UNIT ONE

THEORY OF CONSUMER BEHAVIOR AND DEMAND

1.1 Utility
Utility is the level of satisfaction that is obtained by consuming a commodity or undertaking an
activity.
In strict preference, 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.
 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.
A Consumer considers the following points to get maximum utility or level of satisfaction:
 How much satisfaction he gets from buying and then consuming an extra unit of a good
or service.
 The price he pays to get the good.
 The satisfaction he gets from consuming alternative products.
 The prices of alternative goods and services.
1.2 Approaches to measure Utility
There are two major approaches of measuring utility. These are Cardinal and ordinal approaches.
1.2.1 The Cardinal Utility theory

It was developed by traditional economists called Neo classical economists.

They argued that utility is measurable like weight, height, temperature and they suggested a unit
of measurement of satisfaction called utils. A util is a cardinal number like 1,2,3 etc simply
attached to utility. Hence, utility can be quantitatively measured.

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Assumptions of Cardinal Utility theory
1. Rationality of Consumers. The main objective of the consumer is to maximize his/her
satisfaction given his/her limited budget or income. Thus, in order to maximize his/her
satisfaction, the consumer has to be rational.
2. Utility is Cardinally Measurable. According to 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
commodity measures utility or satisfaction.
3. Constant Marginal Utility of Money. According to assumption number two, money is
the most convenient measurement of utility. However, if the marginal utility of money
changes with the level of income (wealth) of the consumer, then money cannot 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.
5. Diminishing Marginal Utility (DMU).The utility derived from each from each
successive units of a commodity diminishes. In other words, the marginal utility of a
commodity diminishes as the consumer acquires larger quantities of it.
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,

X 1 , X 2 ,. . . X n the

total utility is given by: TU=f (

X 1 , X 2 .. .. . . X n )
1.3 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.
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

2
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:
ΔTU
MU =
ΔQ Where, TU is the change in Total Utility, and,
Q is change in the amount of product consumed.
Relationship between Total and marginal utility
The total utility increases, at an increasing rate when the marginal utility is increasing and then
increases at a decreasing rate when the marginal utility 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 11 utils.
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. Graphically
TUx

TUX

Quantity of X
MUx

Qx

3
 Mux
1.4 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, the utility derived from each successive unit decreases after some
points, consumption of all other commodities remaining constant.
The LDMU is best explained by the MU curve that is derived from the relationship between the
TU and total quantity consumed.

1.5 Equilibrium of a consumer under cardinal approach

The fundamental condition of consumer’s equilibrium is the law of equi-marginal utility. The
law of equi-marginal utility states that, a consumer gets maximum satisfaction when the ratio of
marginal utilities of all commodities and their prices is equal. In other words, the consumer
should incur expenditure on different commodities in such a manner that the marginal utility of
the last Birr spent on each one of them is equal.

Mathematically, the conditions of equilibrium are as follows.

For example, if the consumer consumes a bundle of n commodities i.e x1,x2,…,xn,he/she would
be in equilibrium or utility is maximized if and only if:
MU X MU X MU X
1
= 2
= .. . .. .. . .= n
=MU m
PX PX PX
1. 1 2 n Where: MUm –marginal utility of money

Where, MUx = Marginal utility of commodity x; MUy = Marginal utility of commodity y; MUn
= Marginal utility of commodity n, Px = Price of x, Py = Price of y and Pn = Price of n
This condition is necessary condition
2. Expenditure on x + Expenditure on y + ... + Expenditure on n = Consumer’s Income which is
sufficient condition
Px× Qx+ Py× Qx+ ... + Pn× Qn= I

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Diagrammatically,

C
PX

MUX

Figure 2.2 marginal utility of a consumer

Note that: at any point above point C like point A where MUX> Px, it pays the consumer to
consume more. At any point below point C like point B where MUX< Px the consumer
consumes less of X. However, at point C where MUx=Px the consumer is at equilibrium.
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 = P X

Proof

The utility function is: U =f ( X )

If the consumer buys commodity X, then his expenditure will be

Q X P X .Thus, the consumer
wants to maximize the difference between his/her utility and expenditure
Max(U −Q X P X )
The necessary condition for maximization is equating the derivative of a function with zero.
dU d (Q X P X )
− =0
Thus, dQ X dQ X

dU
−P X =0 ⇒ MU X=P X
dQ X

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Table: Utility schedule for two commodities
Orange, Price=2birr Banana, Price=4birr
Quantity TU MU MU/P Quantity TU MU MU/P
0 0 - - 0 0 - -
1 6 6 3 1 6 6 6
2 10 4 2 2 22 16 4
3 12 2 1 3 32 12 3
4 13 1 0.5 4 40 8 2
5 13 0 0 5 45 5 1.85
6 11 -2 -1 6 48 3 0.75

For more than two commodities 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
MU 1 MU 2
=
commodity divided by its market price MU i.e. P1 P2

Thus, the consumer will be at equilibrium when he consumes 2 quantities of Orange and 4
MU orange MU banana 4 8
= = = =2
quantities of banana, because Porange Pbanana 2 4

Derivation of the Cardinalist Demand

You recall 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.

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 P1
a
b

Price
P
Graphically
P2
c
MUX
O Quantity

P1
Price

P
Demand
P2 Curve
O Quantity
Q1 Q Q2
1.2.2 The Ordinal Utility Theory
It was developed by modern economists.
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
st nd rd
commodities in the order of their preference as 1 2 3 and so on.
Assumptions of Ordinal Utility theory
This approach is based on the following assumptions:
1. The Consumers are rational-they aim at maximizing their satisfaction or utility given their
income and market prices.
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.

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 3. 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 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., U=f (
X 1 , X 2 .. .. . . X n )
5. 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).
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
An indifference set refers to a table that shows various combinations of two goods which give
equal level of satisfaction (utility) to the consumer. Since each of these combinations gives equal
satisfaction, the consumer is indifferent among them. Table: Indifference Schedule
Consumption Bundle Orange(X) Banana (Y)
(Combination)
A 1 10
B 2 6
C 4 3
D 7 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 Curves: 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.

8
By transforming the above indifference schedule into graphical representation, we get an
indifference curve.
Indifference Map: To describe a person’s preferences for all combinations potato and meat, we
can graph a set of indifference curves called an indifference map. In other words it is the entire
set of indifference curves is known as an indifference map, which reflects the entire set of tastes
and preferences of the consumer. A higher indifference curve refers to a higher level of
satisfaction and a lower indifference curve shows lesser satisfaction.
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. 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.
The Marginal rate of substitution (MRS)
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 the tangent at that point:

9
 Δy
=MRS X , Y
i.e., Slope of indifference curve Δx
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
Marginal Utility and Marginal rate of Substitution

It is also possible to show the derivation of the MRS using MU concepts. The
MRS X , Y is related
MU X
MRS X , Y =
to the MUx and the MUy is: MU Y Proof:
Suppose the utility function for two commodities X and Y is defined as:
U =f ( X ,Y )
Since utility is constant on the same indifference curve:
U =f ( X ,Y )=C
The total differential of the utility function is:
∂U ∂U
dU = dX + dY =0
∂X ∂Y
MU X dX + MU Y dY =0
MU X dY
=− =MRS X ,Y
MU Y dX
MU Y dX
=− =MRS Y , X
Or, MU X dY

Example
X4
U =5
Suppose a consumer’s utility function is given by Y −2 .Compute the MRSX , Y .
MU X
MRS X , Y =
MU Y
dU dU
MU X = and MU Y =
dX dY
4−1 2
Therefore, MU X =4( X Y )=4 ( X 3 Y 2 ) and MU Y =2 ( X 4 Y 2−1 )=2 X 4 Y

10
 MU X 4 X3 Y 2 Y
MRS X , Y = = 4
=2
MU Y 2X Y X
Special Indifference Curves
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)
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 yx is the same, i.e.
zero).
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.

IC3 IC1 IC2 IC3

Out dated books

IC2
IC1
Right shoe

IC3
Total

IC2
IC1

Mobil Left shoe Food

Panel a panel b panel c

The Budget Line or the Price line

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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, the budget line shows
the market basket that the consumer can purchase, given the consumer’s income and prevailing
market prices.
By assuming that the consumer spends all his/her income on two goods (X and Y), we can
express the budget constraint as:
M =P X X + P Y Y Where, PX=price of good X
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.
M =P X X +P Y Y
M − XP X =YPY
By rearranging the above equation we can derive the general equation of a budget line,

M P
Y= − X X
PY PY

M
PY = Vertical Intercept (Y-intercept), when X=0.

PX
−
PY = slope of the budget line (the ratio of the prices of the two goods)
The horizontal intercept (i.e., the maximum amount of X the individual can consume or
purchase given his income) is given by:

M P
− X X =0
PY PY

M P
= X X
PY PY

12
 M
X=
PX

Derivation of the Budget Line

M/PY

Note: - Any point inside the curve like Point A is attainable (feasible area) but inefficient
- Any point outside the curve like point B isM/PX
unattainable (not feasible area)
- Any point on the curve is both attainable and efficient
Therefore, the budget line is the locus of combinations or bundle of goods that can be purchased
if the entire money income is spent.
Factors Affecting the Budget Line

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.

B B2

B1

M1/PX M/PX M2/PX

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Effects of Changes in Price of the commodities
Price of both commodities changing in equal proportion doesn’t change slope of budget line but
only shift it in either directions. However, if price of one commodity change while income and
price the other remain constant, the slope of BL changes.
Numerical Example

A person has $ 100 to spend on two goods(X,Y) 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?
From our previous discussion the budget line for two commodities was expressed as:

P X X + PY Y =M

3 X +5 Y =100
5 Y =100−3 X
100 3
Y= − X
5 5
3
Y =20− X
5

When the person spends all of his income only on the consumption of good Y,we can get the
Y intercept that is(0,20).However, when the consumer spends all of his income on the
consumption of only good X,then we get the X intercept that is (33.33,0). Using these two
points we can draw the budget line. Thus, the budget line will be:

e)
A
Y
f)
20
A’

B’ B

33.33 X
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 If the budget decreases by 25%, then the budget will be reduced to 75.As a result the
budget line will be shifted in-ward that is indicated by (A’B’).This forces the person
to buy less quantity of the two goods. The equation for the new budget line can be
solved as follows:

3 X +5 Y =75
5 Y =75−3 X
75 3
Y= − X
5 5
3
Y =15− X
5
Therefore, the Y-intercept is 15 while the X-intercept is 25.However, since the ratio of
the prices does not change the slope of the budget line remains constant.

If the price of good X doubles the equation of the budget line will be 6 X +5 Y =100 and if
the price of good Y falls to 4, the equation for the new budget line will be6 X + 4 Y =100 .

Optimum of the Consumer under ordinal approach

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 ( P X / 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 =P X / PY .
Graphically, the consumer optimum or equilibrium is depicted as follows:

Y
A

B
E
IC4

C IC3
15
IC2
D
IC1
Figure: Consumer equilibrium
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 P Y =MU Y P X .. . , =
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 too 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:

MaximizeU =f ( X ,Y )

Subject to P X X+P Y Y =M

We can rewrite the constraint as follows:

M −P X X + P Y Y =0 or P X X + PY Y −M =0

Multiplying the constraint by Lagrange multiplier λ

λ (M −P X X + PY Y )=0

Forming a composite function gives as the Lagrange function:

ℓ=U ( X ,Y )+ λ( M−P X X + PY Y )

Or, ℓ=U ( X ,Y )−λ ( P X X +PY Y −M )

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The first order condition requires that the partial derivatives of the Lagrange function with
respect to the two goods and the langrage multiplier be zero.
∂ ℓ ∂U ∂ ℓ ∂U ∂ℓ
= −λP X =0 ; = −λPY =0 and =−(P X X +PY Y −M )=0
∂X ∂X ∂Y ∂Y ∂λ

From the above equations we obtain:

∂U ∂U
=λP X and = λPY
∂X ∂Y
∂U ∂U
=MU X and =MU Y
∂X ∂Y
Therefore, substituting and solving for λ we get the equilibrium condition:
MU X MU Y
λ= =
PX PY
By rearranging we get:
MU X PX
=
MU Y PY
The second order condition for maximum requires that the second order partial derivatives of the
Lagrange function with respect to the two goods must be negative.
∂ ℓ2 ∂U 2 ∂ ℓ2 ∂ U2
= < 0 and = <0
∂ X 2 ∂ X2 ∂Y 2 ∂ Y 2
Example
A consumer consuming two commodities X and Y has the following utility function
U =XY +2 X .If the price of the two commodities are 4 and 2 respectively and his/her budget is
birr 60.
a) Find the quantities of good X and Y which will maximize utility.

b) Find the
MRS X , Y at optimum.
Solution
The Lagrange equation will be written as follows:
ℓ= XY + 2 X + λ(60−4 X−2 Y )
∂ℓ
=Y + 2−λ 4=0
∂X ……………………….. (1)

17
 ∂ℓ
=X −λ 2=0
∂Y …………………………… (2)
∂ℓ
=60−4 X −2Y =0
∂λ …………………… (3)
From equation (1) we get Y +2=4 λ and from equation (2) we get X =2 λ .Thus, we can get
Y +2 1
X= λ= X
that 2 and equation (2) gives as 2 .
Y +2
X=
By substituting 2 in to equation (2) we get Y =14 and X=8 .
MU X
MRS X , Y =
MU Y
Y +2
=
X
After inserting the optimum value of Y=14 and X=8 we get 2 which equals to the price ratio of
4 PX
(= =2 )
the two goods PY 2 .

2.14 Effects of Changes in Income and Prices on Consumer

A. 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.

18
 Commodity Y

ICC

E3
E2
E1

Commodity X

Engle Curve
Income

I3
I2

I1

X1 X2 X3 Commodity X

Figure 2 .15 the income –consumption and

the Engle curves

From the 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

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The Engle Curve is the relationship between the equilibrium quantity purchased of a good 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.

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.
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

Figure2.16 income consumption curve

B. Changes in Price: Price Consumption Curve (PCC) 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.

20
 In our earlier previous discussion, we have seen that an increase in the price of good X, for
example, increases the absolute value of the slope of the budget line, but it does not affect the
vertical (Y) intercept of the line. Thus, the change in the price of x will result in out ward shift of
the budget line 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.

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.

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
Px 1 to Px 2 to Px 3 .
Commodity Y

PCC

Commodity X

Px1
Price of X

Px2
Individual
Px3 demand curve

X1 X2 X3 Commodity X
Figure2.17 the PPC and derivation of the demand curve
The Consumer Surplus
While consumers purchas goods and services,they offten pay less than what they are willing to
pay.Thus,the difference between what they are willing to pay and what they actually paid is
considered as their surplus.

21
 Therfore,consumer surplus is the difference between what a consumer is willing to pay and
what he actually pays.Graphically,it is measured by the area below the demand curve and above
the price level.

P CS

0
Q
Numerical Example

Suppose the demand function of a consumer is given by:Q=15− p

a. Compute the consumer surplus when the price of the good is 2

b. Compute the consumer surplus when the price of the good is 4
c. Compute the change in consumer surplus when the price changes from 2 to 4.
Solution

When Price is zero the demand for quantity purchased will be 15 and when the demand for
quantity is put to zero then the price level will be 15.And finally,when we insert the given price
level 2 in the demand equation we get the level of qunatity demanded that is 13.Hence,we can
easily compute the area of the triangle that is found above the given price level that is 2.

15 Panel a. Panel b
15
2
4

13 15 11 15
22
In panel a, the area of the triangle above price that is the consumer surplus is and in panel b the
consumer surplus is 60.5.Therfoere,due to a change in the price level the consumer surplus will
be84 . 5−60. 5=24 .5

11
∗13∗13=84 . 5∗13∗13=84 . 5
22

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