Mekelle University

College of Business and Economics

DEPARTMENT OF ECONMICS

MICROECONOMICS (Econ 2063)

Target group: Management Evening Students

BY: Tsegazeab G., M.Sc in Economics

MARCH, 2024 G.C

MEKELLE

1
 CHAPTER ONE
THEORY OF CONSUMER BEHAVIOR AND DEMAND
The theory of consumer choice lies on the assumption of the consumer being rational to
maximize level of satisfaction.

The consumer makes choices by comparing bundle of goods.

1. Consumer Preferences and Choices

In this section you will see how consumers allocate their limited income among different number
of goods and services.

Moreover, you will learn how consumer’s allocation decisions determine quantity demand of
goods and services.

1.1. Consumer Preference

Given any two consumption bundles (groups of goods) available for purchase, how a consumer
compares the goods?

Does he prefer one good to another, or does he indifferent between the two groups.

Strict (strong) preference

Given any two consumption bundles (X1, X2) and (Y1, Y2), if (X1, X2)>(Y1,Y2) or if he chooses
(X1,X2) when (Y1,Y2) is available, the consumer definitely wants the X-bundle than Y.

Weak preference
Given any two consumption bundles(X1,X2) and (Y1,Y2),if the consumer is indifferent between
the two commodity bundles or if (X1,X2) ¿ (Y1,Y2),the consumer would be equally satisfied if
he consumes (X1,X2) or (Y1,Y2).

Transitivity
It means that if a consumer prefers basket A to basket B and to basket C, then the consumer also
prefers A to C.

E.g. if consumption bundle (basket) which contains (x1, x2)> (y1, y2) and (y1, y2) > (z1, z2), then it
means that (x1,x2)> (z1,z2).

More is better than less

Consumers always prefer more of any good to less and they are never satisfied or satiated.
However, bad goods are not desirable and consumers will always prefer less of them.

2
1.2 Utility
Economists use the term utility to describe the satisfaction or enjoyment derived from the
consumption of a good or service.

Definition

Utility is the level of satisfaction that is obtained by consuming a commodity or undertaking an

activity. In defining strict preference, we said that given any two consumption bundles (X1, X2)
and (Y1, Y2) the consumer definitely wants the X bundle than the Y bundle if (X1, X2) > (Y1,
Y2).

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
(factors which may affect a satisfaction a person obtains from consuming a particular good or
service):

 How much satisfaction he gets from buying and then consuming an extra unit of a good
or service.
 The price he pays to get the good.
 The satisfaction he gets from consuming alternative products.
 The prices of alternative goods and services.
2. Approaches to Measure Utility
There are two major approaches of measuring utility. These are Cardinal and ordinal approaches.

2.1 The Cardinal Utility Theory

Neo-classical economists argued that utility is measurable like weight, height, temperature and
they suggested a unit of measurement of satisfaction called utils.

An util is a cardinal number like 1, 2, 3, etc simply attached to utility. Hence, utility can be
quantitatively measured.

3
Example: Suppose a consumer derived 5 utils of satisfaction from consuming the first bread and
7 utils from the second bread. By how much is higher the second bread than the first?

2.1.1. Assumptions of Cardinal Utility theory

1. Rationality of Consumers: The main objective of the consumer is to maximize his/her
satisfaction given his/her limited budget or income. Thus, in order to maximize his/her
satisfaction, the consumer has to be rational.
2. Utility is cardinally measurable: According to this approach, the utility or satisfaction
of each commodity is measurable. Money is the most convenient measurement of utility.
In other words, the monetary unit that the consumer is prepared to pay for another unit of
commodity measures utility or satisfaction.
3. Constant Marginal Utility of Money: According to assumption number two, money is
the most convenient measurement of utility. However, if the marginal utility of money
changes with the level of income (wealth) of the consumer, then money cannot be
considered as a measurement of utility.
4. Limited Money Income: The consumer has limited money income to spend on the
goods and services he/she chooses to consume.
5. Diminishing Marginal Utility (DMU): The utility derived from each successive units of
a commodity diminishes. In other words, the marginal utility of a commodity diminishes
as the consumer acquires larger quantities of it. This law is called LDMU.
6. The total utility of a basket of goods depends on the quantities of the individual

commodities: If there are n commodities in the bundle with quantities,

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

total utility is given by: TU=f (

X 1 , X 2 .. .. . . X n )
2.1.2. Total and Marginal Utility

Definitions

Total Utility (TU): It refers to the total amount of satisfaction a consumer gets from consuming
or possessing some specific quantities of a commodity at a particular time. As the consumer
consumes more of a good per time period, his/her total utility increases. However, there is a
saturation point for that commodity in which the consumer will not be capable of enjoying any
greater satisfaction from it.

Marginal Utility (MU): It refers to the additional utility obtained from consuming an additional
unit of a commodity. In other words, marginal utility is the change in total utility resulting from
the consumption of one or more unit of a product per unit of time. Graphically, it is the slope of
total utility. Mathematically, the formula for marginal utility is:

4
 ΔTU
MU =
ΔQ Where, TU is the change in Total Utility, and,
Q is change in the amount of product consumed.

2.1.3. Law of diminishing marginal Utility (LDMU)

Dear student, is the utility you get from consumption of the first orange is the same as the second
orange? The utility that a consumer gets by consuming a commodity for the first time is not the
same as the consumption of the good for the second, third, fourth, etc.

The Law of Diminishing Marginal Utility States that as the quantity consumed of a commodity
increases per unit of time, the utility derived from each successive unit decreases, 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.

Table1.1 Hypothetical table showing TU and MU of consuming Oranges (X)

Units of
0 1st 2nd 4th 5th 6th
Quantity(x) 3rd unit
Unit Unit unit Unit Unit Unit
consumed
TUX 0 util 10 utils 16 utils 20 utils 22 utils 22 utils 20 utils
MUX 0 10 6 4 2 0 -2

20
MU TU

B
TUX
15

1 2 3 4
Quantity X
MUX
Fig.2.1Derivation of marginal utility from total utility
As the consumer consumes more of a good per time period,

o the total utility increases, at an increasing rate when the marginal utility is increasing and
o increases at a decreasing rate when the marginal utility starts to decrease and
o Reaches maximum when the marginal utility is Zero.
The total utility curve reaches its pick point (Saturation point) at point A. This Saturation point
indicates that by consuming 5 oranges, the consumer attains its highest satisfaction of 22 utils.

5
However, Consumption beyond this point results in Dissatisfaction, because consuming the 6th
and more orange brings a lesser additional utility than the previous orange.

Point B where the MU curve reaches its maximum point is called an inflexion point or the point
of Diminishing Marginal utility.

2.1.4 Equilibrium of a consumer

Single good consumption case: Diagrammatically,

MUx
 At any
Apoint where point C like point A where MUX>Px, it pays the consumer to
1 
consume more. At any point below point C like
C
 point B where MUX<Px the consumer consumes
5
less of X. However, at point C where MUx=Px the
 B consumer is at equilibrium.
2
 B Mathematically, the equilibrium condition
MU X
of a consumer that consumes a single good X
PX
2 5 1 occurs when the marginal utility of X is
Figure 2.2 marginal utility of a consumer
equal to its market price.
MU X = P X

E.g. what amount of consumption of good X maximize utility of the consumer if utility function
of the consumer is estimated as U=2X2, with Px=8$?

Table 1.2 Utility schedules for a single commodity

Marginal utility
Quantity of Marginal utility
Total utility Marginal utility
per Birr (price=2
Orange of money
birr)
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.

6
 Multiple good consumption 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 x 1,x2,…,xn, he/she would
be in equilibrium or utility is maximized if and only if:

MU X MU X MU X
1
= 2
= .. . .. .. . .= n
=MU m
PX PX PX
1 2 n

Where: MUm –marginal utility of money (expenditure)

Table 1.3 Utility schedules for two commodities

Orange, Price=2birr Banana, Price=4birr
Quantity TUo MUo MUo/P Quantity TUB MUB MUB/P
0 0 - - 0 0 - -
1 6 6 3 1 6 6 1.5
2 10 4 2 2 22 16 4
3 12 2 1 3 32 10 2.5
4 13 1 0.5 4 40 8 2
5 13 0 0 5 45 5 1.25
6 11 -2 -1 6 48 3 0.75

Thus, suppose the income of the consumer is 20 birr, the consumer will be at equilibrium when
he consumes 2 quantities of oange and 4 quantities of banana, because
MU orange MU banana 4 8
= = = =2
Porange Pbanana 2 4

Limitation of the Cardinalist approach

The Cardinalist approach involves the following three weaknesses:

1. The assumption of cardinal utility is doubtful because utility may not be quantified.
2. Utility cannot be measured absolutely (objectively). The satisfaction obtained from
different commodities cannot be measured objectively.
3. The assumption of constant MU of money is unrealistic because as income increases, the
marginal utility of money changes.
2.2. The Ordinal Utility Approach

7
In the ordinal utility approach, utility cannot be measured absolutely but different consumption
bundles are ranked according to preferences.

The concept is based on the fact that it may not be possible for consumers to express the utility
of various commodities they consume in absolute terms, like, 1 util, 2 util, or 3 util, but it is
always possible for the consumers to express the utility in relative terms.

It is practically possible for the consumers to rank commodities in the order of their preference
st
as 1 2nd 3rd and so on.

2.2.1. Assumptions of Ordinal Utility theory

This approach is based on the following assumptions:

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

2. Utility is ordinal, i.e. utility is not absolutely (cardinally) measurable. Consumers are
required only to order or rank their preference for various bundles of commodities.

3. Diminishing Marginal Rate of Substitution (MRS): The marginal rate of substitution is the
rate at which a consumer is willing to substitute one commodity (x) for another commodity
(y) so that his total satisfaction remains the same.

4. the total utility of the consumer depends on the quantities of the commodities consumed,

i.e., U=f (
X 1 , X 2 ...... X n )

5. Preferences are transitive or consistent: It is transitive in the senses that if the consumer
prefers market basket X to market basket Y, and prefers Y to Z, and then the consumer also
prefers X to Z.

The ordinal utility approach is expressed or explained with the help of indifference curves. Since
it uses ICs to study the consumer’s behavior, the ordinal utility theory is also known as the
Indifference Curve Analysis.

2.2.2. Indifference Set, Curve and Map

Indifference Set/ Schedule: It is a combination of different quantities of goods for which the
consumer is indifferent, preferring none of any others.

Table.1.4. Indifference Schedule

Bundle (Combination) A B C D
Meat (X) 1 2 4 7

8
 Bread (Y) 10 6 3 1
Each combination of good X and Y gives the consumer equal level of total utility. Thus, the
individual is indifferent whether he consumes combination A, B, C or D.

Indifference Curves: 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 yields the same
utility (level of satisfaction) to the consumer, so that the consumer is indifferent as to the
particular combination he/she consumes. By transforming the above indifference schedule into
graphical representation, we get an indifference curve.

Indifference curve Indifference map

10 A
brea Go
Indiffer
d B od
ence
(Y) 6 B
C
2 IC3
D IC2
1
IC1

1 2 4 7 Good A
Meat
Fig2.4 indifference curves and indifference map.

Indifference Map: To describe a person’s preferences for all combinations bread and meat, we
can graph a set of indifference curves called an indifference map.

2.2.3. Properties of Indifference Curves:

Indifference curves have certain unique characteristics with which their foundation is based.

1. Indifference curves have negative slope (downward sloping to the right).This is because
the consumption level of one commodity can be increased only by reducing the
consumption level of the other commodity.
2. Indifference curves do not intersect each other. Intersection between two indifference
curves is inconsistent with the reflection of indifference curves. If they did, the point of
their intersection would mean two different levels of satisfaction, which is impossible.
3. A higher Indifference curve is always preferred to a lower one. The further away from
the origin an indifferent curve lies, the higher the level of utility it denotes: Baskets of

9
 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.
5. Indifference curves cannot intersect each other.
6. By transitivity, the consumer must also be indifferent between points.
2.2.4. The Marginal rate of substitution (MRS)
Definition: Marginal rate of substitution of X for Y is defined as the number of units of
commodity Y that must be given up in exchange for an extra unit of commodity of X so that the
consumer maintains the same level of satisfaction.

Number of units of Y given up

MRS X , Y =
Number of units of X gained

It is the negative of the slope of an indifference curve at any point of any two commodities such
as X and Y, and is given by the slope of the tangent at that point:

i.e., Slope of indifference curve

Δy
= MRS X , Y
Δx

The diminishing slope of the indifference curve means the willingness to substitute X for Y
diminishes as one move down the curve. MRS is negative. However, we multiply by negative

one and express

MRS X , Y as a positive value.

In the above case the consumer is willing to forgo 4 units of Banana to obtain 1 more unit of
Orange. Marginal Utility and Marginal rate of Substitution

ΔY 4
MRS X , Y (between po int s A and B= = =4 It is also possible to show the derivation of the
ΔX 1
MRS using MU concepts.

MU X
The
MRS X , Y is related to the MUx and the MUy is: MRS X , Y = MU Y

2.2.5. Special types of Indifference Curves

10
Convexity or down ward sloping is among the characteristics of indifference curve and this
shape of indifference curve is for most goods. In this situation, we assume that two commodities
such as x and y can substitute one another to a certain extent but are not perfect substitutes.

However, the shape of the indifference curve will be different if commodities have some other
unique relationship such as perfect substitution or complementary.

Here, are some of the ways in which indifference curves/maps might be used to reflect
preferences for three special cases.

I. Perfect substitutes: If two commodities are perfect substitutes (if they are essentially the
same), the indifference curve becomes a straight line with a negative slope. MRS for perfect
substitutes is constant. (Panel a)
IC3 Out IC1 IC2 IC3
IC2
RightIC1 dated
Total IC3 shoe books
IC
IC1

Mobil Left Food

Panel a Panel b Panel c

Fig.2.6 Special cases of indifference curves

II. Perfect complements: If two commodities are perfect complements the indifference curve
takes the shape of a right angle. Suppose that an individual prefers to consume left shoes (on the
horizontal axis) and right shoes on the vertical axis in pairs. Additional right or left shoes provide

no more utility for him/her. MRS for perfect complements is zero (both MRS XY and MRS YX is
the same, i.e. zero).

III. A useless good: Panel C in the above figure shows an individual’s indifference curve for
food (on the horizontal axis) and an out-dated book, a useless good, (on the vertical axis). Since
they are totally useless, increasing purchases of out-dated books does not increase utility. This
person enjoys a higher level of utility only by getting additional food consumption. For example,

the vertical indifference curve IC 2 shows that utility will be IC 2 as long as this person has some
units of food no matter how many out dated books he/she has.

2.3. The Budget Line or the Price line

Indifference curves only tell us about the consumer’s preferences for any two goods but they
cannot tell us which combinations of the two goods will be chosen or bought.

11
In reality, the consumer is constrained by his/her money income and prices of the two
commodities.
This constraint is often presented with the help of the budget line
The budget line is a line or graph indicating different combinations of two goods that a
consumer can buy with a given income at a given prices.
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 =P X X + P Y Y Where, PX=price of good X; PY=price of good Y;
X=quantity of good X; Y=quantity of good Y; M=consumer’s money income

Suppose for example a household with 30 Birr per day to spend on Meat (X) at 5 Birr each and

bread (Y) at 2 Birr each. That is P X =5 , PY =2 , M =30 birr .

Therefore, our budget line equation will be:

5 X +2 Y =30
Table 1.6 Alternative purchase possibilities of the two goods
Consumption Alternatives A B C D E F
Kgs of Meat (X) 0 1 2 3 4 6
Units of bread (Y) 15 12.5 10 7.5 5 0
Total Expenditure 30 30 30 30 30 30
 At alternative A, the consumer is using all of his /her income for good Y. Mathematically
it is the y-intercept (0, 15).
 And at alternative F, the consumer is spending all his income for good X.
mathematically; it is the x-intercept (6, 0). We may present the income constraint
graphically by the budget line whose equation is derived from the budget equation.
By rearranging the above equation we can derive the general equation of a budget line,

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

12
 PX
−
PY = slope of the budget line (the ratio of the prices of the two goods)

M/PY

B
Fig.1.7. Derivation of the Budget Line
A
 Pt A is attainable but not all of income is the consumer is exhaustively used.
 Pt B is unattainable within current
M/PXincome of the consumer.
Therefore, the budget line is the locus of combinations or bundle of goods that can be purchased if the
entire money income is spent.

2.3.1. Factors Affecting the Budget Line

Effects of changes in income

 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 for normal goods. The slope of
the budget line (the ratio of the two prices) does not change when income rises or falls.
Effects of Changes in Price of the commodities
Changes 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.

Let us now consider the effects of each price changes on the budget line

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

M/py A

Here Px ’<Px, hence M/Px<M/Px1

B B’ X M/Px M/Px '

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.

13
  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?
What would happen if price of Y rises, while the price of good X and money incme remaining
constant?
 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. Fig.2.13
Effect of a fall in price of Y on the budget line
 Since Py decreases, M/Py increases thereby the budget line shifts outward.
 On the other hand decline in Py and Px by the same amount result in the entire outward
shift of budget line in both axis without changing slope of the line and
 Rise in Py and Px by the same amount result in the entire inward shift of budget line in
both axis without changing slope of the line.

2.4. Optimum of the Consumer

A rational consumer seeks to maximize his utility or satisfaction by spending his or her income.
It maximizes the utility by trying to attain the highest possible indifference curve, given the
budget line. This occurs where an indifference curve is tangent to the budget line so that the

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

the indifference curve equals to the slope of the budget line MRS XY =P X / PY .
Graphically, the consumer optimum or equilibrium is depicted as follows:

Y
A
B
E
IC4
C IC3
IC2
D
IC1
X
14
Figure 1.14 Consumer equilibrium

 This equilibrium occurs at the point of tangency between the highest possible indifference
curve and the budget line. Put differently, equilibrium is established at the point where the
slope of the budget line is equal to the slope of the indifference curve.
 Mathematically, consumer optimum (equilibrium) is attained at the point where:
PX MU X MU Y MU X P X
MRS XY = , But we know = =.. . .. .. MU X P Y =MU Y P X .. . , =
PY PX PY MU Y PY

Question

A consumer consuming two commodities X and Y has the following utility function
U =XY +2 X .If the price of the two commodities are 4 and 2 respectively and his/her budget is
birr 60.

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

MRS X , Y
b) Find at optimum.

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

A. Changes In Income: Income Consumption Curve and the Engel Curve
In our previous discussion, we noted that an increase in the consumer’s income (all other things
held constant) results in an upward parallel shift of the budget line. This allows the consumer to
buy more of the two goods. And when the consumer’s income falls, ceteris paribus, the budget
line shifts downward, remaining parallel to the original one.
If we connect all of the points representing equilibrium market baskets corresponding to all
possible levels of money income, the resulting curve is called the Income consumption curve
(ICC) or Income expansion curve (IEC).
The Income Consumption Curve is a curve joining the points of consumer optimum
(equilibrium) as income changes (ceteris paribus). Or, it is the locus of consumer equilibrium
points resulting when only the consumer’s income varies.

C
o ICC
E3
m E2
E1
Commodity X

Inco I3 Engle Curve

me I2
I1
X1 X2 X3 Commodity X
15
 Figure 1.15 the income –consumption and
 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.
B. Changes in Price: Price Consumption Curve (PCC) and Individual Demand Curve
 Here, we hold money income constant and let price change to analyze the effect on
consumer behavior.
 The fall in the price of x will result in out ward shift of the budget line that makes the
consumer to buy more of good x.
 If we connect all the points representing equilibrium market baskets corresponding to each
price of good X we get a curve called price-consumption curve.
 The price-consumption curve is the locus of the utility-maximizing combinations of
products that result from variations in the price of one commodity when other product
prices, the money income and other factors are held constant.
 We can derive the demand curve of an individual for a commodity from the price
consumption curve. Below is an illustration of deriving the demand curve when price of

commodity X decreases from

Px 1 to Px 2 to Px 3 .

C
o
m PCC
m
o
Commodity
X
Px1
Pr
ic Px2
e Individual
of Px3 demand
Figure2.17 the PPC and derivation of the demand curve
X1 X2 X3 Commodity
2.4.1. Income and Substitution Effects X
o Let us Consider the case of a price-decline:

16
 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 commodityinduces 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).

I/py1 Note that:

X 1 X 3 =NE= Total (net)
I’/ effect
A B IC2
py1  
X 1 X 2 = SE=Substitution
C IC1


IE
x1 SE x2 x3 I’/px2 I/px2
NE

I
Px 1
Figure2.18 Income and Substitution effect for a normal good

Suppose initially the income of the consumer is I 1 , price of goodY is Py 1 , and Price of good X
I I
is Px 1 , we have the budget line with y-intercept Py 1 and X-intercept Px 1 . The consumer’s
equilibrium is point A that indicates the point of tangency between the budget line and

indifference curve IC 1 . As a result of a decrease in the price of X from Px 1 to Px 2 the budget line
I I
shifts outward with y-intercept Py 1 & X-Intercept Px 2 . The consumer’s new equilibrium will
be on point B.

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

17
 The total effect of the price change can be conceptually decomposed into the substitution
effect and income effect.
The Substitution Effect

 The substitution effect refers to the change in the quantity demanded of a commodity
resulting exclusively from a change in its price when the consumer’s real income is held
constant; thereby restricting the consumer’s reaction to the price change to a movement along
the original indifference curve.
 Now, imagine that we decrease the consumer’s income by an amount just sufficient to return
to the same level of satisfaction enjoyed before the price decline. Graphically, this is
accomplished by drawing a fictitious (imaginary) line of attainable combinations with a slope
Px 2
corresponding to new ratio of the product price Py 1 so that it is just tangent to the original

indifference curve IC 1
 The point of tangency is the imaginary point C (imaginary equilibrium). The movement from
point A to the imaginary intermediate equilibrium at point C, which shows increase in
consumption of X from X1 to X2 is the substitution effect.In other words, the effect of a
decrease in price encourages the consumer to increase consumption of X than Y.
The Income Effect

o The income effect may be defined as the change in the quantity demanded of a commodity
exclusively associated with a change in real income.
o In figure 2.18, letting the consumer’s real income rise from its imaginary level (defined by
the line of attainable combinations tangent to point C) back to its true level (defined by the
line of attainable combinations tangent to point B) gives the income effect. Thus, the
income effect is indicated by the movement from the imaginary equilibrium at point C to
the actual new equilibrium at point B, the increase in the quantity of X purchased from X 2
to X3 is the income effect.
o This movement does not involve any change in prices
When we look at both the substitution and income effects, the magnitude of the substitution
effect is greater than that of the income effect. The reason is that:

 Most goods have suitable substitutes and when the price of good falls, the quantity of the
good purchased is likely to increase very much as consumers substitute the now cheaper
good for others.

18
Spending only a small fraction of his /her income, i.e. with the consumers purchasing many
goods and spending only a small fraction of their income on any one good, the income effect of a
price change of any one good is likely to be small.

Usually, the income and substitution effects reinforce one another i.e. they operate in the same
direction. The substitution effect is always positive. i.e. if the price of a good X increases and
real income is held constant, there will always be a decrease in the consumption of good X, and
vise versa. However, the income effect in most cases, one would expect that increases in real
income would result in increases in consumption of a good. This is the case for so called Normal
goods.

In short in the case of normal goods, the income effect and the substitution effect operate in the
same direction –they reinforce each other. But not all goods are normal. Some goods are called
inferior goods. For an inferior good, a decrease in the price of the commodity causes the
consumer to buy more of it (the substitution effect), but at the same time the higher real income
of the consumer tends to cause him to reduce consumption of the commodity(the income effect).

We usually observe that the substitution effect still is the more powerful of the two; even though
the income effect works counter to the substitution effect, it does not override it. Hence, the
demand curve for inferior goods is still negatively sloped.

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

Y KEY:
X1X3= NE=Net effect

E3 X1X2= SE=Substitution
effect

X2 X3= IE=Income effect

E1 IC2
E2

X1 X3 X2 X
IE
NE

SE

IC1

19
Numerical Example

Suppose that the consumer has a demand function for good X is given by

X =20+ MP
X −2

Originally his income is $ 200 per month and the price of the good is 5$ per killogram.

200
20+ =28
Therefore,his demand for good X will be 52 per month.

Suppose that the price of the good falls to 4 per kilogram.Therefore,the new demand at the new
200
20+ =32 .5
price will be: 42 per month.

Thus,the total change in demand is 4.5 that is 32.5-28.

When the price falls the purchasing power of the consumer changes.Hence,in order to make the
original consumption of good X,the consumer adjusts his income.This can be calculated as
follows:

M 1 =P '1 X +P y Y
M=P1 X+P y Y

Subtracting the second equation from the first gives:-

M 1 −M=X [ P'1−P 1 ]
ΔM =XΔP 1

Therefore, new income to make the original consumption affordable when price falls to 4 is:
ΔM =XΔP 1
ΔM =28∗[ 4−5 ]=−28

Hence,the level of income necessary to keep purchasing power constant is

M 1 =M + ΔM=200−28=172

The consumers new demand at the new price and income will be :

172
X ( 4 , 172)=20+ =30 . 75
42

Therfore,the substitution efffect will be:

ΔX = X (4 , 172 )−X (5 , 200 )=30 .75−28=2 . 75

The income effect will be:

20
 X ( 4 , 200 )−X ( 4 , 172)=32 . 5=30 . 75=1 .75

Since the result We obtained is positive we can conclude that the good is a normal good.

CHAPTER TWO: THEORY OF PRODUCTION

2.1. Introduction
What is Production?
Production is the process of transforming inputs into outputs. Production is the process of
converting economic resources (inputs) into consumable forms (goods and services).
What is Production Function?
It describes the relationship between the amount of inputs and the amount of output that can be
obtained.
2.2. Technological Relationship between Inputs and Output
It can be given as Q = f (labor, capital, natural resource, etc.)
Inputs are resources (raw materials or factors of production) used in the process of production.
 Land. The economy’s NRs such as land, trees, and minerals.
 Labor. The mental and physical skills of individuals
 Capital. Goods-such as tools, machines, and factories-used in production.
 Entrepreneurship- is special talents of human being that helps to organize and manage
other factors of production like land, labor and capital.
 Q=f(L, K,…) , where L and K are the amount of labor and capital, respectively.
2.3. Classification and Production Periods of the Variables
Inputs can be broadly divided into two: Fixed and variables inputs

Fixed inputs are inputs whose quantity cannot be easily varied over a short period of time to change
the level of output. Land, building, heavy machines, etc.. are examples of fixed inputs.

Variable inputs are inputs that can be varied easily according to the desired level of output.

21
 – E.g. Labour, raw material, etc…
Economists identify two periods of productions:

The short run: Is a period of time during which firms or producers can adjust production by
changing only variable factors but cannot change fixed factors.

The long run: Refers to a period of time, which is long enough to allow changes in the level of all
inputs. In the long run all inputs are variable and there are no fixed inputs.

2.4. Theory of Short Run Production

Short run production theory tells us the relation between inputs and output when at least one input
is fixed. This relation can be shown by the concepts of Total, Marginal and Average Products.
Assume we have the following a short run production: Q = F(K, L) Labor is the only variable input
and K is fixed at some level.

Suppose that the production of maize require land, fertilizer, water machinery, etc.--, all fixed at
certain quantities. The only input the producer can adjust is labor. Thus, labor is the only variable
input. If labor input (measured in, say, worker/days) is 0, the output of maize is, off course 0.

As we increases the variable input (labor input), the producer will increases the output of maize.
But, a point will come where increasing labor will not increase the output of wheat at all and, in
fact, might even decrease it.

2.1.1. Production with a single variable input (Labor)

Total Product (TP) is the total amount of efficiently utilizing specific and fixed input. The total
amount of output that can be produced by utilizing different quantities of L and fixed is K.

Generally, the short run TP function follows a certain trend: It initially increases at an increasing
rate, then increases at a decreasing rate, reaches a maximum point and eventually falls as the
quantity of the variable input rises. This tells us what shape a total product curve assumes.

22
Figure 2.1: Shape of the total product

Marginal Product (MP)

 It is the change in output attributed to the addition of one unit of the variable input to the
production process, other inputs being constant.

 or MP = dTP/dQ for functional form

 or MP = dTP/dQL for functional form. In other words, MPL measures the

slope curve of the total product at a given point.
In the short run, the marginal product of the variable input first increases, reaches its maximum
and then decreases to extent of being negative.

Average Product (MP)

Average product of an input is the level of output that each unit of input produces, on the
average. It tells us the mean contribution of each variable input to the total product.

Mathematically, it is the ratio of total output to the number of variable input.

If MP is positive then TP is increasing. If MP is negative then TP is decreasing.TP reaches a

maximum when MP=0 If MP > AP then AP is rising. If MP < AP then AP is falling. When either
MP=AP or slope of AP is zero, AP will be maximum. MP reaches maximum if slope of MP is
zero. I.e. dMP/dQL = 0.

2.4.2. Stages of Production

Based on MP behaviour, there are three stages of production:

Stage 1: Positive Marginal Returns: This stage of production covers the range of variable
input levels over which the average product (APL) continues to increase.

It goes from the origin to the point where the APL is maximum (where MPL=APL). This stage is
not an efficient region of production though the MP of variable input is positive.

23
The reason is that the variable input (the number of workers) is too small to efficiently run the
fixed input so that the fixed input is under-utilized (not efficiently utilized).

Stage 2: Diminishing Marginal Returns: Throughout this stage the average product (APL)
decreases Ranges over point where the APL is maximum until MPL is zero. MPL is decreasing
due to the scarcity of the fixed factor. That is, once the optimum capital-labour combination is
achieved, employment of additional unit of the variable input will cause the output to increase at
slower rate, thus, MP diminishes. This stage is efficient region of production. Additional inputs
contributing to TP and optimum utilization of fixed input in the production. Hence, an efficient
region of production is where the marginal product of the variable input is declining but positive.

Stage 3: Negative Marginal Returns: Throughout this stage MPL is negative; aTPL is
decreasing. The volume of the variable inputs is quite excessive relative to the fixed input;

 The fixed input is over-utilized and a rational firm should not operate in stage III.
2.4.3. The Law of Variable Proportion
The law states that the contribution of successive units of a variable input (labour) to total output
is eventually diminishing in the short run.

2.5. The Long-Run Production Function

In the long run, a firm has enough time to change the amount of all its inputs. All inputs are
variable.The long run production process is described by the concept of returns to scale.
Isoquants show combinations of two inputs that can produce the same level of output.

Prosperities of isoquants

Isoquants have the same properties as indifference curves.

1. Isoquants slope down ward. Because isoquants denote efficient combination of inputs
that yield the same output, isoquants always have negative slope.
2. The further an isoquant lays away from the origin, the greater the level of output it
denotes. Higher isoquants (isoquants further from the origin) denote higher combination
of inputs and outputs.
3. Isoquants do not cross each other. This is because such intersections are inconsistent
with the definition of isoquants.
4. Standard isoquant curves are convex to the origin….due to diminishing marginal rate
of technical substitution

24
 5. Isoquants must be thin. If isoquants are thick, some points on the isoquant will become
inefficient.
Isoquants can have different shapes (curvature) depending on the degree to which inputs can
substitute each other.

1-Linear isoquants

• Isoquants would be linear when labor and capital are perfect substitutes for each other.
• This case the slope of an isoquant is constant.
• As a result, the same output can be produced with only capital or only labor or an infinite
combination of both.
2. Input-output isoquants

• The isoquants are L-shaped. It is also called Leontief isoquant.

• This assumes strict complementarities or zero substitutability of factors of production.
• In this case, it is impossible to make any substitution among inputs.
• Each level of output requires a specific combination of labor and capital.
3. Kinked isoquants

• This assumes limited substitution between inputs. Inputs can substitute each other only at
some points.
• The isoquant is kinked and there are only a few alternative combinations of inputs to
produce a given level of output.
• These isoquants are also called linear programming isoquants or activity analysis
isoquants.
Isocost lines represent all combinations of two inputs that a firm can purchase with the same
total cost.

C wL  rK Where, C is total cost; w is wage rate of labour; r is cost of capital.

C w
K   L
r r

25
Equilibrium is attained at MRTSLK = w/r, where the tangency point of isocost line and isoquant
curve. MRTSLK(slope of isoquant curve) = MPL/MPK; w/r(slope of isocost line).

The production function that generates linear Exp. Path keeping input price constant is called
Homothetic production function

2.5.1 Returns to Scale

• Constant returns to scale – a situation in which a proportional increase in all inputs
increases output in the same proportion
• Increasing returns to scale – a situation in which output increases in greater proportion
than input used.
• Decreasing returns to scale – a situation in which output increases less than
proportionally to input used.
If all inputs into the production process are doubled, three things can happen:

– output can more than double: increasing returns to scale (IRTS)

– output can exactly double: constant returns to scale (CRTS)
– output can less than double: decreasing returns to scale (DRTS)
Economists hypothesize that a firm’s long run production function may exhibit at first increasing
returns, then constant returns, and finally decreasing returns to scale.

CHAPTER THREE: THEORY OF COSTS

3.1. Cost Analysis
What are Costs?

To produce goods and services, firms need factors of production or simply inputs.

These factors of production are owned by households. To acquire inputs, they have to buy them
from resource suppliers. Cost is, therefore, the monetary value of inputs used in the production
of an item.

The cost of production is the sum of all payments made to the suppliers of inputs. Inputs could
be supplied by the owner of the business or owners of inputs. It can be classified in to explicit
and implicit costs.

Explicit (accounting) cost refers to actual expenditure/out of pocket expenditure/monetary

payment by the firm to outsiders for those who supply factors of production.

Example: These are wage of workers, ccost of power (electricity and fuel), cost of raw materials,
and ect.

26
Implicit cost refers to the value of inputs owned by the firm and used by the firm in its own
production process.

Example: The owner can be the manager of the firm or the owner can use his/her own building
as a production place. Since these inputs are used for the purpose of producing the item, their
value has to be estimated. If a teacher quits his job and becomes the manager of his/her own
small farm.

Hence, economic cost is the summation of explicit and implicit costs.

 Accounting profit is total revenue minus explicit cost and economic profit is total
revenue minus economic cost (explicit + implicit cost)
 Normal profit is the minimum payment required to retain an entrepreneur in the
business.
 i.e. a firm is said to be earning normal profit, when its economic profit is zero. That
means, E∏ = TR- (ExC+ImC) 0= TR- ExC- ImC, since E∏ = 0, 0=A∏ - EC, since TR-
ExC = A∏ (accounting profit) A∏ = EC
 Thus, when the firm earns normal profit accounting profit is equal to (A∏) = explicit
cost (ExC)

3.2. Short-run Cost Functions

Total, Marginal, and Average Costs

In the short-run we have two types of inputs: fixed & variable inputs. So in the short run, there
are total fixed costs, total variable costs and total costs.

Total costs (TC) are equal to the sum of total fixed costs and total variable costs, i.e.
TC=TFC+TVC

Total fixed costs (TFC) are the costs that the firm incurs in the short run for its fixed inputs;
these are constant regardless of the level of output and of whether it produces or not. An
example of TFC is the rent that a producer must pay for the factory building over the life of a
lease.

Total Variable costs (TVC) are costs incurred by the firm for the variable inputs it uses.
Examples of TVC are raw material costs and some labor costs.

Average fixed cost (AFC) equals total fixed costs divided by output

27
  Average variable cost (AVC) equals total variable costs divided by output
 Average cost (AC) equals total costs divided by output
 AC also equals AFC plus AVC
 Average total cost tells us the cost of a typical unit of output if total cost is divided evenly
over all the units produced.
Marginal cost (MC) equals the change in TC or the change in TVC per unit change in output

 Marginal cost tells us the increase in total cost that arises from producing an additional
unit of output.
Table 3.1 Total, Marginal and Average Costs in the Short-run
Output Q TFC TVC TC AFC AVC ATC MC
0 200 0 200 - - - -
1 200 50 250 200 50 250 50
2 200 90 290 100 45 145 40
3 200 120 320 66.7 40 106.7 30
4 200 140 340 50 35 85 20
5 200 150 350 40 30 70 10
6 200 156 356 33.3 26 59.6 6
7 200 175 375 28.6 25 53.6 19
8 200 208 408 25 26 51 33
9 200 270 470 22.2 30 52.2 62
10 200 350 550 20.0 35 55 80

When MC is below AC, AC will decline, when MC is above AC, the latter (AC) is rising, and
when MC is equal to AC, the latter will reach its minimum point.

The above relationship holds true for MC and AVC, i.e. when MC is below AVC, AVC will
decline, when MC is above AVC, the latter (AVC) is rising and when MC is equal to AVC, the
latter (AVC) will reach its minimum point.

AFC falls continuously because a constant total fixed cost is divided by increasing outputs.

But the AC, AVC and MC curves are U- shaped.

The MC curve reaches its lowest point at a lower level of output than either the AVC curve or the
AC curve. The rising portion of the MC curve intersects the AVC and AC curves at their
minimum point.

The Relationship between production and costs

 Unit products and unit cost curves are mirror images of each other, i.e. For instance,
consider the relationship between AP and AC. When AP is rising AC is falling; when
AP is falling AC is rising; and when AP is maximum AC is minimum

28
  To illustrate this relation, assume a variable input labor (L) which commands a wage rate
w, TVC = w*L AVC = TVC/Q= w*L/Q = w/Q/L=w/APL
4.3 Long-run costs
The long-run is a period of time of such length that all inputs are variable.

If a production technology is characterized by constant return to scale (CRS), doubling output

requires doubling of input, which implies doubling of total output (cost) for given factor prices.

The long-run total cost curve in this case is a straight line through the origin. This implies that
the long-run average and marginal costs are horizontal lines and equal (LAC = LMC).

If we consider the case where total cost first increase at a decreasing rate due to increasing
returns to scale (which implies economies of scale).

Then at an increasing rate attributed to decreasing returns to scale after the optimum size, the
long-run total cost curve will not look like CRS total cost line.

The LAC and LMC curves will be U-shaped. In the long-run, the source of the U-shape is
increasing and decreasing returns to scale.

When the LAC is falling, then LMC < LAC. When LAC is rising, LMC > LAC. The two curves
intersect at a point where the LAC curve achieves its minimum.

When LRAC is declining we say that the firm is experiencing economies of scale. Implies per-
unit costs are falling. When LRAC is increasing we say that the firm is experiencing
diseconomies of scale. Per-unit costs are rising.

CHAPTER FOUR: PRICE AND OUT PUT DETERMNATION UNDER PERFECT

COMPETTION
The structure of a market is identified by referring to variables like, Number of seller and buyer,
Freedom of entry and exit out of the market; Control over price; Type of the product traded and
etc.

29
4.1. Perfectly Competitive market structure
Assumptions (A market is said to be PC, if the following assumptions hold true)

 Large number of sellers and buyers. Therefore, the action of a single seller or buyer
cannot influence the market price of the commodity, since the firm or (the buyer) is too
small in relation to the market.
 Products of the firms are homogeneous: uniform in terms of quantity, quality and the
services associated with sales and delivery are identical. i.e., products are perfect
substitutes for one another.
 Free entry and exit of firms
 The goal of all firms is profit maximization
 No government regulation: there are any discriminator taxes or subsidies, no allocation
of inputs by the procurement, or any kind of direct or indirect control.
 Perfect knowledge about market conditions: all sellers and buyers have a complete
knowledge: The price of the product, quality of the product, etc
Cost, Demand and Revenue functions under perfect competition

 AVC & AC have U –shape due to the law of variable proportions (in the short run)
and the law of returns to scale (in the long run).
 Under PC market structure large number of sellers selling homogenous products and each
seller is a price taker.
 If the seller charges higher price than the market price to get larger revenue, no buyers
will buy the product.
 Thus, firms operating in a PC market sell any quantity demanded at the ongoing market
price and buyers buy any amount they want at the ongoing market price.
Hence, the demand function that an individual seller faces is perfectly elastic (horizontal line).

Total revenue of a firm operating under PC is given by the product of the market price and the
quantity of sales, i.e., TR = P*Q

30
 Since the market price is constant at P*, the total revenue function is linear and the amount of TR
depends on the quantity of sales.

MR and AR are equal under perfectly competitive market since price is constant.

MR = dTR/dQ= d(PQ)/dQ = P*dQ/dQ = P; AR= TR/Q = P*Q/Q = P

Hence, for firm operating under PC market, P = MR = AR

4.2. Short run equilibrium of the firm

Under PC, the firm is said to be in equilibrium when it produces that level of output which
maximizes its profit, given the market price.

Short run equilibrium of the firm can be obtained in two ways:

Ì Total approach

Ì Marginal approach

1. Total Approach

 The profit maximizing level of output is that level of output at which the vertical distance
between the TR and TC curves are maxima. (Provided that the TR curve lies above the
TC curve at this point).
 The profit maximizing output level is Qe because it is at this output level that the vertical
distance between the TR and TC curves (or profit) is maximum.
2. Marginal Approach

The profit maximizing level of output is that level of output at which: MR=MC and given MC is
increasing (slope of MC is positive).This approach is directly derived from the total approach.

 The slope of the TR curve constant and is equal to the MR or market price and the slope
of the TC is equal to MC.
 The distance between the TR and TC curves (Õ) is maximum when MR equals MC.
In the short run, A PCM firm might be in one of the following three cases:

Case 1: Making Profit

If the ATC is below the market price at equilibrium, the firm earns a positive profit equal to the
area between the ATC curve and the price line up to the profit maximizing output. The firm earns a
positive profit because price exceeds AC of production at equilibrium. MC
AC

Case 2: Zero Profits

Costs
Revenue

31 MR=AR
 If the ATC is equal to the market price

at equilibrium, the firm gets zero.

The firm is making zero profits because

at the equilibrium level of output (Qe),

Average Cost is exactly equal to Average Revenue or Price.

Case 3: Making Loss

If the ATC is above the market price at equilibrium, the firm earns a negative profit (incurs a loss)
equal to the area between the ATC curve and the price line. In this case, you may ask that “why do
the firm continue to produce if it had to incur a loss?” In fact, the firm will continue to produce
irrespective of the existing loss as far as the price is sufficient to cover the average variable costs.

The short run supply curve of the firm and the industry

The word ’industry’ is defined as group of firms producing homogeneous products. Thus the
industry supply is the total supply or market supply.

The industry –supply curve is the horizontal summation of the supply curves of the individual
firms. The industry supply curve is obtained by adding the quantities supplied by all the firms
at each price. For example, at price which equals $ 6, firm 1 supplies 50 units, firm 2 supplies 80
units & firm 3 supplies 120 units. The market supply at $ 6 price is thus 250 units (50+80+120
units).

The short run industry- supply is derived by repeating the above process at each price levels.

4.3. The long-run Equilibrium

In the long run, firms are in equilibrium when they have adjusted their plant size so as to produce
at the minimum point of their long run AC curve, which is tangent to the demand curve defined
by the market price.

That is, the firm is in the long run equilibrium when the market price is equal to the minimum
long run AC.

First, if the firms existing in the market are making excess profits (the market price is greater
than their LACs) new firms will be attracted to the industry seeking for this excess profit. He
entry of new firms results in two consequences:

A. The entry of new firms will lead to a fall in market price of the commodity.

32
B. Moreover, the entry of new firms’ results in an upward shift of the cost curves due to the
increase of prices of factors as the industry expends.

Second, if the firms are incurring losses in the long run (P < LAC) they will leave the industry
(shut down).

Thus, due to the above two reasons, firms can make only a normal profit in the long run.

The condition for the long run equilibrium of the firm is that the long run marginal cost (LMC)
should be equal to the price and to the LAC i.e. LMC = LAC = P.

In the short-run the firm should continue production as far as the market price is greater than the
minimum AVC, If the market price falls below the minimum AVC, the firm is well advised to
shut down.

In long run the firm should shut down if its revenue is less than its avoidable or a variable cost

An industry is in the long-run equilibrium when the price is reached at which all firms are in
equilibrium. That is, when all firms are producing at the minimum point of their LAC curve and
making just normal profits, the industry is said to be in the long-run equilibrium.

Under these conditions there is no further entry or exit of firms in the industry (since all the firms
are getting only normal profit), so that the industry supply remains stable.

THE END!

33