON 2011

Addis Ababa University

College of Business and Economics
Department of Economics

Objective of the Course:

 The objective of this course is to introduce students to
the basic microeconomic theories, ideas/concepts
and analytical tools of microeconomics.
Feb 17, 2022
 Chapter One:
Theory of Consumer Behaviour and
Demand
 A consumer can be characterized by many factors and
aspects such as sex, age, lifestyle, wealth, parentage,
ability, intelligence, etc.
 But which are most important ones for us to study
consumer’s behavior in making choices?
 Consumer behaviour is best understood in three distinct steps:
1) Consumer Preferences: The first step is to find a practical
way to describe the reasons people might prefer one good to
another.
 …CONT’D
2) Budget Constraints: In step two, we take in to
account the fact that consumers have limited incomes
which restrict the quantities of goods which they can
purchase.
So, what does a consumer do in this situation?
3) Consumer Choices: Given their preferences and
limited incomes, consumers choose to buy
combinations of goods that maximize their
satisfaction.
1.1 Consumer Preferences
Preferences are relationships between bundles.
 The consumer is assumed to have preferences on
the consumption bundles in X so that he can
compare and rank various goods available in the
economy.
 If a consumer would choose bundle (x1, x2) when
(y1, y2) is available, then it is natural to say that
bundle (x1, x2) is preferred to (y1, y2) by this
consumer.
 Preferences have to do with the entire bundle of
goods, not with individual goods.
 …CONT’D
Notations:
1) (x1, x2) ≻ (y1, y2) means the x-bundle is strictly
preferred to the y-bundle (Strict Preference
Relation), to mean not (y1, y2) ≿ (x1, x2)
2) (x1, x2) ~ (y1, y2) means that the x-bundle is
regarded as indifferent to the y-bundle
(Preference Relation). This also means we
can write x ≿ y and y ≿ x.
3) (x1, x2) ≿ (y1, y2) means the x-bundle is at least
as good as (preferred to or indifferent to) the y-
bundle (Weak Preference Relation)
Assumptions of Preferences(Axioms of
Preferences)
 We want the preferences to order the set of bundles.
 Therefore, we need to assume that they satisfy the
following standard properties.
1) Completeness: Any two bundles can be
compared(not objectionable).
 For any two bundles and , either ≻ or ≻ or ~
(indifferent or both equal).
2) Reflexivity: Any bundle is as good as itself.
 (x1, x2) ≿ (x1, x2)
 This is trivial.
 …CONT’D
3) Transitivity: Implies X ≿ Y and Y ≿ Z, then X ≿ Z
Transitivity implies internal consistency.
4) More is better than less: Consumers always prefer
more of any good to less and they are never satisfied
or satiated. However,
a) Transitivity is necessary for theory of optimal choice
because if this assumption is violated we can’t have
best choice.
Example: Given X is preferred to Y and Y is preferred
to Z. If the consumer prefers Z to X, then a given
bundle will always have a bundle preferred to it.
 …CONT’D

b) we will not deal with preferences that

violate these assumptions (perverse
preferences)
1.2 Utility
 Is the satisfaction which a consumer derives from
consuming commodities and services.
 Preference relations can often be represented by
utility functions.
 Sometimes it is easier to work directly with the
preference relation and its associated sets
(indifference curve).
 But other times, especially when one wants to use
calculus methods, it is easier to work with
preferences that can be represented by a utility
function; that is, a function u: X →R such that X
≿ Y if and only if .
 NOTE:
 ‘Utility’ and ‘Usefulness’ are not
synonymous.
 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.
 The utility of a product can be different at
different places and time. For example, the
utility that we get from meat during fasting is
not the same as any time else.
 …CONT’D
 A Consumer considers the following points to
get maximum utility or level of satisfaction:
i. How much satisfaction he gets from
buying and then consuming of an extra
unit of a good or service.
ii. The price he pays to get the good.
iii. The satisfaction he gets from consuming
alternative products.
iv. The prices of alternative goods and
services.
 How do you measure utility?
A) The Cardinal Utility Approach (Old Way)
Assumptions:
1) Rationality of Consumers
 The consumer in order to maximize his/her
satisfaction, he/she has to be rational.
2) Utility is Cardinally Measurable
 The utility or satisfaction of each commodity is
measurable and Money is the most convenient
measurement of utility.
 …CONT’D
3) Constant Marginal Utility of Money
 if the marginal utility of money changes with the
level of income (wealth) of the consumer, then
money can not be considered as a
measurement of utility.
4) Limited Money Income
 The consumer has limited money income to
spend on the goods and services he/she chooses
to consume.
 …CONT’D
5) Diminishing Marginal Utility (DMU)
 The utility derived from each from each
successive units of a commodity(MU) diminishes.
6) 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, the total utility is given by:
Examples of Utility Functions
1) Perfect substitutes: Perfect substitutes refer to a
pair of goods with uses identical to one another.
 In that case, the utility of a combination of the
two goods is an increasing function of the sum
of the quantity of each good.
 Perfect substitutes have a linear utility
function and a constant marginal rate of
substitution.
Example: utility function for different colour
pencils: here all that matters is total number of
pencils of different colours.
 Thus,
 2) Perfect complements: When two goods are perfect
complements, they are consumed proportionately.
Example: Utility function for shoes
 Here what matters is the minimum of the left and
right shoes you have, .
 x1 and x2 are consumed in one-to-one proportions.
 Generally,
• Interpretation: a units of x1 are consumed with b units
of x2 (e.g., , =>1 cup of coffee (x2) is consumed with 2
tea spoons of sugar (x1).
3) Cobb-Douglass utility function
 Given in the form: or more generally,

where c and d are positive parameters representing

the budget shares of x1 and x2, respectively, that also
show preferences for the two goods.
4) Quasilinear Preferences
 The utility function is linear in the one
good and but nonlinear in the other
good.
 These kind of utility function has a form
Exmaple: or
Utility Measurements
i) Total Utility(TU)
 refers to the total amount of satisfaction a
consumer gets from consuming or possessing
some specific quantities of a commodity at a
particular.
 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 in which the consumer will not be
capable of enjoying any greater satisfaction from
it.
ii) Marginal Utility (MU)
 Is the extra utility from extra consumption
of one of the goods, holding the other good
fixed.
 Graphically, it is the slope of total utility.
 This is a derivative, but a special kind of
derivative—a partial derivative; this just means
that you look at the derivative of keeping X2
fixed — treating it like a constant.
 …CONT’D
 Mathematically, marginal utility is:

where, is the change in total utility, and is the change in the

amount of product consumed.
Examples:
a) If , then
b) If , then,

 Note that marginal utility depends on which utility

function you choose to represent preferences.
Table 1.1: Hypothetical example of total and marginal
utility(The case of one commodity)
Quantity(X) 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
 Law of Diminishing Marginal Utility
 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.
ASSUMPTIONS of LDMU:
 The consumer is rational
 The product is identical or homogenous(similar quality,
color, design, etc.)
 No time gap/constant in consumption of the gg & ss.
 The consumer taste/preferences remain unchanged
Table 1.2: Hypothetical table showing TU and MU of
consuming Oranges (X) and LDMU
Units of 0
Quantity(X) unit
consumed

0 10 16 20 22 22 20
utils utils utils utils utils utils

0 10 6 4 2 0 -2
utils utils utils utils utils utils
 Law of Diminishing Marginal Utility

Fig 1.1: Derivation of marginal utility from total utility

 ...CONT’D
 As indicated in the above figures, as the
consumer consumes more of a good per time
period, the TU increases, at an increasing rate
when the MU is increasing and then increases at
a decreasing rate when the MU starts to decrease
and reaches maximum when the marginal
utility is Zero.
 The total utility curve reaches its pick point
(Saturation point) at point A.
 This Saturation point indicates that by
consuming 5 oranges, the consumer attains its
highest satisfaction of 22 utils.
 ...CONT’D

 However, Consumption beyond this point

results in Dissatisfaction, because consuming
the 6th and more orange brings a lesser
additional utility than the previous orange.
 Point B where the MU curve reaches its
maximum point is called an inflexion point or
the point of Diminishing Marginal utility.
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 MU, the consumer wants to consumer
more of the product because total utility increases.
 However, the consumer has income/budget
constraint.
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.
Proof : Given the utility function:

 The consumer maximizes the difference between

his utility and expenditure.
)
 The necessary condition for maximization is
equating the derivative of a function to zero.
 Thus,
 Because , =
Graphically, for a single commodity

Fig 1.2: marginal utility of a consumer

 …CONT’D

 At any point above point C (like point A)

where , it pays the consumer to consume more.
 When (like point B), the consumer should
consume less of X.
 At point C where the consumer is at
equilibrium.
B) The case of two or more commodities
 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,

 Where, M is the income of the consumer.

Table1.3: Utility schedule for a single commodity
 …CONT’D
 For consumption level lower than 3 units of oranges,
since the MU of orange is higher than the price, the
consumer can increase his/her utility by consuming
more quantities of oranges.
 On the other hand, for quantities higher than three,
since the MU of orange is lower than the price, the
consumer can increase his/her utility by reducing its
consumption of oranges.
 Thus, the equilibrium condition for the consumer is
consuming three units of orange.
Table1.4: Utility schedule for two commodities
• As we discussed earlier, 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, i.e.,

• The MU of the last birr spent on each commodity are

equal.
• Since:

and the total expenditure required for this is 20 the

consumer will be at equilibrium when he consumes 2
units of Orange and 4 units of banana
The Derivation of Cardinalist Demand
 We discussed that marginal utility is the slope
of the total utility function.
 The derivation of demand curve is based on
the concept of diminishing marginal utility.
 If the marginal utility is measured using
monetary units the demand curve for a
commodity is the same as the positive
segment of the marginal utility curve.
 …CONT’D

Fig 1.3: Derivation of Demand curve

 The Cardinalist Approach involves the following
three weaknesses:
1) The assumption of cardinal utility is
doubtful because utility may not be quantified.
2) Utility cannot be measured absolutely
(objectively).
 The satisfaction obtained from different
commodities can not be measured
objectively.
3) The assumption of constant MU of money is
unrealistic because as income increases, the
marginal utility of money changes.
B) The Ordinal Utility Approach (New Way)
 In the ordinal utility approach, utility cannot be
measured absolutely but different consumption
bundles are ranked according to preferences.
 The concept is based on the fact that it may not be
possible for consumers to express the utility of
various commodities they consume in absolute
terms, like, 1 util, 2 util, or 3 util, but it is always
possible for the consumers to express the utility
in relative terms.
 It is practically possible for the consumers to rank
commodities in the order of their preference as
1st , 2nd , 3rd and so on.
 ...CONT’D
ASSUMPTIONS:
Like the previous approach, this approach is based on the
following assumptions:
1) The Consumers are rational
2) Utility is ordinal, i.e. utility is not absolutely
(cardinally) measurable.
 required only to order or rank preference for
various bundles of commodities.
3) Diminishing Marginal Rate of Substitution
(MRS)
 The MRS is the rate at which a consumer is
willing to substitute one commodity (x) for
another commodity (y) keeping TU constant.
 …CONT’D
 When a consumer continues to substitute
X for Y the rate starts decreasing, and
 it is the slope of the Indifference curve.
4) The Total Utility of the consumer depends on the
quantities of the commodities consumed,
i.e.,
5) Preferences are transitive or consistent
 It is transitive implies if the consumer prefers
market basket X to market basket Y, and prefers
Y to Z, and then the consumer also prefers X to
Z.
 When we said consistent it means that if market
basket X is greater than market basket Y (X>Y)
then Y is not greater than X (Y not >Y).
 …CONT’D
 The ordinal utility approach is expressed or
explained with the help of indifference curves.
 An indifference curve is a concept used to
represent an ordinal measure of the tastes and
preferences of the consumer and to show how
he/she maximizes utility in spending income.
 Since it uses ICs to study the consumer’s behavior,
the ordinal utility theory is also known as the
Indifference Curve Analysis.
Indifference Set, Curve and Map
 Indifference Set/ Schedule: It is a combination of
goods for which the consumer is indifferent,
preferring none of any others.
 It shows the various combinations of goods from
which the consumer derives the same utility level.
Table 1.5: Indifference Schedule/Set
Bundle(Combination ) A B C D
Orange (X) 1 2 4 7
Banana (Y) 10 6 3 1
 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.
 …CONT’D
 Indifference curve: is an indifference set/schedule
expressed graphically.
 Indifference map: A set of indifference curves.

Fig 1.4: indifference curves and indifference map

Properties of Indifference Curves
 Indifference curves have certain unique
characteristics with which their foundation is
based.
1) Indifference curves have negative slope
(downward sloping to the right).
2) Indifference curves do not intersect
each other.
3) A higher Indifference curve is always
preferred to a lower one.
 …CONT’D
4) 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.
 It also implies that the commodities can
substitute one another at any point on an
indifference curve, but are not perfect
substitutes.
 …CONT’D

Fig.1.5: Positively sloped and intersected indifference

curves
 ...CONT’D
 As we discussed earlier, ICs cannot intersect each other.
 If they did, the consumer would be indifferent
between C and E, (Right panel of figure 1.5) since
both are on indifference curve one (IC1).
 Similarly, the consumer would be indifferent
between points D and E, since they are on the same
indifference curve, IC2.
 By transitivity, the consumer must also be
indifferent between C and D.
 However, a rational consumer would prefer D to C
because he/she can have more Orange at point D.
 ...CONT.D
Marginal Rate of Substituion(MRS)
 To quantify the amount of one good that a
consumer will give up to obtain more of
another, we often use marginal rate of
substitution as a measurement (MRS).
• Definition: 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 of X so that the consumer maintains the
same level of satisfaction.
 …CONT’D

Fig.1.6: Marginal Rate of Substitution

 …CONT’D
 It is given by the slope of the tangent at that point:
i.e., Slope of indifference curve.
 In other words, MRS refers to the amount of one
commodity that an individual is willing to give
up to get an additional unit of another good
while maintaining the same level of satisfaction or
remaining on the same indifference curve.
 The diminishing slope of the indifference curve
means the willingness to substitute X for Y
diminishes as one move down the curve.
 ...CONT’D
 Note that (MRSx,y) measures the downward
vertical distance (the amount of y that the
individual is willing to give up) per unit of
horizontal distance (i.e. per additional unit of x
required) to remain on the same indifference curve.
 The rationale behind the convexity, that is,
diminishing MRS, is that a consumer’s subjective
willingness to substitute A for B (or B for A) will
depend on the amounts of B and A he/she
possesses.
Example: Lets consider the previous hypothetical
information (Substitute X for Y)
Bundle(Combination ) A B C D
Orange (X) 1 2 4 7
Banana (Y) 10 6 3 1
 (between points A and B)=
 Implies the consumer is willing to forgo 4 units of
Banana to obtain 1 more unit of Orange.
 If the consumer moves from point B to point C, he is
willing to give up only 1.5 units of Banana(Y) to obtain 1
unit of Orange (X), so the MRS is 1.5(ΔY/ΔX = 3/2).
 At point D, the consumer is willing to give up only 2 unit
of Banana so as to obtain 3 units of Orange.
 In this case, the MRS falls to .
 In general, as the amount of Y increases, the
marginal utility of additional units of Y decreases.
 Similarly, as the quantity of X decreases, its
marginal utility increases.
 MRS measures an interesting aspect of the
consumer’s behaviour
 Measures marginal willingness to pay
(give up) (does not depend on prices but on
preferences)
 Not the same as how much you have to
pay (actual-depends on the price of the
good)
 But how much you would be willing to pay.
Relationship Between MU and MRS
 Remember, there is no behavioral meaning of MU.
 The MU depends on the particular utility function
that we use to represent the preference ordering and
its magnitude has no particular significance.
 However, we can use the marginal utility to calculate
something that have behavioral content, i.e. MRS.
 Suppose we have , where k is a constant, which
describes an indifference curve. we want to measure
slope of indifference curve, MRS.
 So consider a change (dx1, dx2) that keeps utility
 …CONT’D
• Then, by totally differentiating the equation for IC,
we find:
=0
+ =0
= (X for Y)
 So we can compute MRS from knowing the utility
function.
 The sign of the MRS is negative for the reason that
in order for the consumer to be at the same level of
satisfaction, an increase in the consumption of one
of the good must be accompanied by decline in the
consumption level of the other good.
 …CONT’D
MUx1
MRS  
MUx2
cX 1c 1 X 2d
MRS  
dX 1c X 2d 1

cX 1c X 2d
X1
MRS  
dX 1c X 2d
X2

cX 1c X 2d  X 2
MRS  
dX 1c X 2d  X 1

c X2
MRS  
d x1

 Thus,
Types of Indifference Curves
 Given a utility function it is relatively easy to draw
the indifference curves by plotting all the points
such that equals a constant.
 For different values of utility we get different
indifference curves.
i) ICs for Cobb-Douglas Utility Function
Suppose the utility function is given by .
 For this utility function the indifference curve is
convex to the origin.
 The indifference curve consist of a set of X1 and X2
such that K = for some constant K.
 …CONT’D
 Solving for results in
 We can draw ICs for different values of and (& their
exact shapes depend on the values of c and d).

Pane A: Panel B:
Fig 1.7: ICs for Cobb-Douglas Preference
ii) ICs for Quasilinear utility function
 This is for a utility function that is linear in good
2, but possibly non-linear in good 1.
 As the name implies it is partly linear utility
function.
 In general, ICs for such utility function of
preference is given by
Example:
 The indifference curve for these utility
functions are vertical translates of each
other or one indifference curve.
 …CONT’D
 The equation for the IC is .
 Higher values of K indicate higher indifference curves.
Example:
 Now lets draw the ICs for different values of K.

Fig 1.8: ICs for Quasilinear utility function

 …CONT’D

Note: In the case of quasilinear utility functions:

 ICs are ‘vertically parallel’
 The MRS is the same along any vertical line.

iii) ICs for Constant Elasticity of Substitution (CES)

utility function
 CES utility functions are written as:

Where is a parameter .
 This utility function gives rise to three special cases
depending on the value of .
 If it equals 1, it becomes linear utility function i.e.
as for perfect substitute.
 If it equals 0 its ICs look like those of Cobb-
Douglas.
 If it equals -, the ICs look like those of Leontief
utility function(Perfect Complement).
Special Indifference Curves
 Convexity or down ward sloping is among the
characteristics of indifference curve and this shape
of indifference curve is for most goods.
 In this situation, we assume that two commodities
such as X and Y can substitute one another to a
certain extent but are not perfect substitutes.
 However, the shape of the indifference curve will be
different if commodities have some other unique
relationship.
 Here, are some of the ways in which indifference
curves/maps might be used to reflect preferences for
some special cases.
1) ICs for Perfect substitutes
 Two products are perfect substitutes if the consumer
is willing to substitute one for the other at a constant
rate.
 The simplest case is when the consumer is willing to
substitute the two goods on one – to – one basis.
 Thus, IC will be characterized by constant MRS.
• for
Example: Blue pencil and Red pencil

• Figure 1.8: ICs for Perfect Substitutes

2) ICs for Perfect complements
• Goods are always consumed in fixed proportions.
• MRS can be zero or infinite(e.g.: Left and Right shoe)

Figure 1.10: ICs for Perfect Complments

3) ICs for Bads
 Bads are items that reduce the satisfaction of the
consumer.
 To keep the consumer at the same level of
satisfaction more of the ‘good’ good should be
given to the consumer to compensate for the
additional consumption of the bad.
 The satisfaction of the consumer increases as we
move down ward because less of the bad good is
consumed.
 ...CONT’D

Figure 1.11: ICs for Bads

4) Neutrals (or useless goods)
 If a consumer is not interested on a product one way
or the other, the consumer is neutral to the product.
 The consumer satisfaction increases as we move in
the right ward(Amount of neutral does not matter).

Figure 1.12: IC for Neutrals

5) Discrete goods: goods not divisible and only
asume finite integers.

Figure 1.13: ICs when one good is a discrete good

 ...CONT’D
 Goods that are consumed in discrete amounts
only (e.g, Automobile-available only in integer
values).
 In this case the bundles indifferent to a given
bundle will be a set of discrete points.
• The set of bundles at least as good as a particular
bundle will be a set of line segments.
Properties of Well-Behaved ICs
1) Monotonicity: more of either good is better
• If (y1, y2) is a bundle of goods with at least as much of both
goods and more of one than (x1, x2), then
• Monotonicity implies negatively sloped IC.

Figure 1.14: An example of (strictly) monotonic preferences

2) Convexity: implies averages are at least as good as
extremes(Strict convexity and weak convexity).
 Take two extreme bundles, and on a given IC.
 Then convexity implies:
, is at least as good as or strictly preferred to either
or
 Or generally,
(weighted average) is at least as good as or strictly
preferred to either (x1, x2) or (y1, y2)
Where, o < t <1.
 …CONT’D
• This weighted average gives a weight of to the x-
bundle and a weight of to the y-bundle.
• Distance from the x-bundle to the average bundle is
just a fraction t of the distance from the x-bundle to the
y-bundle along the straight line connecting the two
bundles.

Figure 1.15: Convexity of ICs

 …CONT’D
 Thus, if P and Q are two bundles, then if the consumer
moves along the straight line PQ from the point P
towards the point Q, then the points on the way like R,
S, and W would lie on successively higher ICs.

Figure 1.16: convex and non-convex indifference curves

The Budget Line or the Price Line
 ICs cannot tell us which combinations of the two
goods will be chosen or bought.
 In reality, the consumer is constrained by his/her
money income and prices of the two commodities.
 Therefore, in addition to consumer preferences, we
need to know the consumer’s income and prices
of the goods.
 In other words, individual choices are also affected
by budget constraints that limit people’s ability to
consume in light of prices they must pay for
various goods and services.
 Whether or not a particular IC is attainable
depends on the consumer’s money income and on
commodity prices.
 ...CONT’D
Budge Line/Price Line:
 represents the combinations of two goods that the
consumer can buy by spending the entire money
income on the two goods at the given prices.
Assumptions:
1) there are only two goods, x1 and x2,
bought in quantities x1 and x2;
2) each consumer is confronted with market
determined prices, P1 and P2, of good x1
and good x2 respectively; and
3) the consumer has a known and fixed
money income (M).
 ...CONT’D
 By assuming that the consumer spends all his/her
income on two goods (X1 and X2), we can express
the budget constraint as:

 Then the budget line equation is given as:

 The formula tells us how many units of good x 2 the

consumer needs to consume in order to just satisfy
the budget constraint.
 The slope of the budget line measures the rate at
which the market is willing to substitute good X1 for
good X2.
 That is, it measures the opportunity cost of good X 1.
Figure 1.17: Budget line

 The slope of the budget line is give by:

Factors affecting the budget line
i) Effects of Changes in Income
• Increase in income causes parallel shift of the
budget line in outward direction while decrease
in income shifts it towards the origin.

Figure 1.18: effect of increase in income

ii) Effects of Change in Prices
A) Chnage in price of a good
 If price of a good increase/decreases keeping
other variables constant, then budget line rotates
inward/outward in the axis of the price
change.
 There will no be a change of the intercept for the
product with unchanged price.
 If the price of the product in the x-axis
increases/decreases, the slope of the budget line
becomes Steeper/Flatter.
 If the price of the product in the y-axis
increases/decreases, the slope of the budget line
becomes Flatter/Steeper.
Figure 1.19: effect of increase in price of i.e.
B) Simultaneous changes in both prices
(proportionate change)
Questions for Discussion: What will happen
1) If price of good one increases and price of
good two decreases and vice versa?
2) If price of good one increases(decreases)
with higher proportion than price of good
one and vice versa?
3) If both increase(decrease) in the same
proportion?
4) If income proportionately increases with
the increase of the two prices.
Notes:
 If the two prices change in opposite directions,
what will happen on the budget line depends on
the stronger of the two.
 But if the two prices increase/decrease
proportionately in the same direction, the budget
line shifts inward/outward as decrease in
income.
 Suppose prices have increased with a proportion
of ‘t’.
o P1 changes to ‘tP1’ and P2 changes to ‘tP2’.
o With this the new budget constraint will be:

o This is the same as

iii) Other Factors
Government intervention
 Government intervention also changes or shifts the
budget line.
 There are many ways in which government can
affect the budget line of consumers:
1) Quantity taxes
2) Value taxes
3) Quantity subsidies
4) Value subsidies
5) Lump sum taxes
6) Rationing
(1)-(4) affect prices, (5) affects income while (6)
affects quantity of goods to be consumed.
Numerical Example
 Suppose a person has $100 to spend on two
goods(, ) whose respective prices are $3 and $5.
a) Draw the budget line.
b) What happens to the original budget line if the
budget falls by 25%?
c) What happens to the original budget line if the
price of X doubles?
d) What happens to the original budget line if the
price of Y falls to 4?
Optimal of the Consumer
 A rational consumer seeks to maximize his utility or
satisfaction by spending his or her income.
 The optimum of the consumer is defined as the
bundle of goods that maximize his or her utility with
given income and market prices
 In general, consumer equilibrium occurs at the point
where the indifference curve is tangent to the
budget line so that the slope of the indifference
curve ( ) is equal to the slope of the budget line( ).
 Graphically, the equilibrium condition occurs at
point E.

Figure 1.20: Optimal of a consumer

 Alternatively, we can derivate the equilibrium
conditions of mathematically as follow.
Max subject to
• This maximization problem can be solved using
Lagrange method.
Lagrange Method
• Step 1: Formulate the Lagrange function

Where  is called Lagrange multiplier.

 And the shape of the Lagrange function is
determined by the utility function.
Step 2: Differentiate the lagarngian function with
respective variables(, and λ).
L u
  P1  0...............................................(1)
x1 x1
L U
  P2  0..............................................(2)
X 2 X 1
L
 P1 X 1  P2 X 2  m  0......................................(3)


Step 3: solve for the optimum values of the

required variables.
 From equation 1:   MU 1 ................(4)
P1
  From equation (2) MU 2  P2
MU 2
 ..................(5)
P2
Example: Cobb-Douglas utility function is given as
MU 1 P1
Using (4) and (5) 
MU 2 P2
u ( x1 , x 2 )  X 1c X 2d ...........................(1)
Subject to P1X1 + P2X2 = m……………………(2)
P c X
MRS  or
X1 , X 2
1
MRS  .......................(3)
X1 X 2
2

P2 d X1
From (3) P1dX1 = P2cX2
P2 c
X1  X 2 ..................................(4)
P1 d
• Substitute equation (4) in the budget constraint (equation (2))
P1 c
P1 ( X 2 )  P2 X 2  m
P2 d
c
P2 X 2  P2 X 2  m
d
md
X2 
p 2 c  P2 d
d m
X2   optimal consumptio n of x 2
(c  d ) P2

• From (3)
P1 d
X2  X 1 ..............................(6)
P2 c

• Substituting it into the budget constraint (equation (2))

P1 d
P1 X 1  P2 ( X1)  m
P2 c
By solving it we arrive at,
c m
X2   optimal consumptio n of x1
(c  d ) P1
• Note that c
and d
cd cd

measure the proportion of income spent on X1 and X2 respectively

at the optimal point.
• Proportion of income spent on X1 is the ratio of expenditure on
X1 and total income available, i.e., P1 X 1
m
c m
P1 (
• Substituting the optimal amount of X1, c  d P1

c
m cd

• This is the proportion of income spent on X1 at optimum.

• Similarly, the proportion of income spent on X2 is given as,
P2 X 2
and substituting the optimal amount of X2,
m
d m
P2 ( )
c  d P2 d

m cd
Perfect substitutes
• The optimum of perfect substitutes depends on the price of the two
goods.

Figure 1.23. only x1 is bought if P 1< P2 and the MRS is -1

• If P1< P2, the optimum is will be at the x1- intercept i.e the consumer
will consume only good 1 by spending all of his income. (Figure
1.23)
• If P1> P2, the optimum will be at the Y- intercept i.e the consumer will
consume only good 1 by spending the entire income (Figure 1.24).
• Please note that the heavy line is the budget line in both figures
1.23 and 1.24
X2

X1

Figure 1.24. Only x2 is purchased

• If P1= P2, there is a whole range of optimal choices where any
amount of good 1 and good 2 that satisfies the budget constraint is
optimal. In this case the budget line will coincide with the
indifference curve.
• Therefore the demand function will be as follows.
 m
p when p1  p 2
 2
x 2  any number between 0 and m / p 2 when p1  p 2
0 when p1  p 2



Perfect Complements
• The optimal choice always lies at the sharp point
where the budget line passes through the vertex no
matter what the prices are (Figure 1.25)
 Figure 1.25
• Example: The utility function U(X,Y) = min (X, 4Y)
• The person will consume goods so that,
• X = 4 Y Y = X / 4
• I = Px X + Py Y = Px X + Py X/4
= (Px + 0.25 Py) X
• The demand function for X is therefore,
I
X*=
Px  0.25 Py

• Similarly I = Px X + Py Y = (Px 4Y + Py Y)
=(4 Px + Py) Y
I
Y* =
4 Px  Py

 For instance if I =160, px=2 and py=8

Effects of Change in Income and Prices on
Consumer Optimum
• The optimal choice of the consumer depends on
the consumer’s income and the price of the
product.
• Any change in the price of the good and income
affects the optimal choice of the consumer i.e the
demanded bundle.
A) Changes in Icome: Income consumption Curve
(income offer curve) and the Engel Curve

How does the consumer’s demand and optimal

choice change as his income changes?
• Here we will examine the change in the optimal choice and
demand of the consumer as income changes holding prices
fixed.
• In our previous discussion, we noted that an increase in the
consumer’s income (all other things held constant) results in an
upward parallel shift of the budget line.
• This allows the consumer to buy more of the two goods.
• And when the consumer’s income falls, ceteris paribus, the
budget line shifts downward, remaining parallel to the original
one.
• If we connect all of the points representing equilibrium market
baskets corresponding to all possible levels of money income,
the resulting curve is called the Income consumption curve
(ICC), income offer curve (IOC) or Income expansion
curve/path (IEC).
ICC is the locus of consumer equilibrium points
resulting when only the consumer’s income varies.

Figure 1.26. ICC and Engel curve for normal goods

 From the ICC we can derive the Engle Curve.
 The Engle Curve is named after Ernest Engel, the
German Statistician who pioneered studies of
family budgets and expenditure positions.
 The Engle Curve is the relationship between the
equilibrium quantity and the level of income.
 It shows the equilibrium (utility maximizing)
quantities of a commodity, which a consumer will
purchase at various levels of income; (celeries
paribus) per unit of time.
NOTE: In relation to the shape of the ICC and Engle
curves goods can be categorized as normal (superior)
and inferior goods.
 NORMAL when the ICC and its Engle
curve are positively sloped; meaning that
more of the goods are purchased at higher
levels of income (Figure 1.26).
 INFERIOR when the ICC and Engle
curve are negatively sloped, i.e. their
purchase decreases when income
increases (Figures 1.27 and 1.28).
Figure 1.27: ICC for Inferior Goods
• For example, in Figure 1.27 good Y is a
normal good while good X is a normal good
until the person’s level of income reaches M2.
• Thus, when income increases beyond M2, the
person will buy less of good X as his income
increases.
• Therefore, good X is a normal good up to
point A and becomes an inferior good as the
income consumption curve bends backward.
 Figure 1.28. Engel curve for inferior good
NOTE: We can use derivatives of demand functions to
know if a good is normal or inferior
 If , the good is a normal good
 If , the good is inferior good
 Changes in Price: Price Consumption Curve
(PCC) (Price Offer Curve) and Individual
Demand Curve
 Here, we hold money income constant and let price
change to analyze the effect on consumer behavior.
 Let us consider a change in price of good one
holding price of good two and income of the consumer
constant.
Decrease in price of good one will be followed by
increase in the demand of this good.
The budget line becomes flatter and the vertical
intercept remains unchanged.
With this change, the optimal choice of good one
move to the right and the quantity demanded of good
one increases(See Figure 2.30).
Figure 1.30 Price offer curve for (Ordinary good)
 However, this is not always the case. (e.g.: Giffen
goods).
 For a giffen good , the change in price and demand
go in the same direction.
• The Giffen good is not implausible purely on logical
grounds, although Giffen goods are unlikely to be
encountered in real world behavior.
Price offer curve for ordinary good.
• Suppose that we let the price of good 1 to change
while we hold P2 and income fixed. Geometrically this
involves pivoting the budget line.
• The price offer curve is obtained by connecting the
successive optimum points arising due to successive
changes in price of one of the goods, keeping income
and price of the other good constant (Figure 1.30)
• The demand curve derived from price offer curve is
given in Figure 1.31

Figure 1.31: Demand curve for ordinary good

The price offer curve for a Giffen good.
(After the 19th century English economist Sir Robert
Giffen, who developed the notion)
• Suppose that good 1 is a Giffen good and good 2 is
ordinary good.
• In the case of Giffen goods, the demand for the good
may decrease when its price decrease (Figure 1.32).
• It is possible but not likely to have a demand curve
with positive slope.

Figure 1.32. Price offer curve for Giffen good

Decomposition of Income and Substitution
Effects (normal, inferior or Giffen goods)
• When a price of a good changes there are two
sorts of effects:
1) The rate at which you can exchange one good
for another changes:
If price falls (rises), the good becomes
cheaper (more expensive) relative to other
goods; and consumers substitute toward
(away from) the good.
This is the substitution effect.
2) The total purchasing power of the consumer’s
income changes:
As price falls (rises), the consumer’s purchasing
power increases (decreases).
 This effect is called the income effect.
Example: Let price of pen be 0.75 cents (good 1)
Price of pencil be 0.25 cents (good 2).
Assume the price of good 1 becomes cheaper that is
decrease in the price of pen to 0.50 cents.
 It means that you have to give up less of good 2 to
purchase good 1(Substitution Effect).
 The change in demand due to the change in
purchasing power is called income effect.
 The combined effect of the two is known as the
total effect (net effect).
Consider goods x and y.
• The price of x (normal good) decreases from px1 to px2
while the price of good y and income remain fixed at p y1
and I, respectively.
• Figure 1.33 shows the substitution effect, the income
effect and the total effect on quantity of x consumed of
the decline in price of x from px1 to px2
• Initially we have the budget line with y-intercept I/p y1 and
X-intercept I/px1
• The consumer’s equilibrium is point A that indicates the
point of tangency between the budget line and
indifference curve IC1 .
• As a result of a decrease in the price of X from Px1 to Px2
the budget line shifts outward with y-intercept I/p y1 and
Figure 1.33: Income and Substitution effects for a normal good
• The total effect of the price change can be conceptually
decomposed into the substitution effect and income
effect.
• The Substitution Effect: The substitution effect refers
to the change in the quantity demanded of a Commodity
resulting exclusively from a change in its price when
the consumer’s real income is held constant; thereby
restricting the consumer’s reaction to the price change to
a movement along the original indifference curve.
• The decline in the price of X results in an increase in the
consumer’s real income, as evidenced by the movement
to a higher indifference curve even though money
income remains fixed.
• Now, imagine that we decrease the consumer’s income
by an amount just sufficient to return to the same level of
satisfaction enjoyed before the price decline.
• Graphically, this is accomplished by drawing a
fictitious (imaginary) line of attainable
combinations with a slope corresponding to new
ratio of the product price p x2/py1 so that it is just
tangent to the original indifference curve IC 1
• The point of tangency is the imaginary point C
(imaginary equilibrium).
• The movement from point A to the imaginary
intermediate equilibrium at point C, which shows
increase in consumption of X from X1 to X2 is
the substitution effect.
• In other words, the effect of a decrease in price
encourages the consumer to increase
consumption of X than Y.
 The Income Effect: the change in the quantity
demanded of a commodity exclusively associated
with a change in real income.
 : is change in quantity demanded of a commodity
that is associated solely with the change in the
consumer’s real income.
 In figure 1.33, letting the consumer’s real income
rise from its imaginary level (defined by the line of
attainable combinations tangent to point C) back to
its true level (defined by the line of attainable
combinations tangent to point B) gives the income
effect.
 Thus, the IE is indicated by the movement from the
imaginary equilibrium at point C to the actual new
equilibrium at point B, the increase in the quantity of
X purchased from X2 to X3 is the income effect.
 When we look at both the substitution and income
effects, the magnitude of the SE is greater than that of
the IE.
The reason is that:
 Most goods have suitable substitutes.
The IE of a price change of any one good is likely to
be small because small fraction of income is spent on
a good.
Thus, usually, the income and substitution effects
reinforce one another i.e. they operate in the
same direction.
Note:
1) If the substitution effect and income effect have the
same directional effect, the good is Normal Good.
2) However, if income effect and substitution effect
have opposite effects, then the good is Inferior good.
In this case, if the IE is greater than SE(income effect
actually overrides the substitute effect) the goods are
called Giffen goods which are special types of inferior
goods.
• Hence, the demand curve for inferior goods is still
negatively sloped.
• Let us consider Figure 1.34 that shows the income,
substitution and net effect for an inferior
commodity in the case of a decline in the price of
good X.
Figure 1.34: IE, SE, and Net Effects for inferior commodity
Note:
 to is Substitution Effect which is Positive.
 to is Income Effect which is Negative.
 to is the total Effect which is Positive.
• In very rare occasions, a good may be so strongly inferior
that the income effect actually overrides the substitute
effect.
• Such an occurrence means that a decline in the price of a
good would lead to a decline in the quantity demanded
and that a rise in price will induce an increase in quantity
demanded.
• The name given to such a unique situation is Giffen
paradox; and it constitutes an exception to the Law of
demand (Figure 1.35).
• That is for Giffen goods the income effect decreases
the quantity demanded and offsets the substitution
effect which increases the quantity demanded, with
the result that the quantity demanded is directly related
to the price, at least over some range of variation of
price.
Figure 1.35: IE, SE and net effects for a Giffen good (), Note:
 to is Substitution Effect which is Positive.
 to is Income Effect which is Negative.
 to is the total Effect, which is Negative.
The Slutsky Equation
 As we have discussed earlier, when the price of a good
decreases, there will be two effects in consumption.
The change in relative prices makes the consumer to
consume more of the cheaper good-substitution effect.
The increase in purchasing power due to the lower price may
increase or decrease consumption of the good- Income
Effect.
Generally, the Slutsky equation says that the total change in
demand is the sum of the substitution effect and the income
effect.
Numerical Example: Suppose that the consumer has a demand
function for good X given M by
X  20 
p x2

Where X is quantity demanded, M is income and p x is a unit price

of good X
Originally his income is $ 200 per month and the
price of the good is 5 per kilogram.
Therefore, his demand for good X will be
20+(200/52)=28 per month.
Suppose that the price of the good falls to 4 per
kilogram.
Therefore, the new demand at the new price will
be:20+(200/42)=32.5 per month.
Thus, the total change in demand is 4.5 that is
32.5-28.
• When the price falls the purchasing power of the
consumer changes.
• Hence, in order to make the original consumption
of good X affordable, the consumer adjusts his
income.
This can be calculated as follows:
• Note that both the adjusted income, and the unadjusted income,
M can afford to buy the old bundle. Hence:
M   p1 X  P2Y
M  p1 X  p 2Y
Where is the new price of X
• Subtracting the second equation from the first gives:

• Therefore, new income to make the original consumption

affordable when price falls to 4 is:

• Hence, the level of income necessary to keep purchasing

power constant is:
The consumers new demand at the new price and income will be :

Therefore, the substitution efffect will be

The substitution effect is sometimes called the change in the

compensated demand.
This isolates the pure effect from changing the relative prices
• The income effect will be:

• Since the result we obtained is positive we can conclude that the good
is a normal good.
Total change in demand (x)
• x is substitution effect plus the income effect, or it is the change in
demand due to the change in price holding nominal income constant
x = x(p’1,m)-x(p1,m) (m is constant).
 In terms of substitution and income effects
x = xs + xn, where xs = SE, and xn = IE
OR,
x(p’1,m)-x(p1,m) = [x(p’1,m’)-x(p1,m)]+[x(p’1,m) -
x(p’1,m’)]
This equation is called the Slutsky identity (Named
for Eugen Slutsky (1880-1948), a Russian
Economist who investigated demand theory).
 Generally,
 If the total change of a good resulting from a
change in its price is opposite to the direction of
price change, the good is called Ordinary good
and,
 If they move in the same direction, the good is
called a Giffen good.
 Consumer Surplus
• The consumer’s surplus is defined as the
difference between the amount of money that a
consumer actually pays to buy a certain quantity
of a commodity X and the amount that he would
be willing to pay for this quantity.
• Graphically, the consumer’s surplus can be found
by the area below the demand curve and above
the market price.
• Assume that the consumer’s demand for a good is a
straight line (Figure 1.40).
• The demand curve measures the amount of good
that will be demanded at each price.
 p
A
P2
P1

P C

O q2 q1 Q B q

Figure 1.40. Linear demand function for good q

• Let the market price of good q be ‘P’ at which the

consumer actually purchases Q amount of the good.
• For amount ‘q1’ the consumer was willing to pay P1
amount of money but the actual price of the good is P.
again for amount of q2 the consumer was willing to pay P2
but he actually paid P amount which is the market price.
• Therefore the difference between the actual payment to
each unit of good and the maximum price that the
consumer is willing to pay for each unit is taken as a
measure of the net welfare benefit to the consumer.
• Consumer surplus from q1 equals P1- P
• Consumer surplus from q2 equals P2 - P
• If the consumer purchase ‘Q’ amount of the good, the area
OACQ represent the gross (total) benefit to the consumer.
• The consumer actually pays OPCQ amount which is less
than what the consumer was willing to pay for the product.
Net gain = OACQ – OPCQ= PAC
• The maximum price the consumer is willing to pay for a
unit of product is called reservation price.
 What is the use of consumer’s surplus?
• Consumer’s surplus provides a measure of the aggregate benefit (net
of cost) of a product to the society when it is added up across
individuals.
• Consumer’s surplus is also used to evaluate the impact of
government policies on the consumer’s welfare.
• Example: suppose the government imposed a quantity tax on the
consumption of a product.
• Due to tax price of the product increase from p to p 1 (Figure
1.42)
• Initial consumer surplus = A + B + C
• After tax the consumer surplus = A
• Change in consumer’s surplus = B + C
• B = is loss in consumer’s welfare due to the fact that price has gone
up.
• C = represents the net welfare value of the lost Consumption due to
reduction in quantity purchased from Q1 to Q2.
 P

A
P1
B C
P

Q2 Q1 q

Figure 1.42. Impact of quantity tax on CS

Exercise: if the demand for a good is Q = 20 – 2P, calculate the

change in consumer’s surplus when price changes from 3 to 4.