Chapter Three

Theory of Consumer Behaviour

Theory of consumer behavior
The explanation of how consumers
allocate income to the purchase of
different goods and services
Introduction
 In our day –to- day life, we buy different goods and
services for consumption. As consumer,
 we act to derive satisfaction by using goods and services.

Consumer behaviour can be best understood in three

steps. First, by examining consumer‘s preference, we
need a practical way to describe how people prefer one
good to another. Second, we must take into account that
consumers face budget constraints – they have limited
incomes that restrict the quantities of goods they can buy.
Third, we will put consumer preference and budget
constraint together to determine consumer choice.
Chapter objectives
After successful completion of this chapter, you will be
able to:
 explain consumer preferences and utility
 differentiate between cardinal and ordinal utility
approach
 define indifference curve and discuss its properties
 derive and explain the budget line
 describe the equilibrium condition of a consumer
WHAT IS THE THEORY OF CONSUMER
BEHAVIOR?
A consumer is an individual or a household who
uses/consumes final goods and services
with a primary objective of maximizing utility.
Consumers Behavior
Assumptions
 A consumer is a rational being
 Consumer has a full knowledge of
 Knowledge of the goods and services available.
 Knowledge of their technical capacity to satisfy
his wants.
 Knowledge of market prices.
 Knowledge of his money income.
 The term utility describe the satisfaction or
enjoyment derived from the consumption of a good
or service
The concept of utility
What is utility?
 The term utility describe the
satisfaction or enjoyment derived from
the consumption of a good or service.
Utility is the satisfaction or pleasure
derived from the consumption of a
good or service.
Utility is the power of the product to
satisfy human wants.
The concept of utility
 Given any two consumption
bundles X and Y, the consumer
definitely wants the X-bundle
than the Y-bundle if and only if
the utility of X is better than the
utility of Y.
 Properties of utility
Utility’ and ‘Usefulness’ are not

synonymous. usefulness is product centric

whereas utility is consumer centric.
Utility is subjective. The utility of a product

will vary from person to person. That

means, the utility that two individuals derive
from consuming the same level of a product
may not be the same. For example, non-
smokers do not derive any utility from
cigarettes.
The concept of utility
 Utility can be different at different places and
time. For example, the utility that we get
from drinking coffee early in the morning may
be different from the utility we get during
lunch time.
 3.3 Approaches of measuring utility
 There are two major approaches to measure or
compare consumer‘s utility:
 Accordingly, we have two approaches

◦ Cardinal utility approach

◦ Ordinal Utility approach
 The cardinals school postulated that utility can
be measured objectively.
 According to the Ordinals school, utility is not

measurable in cardinal numbers rather the

consumer can rank or order the utility he
derives from different goods and services.
3.3.1 The cardinal utility theory
 According to the cardinal utility theory,
utility is measurable by arbitrary unit of
measurement called utils in the form of 1,
2, 3 etc. For example, we may say that
consumption of an orange gives Bilen 10
utils and a banana gives her 8 utils, and so
on. From this, we can assert that Bilen gets
more satisfaction from orange than from
banana.
3.3.1.1 Assumptions of cardinal utility theory

The cardinal approach is based on the following major

assumptions.
1. Rationality of consumers. The main objective of the
consumer is to maximize his/her satisfaction given his/her
limited budget or income. Thus, in order to maximize
his/her satisfaction, the consumer has to be rational.
2. Utility is cardinally measurable. According to the
cardinal approach, the utility or satisfaction of each
commodity is measurable. Utility is measured in subjective
units called utils.
Assumptions of cardinal utility theory

3. Constant marginal utility of money. A

given unit of money deserves the same
value at any time or place it is to be spent.
4. Diminishing marginal utility (DMU).
The utility derived from each successive
units of a commodity diminishes. In other
words, the marginal utility of a commodity
diminishes as the consumer acquires larger
quantities of it.
Assumptions of cardinal utility theory

5. Consumer is price taker: He cannot influence

the market price of goods and services.
6. Utility is independent on the quantity of the
individual commodity/Additivity of Utility:
 If there are n commodities in the bundle with

quantities X1, X2, X3 …… Xn the total utility is

TU = f (X1, X2, X3 ……. Xn).
 Utility is also additive,
i.e., U(X1) + U(X2) +U(X3) ……… +U ( Xn ) = Total
Utility (TU)
Total and marginal utility

Total Utility: refers to the total amount of

satisfaction a consumer gets from
consuming or possessing some specific
quantities of a commodity at a particular
time.
 If a consumer consumes 4 units of a
commodity and derives U1, U2, U3 and U4
from the successive units consumed,
then TU = U1+U2+U3+U4.
 In case the number of commodities
consumed is greater than one, then
TU= TUx +TUy + TUz + …TUn
Total and marginal utility
Marginal Utility (MU) It can be defined as total
utility derived from, the last unit of a
commodity consumed.
◦ It is the change in the total utility resulting from unit
change in commodity consumed
◦ It is the slope of total utility,
MU = TU/ Q =dTU/dQ
TU = Change in Total Utility
Q = Change in quantity consumed
Total and Marginal Utility
 To explain the relationship between TU and
MU, let us consider the following hypothetical
example.

Quantity Total utility (TU) Marginal utility (MU)

Consumed
0 0 -
1 10 10
2 18 8
3 24 6
4 28 4
5 30 2
6 30 0
Total and Marginal Utility
 The total utility first increases, reaches
the maximum (when the consumer
consumes 6 units) and then declines as
the quantity consumed increases. On
the other hand, the marginal utility
continuously declines (even becomes
zero or negative) as quantity consumed
increases.
TU
Total and Marginal Utility
P
30
1 TU As it can be observed
8
from the above figure,
 When TU is
0 increasing, MU is
6 Quantity
Consumed positive.
 When TU is
MU
maximized, MU is
zero.
 When TU is
decreasing, MU is
0
2 6 Quantity negative.
Consumed
 3.3.1.3 Law of diminishing marginal utility
(LDMU)
 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
The law of diminishing marginal utility is
based on the following assumptions.
 The consumer is rational
 The consumer consumes identical or
homogenous product. The commodity to
be consumed should have similar quality,
color, design, etc.
 There is no time gap in consumption of
the good
 The consumer taste/preferences
remain unchanged
Equilibrium of the Consumer under the
Cardinal Utility Theory
 Let’s begin our analysis of the equilibrium of the
consumer with a simple model of a single commodity, X.
The consumer has two alternatives for the use of his/her
income: either to buy X or retain the money income, Y.
Under this condition, the consumer is in equilibrium (at
the highest possible level of satisfaction) when the
marginal utility of X is equal to its market price (Px).
Question
1. Suppose the total utility function of a
consumer is given by TU(x) = 2x2.
What is the marginal utility of X?
Solution: Mux = ∆Tux = 2 x 2X = 4X
∆Qx
2. If u(x1,x2) = x1+x2, then MU1 =
du/.dx1 = 1
Marginal utility of a commodity is the extra satisfaction that
one can derive from one additional unit of the commodity.
Symbolically, the equilibrium of the consumer can be
represented as: MUx = Px
Where: MUx is the marginal utility of the commodity (X),
and Px is the price of the commodity (X)
If the marginal utility of X is greater than its price (MUx >
Px), the consumer can increase his/her welfare by
purchasing more units of the commodity X.
 That means the consumer can purchase more amount

commodity/good X.
 Similarly, if the marginal utility of the
commodity is less than its price, the consumer
can increase his/her total satisfaction by
cutting down the quantity of the commodity X
and keeping more of his/her income unspent.
That means the consumer can purchase Less
amount commodity/good X.
 Therefore, the consumer attains the maximum

level of satisfaction (utility) when MUx = Px.

 So far, for the sake of simplicity we have been assuming
that there is only one commodity. However, in reality,
since the consumer may consume more than one
commodity, we can extend our analysis of the consumer
into the case of many commodities. If there are more
commodities, the condition for the equilibrium of the
consumer is the equality of the ratios of the marginal
utilities for the individual commodities to their prices.
 Symbolically, assuming that there are N commodities: X,

Y, Z, ………..N, the equilibrium is attained when:

MUX/PX = MUY/PY = MUZ/PZ ... MUN/PN
Mathematically, we can derive the
equilibrium of the consumer as follows:
Suppose the utility function in a simple
model of single commodity X is given by:
U= f (Qx) where U is total utility measured
in monetary units and Qx is quantity of the
commodity X.
Equilibrium of a consumer
One Commodity Case
 The objective of a rational consumer is to
maximize total utility. so as to get the maximum
total utility.
 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
 Given the utility function U = f (X)
 Suppose the consumer’s utility function is given

as U =f (QX)
Equilibrium of a consumer
One Commodity Case
his/her total income spent (expenditure) on commodity X
–Total Expenditure would be: TE = QxPx
 Where Qx is amount of commodity x and Px is price of
good X.
 The consumer would like to maximize the difference
between the utility (satisfaction) and expenditure
(sacrifice).
 The problem is a simple maximization of the function.
Max U – TE or
U – Px Qx
Two conditions must be fulfilled
Necessary Condition (F.O.C)
Sufficient Condition (S.O.C)
The necessary condition (First
Order Condition) for maximum,
require that the derivative of the
function with respect to
independent variable (Qx) must be
equal to zero.
dU d (Q X PX )
 0
dQ X dQ X
dU d (Q X PX )

dQ X dQ X
but since price is constant we
 MUx = Px
can factor it out and find

MU X  PX
MUx
1
Px
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 and the whole income has
been spent Total Expenditure
=Total Income
The case of two or more commodities

MU X 1 MU X MU X
  ......... 
2 n

PX 1
PX 2
PX
n

Recall that utility is maximized when the

condition of marginal utility of one
commodity divided by its market price is
equal to the marginal utility of the other
commodity divided by its market price.
Limitation of the cardinal approach

1. The assumption of cardinal utility is

doubtful because utility may not be
quantified. Utility cannot be measured
absolutely (objectively).
2. The assumption of constant MU of money
is unrealistic because as income increases,
the marginal utility of money changes.
At any point above point C (like point A)
where MUX > PX, it pays the consumer to
consume more. When MUX < PX (like
point B), the consumer should consume less
of X. At point C where MUX = PX the
consumer is at equilibrium. If MUx is greater
than Px, the consumer can increase his welfare
by purchasing more units of X. If, on the other
hand, MUx is less than Px, the consumer can
increase its welfare by reducing the quantity of x
he purchases. Utility is maximized when the
condition MUx = Px is satisfied.
 3.3.2 The ordinal utility theory
The Ordinalist school argue that utility
is not cardially measurable,
 but it is an ordinal in magnitude.
 That is, the consumer may not know
the specific unit of utility derived
from different commodity.
 But he is able to rank or order
different basket of good in utility.
 The modern theory of consumer’s
behavior is on the basis of
consumers preference
 The ordinal utility theory
 Given any two consumption bundles,
◦ the consumer can choose or prefer one of
consumption bundles than the other.
◦ Goods and services however differ in their ability to
satisfy a want.
◦ An individual may prefer coffee to tea.
◦ Another person may prefer tea to coffee
◦ but both consumers will derive some level of
satisfaction by consuming the good they have
chosen.
Assumptions of ordinal utility theory
 The ordinal approach is based on the following
assumptions.
1. Consumers are rational - they maximize their
satisfaction or utility given their income and market
prices.
2. Utility is ordinal - utility is not absolutely (cardinally)
measurable. Consumers are required only to order or rank
their preference for various bundles of commodities.
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.
4. The total utility of a consumer is measured
by the amount (quantities) of all items he/she
consumes from his/her consumption basket.
5. Consumer’s preferences are consistent. For
example, if there are three goods in a given
consumer‘s basket, say, X, Y, Z and if he
prefers X to Y and Y to Z, then the consumer is
expected to prefer X to Z. This property is
known as axioms of transitivity.
 Indifference Set/Sechedule

 The ordinal utility approach is explained with the help of

indifference curves. Therefore, the ordinal utility theory is
also known as the indifference curve approach.
3.3.2.2 Indifference Set, Curve and Map
Indifference set/ schedule is a combination of goods for
which the consumer is indifferent.
 It shows the various combinations of goods from which

the consumer derives the same level of satisfaction.

Indifference Set/Sechedule
 Considera consumer who consumes
two goods X and Y (table 3.3).
 Table 3.3: Indifference schedule

Bundle (Combination) A B C D
Orange 1 2 4 7
Banana 10 6 3 1
 Indifference Set/Sechedule
 Intable 3.3 above, each
combination of good X and Y gives
the consumer equal level of total
utility. Thus, the individual is
indifferent whether he consumes
combination A, B, C or D.
Indifference Curve
 The graphical representation of

consumer’s preference is called

Indifference Curve (IC)
 When the indifference

set/schedule is expressed
graphically, it is called an
indifference curve.
Indifference Curve
An indifference curve shows
different combinations of two
goods which yield the same
utility (level of satisfaction) to
the consumer
A set of indifference curves is
called indifference map.
Indifference Curve
G Banana Banan
1 A a
0 IC3 > IC2 >
IC1

6 B

C IC3
3
D IC
1
IC12

1 2 4 7 Orang
Orange
ii) Indifference e
i) Indifference curve Map
An indifference curve is an iso or equal utility curve.
Properties of indifference curves
. Indifference curves have negative slope
1

(downward sloping to the right).

Indifference curves are negatively sloped
because the consumption level of one
commodity can be increased only by
reducing the consumption level of the other
commodity. In other words, in order to keep
the utility of the consumer constant, as the
quantity of one commodity is increased the
quantity of the other must be decreased.
Properties of indifference curves
2. Indifference curves are convex to the origin.
This implies that the slope of an indifference
curve decreases (in absolute terms) as we move along the
curve from the left downwards to the right. The convexity
of indifference curves is the reflection of the diminishing
marginal rate of substitution. This assumption implies that
the commodities can substitute one another at any point
on an indifference curve but are not perfect substitutes .
Properties of indifference curves
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.
Properties of indifference curves
4. Indifference curves never cross each
other (cannot intersect). The assumptions
of consistency and transitivity will rule out
the intersection of indifference curves.
 Figure 3.4 shows the violations of the

assumptions of preferences due to the

intersection of indifference curves.
Properties of indifference curves
If indifference curves intersect to each
Good
Y
other, they will violate the assumption of
transitivity and consistency.

C IC2

IC1
Good X

Figure 3.4: Intersection of indifference

curves
Indifference curves never cross each
other (cannot intersect).
Consistency: The consumer behaves
consistently, that is, if he/she chooses bundle
 A in a situation in which bundle B was also
available to him/her, he/she will not choose B
in an identical situation in which A is also
available. Symbolically, if A > B, then B ≯ A.
Transitivity: If in any particular situation A > B
and B > C, then A > C.
 Marginal Rate of Substitution
(MRS)
 Marginal Rate of Substitution (MRS) is a rate
at which one commodity can be substituted for
another, with out changing the level of
satisfaction.
 The slope of an indifferent curve is called
Marginal Rate of Substitution
 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
Marginal Rate of Substitution (MRS)
Since one of the goods is scarified to
obtain more of the other good, the MRS is
negative. Hence, usually we take the
absolute value of the slope.
Number of units of Y given up y
MRS X ,Y   
Number of units of X gained x
MRS X Y = - dY/Dx = - Slope of the Indifference Curve

The slope of an indifferent curve is

called Marginal Rate of Substitution (MRS)
Marginal Rate of Substitution (MRS)
 To understand the concept, consider the
following indifference curve.
Good Y

30 A

2 B
0
1 C
2 D
8
IC
5 1 15 20 Good X
0
Figure 3.5: Indifference curve for two products X
and Y
Marginal Rate of Substitution (MRS)
Y 30  20
MRS X ,Y (between points A and B )    / 2 /  2
X 5  10

For example, MRSX,Y = 2 can be interpreted as:

two units of Y must be sacrificed in order to
increase the consumption of X by one unit and
leave the consumer on the same level of
satisfaction. Similarly, MRSY,X = 3 can be
interpreted as: three units of commodity X must be
sacrificed in order to increase the consumption of
commodity Y by one unit and leave the consumer
on the same level of satisfaction.
Marginal Rate Of Substitution (MRS)
 From the above graph, MRSX,Y associated with the
movement from point A to B, point B to C and point C to
D is 2.0,1.6, and 0.8 respectively. That is, for the same
increase in the consumption of good X, the amount of
good Y the consumer is willing to scarify diminishes.
 This principle of marginal rate of substitution is reflected

by the convex shape of the indifference curve and is

called diminishing marginal rate of substitution.
Marginal Rate Of Substitution (MRS)
It is slope of an indifference curve

y
 MRS X ,Y
x
MRS decreases as a consumer continues to
substitute one commodity for another
Consider the following table Above
Marginal Utility and Marginal
rate of Substitution
MRS is also equals to the ratio of MU of
commodities involved in the utility function.

MU X MUY
MRS X ,Y  MRSY , X 
MU Y MU Y
 Where, MRSx,y is marginal rate of substitution of x for y
 MRSy,x is marginal rate of substitution of y for x
 MUx is marginal utility of commodity x
 MUy is marginal utility of commodity y
 We can prove the above relationship between MRS and

MU
We can prove the above relationship
between MRS and MU
 Proof:
 Suppose the utility function for two commodities X and

Y is defined as:

U  f ( X ,Y )

The equation of an indifference curve is: U = f

(x,y) = K, where K is a constant.
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
since there is no change in utility for any
movement along the same indifference curve
 MU X dX  MU dY  0
Y
MU X dY
  MRS X ,Y
MU Y dX

Similarly, MU Y   dX  MRS
Y ,X
MU X dY
Example: Suppose a consumer’s utility
function is given
U  5
X
Y
by Compute
4

2

the
MRSX ,Y .
MU
Solution: MRS X ,Y  X

MU Y
dU dU
MU X  and MU Y 
dX dY
Therefor MU X  4( X 41Y 2 )  4( X 3Y 2 ) and MU Y  2( X 4Y 21 )  2 X 4Y
e,

MU X 4 X 3Y 2 Y
MRS X ,Y   4
2
MU Y 2X Y X
MRSX ,Y .
Example 2

2. Suppose a consumer’s utility function is given

as U  20 X 0.4Y 0.6 and we are required to find MRSX,
Y
MU Y dU dU
MRS X ,Y  MU X  MU Y 
dX dY
MU X
Solution:
MU X  0.4(20 X ( 0.41) 0.6
Y ) MU Y  0.6(20 X 0.4Y ( 0.61) )

MU X  8 X 0.6Y 0.6 MU Y  12 X 0.4Y 0.4

MU Y 8 X 0.6Y 0.6 2Y
MRS X ,Y   MRS X ,Y 
MU X 12 X 0.4Y 0.4 3X
Example 3
3. Suppose that the consumer’s utility function
is given by  .Compute both
1/ 2 1/ 4
U 10 X Y
MRS X ,Y and MRS Y , X . Is there any difference
between the two?
4. Suppose that the consumer’s utility function
is given by TU = 1/4XY. Then Compute both
MRS X ,Y and MRS Y , X .Is there any difference
between the two?
Exercise
1. Find the MRSX, Y and MRSY, X if a
consumer’s utility function isU  50 X
0.8
Y 0.2

Is there any difference between the

two? Explain your answers.
1 3
2. If TU  15 Q  7Q - Q , 2

3
Then find
(a) the MU function,
(b) the point of diminishing marginal utility,
 Diminishing MU is where MU has a maximum, or the
derivative of MU is zero.
 dMU = 0 14 – 2Q = 0
dQ
3. If the utility function of a consumer is given by U = X2Y2,
what is the MRSxy?
 a. Y/X

 b. X/Y

 c. X/Y2

 d. Y2/X

 e. X2/Y

 f. X/Y3
4. When we rank the utility gained from the consumption
of different commodities as
 1st , 2nd and 3rd etc, we are measuring utility:
 a. Ordinally
 b. cardinally
 c. in both approaches
 d. traditionally

5. Given Cobb-Douglas type utility function,

TU = X1cX2d Then compute the MRS ? Answer
MRSX1,X2 =(c/d ) (X2/X1)
THE BUDGET LINE OR THE PRICE LINE

A utility maximizing consumer would

like to reach the highest possible
indifference curve on his/her
indifference map.
 But the consumer’s decision is

constrained by his/her
◦ money income and
◦ prices of the two commodities
 This
limitation is called consumer’s
budget constraint
This limitation is called budget constraint
is represented by the budget line
The budget line is a line representing
different combinations of two goods that a
consumer can buy with a given income at a
given prices level
Assumptions
 There are only two goods, X and Y, bought
in quantities X and Y;
Each consumer is confronted with market
determined prices, Px and Py, of good X and
good Y, respectively
The consumer has a known and fixed
income (I).
Budget Line (Cont…)
 Assuming that the consumer spends all his/her income
on the two goods (X and Y), we can express the budget
constraint as:

M  PX X  PY Y
Where, PX= price of good X
PY = price of good Y
X=quantity of good X
Y= quantity of good

M=consumer’s money income

Budget Line (Cont…)
 Suppose for example a household with 30
Birr per day to spend on banana(X) at 5 Birr
each and Orange(Y) at 2 Birr each.
 That is,

PX  5, PY  2, M  30 BIRR
Therefore, our budget line equation will be:

5 X  2Y  30
Budget Line (Cont…)
 By rearranging the above equation we can
derive the general equation of a budget line:
M PX
Y   X
PY PY

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

PY
PX
 = Slope of the budget line (the ratio of the prices
PY
of the two goods)
Budget Line (Cont…)
 The horizontal intercept (i.e., the maximum
amount of X the individual can consume or
purchase given his income) is given by:

M PX
 X 0 M/PY Point A the budget line is
PY PY attainable.

M P B Point B is unattainable


 X X (unaffordable).
PY PY 

M
A
X 
PX

M/PX
Figure 3.6: The budget line
 Example1: A consumer has $100 to spend on two
goods X and Y with prices $3 and $5 respectively.
a. Derive the equation of the budget line
b. sketch the graph.

c. Vertical Intercept (Y-intercept)

d. slope of the budget line
e. What happens to the original budget line if the
budget falls by 25%?
f. What happens to the original budget line if the
price of X doubles?
g. What happens to the original budget line if the
price of Y falls to 4?
Solution: The equation of the budget line can be derived as
follows. PX X  PY Y  M
Budget Line (Cont…)
The budget line is PX X  PY Y  M

3 X  5Y  100 20

5Y  100  3 X
100 3
Y   X
5 5
33.3
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:
 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:

 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 and if the price of good Y
falls to 4, the equation for the
new budget line will be .
Factors Affecting the Budget Line

a. 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 income causes an
upward/outward shift of the budget line that
allows the consumer to buy more goods and
services and decreases in income causes a
downward/inward shift of the budget line that
leads the consumer to buy less quantity of the
two goods.
Factors Affecting the Budget Line
 Itis 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.
Factors Affecting the Budget Line
 Slope is constant
M2/Py Where M2>M>M1

M/Py
M1/Py
B B2
BM1 /P
1
X
M/PX M2/PX

Figure 3.7: Effects of increase (right) and

decrease (left) in income on the budget line
Effects of Changes in Price of the commodities

a. Change in prices: An equal increase in the prices of the

two goods shifts the budget line inward. Since the two
goods become expensive, the consumer can purchase the
lesser amount of the two goods. An equal decrease in the
prices of the two goods, on the other hand, shifts the
budget line out ward. Since the two goods become
cheaper, the consumer can purchase the more amounts of
the two goods.
Effects of Changes in Price of the
commodities
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.
Effects of Changes in Price of the
commodities
Good
Y M/Py

B B2
B1

M/ Good X
Px

Figure 3.8: Effect of proportionate increase

(inward) and decrease (out ward) in the prices of
both goods
 Effects of Changes in Price of the
commodities
 An increase or decrease in the price of one

of the two goods, keeping the price of

the other good and income constant,
changes the slope of the budget line by
affecting only the intercept of the
commodity that records the change in
the price.
Effects of Changes in Price of the
commodities
 if the price of good X decreases while both the price of
good Y and consumer‘s income remain unchanged, the
horizontal intercept moves outward and makes the
budget line flatter. The reverse is true if the price of good
X increases. On the other hand, if the price of good Y
decreases while both the price of good X and consumer‘s
income remain unchanged, the vertical intercept moves up
ward and makes the budget line steeper. The reverse is true
for an increase in the price of good Y.
Effects of Changes in Price of the
commodities

Y Y
Good y
B1 B1
 flatter B Steeper
B
X X

Good X

Figure 3.9: Effect of decrease in the price of only good X

and goods Y on the budget line
Questions
1. Assume a budget line is drawn for two commodities: X
on the x-axis and Y on the y-axis. If the income of the
consumer is 100 Birr, the y-intercept is 4, and the slope
of the budget line is -2, the price of commodity X is:
a. 25 Birr
b. 12.5 Birr
c. 50 Birr
d. 8 Birr
e. None
Equilibrium of the consumer
 The preferences of a consumer (what
he/she wishes to purchase) are
indicated by the indifference curve.
The budget line specifies different
combinations of two goods (say X and
Y) the consumer can purchase with the
limited income.
Consumer Equilibrium Under Ordinalist Approach
 Consumer equilibrium will be reached when s/he is deriving the
maximum possible satisfaction from the goods & no further adjustment
on the amount of the purchases of the goods.
 The indifference map in combination with the budget line allows us to
determine equilibrium amounts of goods and services that the consumer
most wants and is able to purchase. This is the consumer equilibrium.
 There are two conditions of equilibrium; MUx Px
MRS X,Y  
a) Necessary condition (FOC) .i.e. the marginal rate of substitution
MUy Py (MRS) must be
equal to the ratio of commodity prices.

b) Sufficient condition (SOC). I.e. The first condition is fulfilled at the highest
possible indifference curve.
 Therefore, equilibrium occurs at the point where the slope of an IC
U  That
equals the slope of the price line. f ( X , Ymeans
) at the purchase level, the
indifference curve becomes tangent to the budget line.
I  PX * X  P Y * Y
 Mathematically: Maximization of
Subject to
Equilibrium of the consumer
 Therefore, a rational consumer tries to attain
the highest possible indifference curve, given
the budget line. This occurs at the point where
the indifference curve is tangent to the budget
line so that the slope of the indifference curve
is equal to the slope of the budget line MRS XY
 In figure 3.10, the equilibrium of the consumer
( PX / PY ).

is at point “E” where the budget line is tangent

to the highest attainable indifference curve
(IC2).
Consumer Equilibrium . . . Cont’d
 The consumer maximizes
satisfaction by purchasing the
combination of goods that is
on the indifference curve
farthest from the origin but
attainable given the
consumer’s budget.
 At point ‘A’, the slope of an
IC1 is greater than the slope
of the BL.
 At point ‘B’, the slope of an
IC1 is less than the slope of
the BL.
 At point ‘C’, the slope of an 08/07/2024 95
 Equilibrium of the consumer

 Graphically, the consumer optimum or

equilibrium is depicted as follows:

Y A

B
E
IC4
C IC3
IC2
D
IC1
X

Figure 3.10: Consumer equilibrium under indifference curve

approach
Equilibrium of the consumer
 Mathematically,consumer
optimum (equilibrium) is attained
at the point where:
 Slopeof indifference curve = Slope
of the budget line
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
Equilibrium of the consumer
Example 1 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 budget line equation ?
b. Find the quantities of good X and Y which
will maximize utility.
c. Find the MRS at optimum.
X ,Y
Equilibrium of the consumer
The budget constraint of the consumer is
given by:
PX.X+ PY.Y = M
4X+2Y= 60 …………….…………. (i)
Moreover, at equilibrium

MU X MU Y MU X PX
  
PX PY MU Y PY
Y 2 4 Y 2
  2
X 2 X
Equilibrium of the consumer
 Y = 2X - 2………….………… (ii)
 Substituting equation (ii) into (i), we obtain

Y = 14 and X = 8.
b.
MU X (At the equilibrium, MRS
MRS X ,Y 
MU Y can also be calculated as
Y 2 the ratio of the prices of
MRSxy 
X the two goods)
14  2
MRSxy  2
8
Example 2
2. Maximize U  X 0.5Y 0.5
Subject to 5X + 10Y = 100, then Calculate the
following Questions
a) Compute MUX, MUY & MRS(X for Y).

b) Calculate the amount of X & Y that should be purchased

to maximize total utility.
Any question?
Work Sheet
1. Given utility function U= X0.5 Y0.5 where PX =
12 Birr, Birr, PY = 4 Birr and the income of the
consumer is, M= 240 Birr.
A. Find the utility maximizing combinations of X
and Y.
B. Calculate marginal rate of substitution of X for
Y (MRSX,Y) at equilibrium and interpret your
result.
 Work Sheet
2. A consumer consuming two commodities X and Y has the following utility
function.
U = XY2 , If the price of the two commodities are 3 and 4 respectively and
his/her budget income is birr 100. What is the quantities of good X and
Y which will maximize utility.
A. 9/100 and 75/3 B. 100/9 and 50/3 C. 50/9 and 100/3 D. ¾
and 250,000/81
3. On Question number 2 above what is Total utility at equilibrium.
A. 5000/27 B. 2500/9 C. 250,000/81 D. 1000/81
4. On Question number 1 above what is the MRSx,y at optimum point?
A. 4/3 B. 50/3 C. 9/100 D. ¾
5. Suppose the utility function of the person consuming two commodities
X and Y with income birr 600 is given by U = 2X0.6 Y0.4. If the per unit
price of X is birr 20 and per unit price of Y is birr 40. What is the budget
line equation?
A. 20X + 40Y = 600 B. X + 2Y = 30 C. 2X0.6 Y0.4 D. A and B
6. On Question number 1 above what is the MRSx,y at x = 30 and y = 10.
A. 1.5 B. 4.5 C. 0.5 D. 2.5
7. Assume that the production function is Q = 4KL0.5. Find the average
product of labor when K= 12 and L= 36. A. 4 B. 8 C.
16 D. 288
 Work Sheet
8.Let a consumer have an income =
2000 birr, Px = 50birr, Py = 40birr
a. Develop budget line equation in
terms of X and Y
b. Find the maximum amount of X
and Y a consumer can buy
c. Draw the graph of budget line
Work Sheet
9. Given MUx = X, MUY = 4Y, Price of X is 3 Birr per
unit and price of Y is also 3 Birr per unit. If the income
of the consumer is 1200 Birr, find the amounts of X and
Y that the consumer chooses to consume so as to
maximize his utility.
Part I. Write True if the statement is true or write
False if it is not true on the provide space.
1. Marginal Utility is the slope of total utility.
2. The slope of the budget line is the ratio of the
prices of the two commodities.
3. An equal decrease in the prices of the two goods, on the
other hand, shifts the budget line out ward.
4. At optimum Slope of indifference curve is equal to Slope
of the budget line
5. Indifference curves never cross each other.
6. When marginal product reaches maximum, total
product became zero.
Part I. Write True if the statement is true or write
False if it is not true on the provide space
7. Whenever TU decreases MU is Negative.
8. When MP = AP, this means that AP is
minimum.
9. Utility is the power of the product to satisfy human
wants.
10. A set of indifference curves is called indifference
map.
WORK OUT QUESTIONS
11. The graphical representation of consumer’s preference
is called ________________
12. Suppose a consumer consuming two commodities X
and Y has the following utility function U.If
 Xprice
0 .4 0 . 6
Y
of good X and Y are 2 and 3 respectively and income
constraint is Birr 50.
A. Find the utility maximizing combinations
of X and Y.
B. Calculate (MRSX,Y) at equilibrium.
C. Write Budget line equation
D. Write Slope of the budget line
Part I. Write True if the statement is true or write
False if it is not true on the provide space for buma
1. The slope of an indifferent curve is called Marginal Rate
of Substitution
2. Total Utility is the slope of marginal utility.
3. An equal increase in the prices of the two goods shifts the
budget line inward.
4. At equilibrium Slope of indifference curve is equal to
Slope of the budget line
5. Indifference curves never cross each other.
6. When marginal product reaches maximum, total
product became zero.
Part I. Write True if the statement is true or write
False if it is not true on the provide space

7. Whenever TU decreases MU is positive.

8. When MP = AP, this means that AP is
minimum.
9. Utility is the satisfaction or pleasure derived from the
consumption of a good or service.
10. A set of indifference curves is called indifference map.
WORK OUT QUESTIONS
11. Whenever the Total Utility (TU) curve reaches
at its maximum, Marginal utility will be
________
12. Given utility function U= X0.5 Y0.5 where PX =
12 Birr, Birr, PY = 4 Birr and the income of the
consumer is, M= 240 Birr.
A. Find the utility maximizing combinations
of X and Y.
B. Calculate (MRSX,Y) at equilibrium.
C. Write Budget line equation
D. Write Slope of the budget line
Part I. Write True if the statement is true or write
False if it is not true on the provide space for Rest
1. The Slope of the budget line is equal to the ratio of the
prices of the two goods
2. Total Utility is the slope of marginal utility.
3. An equal decrease in the prices of the two goods shifts the
budget line outward.
4. At equilibrium Slope of indifference curve is equal to
Slope of the budget line
5. A higher indifference curve is always preferred to a lower
one.
6. When marginal product reaches maximum, total
product became zero.
Part I. Write True if the statement is true or write
False if it is not true on the provide space

7. Whenever TU decreases MU is positive.

8. When MP = AP, this means that AP is
minimum.
9. Utility is the satisfaction or pleasure derived from the
consumption of a good or service.
10. A set of indifference curves is called indifference map.
WORK OUT QUESTIONS
11. Whenever the Total Product (TP) curve
reaches at its maximum, Marginal Product will
be ________
12. Given utility function U= X1/2 Y1/2 where PX =
3 Birr, Birr, PY = 1Birr and the income of the
consumer is, M= 60 Birr.
A. Find the utility maximizing combinations
of X and Y.
B. Calculate (MRSX,Y) at equilibrium.
C. Write Budget line equation
D. Write Slope of the budget line