Chapter I: The Theory of Consumers Behavior and Demand

• Recall the definition of

– demand and
– the law of demand
• Demand : Is the quantity that a consumer is willing to buy
at a particular price (Ceteris paribus)
• Law of Demand : State that there is an inverse relationship
between price of a commodity and the quantity demanded.
• I.e., consumers will buy more of a commodity at lower
price and vice versa
• How a consumer decides how much of a commodity to
buy at a particular price?
• Why a consumer will buy more of a commodity at lower
price?
• How consumer optimum can be indicated using
constrained optimization approach
– Objective fun…………….Utility function
– Constraint function…….budget constraint
• Level of satisfaction enjoyed by consumer at optimum
consumption point 1
 Consumers Behavior (Cont…)
• Major assumptions in the theory of
consumers behavior :
1. A consumer is being rational
2. Consumer has a full knowledge of
– all the available commodity,
– their price and
– his income.
3. The goal of the consumer is to
maximize his utility
4. The non-satiation assumption or more
is better than less…Utility decreases
as a consumer moves further away
from the best combination
Micro. lecture notes 2
 What is utility?
• Utility describe the expected satisfaction or
enjoyment derived from the consumption of a good
or service.
• Properties of utility
A. ‘Utility’ and ‘Usefulness” are not synonymous.
– E.g. Paintings by Picasso may be useless functionally but offer
great utility to art lovers.
B. Utility is subjective: The utility of a
product will vary from person to person.
– For example, non-smokers do not derive
any utility from cigarettes
C. The utility of a product can be different at
different places and time.
– Utility from eating meat is zero during fasting
Micro. lecture notes 3
 Approaches to consumer optimum
• Two approaches of showing
consumer optimum
– Cardinal utility theory
– Ordinal utility theory
• Major difference is the assumption
that utility can/ can not be measured
in absolute / cardinal numbers

Micro. lecture notes 4

1.1. Cardinal Utility Approach
• This school postulates that utility can be measured in
absolute terms
• What is the measurement unit?
– Monetary unit
– By a subjective unit called util
Assumptions
A. Rationality
B. Cardinal Utility: The utility of each commodity is
measurable and the most convenient unit of
measurement is money.
C. Constant Marginal Utility of Money.
– The essential feature of a standard unit of measurement is that
it is consistent.
D. Limited money income of the consumer and all is
income is spent in the consumption process.
– That is, saving gives no positive utility to the
consumer.
E. Diminishing Marginal Utility (DMU).
– The utility derived from each successive units
of a commodity diminishes. .
Micro. lecture notes 5
 Cardinal Utility (cont…)
F. Total utility depends on the quantity of the commodities
consumed.
– If there are n commodities in the bundle with quantities X1, X2, X3 …… Xn
the total utility is then
– U = f (X1, X2, X3 ……. Xn).
G. Utility is also additive, i.e., Total Utility (TU) = U (X1) + U (X2) +U (X3)
……+U ( Xn )

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.
Micro. lecture notes 6
 Cardinal Utility (cont…)
Marginal Utility (MU) :
• total utility derived from, the last unit
of a commodity consumed.
• It is the change in the total utility
resulting from a unit change in
commodity consumed
• It is the slope of total utility function,
• MU = TU/ Q
– TU = Change in Total Utility
– Q = Change in quantity consumed
Micro. lecture notes 7
 Cardinal Utility (cont…)
• Utility Schedule for banana

Quantity of 0 1 2 3 4 5
Banana
Consumed
Total 0 3 8 10 11 11
Utility (TU)
Marginal 0 3 5 2 1 0
Utility (MU)

Micro. lecture notes 8

 Marginal Utility (cont…)

Utility

Marginal utility

0 5

Micro. lecture notes

Quantity
9
 Basic rules
• Differential calculus measures a marginal change in the dependent variable
due to a marginal (unit change) in the independent variable

• Marginal Utility measures a marginal change in total utility due to a unit

change in commodity consumed. dU
• TU/ Q = dQ X
• Derivative of TU with respect to Q

The Law Diminishing Marginal Utility:

• States that as the quantity consumed of a commodity increases, the utility
derived by the consumer from the successive units decreases, ceteris
paribus.
This law stems from the facts that:-
• The utility derived from a commodity depends on the intensity of the need
for that commodity
• As more and more quantity of a commodity is consumed the intensity of
desire decreases and therefore, the utility derived at the margin decrease.
Micro. lecture notes 10
 Consumer’s Equilibrium: One
Commodity Case
Suppose the consumer’s utility function is given as U  f (X )
and his/her total income spent (expenditure) on commodity X –Total
Expenditure would be: TE Q X PX
• 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 – PxQx
• Two conditions must be fulfilled
– Necessary Condition (F.O.C)....................MU=P x
– Sufficient Condition (S.O.C)....................M=E

• 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.

Micro. lecture notes 11

 Max (U – TE)
or
dU
U –dPxQx
(Q X PX )  MUx - Px =0
 0
dQ X dQ X
 MUx
MU X  PX Px
1

At optimal point:
1. 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
2. the whole income has been spent or Total Expenditure
=Total Income
Utility

E Px (Mum)

MUx
X Quantity of X

Micro. lecture notes 12

Consumers Equilibrium: The General Case: (The
law of equi-marginal Utility)
• In reality, however, a consumer consumes a
large number of goods.
• The MU schedules of different commodities
may not be the same.
• A utility maximizing consumer consumes
commodities in order of their utilities.
• He picks up the commodity, which yields the
highest utility followed by the commodity
yielding the second highest utility and so on.
• He switches his expenditure from one
commodity to another in accordance, with
their marginal utility.
Micro. lecture notes 13
 Cardinal Utility (cont…)
• He continues to switch his expenditure
from one commodity to the other till he
reaches a stage where MU per Birr of
each commodity the same
• Therefore, the consumer optimum follows
the law of equi-marginal utility.
• We can use a single commodity case to
determine the general case.
• For commodity X, equilibrium occurs when
MUx = Px
• MUx = Px and this can be written as
• MUx / Px = 1 Micro. lecture notes 14
• For n number of goods, he/she would be in
equilibrium or utility is maximized if and only if:
MU X 1 MU X 2 MU X n
 .........   MU m
PX 1 PX 2 PX n

– And Total expenditure = total income

• Numerical example
– Consider a consumer having only birr7 in his pocket to buy bread

and banana and price of banana is birr 4/kg while price of

bread is birr one per unit, and total utility schedule as

shown below, determine:

i. The marginal utility schedule for the two commodities

ii. Determine the optimum consumption of these two
goods
iii. The total utility at optimum consumption
 Solutions
Bread , Price=birr 1/unit Banana, Price=4birr/kg
Quantity TU MU MU/P Quantity TU MU MU/P
0 0 - - 0 0 - -
1 6 6 6 1 12 12 3
2 11 5 5 2 20 8 2
3 14 3 3 3 26 6 1.5
4 16 2 2 4 29 3 0.75
5 16 0 0 5 31 2 .5
6 14 -2 -2 6 30 -1 -0.25

Attempt the above questions assuming income of birr 12, ceteris paribus.
 Quantity Deriving Cardinalist Demand
of Y E3 P3
E2
P2
E1 P1
X3 X2
X1
MU X Quantity of X

Price
a
P3
P2 b

P1 c
Demand Curve

X3 X2 X1 Quantity of X
 Limitations of the Cardinal approach
a) The assumption that utility is a cardinal
concept (utility is objectively
measurable) is doubtful.
– Utility is a subjective concept, which cannot
be measured objectively.
b) The assumption of constant
marginal utility of money is also
unrealistic..
c) The psychological law of diminishing marginal
utility has been established from introspection
d) The cardinal utility approach is on
the basis of Ceteris Paribus assumption.
– As a result it ignores the substitution and
income effect. Micro. lecture notes 18
 1.2 Ordinal Utility
The
Approach
ordinals school argue that utility is not
cardinally measurable,
• It is ordinal in magnitude.
• The consumer may not know the specific
unit of utility derived from different
commodity.
• He is able to rank or order different basket
of goods
• A market basket is just a collection of one
or more commodities.
• The modern theory of consumer’s behavior
is on the basis of consumers preference
Micro. lecture notes
19
 Ordinal Utility (Cont…)
What is preference?
• It shows choice of the consumer
• Three types
– Strict preference …..one is preferred over the
other
– Weak preference….one is sometimes
preferred and sometimes treated as same
– Indifference …….the consumer treats them as
same
• Given any two consumption bundles,
• the consumer may choose or prefer one of
the consumption bundles over the other. Or
• May be indifferent in choosing one over the
other.
Micro. lecture notes 20
 Ordinal Utility (Cont…)
a) Strict preference
B) Weak preference
C) Indifference
(Y1 , Y2 )  ( X 1 X 2 ) ……………………..Strict Preference
(Y1 , Y2 )( X 1 X 2 ) ……………………..Weak Preference
(Y1 , Y2 ) ( X 1 X 2 ) ………… …Indifference

Micro. lecture notes 21

 Other Properties of preference
• Completeness
– any two bundles can be compared by a consumer
• Transitivity
– if A is preferred to B and B is preferred to C
then, A is preferred to C.
• Monotonicity
– More is better than less
– Non satiation assumption
• Reflexive Behaviour
– Any bundle is at least as good as itself
Micro. lecture notes 22
 Ordinal Utility (Cont…)
• The ordinal utility approach is also on the basis of the
following assumptions:-
1. Rationality: The consumer is assumed to be rational
aiming at maximizing his utility
2. Utility is Ordinal: The consumer can rank or order his
preferences
3. Consistence of Choice:
– If he preferred bundle A to B, he will not choice bundle
B over A another time.
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.
– MRS diminishes as substitution increases
5.Limited money income.
• The consumer is confronted with limited money income so that
optimization is mandatory.
Micro. lecture notes 23
 Indifference Set, Curve and Map
• IC : is the locus of different combinations of
two commodities, which are equally preferred
• or it is the locus of different combinations of
goods that yields the same level of
satisfaction.
• Indifference Schedule is a tabular
presentation of points or combinations of
same utility
• An indifference curve is an iso or equal utility
curve.
• The graphical representation of consumer’s
preference is called Indifference Curve (IC)
• Indifference Map: It is a set of indifference curves
with different levels ofMicro.
satisfaction
lecture notes
24
 Indifference Schedule
Bundle (Combinations) A B C D

Orange (X) 1 2 4 7

Banana (Y) 10 6 2 1

Banana (Y)
10 A
Indifference

6 B Curve (IC)

2 C
D
1

1 2 4 7 Orange(X)
Good B
Indifference map

IC3
IC2
IC1
Good A
Indifference Map: It is a set of indifference curves with different levels of
satisfaction
 Properties of Indifference Curves:
a) Indifference curves have a negative slope:
• The negative slope of indifference curve implies that the two
commodities are substitute for each other.
• if quantity of one-commodity decreases, quantity of the
other commodity must increase if the consumer has to stay
at the same level of satisfaction.
b) Indifference curves are convex to the Origin:
The convexity of indifference curves implies
– The two commodities are not perfectly substitute one for
another
– The marginal rate of substitution (MRs) between the two
goods decreases as a consumer moves along the
indifference curve
– Averages are preferred to extreme values
c) Indifference curves do not intersect each other.
• What would happen if they cross each other?
• If two different curves cross each other it would be violation
Micro. lecture notes 27
of transitivity assumption in consumer’s preference.
Banana

A Figure shows the case of

intersecting ICs

C
B IC2
IC1

Orange

Points like, A, B and C represents three different combinations of commodities X

and Y. Not that combination B is common to both indifference curves.
A = B and B = C , then A = C ……..But A # C
D) 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:
 The Marginal Rate of Substitution (MRS)

• The slope of an indifferent curve is called Marginal

Rate of Substitution.
• Marginal Rate of Substitution has an important
economic meaning.
• Marginal Rate of Substitution (MRS) is a rate at
which one commodity can be substituted for
another, with out changing the level of satisfaction.
• 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
Micro. lecture notes 29
 MRS ( Cont…)
• As a 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
Bundle A B C D
(Combinatio
n)
Orange (X) 1 3 5 7
Banana (Y) 23 15 9 6
Y 8
MRS X ,Y (between point s A and B )   4
X 2

Micro. lecture notes 30

 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
MRS X ,Y 
MU Y
Proof:
Suppose the utility function for two commodities X and Y is
defined as:

U  f ( X ,Y )
 MRS ( Cont…)
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 , dU=0
The relationship b/n MRS and MU
MU X dX  MU Y dY 0
MU X dY
  MRS X ,Y
MU Y dX
 Exceptional Indifference
Curves
• Indifference curves are convex to
the origin and downward sloping
• However, the shape of the indifference
curve reflects the degree of substitution
between the two commodity
• The shape of an indifference curve might
be different if the relationship between
two commodities is unique
• Perfect substitutes: perfect
substitutes are goods which can be
replaced for one another at a constant
rate. Micro. lecture notes 33
 Exceptional IC (Cont …)
• Perfect substitutes.
• The indifference curve becomes straight
line
Total
IC3

IC2

IC1

Mobile
Micro. lecture notes 34
 Exceptional IC (Cont …)
• Perfect complements: perfect
complements are goods which are to be
consumed jointly at a constant rate
• If two commodities are perfect
complements the indifference curve
takes the shape of a right angle (L –
shape)
• Graphically it is shown as follows.

Micro. lecture notes

35
 Exceptional IC (Cont …)
• Perfect complements

Right shoe
IC3

(3,3)

IC2
(2,2)

(1,1) IC1

Left shoe
Micro. lecture notes 36
 Exceptional IC (Cont …)
• A useless good: This shows the
relationship between useless good and
another normal good.
• A good example is outdated book and
food.
• since the outdated books are totally
useless, increasing their purchases does
not increase utility.
• The person enjoys a higher level of
utility only by getting additional food
consumption
• The indifference curve in this case will
have a vertical one
Micro. lecture notes 37
 Exceptional IC (Cont …)
• IC involving a useless good(Y axis)

IC1 IC2 IC3

Out dated books

Micro. lecture notes Food 38

 Indifference curve of a bad commodity
• “BADS” in economics are
commodities that lowers a
consumer's level of happiness as
their consumption increases.
• i.e. their consumption has a
negative effect on utility of a
consumer.
• For example, air pollution, traffic
congestion, passive smoking etc.
11/13/2024 Micr. I lecture notes 39
 Indifference curve of a bad commodity
• Bad Commodity IC( Y-axis)

Bad Good(Y) IC

Y2

Y1

X1 X2 Good Commodity(X)

Micro. lecture notes 40

 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
Micro. lecture notes 41
 Budget Line (Cont…)
• 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
A. There are only two goods, X and Y,
bought in quantities X and Y;
B. Each consumer is confronted with
market determined prices, Px and Py,
of good X and good Y respectively
C. The consumer has a known and fixed
income (I). Micro. lecture notes 42
 Budget Line (Cont…)

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 Y
M=consumer’s money income
• Suppose a household has 60 Birr to spend
– on banana (X) at Birr 2 each and
– Orange (Y) at Birr 4 each. .
• Therefore,
• our budget line equation will be:

2 X  4Y 60

Micro. lecture notes 43

 Budget Line (Cont…)
Alternative purchase possibilities of the two goods

Consumption
A B C D E F
Alternatives
banana (X)
in (kgs)… 0 1 2 3 4 5
PX=2
Orange (Y)
15 14.5 14 13.5 13 12.5
in (kgs).Py= 4
Total
60 60 60 60 60 60
Expenditure
11/13/2024 44
 Three areas of a budget line
• The Budget Line

Three areas of a budget line

• Inside…feasible but inefficient
M/PY • On the line… feasible and efficient
 B • Outside…..not feasible

A


M/PX

Micro. lecture notes

45
 Factors Affecting the Budget
Line
• Budget line depends on the price of the
two goods and the income of the
consumer
• A change in the income of the
consumer results in a shift in the
budget line
• Where as a change in the price of a
commodity will rotate the budget line
• The effect of change in income of
consumer can be shown in the
Micro lecture notes 46
 Effect of change in income on BL

M2/Py

Mo/Py

M1/Py Bo B2

B1

M1/PX Mo/PX M2/PX

Where M2>Mo>M1
Effects of Changes in Price of the commodities

Effects of Changes in Price of the

commodities

M/Px1 M/Px2 X
Effects of Changes in Price
of the commodities

Y
M/Py2

M/Py1

X
M/Px
 Optimum of the
Consumer
• A consumer reach at optimum when he
chooses the quantity that maximizes
his utility given his income and market
prices of commodities
• This occurs when an indifference curve
is tangent to the budget line
• At the point of tangency the slope of
the indifference curve (MRSxy) is equal
to the slope of the budget line
MRS X ,Y  PX / PY
Micro. lecture notes 50
 Consumer’s Optimum (Cont…)
Consumer
Y
optimum

E
Y*
IC4
IC3

IC1 IC2

X* X
 Mathematical derivation of
equilibrium
• Suppose that the consumer
consumes two commodities X and
Y given their prices and level of
money income M.
• The objective of the consumer is
maximizing his utility subject to
his limited income and market
prices.
• State the problem
• The maximization
MaximizeU  problem
f ( X ,Y ) may be
formulated as follows:
Subject to PX X  PY Y  M
Micro. lecture notes 52
 Consumer’s Optimum (Cont…)

• To solve the constrained problem; we

use the Lagrange Multiplier Method.
The steps involved are:
A). Rewrite the constraint function as
follows: M  P X  P Y 0 (  will have positive value) or
X Y

PX X  PY Y  M 0 ,   will have negative value

B) Multiply the constraint by Lagrange

multiplier  ( M  P X  P Y ) 0
X Y

  ( PX X  PY Y  M ) 0
Micro. lecture notes 53
 Consumer’s Optimum (Cont…)
C) Form a composite function or the Lagrange
function: U ( X , Y )   ( M  ( PX X  PY Y ))
 U ( X , Y )   ( PX X  PY Y  M )
D) The first order condition for maximum
requires that the partial derivatives of the
Lagrange function with respect to the two
goods and the Lagrangian constraint be
equals
 U tozero.
 U 
  P X0;   P 0 and Y   ( P X  P Y  M ) 0 X Y
X X Y Y 

From the above U U

PX and PY
equations we obtain: X Y

Micro. lecture notes 54

 Consumer’s Optimum (Cont…)
• Therefore, substituting and solving for

we get the equilibrium condition:

MU X MU Y
 
PX PY

MU X PX
By rearranging we get: 
MU Y PY

55
Micro. lecture notes
 Consumer’s Optimum (Cont…)
E) 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.
2 2 2 2
 U  U
2
 2
 0 and 2
 2
 0
X X Y Y

Micro. lecture notes 56

 Consumer’s Optimum (Cont…)
Example 1
• A consumer consuming two
commodities X and Y has the
following utility function.
– U=2X0.5Y0.5
• If the price of the two commodities
are 2 and 4 respectively and his/her
budget is birr 80.
i. Find the quantities of good X and Y
which will maximize utility.
ii. Total utility at equilibrium.
iii. Find the MRSxy at optimum point
Micro. lecture notes 57
 Consumer’s Optimum (Cont…)
Example 2
• A consumer consuming two
commodities X and Y has the following
utility function. U =X2Y2
• If the price of the two commodities are
Birr 1 and 4 respectively and his/her
budget is birr 10.
i. Find the quantities of good X and Y
which will maximize utility.
ii. Total utility at optimum point
iii. Find the MRSxy and MRSyx at optimum
point Micro. lecture notes 58
 Effects of Changes in Income and Prices on Consumer‘s
equilibrium

Changes In Income: depends on the nature of the

good
• Two types of goods
– Normal Goods are goods whose demand increases with an
increase in income
– Inferior goods are goods whose consumption decreases as
income increase
Income Consumption Curve and the Engel Curve
i. The case of normal goods
• An increase in the consumer’s income (all other
things held constant) leads to an upward parallel
shift of the budget line.
• As a result a consumer moves to different
consumption level.
• The following figure shows this condition
Micro. lecture notes 59
 Since both X and Y increased as income increase this shows the case of normal goods

Commodity Y

ICC

E3
Y3
E2

Y1 E1

X1 X3 Commodity X
 Effects of Income Changes (Cont
…)
• Income Consumption Curve (ICC) :
is a locus of all points that
representing various combinations
of the two commodities purchased
by the consumer at different levels
of his income, all other things
remaining the same
• Normal Good is a good whose demand
increases with income increase
• For normal good income effect is
positive Micro. lecture notes 61
 Effects of Income Changes (Cont
…)
ii. The case of inferior goods
• Inferior good: is a good whose
consumption decreases as income
increase
• Engle curve will have a negative
slope for inferior good as indicated in
the figure below

Micro. lecture notes 62

the income –consumption curve when good X is inferior

Y
I CC
Y3

Y2

Y1

X
X3 X2 X1
 Effects of Income Changes (Cont
…)
• ICC is used to derive Engle Curve:
• Engle Curve:is a line representing the
relationship between the equilibrium
quantity purchased of a good and the
level of income
• For normal goods Engle curve will
have positive slope
• For inferior goods Engle curve will
have a negative slope

Micro. lecture notes 64

 Effects of Price Change
Price Consumption Curve (PCC) and Individual
Demand Curve
• When one of the two commodity price
changes while other things remain
unchanged the budget line will rotate and the
consumer will be at a new equilibrium point
• If we connect such equilibrium points that
would occur at different price level we get a
line called Price Consumption Curve (PCC)
• PCC: 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.
Micro. lecture notes 65
The Effect of price change on Consumer’s Equilibrium

Y The case of decrease in price

of X
L

PCC
E3
E2
E1

M M’ M’’ X

• We use the PCC to derive the individual demand curve

for a particular commodity .How ?
• By plotting PCC from commodity space to price and
quantity space as shown below
Commodity Y

PCC

Commodity X
Price of
X Px 1

Px2
Individual
Px3 demand curve

X1 X2 X3
Commodity X
Income and Substitution effects of a price change

• When price of one of the commodity changes, while

other thing remain unchanged, the budget line will
rotate accordingly.
• This price change will brings two major effects:
• Substitution
• Income
A) 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;
If a price of commodity X falls while Price Y and
income of a consumer remain unchanged.
• Commodity X will relatively be cheaper and this
induces consumer to substitute cheaper
commodity (X) for more expensive one.

Micro. lecture notes 68

B) The Income Effect
• The change in the price of a commodity will
also have an income effect.
• When price of commodity X decreases ( other
things remain), the relative purchasing
power of consumer will increase.
– i.e. the real income will increase (meaning a
consumer can afford to buy more of the two
commodities with the existing income depending
on the nature of the commodity.
Micro. lecture notes 69
 The Slutsky vs Hicksian decomposition

• Sir John Hicks(1904-1989)

• the Hicks substitution effect keeps utility
constant rather than keeping purchasing
power constant.
• Eugen Slutsky (1880- 1948)
– The change in demand when prices change but a
consumer’s purchasing power is held constant, so
that the original bundle remains affordable.

Micro. lecture notes 70

 The following figure will depict these two effects according to Hicksian
decomposition

Suppose the consumer is at equilibrium at point A consuming X1 unit of X

Suppose price of X falls while
A other things remain unchanged
The budget line will shift from
AB to AB’
C •A consumer move to a new
A B IC2
  equilibrium point at point B
C IC1 consuming X3 units

•The movement from A to B is
called Total Effect or Net effect
of price change
x1 x2 B x3 C’ B’
SE IE •The TE consists of SE and IE
NE
 TE = Substitution effect + Income Effect , TE = SE + IE

How can we split these two effects?

We can split these two effects by drawing an
A imaginary budget line which is parallel to the new
budget line (AB’) and tangent to the original IC1

C
P R IC2
Point Q represents imaginary
  equilibrium
Q IC1 The movement from P to Q and a
 resulting increase in demand by X1X2 is
substitution effect.

x2 B The movement from Q to R and

x1
SE IE
x3 C’ B’ increase in demand by X2X3 is
NE
due to income effect
• In the above case income effect and
the substitution effects operate in the
same direction – they reinforce each
other.
• This is the case for a good called
Normal goods.
• But, not all goods are normal. Some
goods are called inferior goods
• What is inferior good?
Micro. lecture notes 73
• Inferior good: Is a good whose
quantity demand decrease with
income increase.
• Is a good whose demand is
negatively related to the income of a
consumer
• 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 tends the consumer to
reduce consumption of the
commodity (negative income
effect). Micro. lecture notes 74
 Suppose the consumer is at equilibrium at point A consuming X1 unit of X

When price of X falls while other

things remain unchanged
Y The budget line will shift from
AB to AB’
A
•A consumer move to a new
R equilibrium point at point R
C
P consuming X2 units
Q2
•The movement from A to B is
Total Effect or Net effect of price
B’
change
B
X1 X2 X3 X
IE
NE

SE
The TE can be split into SE and IE by drawing imaginary budget line CC’
Where:
X1X3= NE=Net effect Point Q represents imaginary equilibrium
X1X2= SE=Substitution effect
X2 X3= IE=Income effect The movement from P to Q2 and a
Y resulting increase in demand by X1X3
is substitution effect.
A

R The movement from Q to R and

C decrease in demand by X3X2 is due to
P income effect. Increased real income
Q2 decreases demand for inferior good
decreases
B B’

X1 X2 X3 X
IE
NE

SE
• In this case we observe that,
– the substitution effect still is more
powerful than the income effect (SE
>IE)
– even though the income effect works
against the substitution effect, it
does not override it.
– As a result the law of demand hold
– Hence, the demand curve for most
inferior goods is still
Micro. lecture notes
negatively
77
• In very rare occasions, a good may be so
strongly inferior that the income effect
actually overrides the substitute effect.
• As a result the law of demand may be
violated.
• I.e., decline in the price of a good would lead
to a decline in the quantity demanded
• In other words, price and quantity move in
the same direction which is against the law
of demand.
• Such goods are called Giffen Goods

Micro. lecture notes 78

• Giffen goods: are goods whose demand
decreases as price of a commodity
decreases.
• That is, the quantity demanded is
directly related to the price
• The graph below shows the substitution
and income effect of Giffen goods

Micro. lecture notes 79

 Suppose the consumer is at equilibrium at point P consuming X1 unit of X

Y When price of X falls while other

things remain unchanged
A
R The budget line will shift from AB
IC2 to AB’
C
•A consumer move to a new
equilibrium point at point R
P consuming X3 units
Q
IC1 •The movement from P to R is
B’ Total Effect or Net effect of price
B C’ change
X3 X1 X2 X
SE
NE

IE
 The TE can be split into SE and IE by drawing imaginary budget line CC’

Y Point Q represents imaginary equilibrium

A
R The movement from P to Q and a
IC2 resulting increase in demand by X2X3 is
C substitution effect.
The movement from Q to R and
P decrease in demand by X1X3 is
Q due to income effect.
IC1 We observe that the income effect
B’
B C’ is greater than substitution effect.
X1 X2 X3 X The net effect is that as price fall
SE
NE demand for giffen good will also
decrease
IE
• The strong negative income effect
outweighs the substitution effect ( IE >
SE)
• This reduces quantity demanded of a
giffen good
• Which means as price of a giffen good
decreases quantity demanded will also
decrease
• Which is against the law of demand

Micro. lecture notes 82

 Numerical example: Slutsky equation
• Given:
– Suppose that the consumer has a demand
function for milk of the form X 10  10mP1
1

– and originally his income is $120 per month and

the price of milk is $3 per unit.
– suppose that the price of milk falls to $2 per unit.
• Required
– Find the substitution and income effects of the
change in price of milk

Micro. lecture notes 83

 The Consumer Surplus
• Demand curve shows the price that
consumers are willing to pay for
various quantity demanded.
• While consumers purchase goods
and services,
– they often pay less than what
they are willing to pay.
• the difference between what they
are willing to pay and what they
actually paid is considered as their
surplus. Micro. lecture notes 84
• Therefore, 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.
• More precisely it is the area of the
triangle above the price but below the
demand curve.
Micro. lecture notes 85
P Consumers Surplus

P1

CS
E

Pe

Q1 Q
 Elasticity of Demand
• Consider the law of demand,
– when the price of a good goes up
people will buy less of it and
– if the price falls then people will buy
more of it
• Consumer responds to any change in the
determinants of demand like,
– Commodities own price
– Prices of related goods
– Consumers Income
– Taste and preferences
– And other factors
Micro. lecture notes 87
• The question however is that what is
the magnitude of the responsiveness of
consumers for these change?
• Economists have developed a tool that
measure responsiveness of consumers
demand for the change in the
determinants of demand.
• This measurement is called Elasticity of
demand
• We have as many elasticity of demand
as the number of determinants of
demand

Micro. lecture notes 88

The most common types of elasticity of demand
are of the following:-
• Price elasticity of demand (own price elasticity
of demand)
• Cross price elasticity of demand
• Income elasticity of demand

1. Own Price Elasticity of demand.

It is a measurement of responsiveness of quantity

demanded to change in the commodities own
price Micro. lecture notes 89
• Price elasticity of demand is measured
as a percentage change in quantity
demanded resulting from a percentage
change in price.
• Depending on the magnitude of the
change in price, we have two types of
price elasticity of demand.
– Point price elasticity of demand
– Average or arc price elasticity of
demand

Micro. lecture notes 90

• Point elasticity of demand:- is used to measure
price elasticity of demand when the change in
price is very small or at a point.
• the point price elasticity coefficient (Ep) can be
determined as,
% change in qunatity demand of X
Ed 
% change in price of X

Micro. lecture notes 91

  Q2  Q1 
  x100 Q P
Ed   Q1  p  
P2  P1 P Q
( ) x100
P1
Q Represents slope of the demand curve

P
Suppose the demand function is Qd  a  bP

Q
= -b

P
• Price Elasticity of demand is therefore

Ep = - b x P/Q
Example: Consider the following demand and
supply equation.
P = 20-0.5 Q and P = 16+0.5Q
Determine price elasticity of demand at the
equilibrium point and interpret the result!
Example 2
– Suppose that a household demands 50
units of oranges at the price 40 cents per
piece. If the price falls to the price 30
cents per piece, 100 oranges are
demanded. What is the elasticity of
demand for Oranges?
• The value of Price elasticity is always a
negative and is unit free
• This because of the inverse relationship
between price and quantity demanded of a
commodity.

Micro. lecture notes 94

• The value of price elasticity of demand
ranges from zero to infinite.
• In absolute terms, the values of price
elasticity of demand ranges from 0<Ed< .
• demand is elastic when the value of
elasticity is greater than one ( Ep > 1)
• Demand is inelastic when the value of
elasticity is less than one (Ep < 1)
• Demand is unitary elastic when the value
of price elasticity of demand is equal to
one ( Ep = 1)
Micro. lecture notes 95
• Price elasticity of demand is perfectly
elastic, when the value of price elasticity of
demand is infinite (Ep = , )
• Price elasticity of demand is perfectly
inelastic, when the value of elasticity equals
to than zero, ( Ep= 0)
• Arc Elasticity of Demand: Arc Elasticity
measurement is used when the change in
price is relatively large.
• That is, it measures elasticity between to
points.
• It is an estimation of an average elasticity of
an arc Micro. lecture notes 96
• Arc elasticity measures an average
elasticity of the segment AB

εp 
ΔQ
X
P1  P2 
ΔP Q1  Q 2 

Example: If price of good X rises from birr 3 to birr 5 and its

quantity demand falls from 240 units to 180 units. Calculate the arc
price elasticity of demand.

Micro. lecture notes 97

Determinants of the Price Elasticity of Demand
• There are about four factors which affect the
degree of elasticity of demand function. These
are:
i. The Availability of Substitutes
ii. Nature of the Commodity (Luxury Vs
Necessity)
iii. The percentage that the commodity
represents in the consumers Income commodity
iv. Time period available for adjustment.
Micro. lecture notes 98
2. Cross Price Elasticity of Demand
• Demand for a good is also affected by
the change in the price of related goods.
• Consumers respond for the change in
the price of related goods by either
cutting their consumption or by
increasing their consumption.
• Cross price elasticity measures
responsiveness of demand for the
change in the relative price of related
goods.
• Cross price elasticity of demand between
commodity XY, measures responsiveness
quantity demanded of Commodity X for a
unit change in price of commodity y

Micro. lecture notes 99

• It is a percentage change in quantity
demanded of commodity X divided by
the percentage change in price of Y
• This can be shown as

percentage change in quantity demanded good X

ε XY 
percentage change in price of good Y

ΔQ X P1Y  P 2Y
ε XY  
ΔPY Q1X  Q 2X

Micro. lecture notes 100

• The cross price elasticity can have both
positive and negative value,
• Such value determine the nature of the
relationship between the two goods.
• The cross–price elasticity of demand is
zero if the two goods are not related at
all.
• When cross price elasticity of demand is
positive, the two goods are substitute.
• When to goods are complementary the
cross price elasticity between goods will
have negative value.
Micro. lecture notes 101
Example:
• Due to unknown reason the price of beef meat
increased from 40 birr per kilo to 80 birr per
kilo.
• As a result of this change the quantity
demanded of chicken increase from 30
thousand per month to 50 thousand.
• Determine the cross price elasticity of demand
between beef and chicken and interpret the
result
• Determine the nature of their relationship?

Micro. lecture notes 102

Solution
a) Coefficient of cross price
elasticity
50 - 30 80  40 2400
ε AB    0.75
80 - 40 50  30 3200
b) Interpretation
When the price of beef meat increases by 1%, the quantity
demanded of chicken also increases by 0.75% and vice versa.
These two goods are substitute because when the price of beef
goes up people will substitute it by purchasing more quantity of
chicken and less of beef.

Micro. lecture notes 103

Income Elasticity of Demand
• Income of consumer is one of the
determinants of demand.
• A consumer also responds to the change
in their income by either consuming more
or less of a good.
• Income Elasticity of Demand (I)
measures the responsiveness of demand
for the change in consumer’s income.
• It is a percentage in quantity demanded
due to a unit change in the consumer’s
income
Micro. lecture notes 104
 percentage change in quantity demanded
ε IX 
percentage change in income
ΔQ A I1  I 2
ε IX  
ΔI Q1  Q 2

Where Q = change in quantity demanded (Q2-Q1), I = Change in income, I1 and I2 =

Income of consumer.
• The coefficient of income elasticity of
demand can have both positive and
negative values.
• When the value of income elasticity of
demand is positive (EI­ > 0), the good is
normal.
• Where as negative value of income
elasticity of demand (EI < 0) implies the
good is inferior.

Micro. lecture notes 106

Example
Use the information given in the table below to determine: -
A) Income elasticity of demand of the two goods
B) Interpret the result and determine the nature of these goods.

Year Income Consumption Per

Per Year year
Commodi Commo
ty X dity Y
1996 1500 500 units 1000
units
1997 2500 1500 units 500 units
 Price Elasticity of Demand and
Total Revenue

• Here we will try to look at the

relationship between demand , total
revenue and price elasticity of demand
• From the demand curve we can derive
total expenditure of consumers
• This total expenditure practically make
revenue to business firms.
Suppose the demand curve is given by
Q = 18 – 2P
• The following table shows how total
revenue is derived from this demand
curve Micro. lecture notes 108
Quantity Price per Elasticit Total Elasticity
demande Unit(2 y Revenue( Range
d(1) ) 2x1)
2 8 8 16 Elastic
4 7 3.5 28 Elastic
6 6 2 36 Elastic
8 5 1.25 40 Elastic
9 4.5 1 40.5 Unit elastic
10 4 0.8 40 Inelastic
12 3 0.5 36 Inelastic
14 2 0.29 28 Inelastic
16 1 0.13 16 Inelastic
• From the above table we observe that increasing
price of a commodity would not always increase
TR for the firms
• Once TR is derived we can also easily derive
Marginal Revenue which is the slope of TR
• To do so first solve the above demand function
for price to get,
• bP =a – Q which is P = a/b -1/bQ
• say a/b = bo and 1/b =b1
• Replacing in the above equation we have the
inverse demand function P =bo – b1Q
• TR = PQ this means TR = (bo-b1Q) Q
• TR = boQ – b1Q2
• MR = bo – 2b1Q we can show graphically as
follows

Micro. lecture notes 110

 P
Ep > 1

Ep = 1
Ep <1

Q
MR

TR

TR
Q
 Total revenue and elasticity

• Total revenue and elasticity are

related.
• Total revenue (TR) is the total amount
of money the seller receives from the
sale of a product,
• Total Revenue (TR) = Price X Quantity
• The effect of a change in price on
total revenue depends on the price
elasticity of demand.
• These effects are summarized bellow.
Micro. lecture notes 112
When demand is elastic /Ed/ > 1
• A decrease in price causes a large
increase in quantity demanded.
• The percentage increase in quantity
demanded is greater than percentage
decrease in price.
• Hence, the total revenue increases
since the quantity effect out ways the
price effect.
• The opposite is true when price
increases.
• A rise in priceMicro.leads
lecture notes to a decrease 113in
 When demand is inelastic /Ed/< 1

• An increase in price increases total

revenue.
• The increase in price leads to a small
decrease in quantity demanded since
demand is inelastic.
• Percentage rise in the price leads to
a less than proportionate fall in
quantity demanded leading to an
increase in total revenue.
• On the other hand, a decrease in
prices leads to a decrease in total
revenue as fall in price outweighs
the corresponding increase
Micro. lecture notes
in
quantity. 114
 When demand is unitary
elastic/Ed/= 1
• If demand is unitary elastic any
decrease or increase in price leads to
an equal increase or decrease in
quantity demanded.
• The decrease in price is the same as
or is cancelled out by an equal
increase in quantity demanded.
• Hence, total revenue remains
unchanged.
Micro. lecture notes 115