Chapter II

The Theory of Consumers Behavior

and Demand
• Recall the definition of
– demand and
– the law of demand
• Demand : Is the quantity that a consumer
is willing to buy at a particular price
(Ceteris paribus)
• Law of Demand : State that there is an
inverse relationship between price of a
commodity and the quantity demanded.
• I.e., consumers will buy more of a
commodity at lower price and vice versa
1
 Major issues/ objectives
• How a consumer decides how much of a
commodity to buy at a particular price?
• Why a consumer will buy more of a
commodity at lower price?
• How consumer optimum can be indicated
using constrained optimization approach
– Objective fun…………….Utility function
– Constraint function…….budget constraint
• Level of satisfaction enjoyed by
consumer at optimum consumption point
 Consumers Behavior (Cont…)
• Major assumptions in the theory of
consumers behavior :
1. A consumer is a rational being
2. Consumer has a full knowledge of
– all the available commodity,
– their price and
– his income.
3. The goal of the consumer is to
maximize his utility
4. The non-satiation assumption or
more is better than less
3
 What is utility?
• Utility describe the expected satisfaction
or enjoyment derived from the consumption
of a good or service.
• Properties of utility
A.‘Utility’ and ‘Usefulness” are not
synonymous.
– E.g. Paintings by Picasso may be useless
functionally but offer great utility to art lovers.

4
 Consumers Behavior (Cont…)
B. Utility is subjective: The utility of
a product will vary from person to
person.
–For example, non-smokers do not
derive any utility from cigarettes
C. The utility of a product can be
different at different places and
time.
– Utility from eating meat is zero
during fasting
5
 Approaches to consumer optimum
• Two approaches of showing
consumer optimum
–Cardinal utility theory
–Ordinal utility theory
• Major difference is the assumption
that utility can/ can not be measured
in absolute / cardinal numbers
 2.1. Cardinal Utility Approach
• This school postulates that utility can be
measured in absolute terms
• What is the measurement unit?
– Monetary unit
– By a subjective unit called util
Assumptions
A. Rationality
B. Cardinal Utility: The utility of each
commodity is measurable and the most
convenient unit of measurement is money.
C. Constant Marginal Utility of Money.
– The essential feature of a standard unit of
measurement is that it is consistent.
7
 Cardinal Utility (cont…)
D. Limited money income of the consumer
and all is income is spent in the
consumption process.
– That is, saving gives no positive
utility to the consumer.
E. Diminishing Marginal Utility
(DMU).
– The utility derived from each
successive units of a commodity
diminishes. .
8
 Cardinal Utility (cont…)
F. Total utility depends on the quantity of
the commodities consumed.
– If there are n commodities in the bundle with
quantities X1, X2, X3 …… Xn the total utility is
then
– U = f (X1, X2, X3 ……. Xn).
G. Utility is also additive, i.e., Total Utility
(TU) = U (X1) + U (X2) +U (X3) ……+U ( Xn )

9
 Cardinal Utility (cont…)
Total and Marginal Utility
Total Utility: refers to the total amount of
satisfaction a consumer gets from consuming or
possessing some specific quantities of a
commodity at a particular time.
• If a consumer consumes 4 units of a commodity
and derives U1, U2, U3 and U4 from the
successive units consumed,
• Then TU = U1+U2+U3+U4.
10
 Cardinal Utility (cont…)
Marginal Utility (MU) :
• total utility derived from, the last unit of
a commodity consumed.
• It is the change in the total utility
resulting from a unit change in commodity
consumed
• It is the slope of total utility function,
• MU = TU/ Q
– TU = Change in Total Utility
– Q = Change in quantity consumed
11
 Cardinal Utility (cont…)
• Utility Schedule for banana

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

12
Graphical representation of total utility

TU
1
2 0
11
8 3

6 5

4
2

O 1 2 3 4 5 Quantity 13
Graphical representation of total utility

TU

11
8
TU
6
4
2

O 1 2 3 4 5 Quantity 14
 Marginal Utility (cont…)

Utility

Marginal utility

0 5
Quantity
15
 Basic rules
• Differential calculus measures a marginal
change in the dependent variable due to a
marginal (unit change) in the independent
variable
• Marginal Utility measures a marginal
change in total utility due to a unit
change in commodity consumed.
• TU/ Q = dU
dQ X

• Derivative of TU with respect to Q

16
 The Law Diminishing Marginal Utility:
• States that as the quantity consumed of a commodity
increases, the utility derived by the consumer from the
successive units decreases, ceteris paribus.
This law stems from the facts that:-
• The utility derived from a commodity depends on the
intensity of the need for that commodity
• As more and more quantity of a commodity is consumed
the intensity of desire decreases and therefore, the
utility derived at the margin decrease.

17
 Consumer’s Equilibrium: One Commodity Case

Suppose the consumer’s utility function is given as

U  f (X ) and his/her total income spent (expenditure) on

commodity X –Total Expenditure would be: TE  QX PX

• Where Qx is amount of commodity x and Px is price

of good X.

• The consumer would like to maximize the difference

between the utility (satisfaction) and expenditure
(sacrifice).

• The problem is a simple maximization of the function.

18
 Cardinal Utility (cont…)
• Max (U – TE) or
• U – PxQx
• Two conditions must be fulfilled
– Necessary Condition (F.O.C)
– Sufficient Condition (S.O.C)
• The necessary condition (First Order
Condition) for maximum, require that the
derivative of the function with respect to
independent variable (Qx) must be equal
to zero.
19
 dU d (Q X PX )
 0
dQ X dQ X

 MUx - Px =0

 MU X  PX
MUx
1
Px
20
 Cardinal Utility (cont…)
• At optimal point:
1. the equilibrium condition of a consumer
that consumes a single good X occurs
when the marginal utility of X is equal
to its market price and
2. the whole income has been spent
or Total Expenditure =Total Income

21
Utility

E Px (Mum)

MUx

X Quantity of X
Consumers Equilibrium: The General Case: (The law of
equi-marginal Utility)
• In reality, however, a consumer consumes a
large number of goods.
• The MU schedules of different commodities
may not be the same.
• A utility maximizing consumer consumes
commodities in order of their utilities.
• He picks up the commodity, which yields the
highest utility followed by the commodity
yielding the second highest utility and so on.
• He switches his expenditure from one
commodity to another in accordance, with
their marginal utility.
23
 Cardinal Utility (cont…)
• He continues to switch his expenditure
from one commodity to the other till he
reaches a stage where MU per Birr of each
commodity the same
• Therefore, the consumer optimum follows
the law of equi-marginal utility.
• We can use a single commodity case to
determine the general case.
• For commodity X, equilibrium occurs when
MUx = Px
• MUx = Px and this can be written as
• MUx / Px = 1
24
• for n number of goods, he/she would
be in equilibrium or utility is
maximized if and only if:

MU X 1 MU X 2 MU X n
  .........   MU m
PX1 PX 2 PX n
•And Total expenditure = total income
 Numerical Example

• Consider a consumer having only birr7 in his

pocket to buy bread and banana and price of
banana is birr 4/kg while price of bread is
birr one per unit, and total utility
schedule as shown below, determine:
i. The marginal utility schedule for the two
commodities
ii. Determine the optimum consumption of
these two goods
iii. The total utility at optimum
consumption
 Bread, Price=birr 1/unit Banana, Price=4birr/kg
Quantity TU MU MU/P Quantity TU MU MU/P
of

0 0 0 0
1 6 1 12
2 11 2 20
3 14 3 26
4 16 4 29
5 16 5 32
6 14 6 31
 Solutions
Bread , Price=birr 1/unit Banana, Price=4birr/kg
Quantity TU MU MU/P Quantity TU MU MU/P
0 0 - - 0 0 - -
1 6 6 6 1 12 12 3
2 11 5 5 2 20 8 2
3 14 3 3 3 26 6 1.5
4 16 2 2 4 29 3 0.75
5 16 0 0 5 32 2 .5
6 14 -2 -2 6 31 -1 -0.25
Attempt the above questions assuming income of birr 12, ceteris paribus.
 Quantity Deriving Cardinalist Demand
of Y E3 P3
E2
P2
E1 P1
X3 X2 X1
MU X Quantity of X

Price
a
P3
P2 b

P1 c
Demand Curve

X3 X2 X1 Quantity of X
 Limitations of the Cardinal approach
a) The assumption that utility is a cardinal
concept (utility is objectively measurable) is
doubtful.
– Utility is a subjective concept, which cannot be
measured objectively.
b) The assumption of constant marginal utility
of money is also unrealistic..
c) The psychological law of diminishing marginal utility
has been established from introspection
d) The cardinal utility approach is on the basis
of Ceteris Paribus assumption.
– As a result it ignores the substitution and income
effect.
30
 Ordinal Utility Approach
The ordinalist school argue that utility is not
cardinally measurable,
• It is ordinal in magnitude.
• The consumer may not know the specific
unit of utility derived from different
commodity.
• He is able to rank or order different basket
of goods
• A market basket is just a collection of one
or more commodities.
• The modern theory of consumer’s behavior
is on the basis of consumers preference
31
 Ordinal Utility (Cont…)
What is preference?
• It shows choice of the consumer
• Three types
– Strict preference …..one is preferred over the other
– Weak preference….one is sometimes preferred
and sometimes treated as same
– Indifference …….the consumer treats them as same
• Given any two consumption bundles,
• the consumer may choose or prefer one of the
consumption bundles over the other. Or
• May be indifferent in choosing one over the other.
32
 Ordinal Utility (Cont…)
a) Strict preference
B) Weak preference
C) Indifference
(Y1 , Y2 )  ( X 1 X 2 ) Strict Preference
……………………..

(Y1 , Y2 )( X 1 X 2 ) …………………….. Weak Preference

(Y1, Y2 )  ( X1 X 2 ) ………… …Indifference

33
 Other Properties of preference

• Completeness
• Transitivity
– if A is preferred to B and B is
preferred to C then, A is preferred
to C.
• More is better than less
– Non satiation assumption
 Ordinal Utility (Cont…)
• The ordinal utility approach is also on the basis
of the following assumptions:-
1. Rationality: The consumer is assumed to be
rational aiming at maximizing his utility
2. Utility is Ordinal: The consumer can rank or
order his preferences
3. Consistence of Choice:
– If he preferred bundle A to B, he will
not choice bundle B over A another
time.

35
 Ordinal Utility (Cont…)
4.Diminishing Marginal Rate of Substitution
(MRS):
• The marginal rate of substitution is the rate
at which a consumer is willing to substitute
one commodity (x) for another commodity
(y) so that his total satisfaction remains the
same.
• MRS diminishes as substitution increases

36
 Ordinal Utility (Cont…)
5. Limited money income.
• The consumer is confronted with limited money income
so that optimization is mandatory.

37
 Indifference Set, Curve and Map
• IC : is the locus of different combinations of two
commodities, which are equally preferred
• or it is the locus of different combinations of
goods that yields the same level of satisfaction.
• Indifference Schedule is a tabular presentation of
points or combinations of same utility
• An indifference curve is an iso or equal utility
curve.
• The graphical representation of consumer’s
preference is called Indifference Curve (IC)
• Indifference Map: It is a set of indifference
curves with different levels of satisfaction
38
 Indifference Schedule

Bundle A B C D
(Combinations)

Orange (X) 1 3 5 7

Banana (Y) 23 15 9 6
Banana (Y)

10 A
Indifference
Curve (IC)
6 B

2 C
D
1

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

IC3
IC2
IC1
Good A
Indifference Map: It is a set of indifference curves with different levels of
satisfaction
 Properties of Indifference Curves:

a) Indifference curves have a negative slope:

• The negative slope of indifference curve
implies that the two commodities are
substitute for each other.
• if quantity of one-commodity decreases,
quantity of the other commodity must
increase if the consumer has to stay at the
same level of satisfaction.

42
 Properties of Indifference (cont..)
b) Indifference curves are convex to the Origin:
The convexity of indifference curves implies
– The two commodities are not perfectly
substitute one for another
– The marginal rate of substitution (MRs)
between the two goods decreases as a
consumer moves along the indifference
curve

43
 Properties of Indifference (cont..)
c) Indifference curves do not intersect each
other.
• What would happen if they cross each
other?
• If two different curves cross each other it
would be violation of transitivity
assumption in consumer’s preference.
• The following figure will show this
condition
44
Banana

C
B IC2
IC1

Orange
Points like, A, B and C represents three different
combinations of commodities X and Y. Not that combination
B is common to both indifference curves.
A = B and B = C , then A = C ……..But A # C
 Properties of Indifference (cont..)
D) A higher Indifference curve is always
preferred to a lower one.
• The further away from the origin an
indifferent curve lies, the higher the level of
utility it denotes:

46
 The Marginal Rate of Substitution
(MRS)

• The slope of an indifferent curve is called

Marginal Rate of Substitution.
• Marginal Rate of Substitution has an
important economic meaning.
• Marginal Rate of Substitution (MRS) is a
rate at which one commodity can be
substituted for another, with out changing
the level of satisfaction.

47
 MRS ( Cont…)
• 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
48
 MRS ( Cont…)
• As a slope of an indifference curve

y
 MRS X ,Y
x
• MRS decreases as a consumer continues
to substitute one commodity for another
• Consider the following table
49
level of consumption of good X and Y

Bundle A B C D
(Combination)
Orange (X) 1 3 5 7
Banana (Y) 23 15 9 6

Y 8
MRS X ,Y (between point s A and B)   4
X 2
Marginal Utility and Marginal rate
of Substitution
MRS is also equals to the ratio of MU of
commodities involved in the utility
function.
MU X
MRS X ,Y 
MU Y
Proof:
Suppose the utility function for two commodities X and Y is
defined as:

U  f ( X ,Y )
 MRS ( Cont…)

Since utility is constant on the same

indifference curve:
U  f ( X ,Y )  C
The total differential of the utility function is

U U
dU  dX  dY  0
X Y
since there is no change in utility for any movement
along the same indifference curve , dU=0
 MRS and MU
• The relationship b/n MRS and MU

MU X dX  MU Y dY  0

MU X dY
  MRS X ,Y
MU Y dX
 Exceptional Indifference Curves
• indifference curves are convex to the origin
and downward sloping
• However, the shape of the indifference curve
reflects the degree of substitution between the
two commodity
• The shape of an indifference curve might be
different if the relationship between two
commodities is unique
• Perfect substitutes: perfect substitutes are
goods which can be replaced for one another
at a constant rate.
• 54
 Exceptional IC (Cont …)
• Perfect substitutes.
• The indifference curve becomes straight line

Total
IC3

IC2

IC1

Mobile
55
 Exceptional IC (Cont …)
• Perfect complements: perfect complements
are goods which are to be consumed jointly
at a constant rate
• If two commodities are perfect complements
the indifference curve takes the shape of a
right angle (L –shape)
• Graphically it is shown as follows.

56
 Exceptional IC (Cont …)
• Perfect complements

Right shoe
IC3

(3,3)

IC2
(2,2)

(1,1) IC1

Left shoe 57
 Exceptional IC (Cont …)
• A useless good: This shows the relationship
between useless good and another normal
good.
• A good example is outdated book and food.
• since the outdated books are totally useless,
increasing their purchases does not increase
utility.
• The person enjoys a higher level of utility only
by getting additional food consumption
• The indifference curve in this case will have a
vertical one

58
 Exceptional IC (Cont …)
• IC involving a useless good(Y axis)

Out dated books IC1 IC2 IC3

Food 59
Indifference curve of a bad commodity
• Bad Commodity IC( Y-axis)

Bad Good(Y) IC

Y2

Y1

X1 X2 Good Commodity(X)
 The Budget Line or the Price line
• A utility maximizing consumer would like to
reach the highest possible indifference
curve on his/her indifference map.
• But the consumer’s decision is constrained
by his/her
– money income and
– prices of the two commodities
• This limitation is called consumer’s budget
constraint

61
 Budget Line (Cont…)
• This limitation is called budget constraint
– is represented by the budget line
• The budget line is a line representing different
combinations of two goods that a consumer can
buy with a given income at a given prices level
Assumptions
A. There are only two goods, X and Y, bought in
quantities X and Y;
B. Each consumer is confronted with market
determined prices, Px and Py, of good X and good
Y respectively
C. The consumer has a known and fixed income (I).

62
Budget Line (Cont…)

M  PX X  PY Y
Where, PX=price of good X
PY=price of good Y
X=quantity of good X
Y=quantity of good
M=consumer’s money income

63
 Budget Line (Cont…)
• Suppose a household has 60 Birr to spend
– on banana (X) at Birr 2 each and
– Orange (Y) at Birr 4 each. .
• Therefore, our budget line equation will
be:
2 X  4Y  60

64
 Budget Line (Cont…)
Alternative purchase possibilities of the two goods

Consumption
A B C D E F
Alternatives
banana (X)
in 0 1 2 3 4 5
(kgs)…PX=2
Orange (Y)
15 14.5 14 13.5 13 12.5
in (kgs).Py= 4
Total
60 60 60 60 60 60
Expenditure 65
 Three areas of a budget line
• The Budget Line

M/PY
B

A


M/PX
66
 Factors Affecting the Budget Line
• Budget line depends on the price of the
two goods and the income of the consumer
• A change in the income of the consumer
results in a shift in the budget line
• Where as a change in the price of a
commodity will rotate the budget line
• The effect of change in income of
consumer can be shown in the following
figure
67
 Effect of change in income on BL

M2/Py

Mo/Py

M1/Py Bo B2

B1

M1/PX Mo/PX M2/PX

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

Effects of Changes in Price of the commodities

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

Y
M/Py2

M/Py1

X
M/Py
 Optimum of the Consumer
• A consumer reach at optimum when he
chooses the quantity that maximizes his
utility given his income and market prices of
commodities
• This occurs when an indifference curve is
tangent to the budget line
• At the point of tangency the slope of the
indifference curve (MRSxy) is equal to the
slope of the budget line
MRS X ,Y  PX / PY
71
 Consumer’s Optimum (Cont…)
Consumer optimum
Y

E
Y*
IC4
IC3

IC1 IC2

X* X
 Mathematical derivation of equilibrium
• Suppose that the consumer consumes two
commodities X and Y given their prices and
level of money income M.
• The objective of the consumer is
maximizing his utility subject to his
limited income and market prices.
• State the problem
• The maximization problem may be
formulated as follows:
MaximizeU  f ( X , Y )
Subject to PX X  PY Y  M
73
 Consumer’s Optimum (Cont…)
• To solve the constrained problem; we use
the Lagrange Multiplier Method. The
steps involved are:
A). Rewrite the constraint function as
follows:
M  PX X  PY Y  0(  will have positive value) or
PX X  PY Y  M  0 , will have negative value

74
 Consumer’s Optimum (Cont…)
B) Multiply the constraint by Lagrange
multiplier

 (M  PX X  PY Y )  0

 (PX X  PY Y  M )  0

75
 Consumer’s Optimum (Cont…)
C) Form a composite function or the Lagrange
function:

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

76
 Consumer’s Optimum (Cont…)
D) The first order condition for maximum requires
that the partial derivatives of the Lagrange function
with respect to the two goods and he Lagrangian
constraint be equals to zero.

 U  U 
  PX  0 ;   PY  0 and  ( PX X  PY Y  M )  0
X X Y Y 

From the above equations we obtain:

U U
 PX and  PY
X Y
77
 Consumer’s Optimum (Cont…)
• Therefore, substituting and solving for we
get the equilibrium condition:

MU X MU Y
 
PX PY

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

78
 Consumer’s Optimum (Cont…)
E) The second order condition for maximum
requires that the second order partial
derivatives of the Lagrange function with
respect to the two goods must be negative.

 2
U 2
2
U 2
  0 and   0
X 2
X 2
Y 2
Y 2

79
 Consumer’s Optimum (Cont…)
Example 1
• A consumer consuming two commodities X
and Y has the following utility function.
• If the price of the two commodities are 3 and 4
respectively and his/her budget is birr 100.
i. Find the quantities of good X and Y which will
maximize utility.
ii. Total utility at equilibrium.
iii. Find the MRSxy at optimum point

80
 Consumer’s Optimum (Cont…)
Example 2
• A consumer consuming two commodities X and Y
has the following utility function. U =X2Y2
• If the price of the two commodities are Birr 1 and
4 respectively and his/her budget is birr 10.
i. Find the quantities of good X and Y which will
maximize utility.
iii. Total utility at optimum point

81
 Effects of Changes in Income and Prices on
Consumer‘s equilibrium
Changes In Income: depends on the nature
of the good
• Two types of goods
– Normal Goods are goods whose demand
increases with an increase in income
– Inferior goods are goods whose consumption
decreases as income increase

82
Income Consumption Curve and the Engel
Curve
i. The case of normal goods
• An increase in the consumer’s income
(all other things held constant) leads to
an upward parallel shift of the budget
line.
• As a result a consumer moves to
different consumption level.
• The following figure shows this
condition
 Since both X and Y increased as income increase this shows the case of normal goods

Commodity Y

ICC

E3
Y3
E2

Y1 E1

X1 X3 Commodity X
 Effects of Income Changes (Cont …)
• Income Consumption Curve (ICC) : is a
locus of all points that representing
various combinations of the two
commodities purchased by the consumer
at different levels of his income, all
other things remaining the same
• Normal Good is a good whose demand
increases with income increase
• For normal good income effect is positive

85
 Effects of Income Changes (Cont …)

ii. The case of inferior goods

• Inferior good : is a good whose
consumption decreases as income
increase
• Engle curve will have a negative slope for
inferior good as indicated in the figure
below

86
the income –consumption curve when good X is inferior

Y3

Y2

Y1

X
X1 X1 X3
 the income –consumption curve when good y is inferior good

Y3
Y1
ICC

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

89
 Effects of Price Change
Price Consumption Curve (PCC) and Individual
Demand Curve
• When one of the two commodity price changes
while other things remain unchanged the budget
line will rotate and the consumer will be at a
new equilibrium point
• If we connect such equilibrium points that would
occur at different price level we get a line
called Price Consumption Curve (PCC)
• PCC: is the locus of the utility-maximizing
combinations of products that result from
variations in the price of one commodity when
other product prices, the money income and
other factors are held constant.
90
The Effect of price change on Consumer’s Equilibrium

Y The case of decrease in price of X

PCC
E3
E2
E1

M M’ M’’ X
 Effects of Price Change (Cont …)
• We use the PCC to derive the individual demand
curve for a particular commodity
How ?
• By plotting PCC from commodity space to price
and quantity space as shown below

92
Commodity Y

PCC

Commodity X
Price of
X Px1

Px2
Individual
Px3 demand curve

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

• When price of one of the commodity

changes, while other thing remain
unchanged, the budget line will rotate
accordingly.
• This price change will brings two major
effects:
• Substitution
• Income

94
A) Substitution effect : refers to the change
in the quantity demanded of a Commodity
resulting exclusively from a change in its
price when the consumer’s real income is
held constant;
If a price of commodity X falls while Price Y
and income of a consumer remain unchanged.
• Commodity X will relatively be cheaper and
this induces consumer to substitute cheaper
commodity (X) for more expensive one.

95
B) The Income Effect
• The change in the price of a commodity will also
have an income effect.
• When price of commodity X decreases ( other
things remain), the relative purchasing power
of consumer will increase.
• I.e.,the real income will increase (meaning a
consumer can afford to buy more of the two
commodities with the existing income depending
on the nature of the commodity.
The following figure will depict these two effects

96
 Suppose the consumer is at equilibrium at point A consuming X1 unit of X

Suppose price of X falls while

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

How can we split these two effects?

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

C Point Q represents imaginary

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

x2 B The movement from Q to R and

x1
SE IE
x3 C’ B’ increase in demand by X2X3 is
NE
due to income effect
• In the above case income effect and the
substitution effects operate in the same
direction – they reinforce each other.
• This is the case for a good called Normal
goods.
• But, not all goods are normal. Some goods
are called inferior goods
• What is inferior good?

99
• Inferior good: Is a good whose quantity
demand decrease with income increase.
• Is a good whose demand is negatively
related to the income of a consumer
• For an inferior good, a decrease in the
price of the commodity,
– causes the consumer to buy more of it
(the substitution effect),
– but at the same time the higher real
income tends the consumer to reduce
consumption of the commodity (negative
income effect).

100
 Suppose the consumer is at equilibrium at point A consuming X1 unit of X

When price of X falls while other

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

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

R The movement from Q to R and

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

X1 X2 X3 X
IE
NE

SE
• In this case we observe that,
– the substitution effect still is more
powerful than the income effect (SE >IE)
– even though the income effect works
against the substitution effect, it does not
override it.
– As a result the law of demand hold
– Hence, the demand curve for most inferior
goods is still negatively sloped.

103
• In very rare occasions, a good may be so strongly
inferior that the income effect actually
overrides the substitute effect.
• As a result the law of demand may be violated.
• I.e., decline in the price of a good would lead to a
decline in the quantity demanded
• In other words, price and quantity move in the
same direction which is against the law of
demand.
• Such goods are called Giffen Goods

104
• Giffen goods: are goods whose demand
decreases as price of a commodity
decreases.
• That is, the quantity demanded is directly
related to the price
• The graph below shows the substitution
and income effect of Giffen goods

105
 Suppose the consumer is at equilibrium at point P consuming X1 unit of X

Y When price of X falls while other

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

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

Y Point Q represents imaginary equilibrium

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

108
End of chapter two????????
 The Consumer Surplus
• Demand curve shows the price that
consumers are willing to pay for various
quantity demanded.
• While consumers purchase goods and
services,
– they offten pay less than what they
are willing to pay.
• the difference between what they are
willing to pay and what they actually
paid is considered as their surplus.
110
• Therefore, consumer surplus is the
difference between what a consumer is
willing to pay and what he actually pays.
• Graphically it is measured by the area below
the demand curve and above the price level.
• More precisely it is the area of the triangle
above the price but below the demand
curve.

111
P Consumers Surplus

P1

CS
E

Pe

Q1 Q
 Price Elasticity of Demand
• Consider the law of demand,
– when the price of a good goes up people will
buy less of it and
– if the price falls then people will buy more
of it
• Consumer responds to any change in the
determinants of demand like,
– Commodities own price
– Prices of related goods
– Consumers Income
– Taste and preferences
– And other factors
113
• The question however is that what is the
magnitude of the responsiveness of
consumers for these change?
• Economists have developed a tool that
measure responsiveness of consumers
demand for the change in the
determinants of demand.
• This measurement is called Elasticity of
demand
• We have as many elasticity of demand as
the number of determinants of demand
114
The most common types of elasticity of
demand are of the following:-
• Price elasticity of demand (own price
elasticity of demand)
• Cross price elasticity of demand
• Income elasticity of demand
1. Own Price Elasticity of demand.
It is a measurement of responsiveness of
quantity demanded to change in the
commodities own price
115
• Price elasticity of demand is measured as
a percentage change in quantity
demanded resulting from a percentage
change in price.
• Depending on the magnitude of the
change in price, we have two types of
price elasticity of demand.
– Point price elasticity of demand
– Average or arc price elasticity of
demand
116
• Point elasticity of demand:- is used to measure
price elasticity of demand when the change in
price is very small or at a point.
• the point price elasticity coefficient (Ep) can be
determined as,
% change in qunatity demand of X
Ed 
% change in price of X

117
  Q2  Q1 
  x100 Q P
Ed   Q1  p  
P2  P1 P Q
( ) x100
P1
Q Represents slope of the demand curve

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

Q
= -b

P
• Price Elasticity of demand is therefore

Ep = - b x P/Q

Example: Consider the following demand and

supply equation.
P = 20-0.5 Q and P = 16+0.5Q
Determine price elasticity of demand at the
equilibrium point and interpret the result!
Example 2
– Suppose that a household demands 50 units of
oranges at the price 40 cents per piece. If
the price falls to the price 30 cents per
piece, 100 oranges are demanded. What is
the elasticity of demand for Oranges?
• The value of Price elasticity is always a negative
and is unit free
• This because of the inverse relationship
between price and quantity demanded of a
commodity.
120
• The value of price elasticity of demand
ranges from zero to infinite.
• In absolute terms, the values of price
elasticity of demand ranges from 0<Ed< .
• demand is elastic when the value of
elasticity is greater than one ( Ep > 1)
• Demand is inelastic when the value of
elasticity is less than one (Ep < 1)
• Demand is unitary elastic when the value
of price elasticity of demand is equal to
one ( Ep = 1) 121
• Price elasticity of demand is perfectly
elastic, when the value of price elasticity of
demand is infinite (Ep = , )
• Price elasticity of demand is perfectly
inelastic, when the value of elasticity equals
to than zero, ( Ep= 0)
• Arc Elasticity of Demand: Arc Elasticity
measurement is used when the change in
price is relatively large.
• That is, it measures elasticity between to
points.
• It is an estimation of an average elasticity 122of
an arc
• Arc elasticity measures an average
elasticity of the segment AB

εp 
ΔQ
X
P1  P2 
ΔP Q1  Q 2 
Example
If price of good X rises from birr 3 to birr 5 and its quantity demand falls from 240 units to
180 units. Calculate the arc price elasticity of demand.

123
• Determinants of the Price Elasticity of
Demand
• There are about four factors which affect
the degree of elasticity of demand function.
These are:
i. The Availability of Substitutes
ii. Nature of the Commodity (Luxury Vs
Necessity)
iii. The percentage that the commodity
represents in the consumers Income
commodity
iv. Time period available for adjustment.
124
2. Cross Price Elasticity of Demand
• Demand for a good is also affected by the
change in the price of related goods.
• Consumers respond for the change in the price
of related goods by either cutting their
consumption or by increasing their consumption.
• Cross price elasticity measures responsiveness
of demand for the change in the relative price
of related goods.
• Cross price elasticity of demand between
commodity XY, measures responsiveness
quantity demanded of Commodity X for a unit
change in price of commodity X 125
• It is a percentage change in quantity
demanded of commodity X divided by the
percentage change in price of Y
• This can be shown as
percentage change in quantity demanded good X
ε XY 
percentage change in price of good Y

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

126
• The cross price elasticity can have both
positive and negative value,
• Such value determine the nature of the
relationship between the two goods.
• The cross–price elasticity of demand is zero if
the two goods are not related at all.
• When cross price elasticity of demand is
positive, the two goods are substitute.
• When to goods are complementary the cross
price elasticity between goods will have
negative value. 127
Example:
• Due to unknown reason the price of beef meat
increased from 40 birr per kilo to 80 birr per kilo.
• As a result of this change the quantity demanded
of chicken increase from 30 thousand per month
to 50 thousand.
• Determine the cross price elasticity of demand
between beef and chicken and interpret the
result
• Determine the nature of their relationship?
128
 Solution
a) Coefficient of cross price elasticity
27 - 21 14  10 5/ 4
ε AB     0.75
14 - 10 27  21 24 / 48
b) Interpretation
When the price of beef meat increases by 1%, the quantity
demanded of chicken also increases by 0.75% and vice versa.
These two goods are substitute because when the price of beef
goes up people will substitute it by purchasing more quantity of
chicken and less of beef.
129
Income Elasticity of Demand
• Income of consumer is one of the
determinants of demand.
• A consumer also responds to the change in
their income by either consuming more or
less of a good.
• Income Elasticity of Demand (I) measures
the responsiveness of demand for the
change in consumer’s income.
• It is a percentage in quantity demanded due
to a unit change in the consumer’s income
130
 percentage change in quantity demanded
ε IX 
percentage change in income
ΔQ A I1  I 2
ε IX  
ΔI Q1  Q 2

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

Income of consumer.
• The coefficient of income elasticity of
demand can have both positive and
negative values.
• When the value of income elasticity of
demand is positive (EI > 0), the good is
normal.
• Where as negative value of income
elasticity of demand (EI < 0) implies the
good is inferior. 132
Example
Use the information given in the table below to determine: -
A) Income elasticity of demand of the two goods
B) Interpret the result and determine the nature of these goods.

Year Income Consumption Per year

Per Year Commodity Commodit
X y Y
1996 1500 500 units 1000
units
1997 2500 1500 units 500 units
 Price Elasticity of Demand and Total
Revenue

• Here we will try to look at the relationship

between demand , total revenue and price
elasticity of demand
• From the demand curve we can derive total
expenditure of consumers
• This total expenditure practically make
revenue to business firs
Suppose the demand curve is given by
Q = 18 – 2P
• The following table shows how total revenue
is derived from this demand curve
134
Quantity Price per Elasticit Total Elasticity
demande Unit(2 y Revenue( Range
d(1) ) 2x1)
2 8 8 16 Elastic
4 7 3.5 28 Elastic
6 6 2 36 Elastic
8 5 1.25 40 Elastic
9 4.5 1 40.5 Unit elastic
10 4 0.8 40 Inelastic
12 3 0.5 36 Inelastic
14 2 0.29 28 Inelastic
16 1 0.13 16 Inelastic
• From the above table we observe that increasing
price of a commodity would not always increase TR
for the firms
• Once TR is derived we can also easily derive Marginal
Revenue which is the slope of TR
• To do so first solve the above demand function for
price to get,
• bP =a – Q which is P = a/b -1/bQ
• say a/b = bo and 1/b =b1
• Replacing in the above equation we have the inverse
demand function P =bo – b1Q
• TR = PQ this means TR = (bo-b1Q) Q
• TR = boQ – b1Q2
• MR = bo – 2b1Q we can show graphically as follows136
 P

Ep = 1

Q
MR

TR

TR
Q
 Total revenue and elasticity

• Total revenue and elasticity are related.

• Total revenue (TR) is the total amount
of money the seller receives from the
sale of a product,
• Total Revenue (TR) = Price X Quantity
• The effect of a change in price on total
revenue depends on the price elasticity
of demand.
• These effects are summarized bellow.
138
When demand is elastic /Ed/ > 1
• A decrease in price causes a large increase
in quantity demanded.
• The percentage increase in quantity
demanded is greater than percentage
decrease in price.
• Hence, the total revenue increases since the
quantity effect out ways the price effect.
• The opposite is true when price increases.
• A rise in price leads to a decrease in total
revenue.
139
 When demand is inelastic /Ed/< 1

• An increase in price increases total

revenue.
• The increase in price leads to a small
decrease in quantity demanded since
demand is inelastic.
• Percentage rise in the price leads to a less
than proportionate fall in quantity
demanded leading to an increase in total
revenue.
• On the other hand, a decrease in prices
leads to a decrease in total revenue as fall
in price outweighs the corresponding
increase in price 140
 When demand is unitary
elastic/Ed/= 1
• If demand is unitary elastic any decrease
or increase in price leads to an equal
increase or decrease in quantity
demanded.
• The decrease in price is the same as or
is cancelled out by an equal increase in
quantity demanded.
• Hence, total revenue remains unchanged.

141