Chapter one: Theory of Consumer Behaviour and demand

0. Introduction
A consumer is an individual or a household who uses/consumes final goods and services with a primary
objective of maximizing utility. The theory of consumer behavior is a description of how consumers
allocate income among different goods and services to maximize their well-being. It answers the
question: “How can a consumer with a limited income decide which goods and services to buy with the
objective of maximizing their utility?” It deals with how consumers allocate their income across various
goods and services and explain how these allocation decisions determine the demands for the various
goods and services.
The analysis of the demand side and the supply side of the market involve the study of the behaviors of
households (demanders of final goods and services in the product market) and firms (suppliers of final
goods and services in the product market). Thus, therational for studying the theory of consumer behavior
is the fact that it is the basis for the theory of demand. This is because the market demand is assumed to
be the horizontal summation of the demand of the individual consumers. That means, we first analyze the
behavior of a consumer to determine the individual demand, and then stepping on the demand of an
individual consumer we will develop the market demand.
1. Consumer Preferences and Choices
1.1. Consumer Preference
Preferences: Always people choose the best bundle of goods they can afford. The budget line tells us
what the consumer can afford while consumer’s preference tells us the best things they prefer.
Consumer’s preference: We describe consumers’ preferences depending on how consumers compare
and rank alternative consumption bundles. Suppose that given any two consumption bundles, (X1,X2) and
(Y1,Y2) denoted by X and Y respectively, the consumer can rank them as to their desirability i.e. the
consumer can determine that one of the consumption bundles is strictly better than the other, or decide
that he/she is indifferent between the two bundles.
(X1,X2) > (Y1,Y2) - the consumer strictly prefers bundle X to Y.
(X1,X2) ~ (Y1,Y2) - the consumer is indifferent between the two bundles of goods. (Each bundle gives
him/her the same level of satisfaction)
(X1,X2)  (Y1,Y2) - the consumer weakly prefers bundle X to Y. (The consumer prefers or is indifferent
between the two) which means bundle X is at least as good as bundle Y.
N.B. If (X1,X2)  (Y1,Y2) and (Y1,Y2)  (X1,X2), the conclusion will be (X1,X2) ~ (Y1,Y2).
Assumptions about Preferences
There are certain axioms that are taken fore granted regarding the consistency of consumer’s preferences.
They are called axioms of consumer’s theory. These are:-
1. Completeness – consumer’s preferences are complete in a sense that a consumer can compare and rank
all the consumption possibilities. Given consumption bundles X and Y, the consumer will either prefer A
to B, or B to A, or will be indifferent between A and B.
2. Transitivity of Preference – Given three bundles, X, Y and Z; if a consumer Prefers X to Y and Y to Z,
then the consumer prefers X to Z.
If (X1,X2)  (Y1,Y2) & (Y1,Y2)  (Z1,Z2) then (X1,X2)  (Z1,Z2)
If (X1,X2) >(Y1,Y2) & (Y1,Y2) >(Z1,Z2) then (X1,X2) >(Z1,Z2)
If (X1,X2) ~(Y1,Y2) & (Y1,Y2) ~(Z1,Z2) then (X1,X2) ~(Z1,Z2)
3. Reflexivity of Preference – Any bundle is at least as good as itself, (X1, X2)  (X1, X2). This implies
that the consumer is indifferent between identical bundles => (X1, X2) ~ (X1, X2).

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4. More is better than less (Non satiation): Goods are assumed to be desirable – i.e., to be good.
Consequently, consumers always prefer more of any good to less. In addition, consumers are never
satisfied or satiated; more is always better, even if just a little better. This assumption is made for
academic reasons; namely, it simplifies the graphical analysis. Of course, some goods such as air
pollution may be undesirable, and consumers will always prefer less.
1.2. Utility
Why does a person demand a certain commodity? An obvious reason is that the commodity is expected to
satisfy some need or desire of the consumer. Economists call the satisfaction from consumption of
commodities utility.
Utility is the satisfaction or pleasure that a consumer can/will derive from consuming goods and services.
It is psychological phenomena: it is feeling of satisfaction, pleasure, happiness or well-being which
consumer drives from consumption of commodity. A rational consumer build-up a demand for a
product- or will have willingness and ability to purchase a given product expecting a satisfaction as a
reward. To analyze the behavior of consumers we need to make an important assumption that each
consumer has exact and full (perfect) knowledge of all information relevant to his consumption decisions.
Consumers are generally assumed to be rational and hence, as an objective, seek to maximize their
satisfaction or utility from the consumption of goods and services for given money income. The complete
list of these goods and services is called consumption bundle. To achieve the maximization of their
objective, consumers, then, must be able to compare different consumption bundles according to their
desirability. Utility has property: It is Subjective, it does not mean necessary usefulness, it is relative
across time, place and form, it is independent of morality.
Economist’s different view on whether utility is measurable in absolute terms. The classical and neo-
classical economists held the view that utility is cardinally or quantitatively measurable. It can be
measured in cardinal numbers like weight, height, length, etc. Modern economists on the other hand, hold
the view that utility is not cardinally measurable. It can be measured only in ordinal terms i.e less than or
more than.
2. Revision on Approaches to measure Utility
2.1. The Cardinal Utility approach
A utility approach that describes by how much one market basket is preferred to another is called cardinal
utility analysis. It believes that the utility is cardinally or quantitatively measurable. In this regards, a neo-
classical economist, Walres, coined the term ‘util’ meaning unit of utility and used money as the measure
of utility with the following assumptions. Utility of commodity equals the money of consumer
willingness to pay for it. Marginal utility of money remains constant. One util; one unit of money.

2.1.1. Assumptions of Cardinal Utility theory

1. Rationality: the consumer is rational. He/she aims at the maximization of his/her utility subject to
the constraint imposed by his/her given income. Total utility being the function of the quantity of
goods consumed, a consumer would wish to have more of everything. Yet his/her desire is
constrained by his/her limited income. This brings forth the need to prioritize consumption bundles
according to their desirability.
2. Utility is cardinally measurable: the utility derived from each commodity is measurable in absolute
terms. The most convenient measure is money: the monetary units that a consumer is prepared to
pay for a unit of the commodity measure utility.
3. Constant marginal utility of money: while the marginal utility analysis assumes the marginal utility
of a commodity diminishes as more of them are purchased or consumed. But the marginal utility of
money remains throughout when the individual is spending money on a good and due to which the
amount of with him varies. Measurement of marginal utility of money itself remains constant. If the

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 marginal utility of money changes with the level of income (wealth) of the consumer, then money
cannot be considered as a measuring rod of utility.
4. Diminishing marginal utility: the extra satisfaction gained from successive units of a commodity
consumed decreases as a consumer consumes more and more units of it. In other words, the
marginal utility of a commodity diminishes as the consumer acquires larger quantities of it.
Utility is additive: The total utility of a ‘basket of goods’ depends on the quantities of the individual
5.
commodities. If there are n commodities in the bundle with quantities X 1 , X 2 ,..., X n the total
utility is U  f ( X 1 , X 2 ,..., X n ) This assumption implies that as the quantity of goods consumed
.
increases the total utility of the consumer accordingly increases.
Maximization of satisfaction: every rational consumer intends to maximize his/her satisfaction from
6.
given money of income.
2.1.2. Total and Marginal Utility
Total utility (TU): is the total amount of utility that consumers receive from consumption of commodities.
It is given as the sum of the utilities obtained from consumption of each unit of the commodity consumed.
TU=U(X1 )+U(X2 )-----+U(Xn) ………………………………………………………………[1]
Total utility changes as the quantity of the commodity consumed changes. The change in total utility for a
one unit change in the quantity of the commodity consumed is referred to as marginal utility.
Marginal utility (MU): is the amount of satisfaction drives from consuming an additional unit of
commodities. The formula for marginal utility (MU)
Change in total utility U  U n 1
MU   n
Change in quantity consumed Qn  Qn 1
. .………………………….…………[2]
Where, Un is the total utility from consumption of n units of a good, while Un-1 is the total utility from
consuming n-1 units of the good. Un – Un-1, therefore, measures the extra satisfaction from consuming
dU
the nth unit or Mathematically, MU is given as: MU  , where dU (derivative of utility) is change in
dQ
total utility and dQ is change in the quantity of the commodity.
2.1.3. Law of diminishing marginal Utility (LDMU)
The law of diminishing marginal utility states that for a given time period, the greater the level of
consumption of a particular commodity, the lower the marginal utility, holding constant the consumption
of all other goods. It is the center for cardinal utility analysis of consumer behavior
Table 1: Utility Schedule for Coca Cola
Quantity of Coca Cola Total Utility Marginal Utility
0 0 –
1 20 20
2 38 18
3 54 16
4 67 13
5 77 10
6 84 7
7 88 4
8 88 0
9 87 -2
10 82 -5
When one bottle of coca is taken per day, the total utility derived by a person is 20 utile. Since it is the
first bottle of coca, its marginal utility is also 20 utile. With the consumption of the second bottle the total

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utility is raised to 38, but marginal utility falls to 18, it can be seen from the table TU increase at a
decreasing rate. However, when a bottle of coca consumed per day increase the ninth bottle gives
negative marginal utility equals to -2. This is because too many bottle of coca may cause acidity or gas
trouble. Thus, the extra bottle of coca beyond eight, to the individual in question gives him disutility
rather than satisfaction.

The law of diminishing marginal utility is graphically illustrated in figure 1. The total utility and marginal
utility curves have been obtained by plotting the data given in Table 1. Marginal utility is zero when total
utility reaches its maximum. The additional utility (marginal utility) from the consumption of the 8th
bottles of Coca Cola is zero. Total utility, accordingly, reaches its maximum at the 8th bottle of Coca
Cola. To the left of this point marginal utility is positive and total utility rises. To the right of this point
marginal utility is negative and total utility falls.

Figure 1: Total and Marginal Utility

Relationship between total and marginal utility

 As MU decreasing but positive, TU

increasing at decreasing rate
 As MU=0, TU reach at maximum
 As MU negative, TU starts to decline

2.1.4. Equilibrium of a consumer

Consumer equilibrium is explained by the principle of equi-marginal utility. The law of equi-marginal
utility state that the consumer will distribute his money income between the goods in such a way that the
utility derived from the last birr spent on each good is the same. This indicates how a consumer allocates
his money income among various goods, i.e. his equilibrium position. A consumer consuming only one
commodity say, X, given his income level (I) will be at equilibrium level of consumption when:
𝐌𝐔𝐱 = 𝐏𝐱………………………………………………………………………………………………[3]
Where: MUx = marginal utility of good X
Px =Price of good X
 If MUx > 𝑃𝑥 the consumer can increase his welfare (utility) by purchasing more of good X.
 If MUx < 𝑃𝑥 the consumer can increase his welfare by decreasing consumption of good X. That is
he will be better off if he reduces his purchase of good X. Thus, the consumer will be at equilibrium
or attains maximum satisfaction when the additional satisfaction obtained from a good is equal to the
price of the good, and if all of his income is spent for consumption of the good.
Suppose there are two goods X and Y on which a consumer has to spend a given income. In this case, the
consumer’s behavior will be governed by two factors; first the marginal utility of the good; second the
price of the two goods. Suppose also that the prices of the two goods are given for the consumer. The law

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of equi- marginal utility states the consumer will distribute his money income between the goods in such
a way that the utility derived from the last birr spent on each good is the same. The law of equi-marginal
utility can therefore be stated thus the consumer will spend his money income on different goods in such a
way that marginal utility of money expenditure of each good is equal. That is, consumer is in equilibrium
in respect of the purchases of two goods X and Y when;
𝐌𝐔𝐱 𝐌𝐔𝐲
𝐏𝐱
= 𝐏𝐲 Subject to Px X+ PyY= I ………………………………………………………..……………[4]
Generally, extending this for many commodity cases if consumer consumes “n” number of goods: thus
the condition of maximization of satisfaction or optimum level of the consumer will be:
𝐌𝐔𝐱 𝐌𝐔𝐲 𝐌𝐔𝐧
𝐏𝐱
= 𝐏𝐲 = ⋯ … … … … … … … … … . … … … … . 𝐏𝐧 and His or her income allocated for consumption is
exhausted, i.e. PxX+Py….……………….+PnN=I………………………………………..……………[5]
The principle of consumer’s equilibrium stated that a consumer gets the maximum total utility if he
allocates his/her income in such a way that the last Birr spent on each good yield equal marginal utility. A
rational and utility maximizing consumer consumes commodities according to their order of utilities.
He/she switches his/her expenditure from one good to another according to their marginal utility. He/she
continues to switch until he/she reaches the stage where marginal utility of each commodity per unit of
expenditure is the same.
Example: Suppose now the consumer faces two commodities in his utility function, Pepsi and Pizza. The
price of coca cola is Birr 2 a unit and that of Pizza is Birr 3 a unit. Suppose a consumer has birr 28 worth
of purchasing power. The utility schedule of the consumer is given below (See Table 2). Then, the
questions is how the consumer allocate birr 28 for the two goods so as to achieve the maximum utility.
Table 2: Utility Schedule for Two Commodities
Coca cola Pizza
Q TU MU MU/P (P = 2) Q TU MU MU/P (P = 3)
1 32 32 16 1 45 45 15
2 58 26 13 2 87 42 14
3 78 20 10 3 120 33 11
4 92 14 7 4 147 27 9
5 100 8 4 5 165 18 6
6 102 2 1 6 177 12 4
7 98 -4 -2 7 183 6 2
8 90 -8 -4 8 183 0 0
The consumer spends her income of Birr 28 on the two goods, coca and pizza. To spend her income,
he/she has to compare the MUcoca per Birr, (MUcoca/Pcoca) with that of pizza, (MUpizza/Ppizza).
He/she first buys that good which gives higher MU per Birr. Accordingly, the consumer first buys a unit
of coca, because the first unit of coca yields 16 units of satisfaction per Birr.
The next commodity purchased would be pizza, because it yields 15 units of satisfaction compared with
the 13 units for coca. The third commodity purchased will be pizza, because it yields higher satisfaction
per Birr than the second unit of coca. This process continues until the income of Birr 28 is spent. In
maximizing utility, the consumer will buy 5 units of coca (spends Birr 10 on coca) and 6 units of pizza
(spends Birr 18 on pizza).
This allocation gives a total of 277 units of satisfaction–the maximum utility that can be obtained for an
expenditure of Birr 28. Given his/her fixed income and the price level of the two goods, no combination
of the two goods will give higher TU than this level of utility.
At this level of allocation the marginal utility per Birr is equal for the two commodities. If there is any
difference in the MU/P, the consumer can increase its welfare (total utility) by consuming more of the
commodity that gives him/her more MU/P, and consuming less of the commodity that gives him/her less
MU/P. This condition can be defined in algebraic form as:

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 MU Pepsi MU pizza 8 12
   44
PPepsi Ppizza 2 3
2.1.5. Derivation of the Cardinalist Demand
If the marginal utility is measured in monetary units the demand curve for commodity X is identical to the
positive segment of the marginal utility curve since marginal utility of the commodity is equal to price
of the commodity (MUx = Px). As depicted in Figure 2a below, at quantity level X1 the marginal utility
is MU1 which is equal to the price level P1 by definition. Hence, at the price level P1 the consumer
demands X1 units of he commodity (Figure 2b). Similarly, at X2 the marginal utility of the commodity is
MU2, which is equal to P2. Hence, at P2 the consumer will buy X2 units of the commodity, and so on.
Thus, we can observe that Figure 2b shows the demand curve which is derived from the marginal utility
function of a commodity (Figure 2a)

Figure 2a: Marginal Utility of X

Figure 2b: Demand Curve for
X

NB. The negative section of the MUx curve does not form part of the demand curve since negative prices
do not make sense in economics.
Weaknesses of cardinal utility approach:
The assumption of cardinal (measurable) utility is doubtful. The satisfaction derived from the
consumption of various commodities cannot be objectively measured.
The assumption of constant marginal utility of money is also unrealistic. The utility derived from
a unit of money varies with the level of income of the consumer. MU of a unit of money for a
poor person is by far higher than the MU of a rich person. Thus, money cannot be used as a
measuring rod since its own utility changes.
2.2. The Ordinal Utility Approach
Ordinalists hold the view that utility is not cardinally measurable due to it is psychological feeling. It can
be measured only in ordinal terms such that less than or more than and give rank or order the utility he
derives from different goods. The ordinal utility implies that the consumer is capable of simply comparing
the different level of satisfaction. According to this theory, it is meaningless to attach numbers to utility
we derive from a product. Rather, a consumer can order or rank goods he/she would consume in the form
of 1st, 2nd, 3rd etc. Utility is only an expression of the consumer preferences for one commodity over
another. The basic tools ordinalist used for analysis of consumer demand is the indifference curve which
represents all those combinations of goods which gives same satisfaction to consumer.
2.2.1. Assumptions of Ordinal Utility approach
1. Rationality: The consumers are assumed to be rational- they aim at the maximization of their utility,
given their income and market prices.

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2. Utility is ordinal: it is assumed that consumers can rank their preferences according to the
satisfaction of each bundle. They need not know precisely the amount of satisfaction. It suffices that
they express their preference for the various bundles of commodities.
3. The total utility of the consumer depends on the quantities of the commodities consumed. The utility
function is, thus, given as U  f (Q1 , Q2 ,..., Qn ) .
4. Completeness: for any two consumption bundles a and B, the consumers are able to determine the
bundle that provides the most satisfaction:
A is preferred to B if it provides more satisfaction than B. Conversely B is preferred to A if it
provides more satisfaction than A.
If both bundles provide equal level of satisfaction the consumer would be indifferent between the two
bundles.
5. Preferences are transitive- if A is preferred to B and B is preferred to C, then A is preferred to C.
Similarly if the consumer is indifferent between commodity A and B and if he is indifferent between
B and C, then he is indifferent between A and C.
6. Diminishing marginal rate of substitution (MRS): it assumed that as more and more units of X are
substituted for Y, the consumer will be willing to give up fewer and fewer units of Y for each
additional unit of good X.
2.2.2. Indifference Set, Curve and Map
Indifference Curves: can be defined as the locus of points each representing a different combination of
two goods yielding the same level of satisfactions. Each point on an indifference curve yields the same
total utility as any other point on that same indifference curve. If on an indifference curve C is 10, then
each point on the same indifference curve will yield just 10 units of utility.
Table 3: Indifference schedule of commodity X and Y
Combination Commodity X Commodity Y
A 25 5
B 15 7
C 10 12
D 6 20
E 4 30

Figure 3: Indiffernce curve for commodity x and y

30

25 a
Commodity Y

20

15 b

10 c

5 d
e
0
0 5 10 15 20 25 30 35
Commodity X

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The consumer is indifference for the points on indifference curve such as A, B, C and D all provide the
same satisfaction for the consumer.
An indifference map shows all the indifference curves which rank the preferences of the consumer. A
combination of goods lying on higher indifference curve yields higher level of satisfaction and should be
preferred.

X2
Indifference map

I3
Figure 4: Indifference Map
I2

I1

X1

2.2.3. Properties of Indifference Curves

1. The slope of an indifference curve is negative. To keep a consumer at the same level of satisfaction
along a curve, a decrease in the quantity of one of the goods must be compensated by an increase in
the other, and vise versa, this leads to a down ward sloping curve whose slope is negative.
2. The further the utility curve is from the origin, the higher utility it denotes. Bundles on the higher
indifference curve are preferred than on lower indifference curve by a rational consumer.
3. Indifference curves cannot cross each other. If they cross one or more of the standard axioms will be
violated (transitivity of preference).

A ~ B and A ~ C, according to our

assumption, B should be indifferent
Figure 5: ICs Crossing
to C. But here from this diagram we
each Other
observe that A~B, A~C but C>B
because C contains more amount of
X2 and same amount of X1 as B.

4. Diminishing marginal rate of substitution (DMRS). The marginal rate of substitution is defined as the
slope of the indifference curve. It measures the rate at which the consumer is willing to substitute one
good for the other.

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 2.2.4. The Marginal rate of substitution (MRS)
Marginal Rate of Substitution (MRS): is the rate at which one commodity can be substituted for
another, the level of satisfaction obtained remaining the same. Marginal rate of substitution of X for Y is
defined as the number of units of commodity Y that must be given up in exchange for an extra unit of
commodity of X so that the consumer maintains the same level of satisfaction. Marginal rate of
substitution is a measure of substitution of two commodities in consumption.

Number of units of Y given up - Y

MRS X ,Y   …………………………………....………[6]
Number of units of X gained  X

Graphically, it is measured by the slope of an indifference curve. As we move from left to right on an
indifference curve, the marginal rate of substitution decreases in absolute value; this is referred to as the
decreasing marginal rate of substitution. As a consumer receives more and more of a particular good, its
value in terms of other goods declines. This implies that the number of units of commodity Y that the
consumer is willing to sacrifice for additional unit of commodity X declines as the quantity of X
increases.

Figure 6: Marginal Rate of Substitution

At point ‘a’ in the figure above, the consumer consumes 4 units of X and 8 units of Y. At this point X is
relatively scarce and Y is relatively abundant. Therefore, the consumer is willing to give larger quantities
of Y in exchange for a unit of X, or, in other words, he is willing to give fewer quantities of X in
exchange for a unit of Y. Here, the consumer is willing to trade 2 units of X for a unit of Y. At point ‘b’,
however, the consumer has more of X and less of Y, thus is willing to exchange fewer quantities of Y in
exchange for a unit of X. Now, he is willing to trade 25 units of X for a unit of Y. Any movement along
the indifference curve from left to right results in reduction in the rate of exchange between the two
commodities.
dY
Slope of indifference curve =  = MRS X ,Y ………………………………..…………....………[7]
dX
Note: it is important to note that MRS X ,Y is different from MRS Y , X . The former measures the quantity of
Y that must be sacrificed for a unit of X so as to keep the consumer at the same level of satisfaction. The
later measures the quantity of X that must be given up for a unit of Y in consumption such that the
consumer will remain at the same level of utility.

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 MU X MU Y
MRS X ,Y  or MRS Y , X 
MU Y MU X
Example: Suppose a consumer’s utility function is given as U  20 X 0.4Y 0.6 and we are required to find
MRSX, Y.
MU X
MRS X ,Y 
MU Y
dU dU
MU X  MU Y 
dX , and dY
MU X  0.4(20 X ( 0.41)Y 0.6 ) , and MU Y  0.6(20 X 0.4Y ( 0.61) )
MU X  8 X 0.6Y 0.6 , and MU Y  12 X 0.4Y 0.4
MU X 8 X 0.6Y 0.6
MRS X ,Y  
MU Y 12 X 0.4Y 0.4
2Y
MRS X ,Y 
3X
2.2.5. Types of Indifference Curves
There are some cases where indifference curves are not convex
1. Perfect substitutes
Two products are said to be perfect substitute if the consumer is willing to substitute one for the other at a
constant rate. Eg. Red and Blue Pencils (where color is not a factor for selection)
Figure 7: IC of Perfect Substitutes
Red
4 X1 + X2 = 4
3 The slope [MRS] is constant = -1
2

1 2 4 Blue
2. Perfect complement – goods that are consumed together (in a fixed proportion) are called
perfect complements. e.g. Right and left shoe
Figure 8: IC of Perfect Complements

Right slope = 
The slope is either  or 0

5 slope = 0

5 Left
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A consumer wants to have 5 pairs of shoes [5 left, 5 rights]. If we add one additional right shoe, the
combination will be 5 left shoes & 6 right shoes but the consumer will be indifferent between the two
combinations (5, 5) & (5, 6) because the addition of one more right shoe doesn’t increase his/her
satisfaction. The indifference curve for such preface will be L shaped, having a slope of either 0 or ∞.
3. ‘Bads’ :- A bad is a commodity that the consumer doesn’t like. To keep the consumer at the same
level of satisfaction along an indifference curve, an increase in quantity of the ‘bad’ must be
compensated by increasing the quantity of the other good. Because of this the indifference curve will
be positively sloped.

Figure 9: IC of Bad Good

Alcohol
(Bad) The lower the indifference curve is, the
IC1 higher the utility it denotes [given the
IC2 commodity which is on the vertical axis
IC3
is ‘bad’ good.

Orange (good)
N.B. * The “More is better” axiom doesn’t hold for the ‘bads’. The lower the bad good the higher will be
the satisfaction of the consumer.
Figure 10: IC of Neutral Good
4. Neutral(Useless)
Outdated Books IC1 IC2
A good is neutral good if the consumer doesn’t care (neutral) The slope
about it. We say the consumer is neutral about of such
outdated books, when the consumer’s satisfaction is not curve is
affected
-5- by an increase/decrease
Well behaved Preferences:-in books. So the IC
will be vertical line.

Food (normal)

2.3. The Budget Line or the Price line

Budget constraint affects the choice of individuals by limiting their ability to purchase goods and services.
Consider a consumer having a fixed income (M) and who has to make choice between two goods X 1 & X2.
X1 & X2 indicates the total amount of good1 & good2 the consumer affords to consume, respectively.
Suppose P1 is the price of X1 and P2 is the price of X2
P1X1 + P2 X2  M ……….. [budget constraint equation]
P1X1 – is the total amount of money spent on good 1 and P2 X2 – is the total amount of money spent on
good 2.
P1X1 + P2 X2  M………………………………………………………………………………………. [8]
This implies that the total spending by a consumer on the given two goods cannot exceed the consumer’s
total income, given the prices of the two goods. This implies that, the consumer’s affordable bundles are
those that do not cost any more than the total income (M). This set of consumption bundles at prices (P1,
P2) and income M, is called the budget set of the consumer. On the other hand, P1X1 + P2 X2 = M implies
the entire income is used for the consumption of the two goods, X1 & X2.

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N goods; the consumer chooses how much to consume of each. This is indicated as a vector:

x   x1 , x2 ,.... xN  .
She can observe the prices of the goods:

p   p1 , p2 ,.... pN 
Income is given by m.

The budget constraint requires that the amount of money spent on the N goods is no more that the total
amount the consumer has to spend:
p1 x1  p2 x2  ....  p N x N  p  x  m …………………………………………………. [9]
Budget line
It is a line which shows the combination of the maximum amounts of the two goods that the consumer
can buy by spending the entire money income only on these goods, given prices.
P1X1 + P2 X2 = ……………………………………………………………………………………..……. [10]
[budget line equation which shows a set of bundles that costs exactly M]

Figure 11: Budget Set/ Budget line

X2

M
Budget set
P2

Budget line

M
X1
P1

By rearranging equation [10] we can get

M p1
X2 = - X1 …………………………………………………………………………………. [11]
P2 p2
M
This is a formula for a straight line (budget line) with a vertical intercept of , a horizontal intercept
P2
M p
of and a slope of - 1 .
p1 p2
M
=> The amount of X2 the consumer can buy by spending the entire income on X2.
P2

12
 M
=> The amount of X1 the consumer can buy by spending the entire income on X1.
p1
p
- 1 = > the rate at which the market substitutes good 1 for good 2.
p2
If the individual is going to increase her/his consumption of good1 by  X1, by how much will her/his
consumption of good2 changes in order to satisfy the budget constraint?
Let’s say  X1 is change in consumption of good1 &
 X2 is change in consumption of good2
*In order to satisfy the budget constraint a change in consumption of good 1 should be followed by a
change in the consumption of good2.
N.B. The budget constraint should be satisfied both before and after the change in consumption.
Before the change, the budget line equation is P1X1 + P2 X2 = M …………………………….…. [12]
After the change is made the equation will be P1 (X1 +  X1) + P2 (X2 +  X2) = M……………. [13]
Subtract [12] from [13]
P1 (X1 +  X1) + P2 (X2 +  X2) - (P1X1 + P2 X2) = 0 (no change in the income)
P1  X1+ P2  X2 = 0  P2  X2 = - P1  X1
p1  x 2
- = This is the slope of the budget line.
p 2  x1

2.3.1. Factors Affecting the Budget Line

How the budget line changes?
Changes of the Budget Line:
 Variation of income: parallel shift
 Increase in a price: budget line becomes steeper
 Decrease in a price: budget line becomes flatter.
2.3.1.1. Effects of changes in income (keeping P1 & P2 fixed)
Recall equation [12] P1X1 + P2X2 = M
M  P2 X 2 M  P1 X 1
X1= OR X2 =
P1 P2
The horizontal and vertical intercepts of the budget line equation are M and M respectively.
P1 P2
An increase/decrease in income increases/decreases both the vertical and horizontal intercepts by the
same factor but leaves the slope of the budget line unaffected.

X2 Figure 12: Shift in BL due to change in income

M’/P2 An increase in income from M to M’

-- shifts the budget line outward while a
-2M/P2 decrease in income from M to M” shifts
the budget line inward.
M”/P2 The slopes of these budget lines are the
same.

X1
M’’/P1 M/P1 M’/P1
X1

13
2.3.1.2. Effects of Changes in Price
a) A change in the price of one of the two goods
An increase in P1, keeping P2 and M constant, doesn’t affect the vertical intercept but b y affecting the
horizontal intercept makes the budget line steeper.
X2
Figure 13: Shift in BL due to change in Price
M
P2 When P1 increase, the slope of the budget line (- ) will

increase in absolute value and the budget line becomes

steeper.

N.B. The slope of the Budget line in absolute value is .

M M
X1
P '1 P1
Exercise:-1- What is the effect of a decrease in P2 on the budget line (given that M and P1 are constant)
b) A change in the prices of both goods
 If the prices are doubled, (2P1, 2P2) both the horizontal and vertical intercepts shift in ward by a factor
M M
of ½ = ( , ).
2 P 2 2 P1
 If both prices are multiplied by t, the new equation will be
tP1X1 + tP2 X2 = M  t (P1X1 + P2 X2 ) = M
M
P1X1 + P2 X2 = => implies that multiplying both prices by the same amount t means dividing
t
income by that constant t. And the vertical and the horizontal intercepts shift inward by the factor of 1/t.
In this case the slope of the budget line is not affected.
 If the increase in the two prices is not proportional, what happens to the budget line depends on
the strength of their changes.
Eg. If P2 increases by less proportion than P1, the slope of the budget line increases in absolute value
p1
 as a consequence the budget line would be steeper.
p2
Exercise: - 2- What happens to the budget line if we divide both prices by the same constant d?
-3- Analyze the effect of a proportional increase in both the prices & income on the budget line.

2.4. Optimum of the Consumer

A consumer is said to be at optimum when utility is maximized subject to the constraints imposed by
income and prices. i.e. Optimum of the consumer is given by the bundles of goods lying on the highest
indifference curve among the affordable set of commodity bundles. Point e; Where (X1*, X2*) is an
optimal choice. The equilibrium point (E) is defined by the point of tangency of the budget line and the
highest possible (affordable) indifference curve.

14
 Figure 14: Optimum of a Consumer

Two conditions must be fulfilled for the consumer to be at equilibrium.

1) MRS (the slope of the IC) must be equal to the ratio of commodity prices (slope of the budget line)
2) indifference curves must be convex
p
- 1 = the rate at which the market substitutes X1 for X2.
p
2
MUX
- 1 = the rate at which the consumer is willing to substitute X for X
1 2.
MUX
2
Note that, when we compare slopes we have to put the values in absolute value, as a result the values will
be positive.
To the left of tangency point
MUX p
1 > 1 The consumer is willing to substitute X1 for X2 at a higher rate than the market
MUX p
2 2
offers.
To the right of the tangency point
MUX p
1 < 1 The consumer is willing to substitute X1 for X2 at a smaller rate than the market
MUX p
2 2
offers.
The consumer will not be satisfied in both cases. But will be satisfied at point e (tangency point) because
what he/she is doing is consistent with what is offered by the market.
MUX p MUX MUX
1 = 1 => 1 = 2
MUX p P P
2 2 1 2
Mathematically, the optimum of the consumer can be derived by maximizing the utility function
subject to the budget constraint.
Max U(X1, X2) subject to
P1X1 + P2X2 = M

15
To combine the function to be optimized and the constraining function we use what is called
Lagrangian1 function.

L=U(X1, X2) +  M  p1x1 p 2 x 2  ………………………………………………………………. [14]

Lagrangian function states that the optimum of the consumer should fulfill the following three
first order conditions.
L U
Condition 1 = -  P1 = 0 ………………………………………………………. [15]
 X1  X1
L U
Condition 2 = -  P2 = 0 ……………………………..………………………. [16]
 X2  X2
L
Condition 3 = M–P1X1 – P2X2 = 0 ……………………………………………………..…. [17]

From (15) MUX1 =  P1 …………………………………………………………………..……. [18]
From (16) MUX2 =  P 2 …………………………………………………………..……………. [19]
MUX MUX
From (18) & (19) 1 2   ……………………………………………………….... [20]
P P
1 2

Eg. Let’s take the Cob-Douglas2Utility function

U (X1, X2) = X 1c X d2
S.t P1X1 + P2X2 = M Solve for X1 and X2.
L=U(X1,X2) +  M  p1x1 p 2 x 2 
L= X 1c X d2 +  M  p1x1 p 2 x 2 
L c c d
Condition 1 = X 1 X 2 -  P1 = 0
 X1 X1
c c d
X1 X 2 = P ……………………………………………………………………. [21]
X1 1
L d c d
Condition 2 = X1 X 2 -  P = 0
 X2 X2 2

1
Lagrangian optimization is a method for solving optimization problems with constraints. The method named after an Italian-
born French mathematician and astronomer Joseph-Louis Lagrange who was born on 1736).
2
At the 1927 meetings of the American Economic Association, Paul Douglas presented a paper entitled "A Theory of
Production," which he had coauthored with Charles Cobb in 1928. The paper proposed the now familiar Cobb-Douglas function
as a mathematical representation of the relationship between capital, labor, and output. When the Cobb–Douglas function is
applied as a utility function the inputs, K and L, are replaced by the consumption levels of two types of good, say, X and Y. With
this utility function a utility-maximizing consumer will spend a proportion α of their budget on good X and “c” proportion “d”
on good Y.

16
 d c d
X1 X 2 =  P ……………………………………………………………………. [22]
X2 2
L
Condition 3 = P1X1 + P2X2 – M = 0

P1X1 + P2X2 = M ……………………………………………………………………. [23]
c c d d c d
From (1) & (2) X1 X 2 = X1 X 2
X 1 P1 X 2 P2
c d
=
X 1 P1 X 2 P2
dX 1 P1
X2 = ……………………………………………………………………. [24]
cP2
cX 2 P2
X1 = ……………………………………………………………………. [25]
dP1
Sub. (24) in (23)
dX 1 P1
P1X1 + P2 =M
cP2
dP1 c*M c*M c M
X1(P1 + )=M → X1 = = =
c c * P1  d * P1 P1 (c  d ) (c  d ) P1
Sub. (25) in (23)

cX 2 P2
P1 + P2X2 = M
dP1
cP2 d *M d *M d M
X2( + P2) = M → X2 = = =
d c * P2  d * P2 P 2(C  d ) c  d P2
C
At the optimum = C (because c + d=1) refers to the proportion of M spent on X1
(C  d )
d M
= d refers to the proportion of M spent on X2
c  d P2
Exercise
Suppose a consumer spends his/her entire income on food (X1) and clothing (X2) and 25% of the total
income is spent on food. Given, price of X1 = 2, Price of X2 = 3 and M = 200, estimate the utility
function and determine the optimum quantity of X1 and X2.

Given:
 The consumer spent 25% of his income on food (X1) and the remaining 75% of his income on
0.25 0.75
food (X2). Thus, the utility function is estimated as U (X1 , X 2 ) = X1 X 2
 Price of X1 = 2, Price of X2 = 3 and M = 200. Thus, the budget line is estimated as
2X1  3X2 = 200
Required: Estimate the utility function and determine the optimum quantity of X1 and X2.
Solution:

17
 
0.25 0.75
The utility function is estimated as U (X1 , X 2 ) = X1 X 2
 The optimum quantities of X1 and X2 can be obtained using Lagrange Method
( X 1 , X 2 ,  ) = X10.25X 0.75
2   (200  2 X 1  3 X 2 )
Undertake first order condition of Lagrangian function with respect to X 1 , X 2 and  .

( X 1 , X 2 ,  ) ( X 1 , X 2 ,  ) ( X 1 , X 2 ,  )

=0 ; =0 & =0
X 1 X 2 

( X 1 , X 2 ,  )  (X10.25X 0.75   (200  2 X 1  3 X 2 )

=0 2
=0
X 1 X 1
0.25X10.75X 0.75
2  2 = 0
0.125X10.75X 0.75
2 =  …………………………………………………………………….Equation (A)

( X 1 , X 2 ,  )  (X10.25X 0.75   (200  2 X 1  3 X 2 )

=0 2
=0
X 2 X 2

0.75X10.25X 20.25  3 = 0
0.25X10.25X 20.25 =  ……………………….…………………………………………….Equation (B)
( X 1 , X 2 ,  ) (X10.25X 0.75   (200  2 X 1  3 X 2 )
=0 2
=0
 
200  2 X 1  3 X 2 = 0 ………………………….…………………………….…………….Equation (C)

λ=λ from Equation (A) and Equation (B)

0.125X10.75X 0.75
2 =  = 0.25X10.25X 20.25
X 2 = 2X1 ……………………………………….…………………………….…………….Equation (D)

Then Substitute Equation ( D) in to Equation ( C)

200  2 X 1  3 X 2 = 0 but X 2 = 2X1

200  2 X 1  3(2 X 1 ) = 0

200  2 X 1  6 X 1 = 0

200 = 8 X 1
*
X 1 = 25 Units
*
Substitute the value of X 1 = 25 Units in to Equation (D) to find the optimal value of X2.
X 2 = 2 X1

18
 X 2 = 2 * 25 = 50 Units
Thus, the consumer shall purchase and consume 25 units X1 and 50 Units of X2.
The level of utility derived by the consumer at equilibrium is calculated by substituting the optimal values
of X1 and X2 in to Utility function.

U (X1 , X 2 ) = X10.25X 0.75

2 Where X1 =25 Units and X2=50 Units

U (X1 , X 2 ) = 250.25500.75 = 2.236 * 18.80 = 42.036

The Value of Lagrangian Multiplier can be obtained by substituting the optimal values of X1 and X2 in to
either Equation (A) or (B) above.
 = 0.125X10.75X 0.75
2 from Equation (A)

0.125 (50)0.75 0.125(18.80) 2.35

= = = = 0.21
(25)0.75 11.18 11.18

 = 0.25X10.25X 20.25 from Equation (B)

0.25(25)0.25 0.25 (2.236) 0.5590
= = = = 0.21
(50)0.25 2.6591 2.6591
The Lagrange multiplier, λ, measures the increase in the objective function (U(X1, X2) that is obtained
through a marginal relaxation in the constant constraint (a change in M or Income). Thus, a one dollar
increase in consumer’s income leads to a 0.21 units increase in consumption of the two goods (objective
function).
2.4.1. Effects of Changes in Income & Prices on Consumer optimum
2.4.1.1. Changes in Income: Income Consumption Curve and the Engel Curve
For normal goods, the income consumption curve has an upward slope, indicating a positive relationship
between income and consumption, as consumers tend to consume more of the good when their income
increases. Given the general demand function Xi as a function of ‘(P1, P2, M)’, if the good is a normal
X i
good, its demand increases when income increases and decreases as income decreases ( > 0). Hence,
M
the optimum quantity will increase with increasing income holding prices fixed. Income Offer curve
(Income Expansion path) is formed by connecting the equilibrium points E1, E2 and E3.

19
 Figure 15: Income Consumption Curve
when both Goods are normal

The income consumption curve for an inferior good slopes downwards. This downward slope indicates a
negative relationship between income and the quantity consumed. If we plot income on the Y-axis and
quantity on the X-axis, it is evident that as income rises, the consumption of these goods declines. Thus,
X i
the demand for that good decrease as income increase (  0 ) for inferior good.
M

Thus, there is a negative effect of income as a result the income consumption curve (ICC) will become
backward bending or Negative slope for an inferior good. Assume good X as inferior to normal good Y,
then the consumer buys fewer units of good X and more units of good Y. In this case the ICC becomes
backward bending as indicated in figure 15A. Furthermore, assume good Y is an inferior and good X is a
normal good. An increase in the income increases the demand of good X and reduces consumption of good
X which results a downward bending ICC as indicated in figure 15B.

Figure 16A: Income Consumption Curve Good X

is inferior and Good Y is normal. The ICC bends
towards Y-axis (normal good).

20
 Figure 16B: Income Consumption Curve Good Y
is inferior and Good X is normal. The ICC bends
towards X-axis (normal good).

Income consumption lines are the locus of points representing the equilibrium purchase patterns as
income changes, holding preferences and relative prices constant. Engel Curves are the locus of all points
representing the quantities demanded of the goods at various levels of income, when prices and
preferences are held constant (Fig. 17A for normal goods and Fig. 17 B for inferior goods).

Engel’s Law is an economic theory that describes the relationship between household incomes and a
particular good or service expenditures. It states that as family income increases, the percentage of
income spent on food decreases. The theory was introduced by Ernst Engel, a German economist and
statistician, in 1857. Besides Engel’s Law, he is also famous for the Engel curve in microeconomics.

Figure 17A: Engel Curves for normal good.

21
 Figure 17B: Engel Curves for Inferior good.
i.e. Where Good X is Normal and Good Y is
inferior

Generally, when income increases the demand for a good could increase more or less rapidly than an
increase in income. If the demand for the good increases by a greater proportion than an increase in
income, the good is said to be Luxury good. If the demand for the good increases by a lesser proportion
than an increase in the income, the good is necessary good.

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

The price effect deals with the change in quantity demanded of a commodity as a result of change in its
price assuming other things remains the same. When the price of the commodity changes, the buyers can
buy more or fewer units of the commodity. As the price of one good decline the consumer will have
additional purchasing power. PCC is derived by connecting all the optimal bundles across the price
change.
A) Price Consumption Curve in the Case of Normal Substitute goods
Goods are substitutes if they fulfill the same desire. In this type of relation, if the price of one good
declines, the demand for other goods will also decline and vice versa. The change in the price of one
commodity and the change in demand for another related substitute commodity are moving in positive
direction. In the case of substitute goods, the price consumption curve is downward slopping showing the
positive relationship between the change in the price of one good and the change in the demand for its
related commodity. The following figure shows the price effect in the case of Substitute goods and the
downward-sloping PCC.
Suppose there is a decrease in price of good X. As a result of this decrease the budget line swings towards
the Right to AB1 resulting equilibrium E2 on the upper IC2 with higher unit of good X and lower units of
good Y. Similarly, If price of good X falls again, the consumer attains equilibrium at point E3 on a higher
IC3 with higher unit of good X and lower units of good Y. Thus, the consumer increases demand for good
X and lowers good Y at every new equilibrium than before. Thus, the PPC slopes downward in the case
of Normal Substitute goods.

22
 Figure 18: Price Consumption Curve
in the Case of Normal Substitute goods.

B) Price Consumption Curve in the Case of Normal Complementary goods.

The Price Consumption curve in the case of Complementary goods is upward sloping, indicating the
inverse relationship between the change in price of one good and the resulting change in price of the
complementary good. The following figure shows the price effect of in the case of complementary goods
and the upward slopping price consumption curve. Suppose there is a decrease in price of good X. As a
result of this decrease the budget line swings towards the Right to AB1 resulting equilibrium E2 on the
upper IC2 with higher units of both goods. Similarly, If price of good X falls again, the consumer attains
equilibrium at point E3 on a higher IC3 with higher units of both goods. Thus, the consumer increases
demand for both goods at every new equilibrium than before. Thus, the PPC slopes upward in the case of
Normal complementary goods.

Figure 19: Price Consumption Curve in the

Case of Normal Complementary goods.

C) Price Consumption Curve in the Case of Giffen goods.

When the demand for a good decrease as a price decrease and demand increase as price increase then
such a good is known as a Giffen good. Thus, price and demand are positively related for Giffen goods.
Suppose Good X is a Giffen good and Good Y is a normal good. The PCC is backward bending as price
of the Giffen good decreases.

23
Suppose there is a decrease in price of good X (Giffen good). As a result of this decrease the budget line
swings towards the Right to AB1 resulting equilibrium E2 on the upper IC2 with higher units of the
Normal good ( Good Y) and Lower units of good X (Giffen good). Similarly, if price of good X falls
again, the consumer attains equilibrium at point E3 on a higher IC3 with higher units of the Normal good
(Good Y) and Lower units of good X (Giffen good) again. Thus, the consumer increases demand for the
Normal good (Good Y) and Lower units of good X (Giffen good) at every new equilibrium than before.
Thus, the PPC slopes backward bending in the case of Giffen good.

Figure 20: Price Consumption Curve in the

case of Giffen good. (i.e. Good X is Giffen
and Good Y is normal)

Substitution and Income Effects of Price change

A fall in price of a good has two effects:
1) Consumers will tend to buy more of the good that has become cheaper and less of
those goods that are now relatively more expensive. This response to a change in the
relative prices of goods is called the substitution effect.
2) Because one of the goods is now cheaper, consumers enjoy an increase in real purchasing
power. They are better off because they can buy the same amount of the good for
less money, and thus have money left over for additional purchases . The change in
demand resulting from this change in real purchasing power is called the income
effect.
OR in general;
Substitution effect : change in consumption ( demand )due to a change in its
relative price, with the level of utility held constant.
Income effect : change in consumption ( demand ) resulting from a change in
real purchasing power , with relative prices held constant.
N.B:
 The fundamental reasons for the existence of the law of Demand are the
substitution & income effects
- Total Effect(TE)=Price Effect (PE)= Substitution Effect (SE) + Income Effect(IE)

Normally, these two effects occur simultaneously , but it will be useful to

distinguish between them for purposes of analysis . To illustrate this ,there are two
decomposition techniques: Slutsky & Hicksian approaches , however , due to its
popularity, we will apply the Hicksian decomposition technique

24
 .
a) Substitution& Income Effects of price decrease on Normal good
Com y

Y1 P
Y2 R
Y3 Q I2
I1

𝐹′

X1 X3 F X2 H Com x
Illustration:
Substitution Effect (SE)
The first step is to eliminate the income effect : to do this , we assume that
accompanying to fall in the price of X, there is a compensating variation in income which
leaves the consumer at the same level of utility ( real income) as before the price decrease.
The original budget line is labeled AF while the new budget line after the price decrease is
is labeled 𝐴𝐹 ′ until it becomes tangential to the original indifference curve I1. The imaginary
budget line ( compensating variation income ) is GH and the movement of consumer
equilibrium from P to R is the Substitution Effect
-the consumer is no better off but has substituted X1X3 of X for Y1Y3 of Y because of the
change in relative prices, thus the rest of the price change effect will be the income effect.
⟹ 𝑆𝐸 = 𝑋1𝑋3 𝑎𝑛𝑑 𝑝𝑜𝑠𝑖𝑡𝑖𝑣𝑒
Income Effect (IE)
To illustrate the income effect, we will eliminate the substitution effect by holding the relative
prices constant. Accordingly, this will be reflected by movement from one indifference, I1 to
the other indifference curve ,I2 OR movement between the new budget line , A𝐹 ′ and the
imaginary budget line, GH .thus , movement from R to Q is due to income effect – the
consumer buys X3X2 of X and Y3Y2 of Y because of increase in his real income.
⟹ 𝐼𝐸 = 𝑋3𝑋2 𝑎𝑛𝑑 𝑝𝑜𝑠𝑖𝑡𝑖𝑣𝑒 b/c EI >0 for Normal goods
TE = PE =SE + IE= X1X3 + X2X3 =X1X2 ( reflected by movement fom P to R)
N.B: Graphically in general:
Substitution Effect (SE): is reflected by movement from the original equilibrium
To the point of between the original indifference curve
And the imaginary budget line, along the original
Indifference curve.

25
 Income Effect (IE) : is reflected by movement between the two parallel new and
Imaginary budget lines or movement from the point of
Tangency between the original IC and the imaginary budget
Line to the new equilibrium, between the two ICs.

b) Substitution & Income effects of price decrease on Inferior good

com y
A

Y2 Q
G I2
Y1 P

Y3 R

I1
Com x
X1 X2 X3 F H 𝐹′
Applying the same decomposition procedures:
SE- is reflected by movement from P to R
SE= X1X3 and positive
IE- is reflected by movement from R to Q
IE = X3X2 and negative b/c EI<0 for inferior goods
TE- is reflected by movement from P to Q
⟹ 𝑇𝐸 =PE=SE+IE= X1X3+(-X3X2)=X1X3-X3X2=X1X2
∴ The total effect of a decrease in the price of an inferior good positive because the
positive substitution effect outweighs ( exceeds ) the negative income effect. Thus , the
decrease in the price of an inferior good will totally lead to increase in its demand and
consumption.
c) Substitution and Income effects of price decrease on Giffen goods

Com y
A
Q
Y2

G I2
Y1 P

Y3 R

I1

26
 Com x
′
X2 X1 X3 F H 𝐹
Applying the same decomposition procedures:
SE- is reflected by movement from P to R
SE= X1X3 and positive
IE- is reflected by movement from R to Q
IE = X3X2 and negative b/c EI <0
TE – is reflected by movement from P to Q
TE=PE= SE + IE = X1X3 + (-X3X2)
the total effect a decrease in the price of a Giffen good is negative because the negative
income effect outweighs (exceeds ) the positive substitution effect. Thus , a decrease in the
price a Giffen good leads to a decrease in its demand ( consumption ). We can say that
Giffen goods are Inferior good but inferior goods are not always Giffen good.
Exercise
1) Graphically illustrate the substitution ,income & total effects of a price increase on:
a) Normal good
b) Inferior good
c) Giffen good
2) Graphically illustrate the substitution, income & total effects of a price decrease
on:
a) Apple & orange juice
b) Left & right shoes

Mathematical Decomposition of Substitution & Income Effects of price change

Given the demand function as: 𝑥 = 𝑓(𝑃, 𝑚), where P-original commodity price
𝑚- Money income
Assume further that the price of 𝑥 decreases to𝑃′ ,

Thus, we can decompose the substitution & income effects of this decrease in price mathematically
applying the following steps:

i) To determine the substitution effect (SE), first eliminate the income effect. To do this, determine
the change & level of income necessary to keep purchasing power (utility) constant.
∆𝑚 = 𝑥∆𝑃 …………change in income necessary to keep purchasing power Constant

𝑚′ = 𝑚 + ∆𝑚……….level of income necessary to keep purchasing power Constant

ii) SE=∆𝑥 𝑠 = 𝑥(𝑃′ , 𝑚′ ) − 𝑥(𝑃, 𝑚)

IE= ∆𝑥 𝑛 = 𝑥(𝑃′ ,𝑚) − 𝑥(𝑃′ , 𝑚′ )

TE=∆𝑥 = ∆𝑥 𝑠 + ∆𝑥 𝑛

⟹ ∆𝑥 = 𝑥(𝑃′ , 𝑚) − 𝑥(𝑝, 𝑚)

⟹ ∆𝑥 = [𝑥(𝑃′ , 𝑚′ ) − 𝑥(𝑃, 𝑚)] + [𝑥(P′ , 𝑚) − 𝑥(𝑃′ , 𝑚′ )]

Slutsky Identity

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Example: Suppose the consumer has a demand function for milk of the form
𝑚
𝑥 = 10 + 10𝑃 Originally his income is 120 birr per week and the price of milk is 3 birr per cup.

Thus, his demand for milk =10+ 120 =14 cups per week
10*3
Now suppose that the price of milk falls to 2 birr per cup. Let this new price be 𝑃′ =2
New quantity demand = 10+ 120 = 16 cups per week
10*2
Then determine the substitution income & total effects this price change on demand
i) To calculate SE
∆𝑚 = 𝑥∆𝑃 = 14 ∗ (2 − 3) = −14 𝑏𝑖𝑟𝑟
Thus the level of income necessary to keep purchasing power constant
𝑖𝑠 𝑚′ = 𝑚 + ∆𝑚 = 120 − 14 = 106 𝑏𝑖𝑟𝑟
106
𝑥(𝑃′ , 𝑚′ )=𝑥(2 , 106) = 10 + 10∗2 = 15.3 𝑐𝑢𝑝𝑠 𝑜𝑓 𝑚𝑖𝑙𝑘
Thus, the SE:
∆𝑥 𝑠 = 𝑥(2 , 106) − 𝑥(3 , 120) = 15.3 − 14 = 1.3 𝑐𝑢𝑝𝑠 𝑜𝑓 𝑚𝑖𝑙𝑘

∴ 𝑡ℎ𝑒 𝑆𝐸 𝑜𝑓 𝑡ℎ𝑒 𝑑𝑒𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝑡ℎ𝑒 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑚𝑖𝑙𝑘 𝑓𝑟𝑜𝑚 3 𝑏𝑖𝑟𝑟 𝑝𝑒𝑟 𝑐𝑢𝑝 𝑡𝑜 2 𝑏𝑖𝑟𝑟 per cup leads to
an increase in the DD (consumption) of milk by 1.3 cups.

ii) 𝑥(𝑃′ , 𝑚) = 𝑥(2 , 120) = 16

𝑥(𝑃′ , 𝑚′ )= 𝑥(2 , 106) = 15.3

Thus IE:

∆𝑥 𝑛 = 𝑥(2 , 120) − 𝑥( 2, 106) = 16 − 15.3 = 0.7 cups of milk

Since milk in a normal good for this consumer, DD increases when income increases.
iii) TE = PE = SE+ IE= 1.3+0.7= 2
∴ The total effect of a decrease in the price of milk from 3 birr per cup to 2 birr per cup
leads to the increase in the DD (consumption) of milk by 2 cups.
 Consumer Surplus (Cs)
CS is the difference between the willingness to pay and the actual payment. Producer surplus
(PS): is the difference between the actual receipts and the willingness to sell.

i) Geometrical approach

CS = Willingness to pay (demand) −actual payment (price)

= a(OAeq*) – a( OP*eq*) = a(P0Ae)

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 1
⟹ 𝐶𝑆 = 2 (P*A)(q*) unit2 and PS= 0
b)

First determine the equilibrium price and quantity by setting DD=SS

CS= willingness to pay (demand) – actual payment (equilibrium price* equilibrium qty)
= OAeq*−OP*eq* = P*Ae
1
⟹ 𝐶𝑆 = 2 (P*A)(q*) unit2
PS= Actual receipts (equilibrium price *equilibrium qty) – willingness to sell (supply)
= OP*eq*− Oeq*=Oeq*
1
⟹ 𝑃𝑆 = 2(q*)(q*e) unit 2
ii) Integration approach
Case (a)
Given the inverse demand function: P= 𝑎 − 𝑏𝑞 , to determine CS &PS at q =q*
𝑞∗
CS =∫0 (𝑎 − 𝑏𝑞)𝑑𝑞 – [(𝑝 ∗)(𝑞 ∗)] unit2
PS= 0
Case (b)
Given the inverse demand & supply functions as:
DD: P= 𝑎 − 𝑏𝑞
SS: 𝑃 = 𝑐 + 𝑚𝑞
To determine CS&PS, the First step is find the equilibrium price & quantity by setting
DD=SS , thus you will get equilibrium price P* & equilibrium quantity q*,then:
𝑞∗
CS=∫0 (𝑎 − 𝑏𝑞)𝑑𝑞 − [(𝑃 ∗)(𝑞 ∗)]
𝑞∗
PS= [(𝑃 ∗)(𝑞 ∗)] − ∫0 (𝑐 + 𝑚𝑞)𝑑𝑞
N.B: CS+PS= Welfare
Example
Given inverse demand & supply functions:
DD: P=200−2𝑄
SS:𝑃 = 100 + 3𝑄
Then determine the consumer surplus & producer surplus
Solution
i) Geometrical approach
Determine the equilibrium Price & quantity

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DD=SS …………………………..at equilibrium
200−2𝑄 = 100 + 3𝑄 ⟹ 5𝑄 = 100 ⟹ 𝑄 = 20
𝑃 = 200 − 20(20) ⟹ 𝑃 = 200 − 400 ⟹ 𝑃 = 160
∴ 𝑒𝑞𝑢𝑖𝑙𝑖𝑏𝑟𝑖𝑢𝑚 𝑝𝑟𝑖𝑐𝑒 = 160 𝑏𝑖𝑟𝑟 & 𝑒𝑞𝑢𝑖𝑙𝑖𝑏𝑟𝑖𝑢𝑚 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 = 20 𝑢𝑛𝑖𝑡𝑠
Then depict these values on the graph

1 1
CS = 2 (200 − 160)(20)=2 (40)(20) = 400 𝑢𝑛𝑖𝑡2

1 1
PS = 2 (160 − 100)(20) = 2 (60)(20) = 600 𝑢𝑛𝑖𝑡 2

ii) Integration approach

20
20 2𝑄 2
CS = ∫0 (200 − 2𝑄) 𝑑𝑄 − [(160)(20)] = [200𝑄 − ] − 3200
2 0
= [200(20) − (202 )] − 0 − 3200 = 4000 − 400 − 3200
= 400 𝑢𝑛𝑖𝑡2
20
20 3𝑄 2
PS = [(160)(20)] − ∫0 (100 + 3𝑄)𝑑𝑄 = 3200 − [100𝑄 + ]
2 0
202
= 3200 − 100(20) − 3 ( 2
) − 0 = 3200 − 2000 − 600
= 600 𝑢𝑛𝑖𝑡2

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