Microeconomics I Arsi Unversity 2024

CHAPTER ONE
1. THEORY OF CONSUMER BEHAVIOR AND DEMAND
Objectives
After completing this chapter, you will be able to:
 explain the concept of cardinal and ordinal utility approach;
 state effects of changes in money income and price on equilibrium;
 identify the difference between the indifference curve and indifference map;
 discuss the properties of indifference curve;
 derive the budget line
 state and explain consumer and producer surplus;
 derive the market demand;
Introduction
The theory of consumer choice lies on the assumption of the consumer being rational to
maximize level of satisfaction. The consumer makes choices by comparing bundle of goods. You
will see how consumers allocate their limited income among different number of goods and
services to maximize satisfaction. Moreover, you will learn how consumers’ allocation decisions
determine quantity demand of goods and services. There are two approaches to analyze
consumer’s decision making process. These are, the cardinal and ordinal utility approaches.
1.1. Consumer Preferences and Choices
Consumer preference
Given any two consumption bundles (groups of goods) available for purchase, how a consumer
compares the goods? Does he prefer one good to another, or does he indifferent between the two
groups. Given any two consumption bundles, the consumer can either decide that one of
consumption bundles is strictly better than the other, or decide that he is indifferent between the
two bundles.
Strict preference
Given any two consumption bundles(X1, X2) and (Y1,Y2),if (X1,X2>(Y1,Y2) or if he chooses
(X1,X2) when (Y1,Y2) is available the consumer definitely wants the X-bundle than Y. Example
if one bundle contains 5 Oranges and the other bundle 5 Bananas and if Mr. Bonsa preferred 5
Oranges to 5 Bananas then we say Mr. Bonsa decently prefers 5 Oranges to 5 bananas.

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Weak preference
Given any two consumption bundles(X1,X2) and (Y1,Y2),if the consumer is indifferent between
the two commodity bundles or if (X1,X2) ~ (Y1,Y2), the consumer would be equally satisfied if
he consumes (X1,X2) or (Y1,Y2). For example if Mr. Bonsa equally likes 5 Oranges and 5
Bananas, then he is indifferent between the two bundles.
Completeness
For any two commodity bundles X and Y, a consumer will prefer X to Y, Y to X or will be
indifferent between the two. Completeness shows all possible preferences.
1.2. Utility
Economists use the term utility to describe the satisfaction or enjoyment derived from the
consumption of a good or service. Consumption of goods like food, drink, clothes, furniture etc.;
and consumption of services like watching TV, swimming, hotel service, transport, hair dressing
etc.
Definition: Utility is the level of satisfaction that is obtained by consuming a commodity (goods
and services) or undertaking an activity (like running, swimming, playing etc.).

In defining strict preference, we said that given any two consumption bundles(X1,X2) and
(Y1,Y2), the consumer definitely wants the X bundle than the Y bundle if (X1,X2) >
(Y1,Y2).This means, the consumer preferred bundle (X1,X2) to bundle (Y1,Y2) if and only if
the utility (X1,X2) is larger than the utility of (Y1,Y2).
The concept of utility is characterized with the following properties:
 ‘Utility’ and ‘Usefulness” are not synonymous. For example, paintings by Picasso may
be useless functionally but offer great utility to art lovers. Another example is smoking
cigarette is useless but the smoker can enjoy smoking; i.e. the smoker may drive utility
from smoking.
 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, no-smokers do not derive any utility from cigarettes.
 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. Again the
utility we drive eating the same amount and quality of meat at our home and at restaurant
are different.

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1.3. Approaches to measure Utility

There are two major approaches of measuring utility. These are Cardinal and ordinal approaches.
1.3.1. The Cardinal Utility theory
Utility maximization theories are important to deal with consumer behavior. Neo classical
economists argued that utility is measurable like weight, height, temperature and they suggested
a unit of measurement of satisfaction called utils. Util is a cardinal number like 1, 2, 3 etc. simply
attached to utility. Hence, utility can be quantitatively measured using money as a means of
measurement.
1.3.1.1. Assumptions of Cardinal Utility theory
1. Rationality of Consumers. Consumers are assumed to be rational to maximize
satisfaction from consumption of goods and services or under taking activities given
income and prices of the goods or services. 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. Limited Money Income. The consumer has limited money income to spend on the goods
and services he/she chooses to consume. Which means the consumer has limited budget
for the consumption the goods or services from his/her income and income is also limited
(does not change). Example Mrs. Singitan has 5,000 monthly incomes that are fixed in
the short run. Her budget for a consumption of banana is 100 birr per month which is
fixed as long as monthly income is fixed.
3. Constant Marginal Utility of Money. According to assumption number two, money is
the most convenient measurement of utility. Assuming marginal utility of money (utility
derived from ownership of additional unit of money) is constant to, we can measure
utility in cardinal numbers. Marginal utility of money is constant if additional utility from
getting one birr, when we have no money; and additional utility from getting one
additional birr having more money. In this case one birr always have utility equal to
satisfaction we get from owning one birr and it is equal to 1 util.
4. Utility is cardinally Measurable. According to this approach, the utility or satisfaction
of each commodity is measurable. Money is the most convenient measurement of utility.
In other words, the monetary unit that the consumer is prepared to pay for another unit of

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commodity measures utility or satisfaction. In this case for example if we are willing to
pay 16 birr for a kilo of banana then it means that we drive utility equal to 16 utils from
consuming that kilo of banana. However, if the marginal utility of money changes with
the level of income (wealth) of the consumer, as it does in reality, then money cannot be
considered as a measurement of utility, and that is a weakness of cardinal utility
approach.
5. Diminishing Marginal Utility (DMU). The utility derived from consumption of each
successive units of a commodity diminishes in a given period of time. In other words, the
marginal utility of a commodity diminishes as the consumer consumes larger quantities
of it without time gap (in a given period of time)
6. The total utility of a basket of goods depends on the quantities of the individual
commodities. This means that total utility of a basket of goods is summation of utility
derived from each unit of goods in the basket. If there are n-number of commodities in
the bundle (basket) with goods like, X 1 , X 2 ,... X n the total utility is given by:

TU=f ( X 1 , X 2 ...... X n )

1.3.1.2. Total and Marginal Utility

Total Utility (TU): It refers to the total amount of satisfaction a consumer gets from consuming
or possessing 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 in which the consumer will not be capable of enjoying any
greater satisfaction from it. For instance, assuming all bananas are equal by quantity and quality
if price of one banana is 2 birr consider the total utility (TU) Mrs. Singitan drives from different
quantities (Q) of banana.
Table1.1. Hypothetical table showing TU and MU of consuming banana (y)
Q in unit 0 1 2 3 4 5 6 7 8

TU in util 0 5 9 12 14 15 15 14 12

MU in unit - 5 4 3 2 1 0 -1 -2
Marginal Utility (MU): It refers to the additional utility obtained from consuming an additional
unit of a commodity. In other words, marginal utility is the change in total utility resulting from

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the consumption of one or more unit of a product per unit of time. Graphically, it is the slope of
total utility.
Mathematically, the formula for marginal utility is:
TU
MU  Where, TU is the change in Total Utility, and,
Q
Q is change in the amount of product consumed.
1.3.1.3. Law of diminishing marginal Utility (LDMU)
The utility that a consumer gets by consuming a commodity for the first time is not the same as
the consumption of the good for the second, third, fourth, etc. The Law of Diminishing Marginal
Utility states that as the quantity consumed of a commodity increases per unit of time (without
time gap), the utility derived from each successive unit decreases, consumption of all other
commodities remaining constant. The LDMU is best explained by the MU curve that is derived
from the relationship between the total utility (TU) and total quantity (Q) consumed.
Table1.2. Hypothetical table showing TU and MU of consuming Oranges (X)

Qx in unit 0 1 2 3 4 5 6 7
TUX in util 0 4 7 9 10 10 -9 -8

MUX in util - 4 3 2 1 0 -1 -2

10
TUX
9
Total Utility

Quantity X
Marginal Utility

4
3
2
1
0
-1 5
-2
Microeconomics I Arsi Unversity 2024

Quantity X
1 2 3 4 5
MUX

Fig.1.1Derivation of marginal utility from total utility

As indicated in the above figures, as the consumer consumes more of a good per time period, the
TUx increases, at a decreasing rate when the MUx is positive; maximum when MUx is zero and
decreases when MUx is negative.
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 10 utils.
However, consumption beyond this point results in Dissatisfaction, because consuming the 6th
and more orange brings a lesser additional utility (MUx) than the previous orange.
Equilibrium of a consumer
Equilibrium of a consumer is a bundle (basket or set) set of goods or services consumed that
maximizes the consumer’s satisfaction (utility) given prices of the goods and services. The
consumer tries to allocate more money to the good that yields higher utility than lower.
However, as the consumer consume more of one good than the other MU of the good declines. A
consumer that maximizes utility reaches his/her equilibrium position when allocation of his/her
expenditure is such that the last birr spent on each commodity yields the same utility.

For example, if the consumer consumes a bundle of different commodities, like X, Y, Z, … etc.
then he/she would be in equilibrium or utility is maximized if and only if:
MU X MU Y MU Z
  .........   MU m Where: MUm –marginal utility of money
PX PY PZ

Case I: If the consumer consumes only one commodity (Orange, X)

If the Orange is freely available (price=0), the consumer maximizes utility by consuming more
orange as long as MU of each additional Orange is positive. So equilibrium is where Mux=0. In
the following diagram Equilibrium is consuming 5 units of orange. Consuming more than 5 units
leads to negative utility at zero prices. Here since the orange is free, no need of considering
budget (income) of the consumer.

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Marginal Utility

4
3
Of Orange

2
1
0
-1 Quantity X
1 2 3 4 5
-2 MUX

Fig.1.2. Utility maximizing Q where the good is free

Case II: Where the consumer consumes one commodity (Orange), and if the good has
price.
If the good is not free good (price ≠Zero), the consumer should compare the MUx he derives from
consuming the Orange and utility he/she derives from the money expend on the orange to maximize
utility (to reach equilibrium). If the MUx is greater than price of the Orange the consumer should
consume more if he/she has enough money, because he/she is getting more utility from consuming
Orange than keeping his/her money equals price of the Orange. If MUx = Px the consumer is at
equilibrium. If the Mux<Px, however, the consumer should consume less of the good. However, here the
consumer should consider his/her income (budget for Orange) since some times the budget is not enough
to consume at equilibrium, and some times more than enough and he/she save the remaining.

MU X
Thus in one commodity case equilibrium is where  MU m
PX

Mathematically, 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 X  PX

Proof

The utility function is: TUx  f (Qx) If the consumer buys commodity Qx, then his expenditure
will be Qx.Px. Thus, the consumer wants to maximize the difference between his/her utility and
expenditure max: TUx  QX PX
The necessary condition for maximization is equating the first derivative of a function with zero.

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dTUx d (Q X PX ) dTUx
 0   PX  0  MU X  PX
dQ X dQ X dQ X

Case III: Two Commodities Case; Orange (X) and Banana (Y)

In this case income (budget for Orange and Banana) of the consumer is assumed to be limited so that
he/she cannot buy quantities of Orange and Banana as many as they want. Since his/her income is scarce
s/he has to allocate efficiently between Orange and Banana so that utility derived is maximized (reach
equilibrium). So the consumer decides how many Oranges and how many Bananas to consume by the
limited money.
Equilibrium is where MU of Orange bought by one birr equals MU of Banana bought by one birr are
equal. If the MU of one commodity is higher the consumer should allocate more money to the higher MU
commodity, until MU of both is equal. All the money should be spent and no money should be saved.

The consumer would be in equilibrium or utility is maximized if and only if

MU X MU Y
1)   MUm  1 If the consumer has enough money income or
PX PY

2) Allocate more money to the consumption of the good with higher utility until all the money is

spent.
Example: Consider the following schedule that shows Mrs. Singitan’s consumption of Orange
and Banana. Assume price of one Orange is 2 birr and price of one Banana is 1 birr. Here each
unit of the bananas and each of the units of oranges are assumed to have the same quantities and
qualities; i.e. each banana are equal and each oranges are equal. Then based on the table,
a) What are the equilibrium consumption of the two goods if budget/income is 11 birr?
Answer: 3 Oranges and 5 bananas and the entire budget will be spent.
b) What is the equilibrium consumption if budget/income is 6 birr? Answer: 1 Orange and 4
bananas
c) Again, what about, when budget/income is 3 birr per week? Answer: only 3 Bananas

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Table 1.4.Utility schedule for two commodities

Orange, Price=2birr Banana, Price= 1 birr
Quantity TUx MUx MUx/P Quantity TU MU MU/P
0 0 - - 0 0 - -
1 4 4 2 1 5 5 5
2 7 3 1.5 2 9 4 4
3 9 2 1 3 12 3 3
4 10 1 0.5 4 15 2 2
5 10 0 0 5 16 1 1
6 9 -1 -0.5 6 16 0 0
7 8 -2 -1 7 15 -1 -1

Derivation of the Cardinalist Demand

We have 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. It is because, at different market prices of the good there
are different equilibrium consumptions (where Mux=Px). Connecting these points gives us
different combinations of price and quantity demanded that shows inverse relationship.
Figure: 1.5. Derivation of demand curve from Cardinalist Equilibrium

P3
Price

P2
P1 MUX
O
Quantity

P3
Price

P2
P1 Demand
Curve
Q2
Limitations of the Cardinalist approach is that since the marginalQuantity
O
utility of money is not
Q Q3
constant, utility cannot be absolutely (objectively)1 measure like weight, height etc.

1.3.2. The Ordinal Utility Theory

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

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terms, like, 1 util, 2 utils, or 3 utils, 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
st nd rd
order of their preference as 1 2 3 and so on.
1.3.2.1. Assumptions of Ordinal Utility theory
1) The Consumers are rational-they aim at maximizing their satisfaction or utility given
their income and market prices; i.e. they do not waste their income.
2) Utility is ordinal, i.e. utility is not absolutely (cardinally) measurable. Consumers are
required only to order or rank their preference for various bundles of commodities.
3) Preferences are transitive or consistent:
- It is transitive in the senses that 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 not greater than X (Y not >Y).
4) Diminishing Marginal Rate of Substitution (MRS): The marginal rate of substitution is
the rate at which a consumer is willing to substitute one commodity (x) for another
commodity (y) so that his total satisfaction remains the same. When a consumer continues
to substitute X for Y the rate goes decreasing. This is because as the consumer consumes
more of one commodity, MU of that commodity declines and as he/she consumes less of
the other commodity, its MU rises. The MRS is the slope of the Indifference curve.
5) The total utility of the consumer depends on the quantities of the commodities consumed,
i.e., U=f (X, Y, Z, …..)
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.
1.3.2.2. 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 level of utility.
Table: 1.5. Indifference Schedule

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Bundle A B C D E
(Combination)
Orange(X) 1 2 3 4 5
Banana (Y) 11 7 4 2 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.
Indifference Curve: an indifference curve is a graph that shows the various combinations of two
goods that provide the consumer the same level of utility or satisfaction. It is the locus of points
(particular combinations or bundles of good), which yield the same utility (level of satisfaction)
to the consumer, so that the consumer is indifferent as to the particular combination he/she
consumes. By transforming the above indifference schedule into graphical representation, we
get an indifference curve. This IC is a well behaved indifference curve.

12
11 A
Indifference
10
9
Indifference Map (IM)
8
7 B
Curve (IC)
6
Banana (Y)

Banana (Y)

5
C
4
3 IC3
D IC2
2 E
1 IC1

0 1 2
3 4 5 6 Orange(X)
Orange(X) ) (X)
Fig. 1.6. indifference)curves
(X) and indifference map.
Indifference Map: To describe a person’s preferences for all combinations of Orange and
Banana, we can graph a set of indifference curves called an indifference map. In other words
indifference map is the entire set of indifference curves, which reflects the entire set of tastes and
preferences of the consumer.
2.2.3. 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, if we need to
keep satisfaction constant.

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2. Indifference curves do not intersect each other. Intersection between two indifference
curves is inconsistent with the reflection of indifference curves. If they did, the point of their
intersection would mean two different levels of satisfaction, which is impossible.
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 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. This assumption implies that the commodities can substitute one another at any
point on an indifference curve, but are not perfect substitutes.

B
Banana

Banana

E

D IC2
C
A
IC1
X

Orange Orange
Fig. 1.7. Positively sloped and intersected indifference curves
Earlier we discussed that; indifference curves cannot intersect each other. If they did, the
consumer would be indifferent between points like C and E, (Right panel of figure 1.7.) 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 (more Orange by an amount of X).
The Marginal rate of substitution (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).

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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.
Number of units of Y given up
MRS X ,Y 
Number of units of X gained
It is the negative of the slope of an indifference curve at any point of any two commodities such
as X and Y, and is given by the slope of a line tangent to indifference curve at that point: i.e.,
y
Slope of indifference curve  MRS X ,Y
x
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.
Note that ( MRS X ,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
Y
same indifference curve. That is, MRS X ,Y   because of the reduction in Y, MRS is negative.
X
However, we multiply by negative one and express MRS X ,Y as a positive value, since the number
represents quantity which cannot be negative.

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.

Table: 1.6. level of consumption of good X and Y

Bundle A B C D E
(Combination)
Orange(X) 1 2 3 4 5
Banana (Y) 11 7 4 2 1

To make our discussing easy assume the indifference curve is linear (straight line) between the
different points, A, B, C, D, E, …. Then, the MRSx,y of a movement from A to B is

Y 4
MRS X ,Y     4  4  4
X 1

In the above case 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, she is willing to give up only 3 units of

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Banana(Y) to obtain 1 unit of Orange (X), so the MRS is (∆Y/∆X =3). Having still less of
Banana and more of Orange at point D, the consumer is willing to give up only 2 units of Banana
so as to obtain 1 units of Orange. In this case, the MRS falls to 2. 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. In addition, the MRS decreases as one move downwards
to the right.
The Relationship between the Cardinal Marginal Utility and Ordinal Marginal rate of
Substitution
It is also possible to show the derivation of the MRS using MU concepts. The MRS X ,Y is

related to the MUx and the MUy as follows:

MU X
MRS X ,Y 
MU Y
Proof:

Suppose the utility function for two commodities X and Y is defined as: TU  f ( X , Y )
Since utility is constant on the same indifference curve: TU  f ( X , Y )  C , where C represents
a constant number.
The Objective a rational consumer is maximizing Utility. A function is optimal at its first
derivative equals zero. So we need to find the total derivation of TU function.
The total differential of the utility function is:

TU TU
dTU  dX  dY  0
X Y

MU X dX  MU Y dY  0

MU X dY
  MRS X ,Y
MU Y dX

MU Y dX
Or,   MRS Y , X
MU X dY

Example
Suppose a consumer’s utility function is given by TU  5 X 4Y 2 .Compute the MRSx, y.
MU X dTU dTU
MRS X ,Y  where MU X  and MU Y 
MU Y dX dY

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Therefore, MU X  4(5 X 41Y 2 )  20 X 3Y 2 and MU Y  2(5 X 4Y 21 )  10 X 4Y

MU X 20 X 3Y 2 Y
MRS X ,Y   4
2
MU Y 10 X Y X
This means that the consumer is willing to substitute one Orange for two Bananas. For
each one unit additional consumption of orange, the consumer gives up two bananas.

13.2.3. Special Types of Indifference Curves

Convexity or down ward sloping is among the characteristics of indifference curve and this
shape of indifference curve is for most goods. It is a well behaved indifference curve. 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 such as perfect substitution or
complementary. Here, are some of the ways in which indifference curves/maps might be used to
reflect preferences for three special cases.
I. Perfect substitutes: If two commodities are perfect substitutes (if they are essentially the
same), the indifference curve becomes a straight line with a negative slope. MRS for perfect
substitutes is constant. (Panel a)

IC3 IC1 IC2 IC3

IC2
Out dated books

IC1
Right shoe

IC3
Total

IC2
IC1

Mobil Left shoe Food

Panel a Panel b Panel c

Fig.1.8. Special cases of indifference curves

II. Perfect complements: If two commodities are perfect complements the indifference curve
takes the shape of a right angle. Suppose that an individual prefers to consume left shoes (on the
horizontal axis) and right shoes on the vertical axis in pairs. For example, if an individual has
two pairs of shoes, additional right or left shoes provide no more utility for him/her. MRS for
perfect complements is zero (both MRS XY and MRS XY is the same, i.e. zero).

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III.A useless good: Panel C in the above figure shows an individual’s indifference curve for
food (on the horizontal axis) and an out-dated book, a useless good, (on the vertical axis). Since
they are totally useless, increasing purchases of out-dated books does not increase utility. This
person enjoys a higher level of utility only by getting additional food consumption. For example,
the vertical indifference curve IC 2 shows that utility will be IC 2 as long as this person has some
units of food no matter how many out dated books he/she has.
1.4. The Budget Line (the Price line)
Indifference curves only tell us about the consumer’s preferences for any two goods but they
cannot tell us which combinations of the two goods will be chosen or bought (affordable). 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 indifference curve is attainable depends on the consumer’s
money income and on commodity prices. A consumer while maximizing utility is constrained by
the amount of income and prices of goods that must be paid. This constraint is often presented
with the help of the budget line constructing by alternative purchase possibilities of two goods.

The budget line is a line or graph indicating different combinations of two goods that a
consumer can buy with a given income at a given prices. In other words, it shows the different
combination of market baskets that the consumer can purchase, given the consumer’s income
and prevailing market prices.

Assumptions for the use of the budget line

1. there are only two goods, X and Y, bought in quantities X and Y;
2. each consumer is confronted with market determined prices, Px and Py, of good X and good Y
respectivley; and
3. the consumer has a known and fixed money income (M).
By assuming that the consumer spends all his/her income on two goods (X and Y), we can
express the budget constraint as:
M  PX X  PY Y Where, PX=price of good X

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PY=price of good Y
X=quantity of good X
Y=quantity of good Y
M=consumer’s money income
This means that the amount of money spent on X plus the amount spent on Y equals the
consumer’s money income.
Example: Suppose for a household with 30 Birr per week to spend on Orange (X) at 2 Birr each
and Banana (Y) at 1Birr each. That is, PX  2, PY  1, M  30birr .

Therefore, our budget line equation will be: 5 X  2Y  30

Then all the combination listed in the following table can be purchased by 30 birr.
Table: 1.7. Alternative purchase possibilities of the two goods

Consumption
A B C D ----- E F
Alternatives
Units of Orange (X) 0 1 2 3 ----- 14 14.5 15
Units of Banana (Y) 30 28 26 7.5 ----- 2 1 0
Total Expenditure 30 30 30 30 ----- 30 30 30

At alternative A, the consumer is using all of his /her income for good Y. Mathematically it is the
y-intercept (0, 30). And at alternative F, the consumer is spending all his income for good X.
mathematically; it is the x-intercept (15, 0). We may present the income constraint graphically by
the budget line whose equation is derived from the budget equation.
M  PX X  PY Y Solving for YPY we get M  XPX  YPY . By rearranging the above equation we can
derive the general equation of a budget line which is, M PX
Y  X
PY PY

M
Where, - = Vertical Intercept (Y-intercept), when X=0 and
PY
P
 X = slope of the budget line (the ratio of the prices of the two goods)
PY
The horizontal intercept (i.e., the maximum amount of X the individual can consume or purchase
given his income) is given by
M PX M PX M
 X 0   X X 
PY PY PY PY PX

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M/PY

B

Fig. 1.9. Derivation of the Budget Line
A


Therefore, the budget line is the locus of combinations

M/P or bundle of goods that can be purchased
X

if the entire money income is spent.

In the figure above, a combination of the two goods that is represented by point A is affordable,
but there will be idle money (unspent money). So to maximize satisfaction the consumer should
buy more of one or the other or both by the remaining money. Combination that is represented
by point B is not affordable by current income and the consumer needs to get additional money
to consume at that point. Only combinations on the budget line are affordable and efficient.
1.4.1.Factors Affecting the Budget Line
Effects of changes 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 shift of the budget line
that allows the consumer to buy more goods and services and decreases in income causes a
downward shift of 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. The budget line shifts from B to B1 when income decreases
and to B2 when income rises.

M2/Py

M/Py

M1/Py
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Fig.1.10. Effects of change in income

Where M2>M>M1

M1/PX M/PX M2/PX

B B2

B1

Y Y

B1 B1
B
B
X X
Fig.a Fig.b

Fig.1.11. Effects of change in price

Changes in the prices of X and Y is reflected in the shift of the budget lines. In the above figures
(fig.a) a price decline of good X results in the shift from B to B1.A fall in the price of good Y in
figure (b) is reflected by the shift of the budget line from B to B1.We can notice that changes in
the prices of the commodities change the position and the slope of the budget line. But,
proportional increases or decreases in the price of the two commodities (keeping income
unchanged) do not change the slope of the budget line if it is in the same direction.

 What would happen if price of x falls, while the price of good Y and money incme
remaining constant?

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M/py A

Here Px ’ < Px, hence M/Px <M/Px1

B B’
M/Px M/Px ' X
Fig. 1.12. Effect of a decrease in price of x on the budget line

Since the Y-intercept (M/Py) is constant, the consumer can purchase the same amount of Y by
spending the entire money income on Y regardless of the price of X. We can see from the above
figure that a decrease in the price of X, money income and price of Y held constant, pivots the
budget line out-ward, as from AB to AB’.
 What would happen if price of X rises, while the price of good Y and money incme remaining
constant?
Since the Y-intercept (M/Py) is constant, the consumer can purchase the same amount of Y by
spending the entire money income on Y regardless of the price of X. We can see from the
figure below that an increase in the price of X, money income and price of Y held constant,
pivots the budget line in-ward, as from AB to AB’.

A
M/Py

B
B’

M/Px1 M/Px2

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Fig. 1.13. Effect of an increase in price of x on the budget line

 What would happen if price of Y rises, while the price of good X and money incme remaining
constant?
Since the X-intercept (M/Py) is constant, the consumer can purchase the same amount of X by
spending the entire money income on X regardless of the price of Y. We can see from the above
figure that an increase in the price of Y, money income and price of X held constant, pivots the
budget line in-ward, as from AB to A’B.

Y
A
M/py

A’
M/py'

B
M/Px X
Fig.1.14. Effect of a raise in price of Y on the budget line

 What would happen if price of Y falls, while the price of good X and money incme remaining
constant?
Y
M/py' A’

M/py A

B
M/Px X
Fig.1.15 Effect of a fall in price of Y on the budget line

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The above figure shows what happens to the budget line when the price of Y increases while the price of
good X and money income held constant. Since Py decreases, M/Py increases thereby the budget line
shifts outward.
Numerical Example of Effects of change in Income and Price
A person has 100 birr to spend on two goods(X,Y) whose respective prices are 20 birr and 10
birr.
a) Draw the budget line.
b) What happens to the original budget line if the budget falls by 40 %?
c) What happens to the original budget line if the budget falls by 20 birr?
d) What happens to the original budget line if the budget rises to 120 birr?
e) What happens to the original budget line if the price of X falls by half?
f) What happens to the original budget line if the price of Y doubles?
Solutions
a) The budget line for two commodities is expressed as: PX X  PY Y  M
20 X  10Y  100  10Y  100  20 X  Y  10  2 X
When the person spends all of his income only on the consumption of good Y, we can get the Y
intercept that is(0,10). However, when the consumer spends all of his income on the
consumption of only good X, then we get the X intercept that is (5,0). Using these two points we
can draw the budget line. Thus, the budget line is the curve represented by Bgl-1(thick line) in
the following graph.
Good Y

20
12

10

8
6

5 Bgl-3
Bgl-5
Bgl-6
Bgl-1
Bgl-4
Bgl-2

3 4 5 6 10
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Good X

b) If the budget decreases by 40%, then the budget will be reduced to 60 birr.As a result the
budget line will be shifted in-ward that is indicated from Bgl-1 to Bgl-2 in the above
graph. This forces the person to buy less quantity of the two goods. The equation for the
new budget line can be solved as follows:
20 X  10Y  60  10Y  60  20 X  Y  6  2 X
Therefore, the Y-intercept is 6 while the X-intercept is 3. However, since the ratio of the prices
does not change the slope of the budget line remains constant.
c) Since 100-20 is 80, now the consumer can bay 8 units of Y only or 4 units of X only. So
the graph will shift in wards from Bgl-1 to Bgl-3 the broken thick line. The budget
equation is now
20 X  10Y  80  10Y  80  20 X  Y  8  2 X
The slope does not change.
d) If the budget rises to 120 birr, now the consumer can buy more of both goods and
the line shifts upward from Bgl-1 to Bgl-4 (thin broken line). The new budget line
equation is now, 20 X  10Y  120  10Y  120  20 X  Y  12  2 X
e) If price of X declines by half, then the graph will rotate outwards on the X axis,
from Bgl-1 to Bgl-5. The new budget equation is now,
10 X  10Y  100  10Y  100  10 X  Y  10  X

f) If the price of good Y doubles the equation of the budget line rotates inward along the Y
axis, from Bgl-1 to Bgl-6. The new budget line equation is Y=5-X

Exercise
Assume that a consumer consume two products which are X and Y. if price of X is Px =10 and
price of Y is Py=20 birr per unit and the consumer has 250 budget to expend on the two goods,
I) Formulate budget equation, show budget line graphically and find its slope.
II) If price of X doubled, price of Y decreased by half and income by 50, find budget
equation, draw budget line on separate graph and find the new slope.

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1.5. Optimum of the Consumer

A rational consumer seeks to maximize his utility or satisfaction by spending his or her income.
It maximizes the utility by trying to attain the highest possible indifference curve, given the
budget line. This occurs where an indifference curve is tangent to the budget line so that the
slope of the indifference curve ( MRS XY ) is equal to the slope of the budget line ( PX / PY ).
Thus, the condition for utility maximization, consumer optimization, or consumer equilibrium
occurs where the consumer spends all income (i.e. he/she is on the budget line) and the slope of
the indifference curve equals to the slope of the budget line MRS XY  PX / PY .
The preferences of the consumer (what he/she wishes) are indicated by the indifference curve
and the budget line specifies the different combinations of X and Y the consumer can purchase
with the limited income. Therefore, the consumer tries to obtain the highest possible satisfaction
with in his budget line.
However, the consumer cannot purchase any bundle lying above and to the right of the budget
line. Because Indifference curves above the region of the budget line are beyond the reach of the
consumer and are irrelevant for equilibrium consideration. The question then arises as to which
combinations of X and Y the rational consumer will purchase.
Graphically, the consumer optimum or equilibrium is depicted as follows:

Y
A

B
E
IC4

C IC3

IC2
D
IC1

X
Figure: 1.16. Consumer equilibrium

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At point ‘A’ on the budget line, the consumer gets IC1 level of satisfaction. When he/she moves
down to point ‘B’ by reallocating his total income in favor of X he/she derives greater level of
satisfaction that is indicated by IC2. Thus, point ‘B’ is preferred to point ‘A’. Moving further
down to point ‘E’, the consumer obtains the greatest level of satisfaction (IC3) relative to other
indifference curves.
Therefore, point ‘E’ (which represents combination X and Y) is the most preferred position by
the consumer since he/she attains the highest level of satisfaction within his/her reach and point
’E’ is known as the point of consumer equilibrium (or consumer optimum). This equilibrium
occurs at the point of tangency between the highest possible indifference curve and the budget
line. Put differently, equilibrium is established at the point where the slope of the budget line is
equal to the slope of the indifference curve.
Mathematically, consumer optimum (equilibrium) is attained at the point where:
PX MU X MU Y MU X PX
MRS XY  , But we know   .......MU X PY  MU Y PX ..., 
PY PX PY MU Y PY

Mathematical derivation of equilibrium

Suppose that the consumer consumes two commodities X and Y given their prices by spending
level of money income M. Thus, the objective of the consumer is maximizing his utility function
subject to his limited income and market prices. In utility maximization, the function that
represents the objective that the consumer tries to achieve is called the objective function and the
constraint that the consumer faces is represented by the constraint function.
The maximization problem will be formulated as follows:
MaximizeTU  f ( X , Y )

Subject to PX X  PY Y  M

We can rewrite the constraint as follows:

M  PX X  PY Y  0 if we use ( ) or PX X  PY Y  M  0 if we use ( )

Multiplying the constraint by Lagrange multiplier 

  (M  PX X  PY Y )  0

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Forming a composite function gives as the Lagrange function:

  TU ( X , Y )   (M  PX X  PY Y ) Or,
  TU ( X , Y )   ( PX X  PY Y  M )

The first order condition (FOC) requires that the partial derivatives of the Lagrange function
with respect to the two goods and the langrage multiplier be zero.
 TU  TU 
  PX  0 ;   PY  0 and  ( PX X  PY Y  M )  0
X X Y Y 
From these equations we obtain:
TU TU TU TU
 PX and  PY where,  MU X and  MU Y
X Y X Y

Therefore, substituting and solving for  we get the equilibrium condition:

MU X MU Y MU X PX
  By rearranging we get:  which shows equality of slope of the
PX PY MU Y PY
indifference curve and the budget line.

So to solve the utility maximization problem you can simply find slopes of the two curves and equate
them or follow the lagrangian procedure.

The second order condition (SOC) for maximum requires that the second order partial
derivatives of the Lagrange function with respect to the two goods must be negative.
2 TU 2 2 TU 2
  0 and  0
X 2 X 2 Y 2 Y 2
Example
A consumer consuming two commodities X and Y has the following utility function
TU  XY  2 X . If the price of the two commodities are 4 and 2 respectively and his/her budget
is birr 60.
a) Formulate the budget equation
b) Find the slope of the budget line
c) Find the MRS X ,Y at optimum.

d) Find the quantities of good X and Y which will maximize utility.

Solution
a) The budget equation is 4 X  2Y  60

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 Px 4 
b) Slope of the line is negative of the price ratio of the two commodity i.e.     2 
 Py 2 
Note that, commodity X is assumed to have located on the x-axis and Y on the y-axis.
Otherwise the slope becomes multiplicative inverse of the slope of the budget line.
MUx
c) MRS X ,Y 
MUy
TU ( XY  2 X ) TU ( XY  2 X )
MUx    Y  2 and MUy    X , then
X X Y Y
MUx Y  2
MRS X ,Y  
MUy X
Note that, MRS X ,Y and MRS Y , X are reciprocal of each other.

d) The simplest way is to equate the slopes of budget line and the indifference curve we
Y 2
found; i.e. 2  then solve for X or Y and substitute in the budget equation.
X
Y 2 Y  2
X  Inserting in budget equation 4   2Y  60
2  2 
14  2
Y=14 now solve for X which is X  8
2
Interpretation: the consumer consumes X=8 and Y=14 to maximize utility.

The other way is the Lagrange equation approach:

  XY  2 X   (60  4 X  2Y )

 Y  2   4  0 ……………………….. (1)
X

 X   2  0 …………………………… (2)
Y

 60  4 X  2Y  0 …………………… (3)


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From equation (1) we get Y  2  4 and from equation (2) we get X  2 . Solving for 
Y 2 X Y 2 1
 and   since both  are equal, we can equate the two equations  X
4 2 4 2
Y 2
Thus, we can get that X  .
2
Y 2
By substituting X  in to equation (3) we get Y  14 and X  8.
2
The answers in both approaches are the same.
Exercise:
Assume Mr. Hinsarmu has budget of 150 birr for the consumption of tomato (X) and potato (Y)
per month. Assume currently price of tomato is 15 birr per Kg. and price of Potato is 10 birr per
Kg. if utility function of Mr. Hinsarmu is given by TU  5YX 2 find the quantities of tomato and
potato that maximize his utility. Answer: X=5.33* and Y=4

2.4.1. Effects of Changes in Income and Prices on Consumer Equilibrium

Let us now analyze the effect of changes in consumer’s income and the price of the good that are
the two important determinants of quantity demanded (or also consumer equilibrium). Let us first
consider the effect of change in income on the equilibrium of the consumer all other things
remaining constant.

2.4.1.1 .Effects of Changes In Income : (Income Consumption Curve and the Engel
Curve)

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) or Income expansion curve (IEC). The Income Consumption Curve is a curve joining the
points of consumer optimum (equilibrium) as income changes (ceteris paribus). Or, it is the locus
of consumer equilibrium points resulting when only the consumer’s income varies. From the

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Income Consumption Curve 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 See the following graph.

ICC/IEC
Commodity Y

E3
E2
E1

Commodity X

Engle Curve
I3
I2
Income

Figure: 1.17. The income –consumption and the Engle curves

I1

The Engle Curve is the relationship between the equilibrium quantity purchased of a good and
X1 X2 X 3 Commodity X
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.

In relation to the shape of the income-consumption and Engle curves goods can be categorized as
normal (superior) and inferior goods. Thus, commodities are said to be normal, when the income
consumption curve and its Engle curve are positively sloped; meaning that more of the goods are
purchased at higher levels of income. On the other hand, commodities are said to be inferior
when the income consumption curve and Engle curve is negatively sloped, i.e. their purchase
decreases when income increases.

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For example, in the figure below 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.

M3/Py
M3/Py
M2/Py

M2/Py
M1/Py

M1/Py
M1/Px M2/Px M3/Px M1/Px M2/Px M3/Px

Figure: 1.18. Income consumption curve of normal and inferior goods

2.4.1.2. Effects of Changes in Price:
(Price Consumption Curve and Individual Demand Curve)

We now look at the second factor that affects the equilibrium of the consumer that is price of the
goods. The effect of price on the consumption of good is even more important to economists
than the effect of changes in income. Here, we hold money income constant and let price change
to analyze the effect on consumer behavior.
In our earlier discussion, we have seen that a decrease in the price of good X, for example,
decreases the absolute value of the slope of the budget line, but it does not affect the vertical (Y)
intercept of the line. Thus, the fall in the price of x will result in out ward rotation of the budget
line on the x-axis that makes the consumer to buy more of good x. If we connect all the points
representing equilibrium market baskets corresponding to each price of good X we get a curve
called price-consumption curve (PCC).

The price-consumption curve is the locus of the utility-maximizing combinations of products

that result from variations in the price of one commodity when other product prices, the money
income and other factors are held constant.

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We can derive the demand curve of an individual for a commodity from the price consumption
curve. Below is an illustration of deriving the demand curve when price of commodity X
decreases from Px1 to Px 2 to Px3 .

Commodity Y
PCC

Commodity X

Px1
Price of X

Px2
Individual
Px3
demand curve

X1 X2 X3 Commodity X

Figure: 1.19. The PCC and derivation of the individual demand curve

Income and Substitution Effects

We now turn to a more complete analysis of why demand curves slope downward. In our
previous discussion we have noted that there are two effects of a price change. 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. Also, as price falls (rises),
the consumer’s purchasing power increases (decreases). Since the set of consumption
opportunities increases (decreases) as price changes, the consumer changes the mix of his or her
consumption bundle. This effect is called the income effect. Let us analyze each effect in turn,
and then combine the two in order to see why demand is assumed to be downward sloping.

 Let us Consider the case of a price-decline:

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First a decrease in price increases the consumer’s real income (purchasing power), thus
enhancing the ability to buy more goods and services to some extent. Second, a decrease in the
price of a commodity induces some consumers (the consumer) to substitute it for others, which
are now relatively expensive (higher price) commodities.The 1st effect is known as the income
effect, and the 2nd effect is known as the substitution effect. The combined effect of the two is
known as the total effect (net effect).

Note that:
I/py1
X 1 X 3 =NE= Total (net) effect

X 1 X 2 = SE=Substitution effect
I’/py1
A B IC2
  X 2 X 3 = IE=Income effect
C IC1


x1 x2 IE x3 I’/px1 I/px2
SE
NE

Figure: 1.20. Income and Substitution effect for a normal good

Suppose initially the income of the consumer is I 1 , price of goodY is Py1 , and Price of good X
I I
is Px1 , we have the budget line with y-intercept and X-intercept . The consumer’s
Py1 Px1
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 Px 2 the budget
I I
line shifts outward with y-intercept & X-Intercept . The consumer’s new equilibrium
Py1 Px 2
will be on point B.

The total change in the quantity purchased of commodity X from the 1st equilibrium point at A
to the second equilibrium point at B shows the Net effect or total effect of the price decline

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(change). 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
Px 2
new ratio of the product price so that it is just tangent to the original indifference curve IC1 .
Py1
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

h
The income effect may be defined as the change in the quantity demanded of a commodity
exclusively associated with a change in real income. The income effect is determined by
observing the change in the quantity demanded of a commodity that is associated solely with the
change in the consumer’s real income.
In figure 1.20, 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 income effect 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.

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The income effect of a change in the price of good shows the change in quantity demanded via
change in real income, while the relative price ratio remains constant. This movement does not
involve any change in prices; the price ratio is the same in budget line 1 as in budget line 2. It is
due to a change in total satisfaction and such a change is a movement from one indifference
curve to another.
When we look at both the substitution and income effects, the magnitude of the substitution
effect is greater than that of the income effect. The reason is that:
 Most goods have suitable substitutes and when the price of good falls, the quantity of
the good purchased is likely to increase very much as consumers substitute the now
cheaper good for others.
 Spending only a small fraction of his /her income, i.e. with the consumers purchasing
many goods and spending only a small fraction of their income on any one good, the
income effect of a price change of any one good is likely to be small.
Usually, the income and substitution effects reinforce one another i.e. they operate in the same
direction. The substitution effect is always negative. i.e. if the price of a good X increases and
real income is held constant, there will always be a decrease in the consumption of good X, and
vise versa. This result follows from the fact that indifference curves have negative slopes.
However, the income effect is not predictable from the theory alone. In most cases, one would
expect that increases in real income would result in increases in consumption of a good. This is
the case for so called Normal goods.
In short, in the case of normal goods, the income effect and the substitution effect operate in the
same direction –they reinforce each other. But not all goods are normal. Some goods are called
inferior goods because the income effect is the opposite (of that of a normal good) for them-they
operate in opposite direction. For an inferior good, a decrease in the price of the commodity
causes the consumer to buy more of it (the substitution effect), but at the same time the higher
real income of the consumer tends to cause him to reduce consumption of the commodity (the
income effect). We usually observe that the substitution effect still is the more powerful of the
two; even though the income effect works counter to the substitution effect, it does not override
it. Hence, the demand curve for inferior goods is still negatively sloped.

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Microeconomics I Arsi Unversity 2024

Let us consider the following diagram that shows the income, substitution and net effect for an
inferior commodity in the case of a decline in the price of good X.

Y KEY:

X1X3= NE=Net effect

E3 X1X2= SE=Substitution effect

X2 X3= IE=Income effect

E1
E2 IC2

X1 X3 X2 IC1 X
IE
NE

SE
Figure 1.21. Income, Substitution, and Net effect for an inferior commodity

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. In other words, price and quantity move in the same direction. The name
given to such a unique situation is Giffen paradox; and it constitutes an exception to the Law of
demand. That is for Giffen goods the income effect (which decreases the quantity demanded) is
so strong that it 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.

E3
IC2

E1
E2
IC1

X3 X1 X2 X
SE
35
NE

IE
Microeconomics I Arsi Unversity 2024

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