UNIT ONE

THEORY OF CONSUMER BEHAVIOR AND DEMAND

Introduction
The theory of consumer behavior is based on the assumption of the consumer being
rational to maximize level of satisfaction. The consumer makes the buying decision by
comparing available bundle of goods. The study of consumer behavior is done by the two
approaches which are different in their assumptions about measurability of utility or
satisfaction. The two approaches are called cardinal and ordinal utility approaches.
1. Consumer Preferences and Utility
1.1 Consumer Preference
Being a member of consumers in this world, how do you compare goods? Do you prefer
one good to another, or treat any two goods as equal (indifferent between the two groups)?
Given any two consumption bundles, the consumer can either decide that one of
consumption bundles is strictly better than the other, or decide that he is indifferent
between the two bundles. Commodities are desired because of their ability to satisfy wants.
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.
Completeness
Completeness of preference assumption implies that the consumer can compare two or
more goods and can easily indicate his preference. For any two commodity bundles X and
Y, a consumer will prefer X to Y, Y to X or will be indifferent between the two.
Transitivity
According to this rule, if a consumer prefers basket A to basket B and basket B to C, then
the consumer also prefers basket A to basket C. Or if the consumer is indifferent between
basket A and basket B and basket B and basket C, then he will be indifferent between
basket A and basket C
More is better than less
Consumers always prefer more of any good to less and they are never satisfied or satiated.
In any two consumption bundles A and B, A is preferred to B if A contains at least more of
one commodity than B. However, bad goods are not desirable and consumers will always
prefer less of them.

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1.2 Utility
Utility is the satisfaction or enjoyment derived from the consumption of a good or service.
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 prefers
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, non-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 and the prices of alternative goods and services.
How do you measure the satisfaction level (Utility) that you get from goods and services
that you consume?
1.3 Approaches to measure Utility

There are two major approaches of measuring utility. These are Cardinal and Ordinal
approaches.
The Cardinal Utility theory
Utility maximization theories are important to deal with consumer behavior. Neo classical
economists argued that utility is measurable like weight, height, temperature and they
suggested a unit of measurement of satisfaction called utils. Autil is a cardinal number like
1, 2, 3 etc simply attached to utility. Hence, utility can be quantitatively measured.

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1.4 Assumptions of Cardinal Utility theory
The major difference between the two approaches of utility lies in their assumptions and
implications of those assumptions. The basic assumptions of cardinal utility theory are
given below.
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 in cardinal numbers. 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. The essential feature of a standard
unit of measurement is that it is constant.
4. Limited Money Income. The consumer has limited money income to spend on the
goods and services he/she chooses to consume making choice mandatory for the
consumer
5. Diminishing Marginal Utility (DMU).The utility derived from each successive
units of a commodity diminishes. Generally, the utility of the last unit consumed is
less than the utility of the previous item consumed of the same good. 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 consumed.
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 )
In other words, total utility is a positive function of the quantities of goods consumed.

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1.5 Total and Marginal Utility
Total Utility (TU) refers to the total amount of satisfaction a consumer gets from
consuming or possessing some specific quantities of a commodity at a particular time. As
the consumer consumes more of a good per time period, his/her total utility increases.
However, total utility cannot be increased indefinitely. There is a point in which the
consumer will not be capable of enjoying any greater satisfaction from it. There is a point
at which total satisfaction reaches maximum and this point is called saturation point.
Marginal Utility (MU) 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 the consumption of one or more unit of a product per unit of time. Precisely,
it is the slope of the total utility function.
Mathematically, the formula for marginal utility is:

TU
MU  Where, TU is the change in Total Utility, and,
Q
Q is change in the amount of product consumed.

1.6 Law of Diminishing Marginal Utility (LDMU)

Do you think that the utility you derive from consumption of the first, the second, and the
third, etc cup of tea all the same? If not what happens?
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 (LDMU) 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.
The LDMU is best explained by the MU curve that is derived from the relationship
between the TU and total quantity consumed.
Table 1.1 Hypothetical table showing TU and MU of consuming Oranges (X)

Quantity of X 0 1st 2nd 3rd 4th 5th 6th

consumed (unit)
TUX 0 util 10 utils 16 utils 20 utils 22 utils 22 utils 20 utils
MUX 0 10 6 4 2 0 -2

4
 A
20
Total Utility TUX
15

10

Quantity X
Marginal Utility

B
10

Quantity X
1 2 3 4 5
MUX

Fig.1.1Derivation of marginal utility from total utility

As indicated in the above figure, as the consumer consumes more of a good over time
period, the total utility increases, at an increasing rate 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 units of X, the consumer attains its highest satisfaction
of 22 utils. However, Consumption beyond this point results in dissatisfaction, because
consuming the 6th and more units of X brings a negative utility than the previous orange.

1.7 Equilibrium of a consumer

A) one commodity case

Suppose the consumer’s utility function is giver as U  f ( X ) and his/her total income

spent (expenditure) on commodity X would be: Total Expenditure TE  QX PX whereQx is

amount of commodity and Pxis price of good X. The consumer would like to maximize the

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difference between the utility (satisfaction) and expenditure (sacrifice).The problem is
simple maximization of the function.
MaxU  TE
That is:
U  Q X PX

According to the necessary condition (First Order Condition) for Optimization, for utility to
reach maximum, the derivative of the function with respect to Qx must be equal to zero.

dU d (Q X PX )
 0
dQX dQX
MUx -Px =0
 MU X  PX Or
MUx
1
Px
Mathematically, the equilibrium condition of a consumer that consumes a single good X
occurs when the marginal utility of X is equal to its market price and the whole income has
been consumed (Total Expenditure =Total Income)
B) N-commodity case(General Case)

A consumer that maximizes utility reaches his/her equilibrium position when allocation of
his/her expenditure is such that the last birr spent on each commodity yields the same
utility.
For example, if the consumer consumes a bundle of n commodities i.e X1, X2
X3……Xnhe/she would be in equilibrium or utility is maximized if and only if:

MU X 1 MU X 2 MU X n
  .........   MU m And
PX1 PX 2 PX n
Total expenditure (TE) equals to total income
Where: MUm –marginal utility of money

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Diagrammatically,

A

C
PX 

 B

MUQuantity
X
X

Figure 1.2 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.
Table1.2 Utility schedule for a single commodity

Quantity of TU MU Marginal utility per Marginal

Orange Birr(price=2 birr) utility of money
0 0 - - 1
1 6 6 3 1
2 10 4 2 1
3 12 2 1 1
4 13 1 0.5 1
5 13 0 0 1
6 11 -2 -1 1

For consumption level lower than three quantities of oranges, since the marginal utility of
orange is higher than the price, the consumer can increase his/her utility by consuming
more quantities of oranges. On the other hand, for quantities higher than three, since the
marginal utility of orange is lower than the price, the consumer can increase his/her utility
by reducing its consumption of oranges.
Suppose that a consumer consumes two commodities, Orange and Banana. The total
income of the consumer is Birr 20.If price of Orange is Birr 2 per unit and Birr 4 per unit
for Banana. If the utility schedule of the consumer is as indicated below the optimum
combination of the two goods can be calculated as follows.

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Table 1.3 Utility schedules for two commodities

Orange, Price=2 birr Banana, Price=4 birr

Quantity TU MU MU/P Quantity TU MU MU/P
0 0 - - 0 0 - -
1 6 6 3 1 24 24 6
2 10 4 2 2 40 16 4
3 12 2 1 3 52 12 3
4 13 1 0.5 4 60 8 2
5 13 0 0 5 65 5 1.85
6 11 -2 -1 6 68 3 0.75

As we discussed earlier, utility is maximized when the condition of marginal utility of one
commodity divided by its market price is equal to the marginal utility of the other
MU 1 MU 2
commodity divided by its market price MU i.e.  and income equals
P1 P2
expenditure.

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

His total income of birr 20 equals to the total expenditure on 2 units of orange (2X2= birr
4) and 4 units of banana (4x4=birr16)

1.7 Derivation of the Cardinalist Demand

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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 a
P1
b
P

Price
c
P2
MUX
O Quantity

P1
Price

P
Demand
P2 Curve
O Quantity
Q1 Q Q2

Figure 1.3 Derivation of Demand curve

Limitation of the Cardinalist approach
The Cardinalist approach involves the following three weaknesses: The assumption of
cardinal utility is doubtful because utility may not be quantified i.e. cannot be measured
absolutely (objectively), and the assumption of constant MU of money is unrealistic
because as income increases, the marginal utility of money changes.
The Ordinal Utility Theory
In the ordinal utility approach, utility cannot be measured in cardinal numbers or
absolutely. The consumer is expected to rank different consumption bundles according to
his/her preferences. The ordinal utility 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 utils, or 3 utils, but it is always possible for the consumers to
express the utility in relative terms. It is practically possible for the consumers to rank
st nd rd
commodities in the order of their preference as 1 2 3 and so on.
1.8 Assumptions of Ordinal Utility Theory

This approach is based on simplifying assumptions and some of them are:-

1) The Consumers are rational-
They aim at maximizing their satisfaction or utility given their income and market prices.

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 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.
Marginal rate of substitution is the slope of the Indifference curve. When a consumer
continues to substitute X for Y the rate goes on decreasing as the two goods are assumed to
be imperfect substitutes in a standard case.
4) The total utility of the consumer depends on the quantities of the commodities
consumed, i.e., U=f (X1 ,X2, X3,---Xn,)
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.
Consistency of preference implies that If market basket X is preferred to market basket Y
(X>Y) then Y cannot be preferred to X at another time(Y not >X).
6) Limited money income-
The consumer is confronted with limited money income so that optimization is mandatory.
7) Non – satiation assumption-
Consumers always prefer more of any good to less and they are never satisfied or satiated.
In any two consumption bundles A and B, A is preferred to B if A contains at least more
of one commodity. However, bad goods are not desirable and consumers will always
prefer less of them.
The ordinal utility approach is expressed or explained with the help of indifference curves.
An indifference curve is a concept used to represent an ordinal measure of the tastes and
preferences of the consumer and to show how he/she maximizes utility in spending income.
Since it uses ICs to study the consumer’s behavior, the ordinal utility theory is also known
as the Indifference Curve Analysis.
1.9. Indifference Set, Curve and Map
Indifference Set/ Schedule: It is a combination of goods for which the consumer is
indifferent, preferring none of the consumption bundles. It is a tabular presentation of the
various combinations of goods from which the consumer derives the same level of utility.

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 Table 1.4 Indifference Schedule

Bundle (Combination) A B C D

Orange(X) 1 3 5 7

Banana (Y) 23 15 9 6

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: an indifference curve shows the various combinations of two goods
that provide the consumer the same level of utility or satisfaction. It is the locus of points
(particular combinations or bundles of good), which yield the same utility (level of
satisfaction) to the consumer, so that the consumer is indifferent as to the particular
combination he/she consumes. An indifference curve is an Iso or equal utility curve.
By transforming the above indifference schedule into graphical representation, we get an
indifference curve.
10 A

Indifference
B
6 Curve (IC)
Banana (Y)

Good B

C
2 IC3
D IC2
1
IC1

1 2 4 7 Good A
OrangeX
Indifference curve
)) (X) Indifference map
Fig 1.4 indifference curves and indifference map.
Indifference Map: It is a set of indifference curves with different levels of satisfaction. It is
the entire set of indifference curves, which reflects the complete set of tastes and
preferences of the consumer. Any consumer has lots of indifference curves, not just one.
Properties of Indifference Curves:
Indifference curves have certain unique characteristics with which their foundation is
based.

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 1. Indifference curves have negative slope (downward sloping to the right).
Indifference curves are negatively sloped because the consumption level of one commodity
can be increased only by reducing the consumption level of the other commodity for a
movement along an indifference curve. That means, if the quantity of one commodity
increases with the quantity of the other remaining constant, the total utility of the consumer
increases. On the other hand, if the quantity of one commodity decreases with the quantity
of the other remaining constant, the total utility of the consumer reduces. Hence, 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.
2. Indifference curves do not intersect each other
Intersection between two indifference curves is inconsistent with the reflection of
indifference curves. If they do intersect, the point of their intersection would mean two
different levels of satisfaction from a single combination of goods, which is impossible.
3. A higher Indifference curve is always preferred to a lower one-
The further away from the origin an indifferent curve laid 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.
Fig.1.5 positively sloped and intersected indifference curves

B
Banana

Banana

E

D IC2
C
A
IC1

X
Orange Orange

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As we discussed earlier, Indifference curves cannot intersect each other. If they did, the
consumer would be indifferent between C and E, (Right panel of figure 1.5) since both are
on indifference curve one (IC1). Similarly, the consumer would be indifferent between
points D and E, since they are on the same indifference curve, IC2.By transitivity, the
consumer must also be indifferent between C and D. However, a rational consumer would
prefer D to C because he/she can have more Orange at point D (more Orange by an amount
of X).
The left panel of figure 1.5 summarizes the implication of an upward sloping indifference
curve. Point A and B are two points on the same indifference curve which must give the
consumer the same satisfaction. But the consumer is not indifferent between the two
consumption bundles since consumption bundle B contains more of both orange and
banana.
1.10 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. Is the rate at which one commodity can
be substituted for another while keeping the level of satisfaction same.

Number of units of Y given up

MRS X ,Y 
Number of units of X gained

Is negative of the slope of an indifference curve at any point for any two commodities such
as X and Y, and given by the slope of the tangent line at that point:
i.e., Slope of indifference curve
y
 MRS X ,Y
x
In other words, MRS refers to the amount of one commodity that an individual is willing to
give up to get an additional unit of another good while maintaining the same level of
satisfaction or remaining on the same indifference curve. The diminishing slope of the
indifference curve means the willingness to substitute X for Y diminishes as one move
down the curve.
Note that ( MRS X ,Y ) measures the downward vertical distance (the amount of y that the

individual is willing to give up) per unit of horizontal distance (i.e. per additional unit of x
Y
required) to remain on the same indifference curve. That is, MRS X ,Y   because of the
X

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reduction in Y, MRS is negative. However, we multiply by negative one and express
MRS X ,Y as a positive value. MRS is defined for a movement along the same indifference

curve.
Table1.5 level of consumption of good X and Y
Bundle A B C D
(Combination)
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
In the above case the consumer is willing to forgo 8 units of Banana to obtain 2 more unit
of Orange. If the consumer moves from point B to point C, he is willing to give up only 6
units of Banana(Y) to obtain 2 unit of Orange (X), so the MRS is 3(∆Y/∆X =6/2). Having
still less of Banana and more of Orange at point D, the consumer is willing to give up only
3 unit of Banana so as to obtain the same 2 units of Orange. In this case, the MRS falls to
3/2. In general, as the amount of Y increases, the marginal utility of additional units of Y
decreases. Similarly, as the quantity of X decreases, its marginal utility increases. In
addition, the MRS decreases as one move downwards to the right.

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 to the MUx and the MUy as follows:

MU X
MRS X ,Y 
MU Y

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:

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 U U
dU  dX  dY  0 , Since there is no change in utility for any movement along
X Y
the same indifference curve.

U U
MU X dX  MU Y dY  0 , = MUX and = MUy
X Y

MU X dY
  MRS X ,Y
MU Y dX

MU Y dX
Or,   MRS Y , X
MU X dY

Example

Suppose a consumer’s utility function is given by U  10 X 2Y .Compute MRS X ,Y .

MU X
MRS X ,Y 
MU Y

dU dU
MU X  and MU Y 
dX dY

Therefore, MU X  20( X 21Y )  20 XY and MU Y  10( X 2Y 11 )  10 X 2

MU X 20 XY 2Y
MRS X ,Y   
MU Y 10 X 2 X
Exceptional Indifference Curves
In a standard case indifference curves are convex to the origin and downward sloping as we
have seen earlier and this shape of indifference curve is true for most goods. In this
situation, we assume that the two commodities such as X and Y can substitute one another
to a certain extent but are not perfect substitutes. However, the shape of the indifference
curve will be different if commodities have some other unique relationship such as perfect
substitution or complementary. Here, are some of the ways in which indifference
curves/maps might be used to reflect preferences for three special cases.
1. Perfect substitutes: perfect substitutes are goods which can be replaced for one another
at a constant rate. If two commodities are perfect substitutes (if they are essentially the

15
same), the indifference curve becomes a straight line with a negative slope. MRS for
perfect substitutes is constant. (Panel a below)
2. 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. Suppose that an individual prefers to consume left shoes (on the
horizontal axis) and right shoes on the vertical axis in pairs. 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 i.e. there is no substitution between the two goods.
3. A useless good: Panel C 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 shows that utility will be the same as long as this
person has same units of food no matter how many out dated books he/she has.

IC3 IC1 IC2 IC3

Out dated books

IC2
Right shoe

IC1
IC3
Total

IC2
IC1

Mobile Left shoe Food

Panel a Panel b Panel c

Fig.1.6 Special cases of indifference curves

1.11 The Budget Line (the Price line)

Indifference curves show how the rate at which the consumer is willing to substitute one
good for another utility remaining the same. It only tells us the consumer’s preferences for
any two goods but they cannot tell us which combinations of the two goods will be chosen
or bought.
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. Therefore, in addition to consumer preferences,

16
we need to know the consumer’s income and prices of the goods. In other words, individual
choices are also affected by budget constraints that limit people’s ability to consume in
light of prices they must pay for various goods and services. Whether or not a particular
indifference curve is attainable depends on the consumer’s money income and on
commodity prices. A consumer while maximizing utility is constrained by the amount of
income and prices of goods that must be paid. This constraint is often presented with the
help of the budget line constructed by possible alternative purchases of any two goods.
Therefore, before we discuss consumer’s equilibrium, it is better to understand his/ her
budget line.
The budget line is a line or a 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.
Assumptions for the use of the budget line
In order to draw the budget line facing the consumer, we consider the following assumptions:
1. there are only two goods, X and Y, bought in quantities X and Y;
2. each consumer is confronted with market determined prices, Px and Py, of good X and
good Y respectivley; and
3. the consumer has a known and fixed money income (M).
By assuming that the consumer spends all his/her income on two goods (X and Y), we can express
the budget constraint as:

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

PY=price of good Y
X=quantity of good X
Y=quantity of good Y
M=consumer’s money income

According to the above budget equation, the amount of money spent on X plus the amount
spent on Y equals the consumer’s money income.
Suppose for example a household with 60 Birr per day to spend on banana(X) at Birr 2
each and Orange(Y) at Birr 4 each. That is, PX  2, PY  4, M  60birr .
Therefore, our budget line equation will be:
2 X  4Y  60
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Table 1.6 Alternative purchase possibilities of the two goods
Consumption
A B C D E F
Alternatives
banana (X) in
0 1 2 3 4 0
(kgs)
Orange(Y) in
15 14.5 14 13.5 13 30
(kgs)
Total
60 60 60 60 60 60
Expenditure

At alternative A, the consumer is using all of his /her income for good Y. Mathematically;
it is the y-intercept (0, 15). And at alternative F, the consumer is spending all his income
for good X. Mathematically it is the X-intercept (30, 0). We may present the income
constraint graphically by the budget line whose equation is derived from the budget
equation.

M  PX X  PY Y
M  XPX  YPY

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

M/PY
Fig.1.7 Derivation of the Budget Line

B


A


Therefore, the budget line is the locus of combinations

M/PorX bundle of goods that can be purchased if
the entire money income is spent. Given any budget line, there are two possible areas indicated by

18
point A and point B. The area outside the budget line represents non- feasible (un-attainable) area
because it is beyond the reach of the consumer. On the other hand, the area inside or on the budget
line denotes feasible or achievable area.
1.12 Factors Affecting the Budget Line
Budget line depends on the price of the two goods and the income of the consumer. Any
change in the income of the goods or the income of the consumer results in a shift in the
budget line. Let us examine the impact of these changes one by one.
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 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
Bo to B1 when income decreases and to B2 when income rises.

M2/Py

Mo/Py Where M2>Mo>M1

M1/Py
Bo B2
B1
M1/PX Mo/PX M2/PX

Fig.1.8 Effects of change in income

b. Effects of Changes in Price of the commodities

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

19
 Y Y

B1 B1
B
B
X X
Fig. a Fig.b
Fig.1.9 Effects of change in price

Let us now consider the effects of each price changes on the budget line
What would happen if price of x falls, while the price of good Y and money incme remaining
constant?
Y

A
M/py

Here PX1, <Pxo, hence M/Pxo<M/Px1

B B’

M/PX0 M/Px1 X

Fig. 1.10 Effect of a decrease in price of x on the budget line

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

20
 the figure below that an increase in the price of X, money income and price of Y held
constant, pivots the budget line in-ward, as from AB to AB’.

M/Py
A

B
B’

M/Px1 M/Px2

Fig. 1.11 Effect of an increase in price of x on the budget line

What would happen if price of Y rises, while the price of good X and money incme remaining
constant?
Y
M/pyFig 1.12Effect of an increase in price of y on the budget line
A

A’
M/py'

B
X

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

21
 Y
M/py' A’

M/pyA

B
0 X
M/Px
Fig.1.13 Effect of a fall in price of Y on the budget line
The above figure shows what happens to the budget line when the price of Y increases while the
price of good X and money income held constant. Since Py decreases, M/Py increases thereby the
budget line shifts outward.
Some times the price of the two commodities may change proportionally in the same direction and
this will have a shifting impact on the budget line.
Proportional increase in the prices of both goods (X and Y), income remaining the same, reduces the
total quantity of the two goods that the consumer can buy with the given income. For example if the
price of the two goods doubles, the quantity of the two goods bought decreases by half. Since the
slope of the budget line which is the ratio of the prices of the two goods remains the same, there will
be a parallel inward shift of the budget line.
When there is proportional (equal) decrease in price of the two goods income remaining the same,
the quantity bought of the two goods increases which leads o a parallel out ward shift in the budget
line.
M/Py2
Where PX1>PXo>PX2 and
M/Pyo

M/Py1 Bo B2
Where PY1>PYo>PY2
B1

M/PX1 M/PXo M/PX2

Example: A person has Birr 60 to spend on two goods(X, Y) whose respective prices are
Birr 3 and Birr 6.
a) Draw the budget line.
b) What happens to the original budget line if the budget decreases by 50%?
c) What happens to the original budget line if the price of Y doubles?
22
 d) What happens to the original budget line if the price of X falls to Birr 2?
e) What happens to the original budget line if price of both X and Y is doubled?
The budget line for two commodities is expressed as:
PX X  PY Y  M
3 X  6Y  60,
6Y  60  3 X
60 3
Y  X
6 6
1
Y  10  X
2
Y  10  0.5 X
When the person spends all of his income only on the consumption of good Y, we can get
the Y intercept that is(0,10).However, when the consumer spends all of his income on the
consumption of only good X, then we get the X intercept that is (20,0). Using these two
points we can draw the budget line. Thus, the budget line will be:

10 A

A’

B’ B
20 X
If the budget decreases by 50%, then the budget will be reduced to 30.As a result, the
budget line will be shifted in-ward as 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:
30 3 1
3 X  6Y  30  6Y  30  3 X  Y   X  Y  5  X  Y  5  0.5 X
6 6 2

Therefore, the Y-intercept decreases to 5 units while the X-intercept is only 10 units.
However, since the ratio of the prices does not change the slope of the budget line remains
constant.

23
If the price of good Y doubles the equation of the budget line will be 3X  12Y  60 and if
the price of good X falls to Birr 2, the equation for the new budget line will be
2 X  6Y  60 .
If price of both X and Y is doubled, the new budget line equation will be 6X+12Y=60.The
X-intercept and Y-intercept decreases to 10 units and 5 unity respectively. The slope
remaining the same (-0.5), the budget line shifts inward in a parallel way.
1.13 Optimum of the Consumer
A rational consumer seeks to maximize his utility or satisfaction by spending his or her
income. It maximizes the utility by trying to attain the highest possible indifference curve,
given the budget line. This occurs where an indifference curve is tangent to the budget line
so that the slope of the indifference curve ( MRS X ,Y ) is equal to the slope of the budget line

( PX / PY ).
Thus, the condition for utility maximization, consumer optimization, or consumer
equilibrium occurs where the consumer spends all income (i.e. he/she is on the budget line)
and the slope of the indifference curve equals to the slope of the budget line
MRS X ,Y  PX / PY .

The preferences of the consumer are indicated by the indifference curve and the budget line
specifies the different combinations of X and Y the consumer can purchase with the limited
income. Therefore, the consumer tries to obtain the highest possible satisfaction with in his
budget line. However, the consumer cannot purchase any bundle lying above and to the
right of the budget line. Because, Indifference curves above the region of the budget line
are beyond the reach of the consumer and are irrelevant for equilibrium consideration. The
question then arises as to which combinations of X and Y the rational consumer will
purchase. Graphically, the consumer optimum or equilibrium is depicted as follows:

24
 Y
A

B
E
IC4

C IC3

IC2
D
IC1

X
Figure 1.14 Consumer equilibrium

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

Mathematical derivation of equilibrium

Suppose that the consumer consumes two commodities X and Y given their prices and
level of money income M. Thus, the objective of the consumer is maximizing his utility

25
function subject to his limited income and market prices. In utility maximization, the
function that represents the objective that the consumer tries to achieve is called the
objective function and the constraint that the consumer faces is called constraint function.

The maximization problem may be formulated as follows:

MaximizeU  f ( X , Y )

Subject to PX X  PY Y  M

To solve the constrained problem; we use the Lagrange Multiplier Method. The steps
involved are:

A) Rewrite the constraint function as follows:

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

B) Multiply the constraint by Lagrange multiplier 

 (M  PX X  PY Y )  0 ,  will have positive value

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

C) Form a composite function or the Lagrange function:

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

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

D) 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.
 U  U 
  PX  0 ;   PY  0 and  ( PX X  PY Y  M )  0
X X Y Y 
From the above equations we obtain:
U U
 PX and  PY
X Y
U U
 MU X and  MU Y
X Y

26
Therefore, substituting and solving for  we get the equilibrium condition:
MU X MU Y
 
PX PY
By rearranging we get:
MU X PX
 = MRS x,y
MU Y PY
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 U 2  2 U 2
  0 and  0
X 2 X 2 Y 2 Y 2
Example 1
A consumer consuming two commodities X and Y has the following utility function
U  X 1.5Y .If the price of the two commodities are 3 and 4 respectively and his/her budget
is birr 100.
a) Find the quantities of good X and Y which will maximize utility.
b) Total utility at equilibrium.
c) Find the MRS X ,Y at optimum point

Solution
A) The Lagrange equation will be written as follows:
  X 1.5Y   (3 X  4Y  100)

 1.5 X 0.5Y  3  0 ……………………….. (1)
X

 X 1.5  4  0 …………………………… (2)
Y

 100  3 X  4Y  0 …………………… (3)

From equation (1) we get 1.5 X 0.5Y  3 and from equation (2) we get X 1.5  4 .By
1.5
1.5 X 0.5Y X
further simplification, we can get that   and equation (2) gives as .
3 4
Equating  with 

27
 1.5
1.5 X 0.5Y X
   By rearranging and solving for X, we get
3 4
X=2Y--------------------------------------------------------------- (4)
Substituting Equation (4) in equation (3) or the constraint function,
3X +4Y=100
3(2Y) +4Y=100
10Y=100
Y=10units and;
Since X= 2Y from equation (4)
X=2(10) =20 units
Therefore, optimum combination of the two goods is 10 units of Y and 20 units of X
B) The total utility at equilibrium is calculated by inserting the corresponding quantities of
X and Y in the total utility function
U  X 1.5Y When X= 20 and Y= 10,
U  (20)1.5 10
U= 894
MU X
C) MRS X ,Y  ,
MU Y
U U
MU X   1.5 X 0.5Y and MU Y   X 1.5
X Y
1.5(20) 0.5 (10)
MRS X ,Y  , at optimum point
201.5
67
=
89.4
After inserting the optimum value of Y=10 and X=20 we get 0.75 which equals to the price ratio
PX 3
of the two goods (   0.75) .
PY 4
Example 2
A consumer consuming two commodities X and Y has the following utility function
U  X 2Y 2 .If the price of the two commodities are Birr 1 and 4 respectively and his/her
budget is birr 10.
A) Find the quantities of good X and Y which will maximize utility.
28
 B) Find the MRS X ,Y at optimum.

C) Total utility at optimum point

D) The amount that optimum utility changes when quantity of X,Y changes by one unit ( 
Solution
A) The Lagrange equation will be written as follows:
  X 2Y 2   ( X  4Y  10)

 2 XY 2    0 ……………………….. (1)
X

 2YX 2  4  0 …………………………… (2)
Y

 X  4Y  10  0 …………………… (3)

YX 2
From equation (1) we get   2XY 2 and from equation (2) we get   .
2
Since  equals to  , we can solve for either X or Y
2
YX
 = 2XY = 2
YX 2 = 4XY 2 X = 4Y------------------------ (4)
2
By substituting equation (4) in to equation (3) we get,
X+4Y=10
4Y+4Y=10, since X= 4Y
8Y=10
Y= 1.25 and X=4Y, X=4(1.25) =5
Thus optimum combination of the two goods is 5 for X and 1.25 for Y.
B) MRS X ,Y at optimum.

MU X 2 XY 2 Y
MRS X ,Y  , MU X = 2XY 2 and MUy = 2YX 2 MRS X ,Y  2
=
MU Y 2YX X
After inserting the optimum value of Y=1.25 and X=5 we get 0.25 which equals to the price ratio
PX 1
of the two goods (   0.25) .
PY 4

C) TU  5 2 (1.25) 2 =25(1.56) =39

D)   2XY 2 , x= 5 & Y=1.25  2(5)(1.25) 2 =15.625

1
1.14 Effects of Changes in Income and Prices on Consumer‘s equilibrium
Let us now analyze the effect of changes in consumer’s income and the price of the good that are
the two important determinants of quantity demanded (or also consumer equilibrium). Let us first
consider the effect of change in income on the equilibrium of the consumer all other things
remaining constant.
A. Changes In Income: Income Consumption Curve and the Engel Curve
i. The case of normal goods
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).ICC is a locus of points representing various
combinations of the two commodities purchased by the consumer at different levels of his
income, all other things remaining the same. 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.
Commodity Y

ICC
E3
E2
E1
Commodity X

Engle Curve
I3
Income

I2
I1

X1 X2 X3 Commodity X
Figure 1.15 the income –consumption and the Engle curves for normal goods

30
 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.
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.
ii. The case of inferior goods
An inferior commodity is a consumption good whose consumption decreases as income
increases. Y

ICC

ICC
X
Fig 1.16 the income –consumption X
Curve when good X is inferior
Fig 1.17 the income –consumption curve when
good y is inferior

31
 Figure 1.18 Engel curve for inferior goods

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.
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 Px1 to Px 2 to Px3 .
Commod

PCC
ity Y

Commodity X
Px1
Price
of X

Px2
Individual
Px3 demand curve
X1 X2 32 X3 Commodity X
 Figure 1.19 the PPC and derivation of the demand curve

1.15 Income and Substitution effects of a price change

We now turn to a more complete analysis of why demand curves slope downward. In our
previous discussion, we have noted that there are two effects of a price change. If price falls
(rises), the good becomes cheaper (more expensive) relative to other goods; and consumers
substitute toward (away from) the good. This is the substitution effect. Also, as price falls (rises),
the consumer’s purchasing power or real income increases (decreases). Since the set of
consumption opportunities increases (decreases) as price changes, the consumer changes the mix
of his or her consumption bundle. This effect is called the income effect. Let us analyze each
effect in turn, and then combine the two in order to see why demand is assumed to be downward
sloping.
A) The effects of a price-decline on consumer’s equilibrium
When the price of a commodity declines ,the budegt line rotates outward causing a shift in the
optimum point.
First, a decrease in price increases the consumer’s real income (purchasing power), thus
enhancing the ability to buy more goods and services to some extent. Second, a decrease in the
price of a commodity induces some consumers (the consumer) to substitute it for others, which
are now relatively expensive (higher price) commodities.The 1st effect is known as the income
effect, and the 2nd effect is known as the substitution effect. The combined effect of the two is
known as the total effect (net effect).

33