Microeconomics I (Econ 2021)

Chapter One: Theory of Consumer Behavior and

Demand
Key Topics

• Budget Constraint

• Preference

• Utility

• Optimal Choice

• Demand

2
I. Budget Constraint
• Economists assume that consumers choose the best bundle of
goods they can afford.

• “best bundle” - a matter of preference

• “can afford” - a matter of budget constraint

• In this section, we will examine how to describe what a consumer

can afford.

• To develop the budget constraint/budget set of the consumer, we

need assumptions.

• Assumptions maybe unrealistic but they are need to simplify

reality.

3
Assumptions
1. The consumer buys only two goods 𝑥1 𝑎𝑛𝑑 𝑥2

2. The price of 𝑥1 is 𝑝1 and 𝑥2 is 𝑝2 .

3. The Consumer’s income is fixed at M.

• Thus, the budget constraint of the consumer is given by

𝑝1 𝑥1 + 𝑝2 𝑥2 ≤ 𝑀

• What is the implication of the sign ≤?

• The sum of amount of money spent on two goods can not be more than
the consumer’s income.

4
Budget Set and Budget Line
• Budget set: the set of affordable bundles at a given price (𝑝1
and 𝑝2 ) and income M.

• Budget line: the set of bundles that cost exactly M.

𝑝1 𝑥1 + 𝑝2 𝑥2 = 𝑀

• These are bundle of goods that just exhaust the consumer’s

income.

• To draw the budget line, we have to consider the two

extreme income and expenditure relationship, i.e., identify
vertical and horizontal intercept as well as slope.

5
Budget Set and Budget Line
• Intercept: how much of 𝑥1 (𝑥2 ) can the consumer buy, if s/he spent all
of her/his income on 𝑥1 (𝑥2 =0) or 𝑥2 (𝑥1 = 0)?

• If 𝑥2 = 0, 𝑥1 = 𝑀Τ𝑝1

• If 𝑥1 = 0, 𝑥2 = 𝑀Τ𝑝2
• These two extremes or vertical and horizontal intercepts produce a
downward sloping line known as the budget line.

• Slope: Vertical change over horizontal change, i.e., change in 𝑥2 due to

change in 𝑥1 .

𝑥2 = 𝑀Τ𝑝2 − 𝑝1 Τ𝑝2 𝑥1

∆𝑥2 Τ∆𝑥1 = − 𝑝1 Τ𝑝2

6
Budget Set and Budget Line

Budget Set

7
The slope of the budget line
• The slope of the budget line has an interesting economic interpretation.

• The slope indicates the rate at which the market is willing to substitute
good 1 for good 2.

• Suppose the consumer is going to increase her consumption of good 1

by ∆ x1 , by how much should her consumption of good 2 change to
satisfy the budget constraint.

P1x1 +p2x2=M ........... 1

If x1↑ by ∆x1, then x2↓ by ∆x2
P1(x1+ ∆x1 ) +p2(x2 + ∆x2) = M............2
p 1x1+p1 ∆x1 +p2x2+p2 ∆x2=M

8
The slope of the budget line
• By subtracting equation 2 from 1 we get

• p1 ∆x1+p2 ∆x2=0
• p1 ∆x1=-p2 ∆x2
• p2 ∆x2= -p1 ∆x1
• ∆x2/ ∆x1=-p1/p2..................3

• The budget line has negative slope because in order to

consume more of good 1, we have to consume less of
good 2 and vice versa to satisfy the budget constraint.

9
The Budget Line
• Numerical Examples: Draw the budget line in each
case.

a) let M= 200, p1=2,p2=4

b) let M=100,p1=10,p2=5

c) let M = 200 p1=2, p2=3

10
Factors that Shift the Budget Line
• The budget line shifts if one of the following
things change;

1. The consumers income

2. The prices of goods and services

3. Taxes, subsides and rationing

11
Change in Income
Change in income (∆𝑴)

An increase in income causes

a parallel outward shift in the
budget line.

12
Change in Income
• Numerical Examples: Graphically show how the
budget line changes in each case.

a) Initially p1=2, p2= 4 M=200 and then income

increased to M'=400

b) Initially p1=2, p2=4 and M=200 but income

decreased to M″=100.

13
Change in Price
Change in price of good 1 (∆𝒑𝟏 )

• If 𝑝1 increases, the budget

line will shift inward along
the horizontal axis and
become more steep (i.e. its
slope will increase in
absolute value).

14
Change in Price
• Numerical Examples: Initially, p1=2, p2=4 and M=200.
Graphically show how the budget line changes in each
case.

a) p1increased to p1’ = 5.

b) p1 decreased to p1″ = 1.

c) p2 increased to p2’= 5.

d) p2 decreased to p2″=2.

15
Change in Price
• What happens to the budget line if the price of good 1 and 2
change at the same time?

• For example, if we double both prices, both the horizontal

and vertical intercept shifts by a factor of one-half, and the
budget line will also shifts inward by one-half.

• Note: multiplying both prices by a constant ‘t’ is just like

dividing income by ‘t’.

• What will happen to the budget line if we multiply both

prices and income by ‘t’?

16
Exercise
1. Suppose the original budget line equation is p1x1+p2x2=M.
Write down an equation for the new budget line such that
p1 doubles, p2 becomes 8 times more while income
becomes 4 times as large.

2. What happens to the budget line if both p1 and p2

doubles, while income is constant?

3. If the p1 doubles and p2 triples, will the budget line

becomes flatter or steeper (originally p1 = 1 while p2 = 2)?

4. What happens to the budget line if both p1 and p2 go up

and income (M) goes down?

17
Taxes, Subsidies and Rationing
• Three ways in which the government can affect the
consumers budget line.

(i) Taxes

a. Quantity tax: tax paid for each quantity of the good

purchased.

• If the government imposes quantity tax of amount t on the

good 1, then the new price will be p1’=p1+t

• The budget line will become steeper.

18
(i) Tax
b. Value /Ad valorem tax

• Tax is paid on the value (price) of a good, rather than the

quantity purchased of a good.

• If the price of good 1 is p1, but is subjected to ad valorem

tax of t,

• New price p1″= p1+tp1

= (1+t)p1

• The budget line will become steeper.

19
(i) Tax
C. Lump-sum tax

• Tax which is imposed on the income of the consumer.

• If old income = M, the government imposes lump-sum

tax of amount ‘L’; new income M'= M-L

• Since the money income of the consumer has been

reduced, the budget line will show a parallel inward
shift.

20
(i) Tax
• Numerical Examples: Initially, M=100, p1=10,p2=5.
Show how the budget line shifts for the following
cases.

a) A quantity tax of birr 2 is imposed on good 2.

b) An ad valorem tax =10% is imposed on good 1.

c) A lump-sum tax of birr 20 is imposed.

21
(ii) Subsidies
a. Quantity subsidy

• An amount given to the consumer for each unit of good

purchased.

• Suppose that government gives a quantity subsidy of ‘s’

on good 1, for the consumer it is as if s/he pays p1- s.

• X2 = M/p2 - (p1- s) /p2x1

• The budget line will become flatter.

22
(ii) Subsidies
b. An ad valorem subsidy

• A subsidy based on the price of the good being

subsidized.

• It is an amount paid the consumer as percentage of

price.

• If a value subsidy of ‘S’% is imposed on good 1 (p1), new

price (p’1) = p1- ‘S’ p1= (1- ‘S’)p1.

• The budget line will become flatter.

23
(ii) Subsidies
C. Lump-sum Subsidy

• A subsidy based on income of a consumer, i.e., it is

an addition to income.

• Let old income = M, if the government gives a

lump-sum subsidy of s’, new income M″= M+S’.

• The budget line will exhibit a parallel outward shift.

24
(iii) Rationing
The amount of a good that
can be purchased by the
consumer is fixed.

Example: a maximum
amount of sugar that can
bought (𝑥ҧ1 ) = 5kg

The new budget line will

be lopped/ cut off at 𝑥ҧ1 .

25
Exercise
1. Suppose the price of good 1 is p1 and price of good 2 is p2 and
income is m. X1 is rationed/fixed at 𝑥ҧ1 and if the consumer
wants to buy more than 𝑥ҧ1 , she has to pay a quantity tax of t.
Draw the new budget line.

2. Old budget line is p1x1+p2x2=m if quantity tax of ‘t’ is imposed

on x1, value subsidy of ‘s’ is imposed on x2 and lump-sum tax of
‘L’ is imposed on income. Write down the new budget line
equation.

3. Suppose that p1 and p2 are Br.10 and Br.5 respectively. The

consumer income is Br.100 per given period of time. If the
government impose a sales tax of 10% on good x1 but
subsidized good x2 by Br.1 per unit, what would be the effect of
such action on the budget line of the consumer?

26
II. Preference
• In this section, we will focus on the concept of how the
consumer determine what is best, i.e., the best bundle.

• Consumption bundles is a complete list of the goods and

services that are involved in the choice problem we are
investigating.

• Assume the consumption bundle consists of only two goods

(𝑥1 , 𝑥2 ).

• Given any two consumption bundles, {x1, x2} and {y1, y2}, the
consumer can rank/order them according to his/her
preference.

27
Preference Ranking
• There are three ways of ranking:

• (x1, x2) > (y1, y2) ………………. Strictly Preferred (i.e. the
consumer strictly preferred bundle x than y).

• (x1, x2) ~ (y1, y2) ………………….. Indifferent (i.e. the

consumer would be just satisfied consuming bundle x
as she would be consuming bundle y).

• (x1, x2) ≥ (y1, y2) ………………. Weakly Preferred (i.e. the

consumer preferred or is indifferent between the two
bundles).

28
Assumptions (axioms) of Consumer Preferences

• This assumptions are basically made to ensure consistency

in consumer preference, for instance it is contradictory to
say (x1, x2) > (y1, y2) and at the same time (x1, x2) < (y1, y2) or
vice versa.

o Complete: any two bundles can be compared (the

consumer can rank his/her preference or is able to make
choice between any two bundles).

o Reflexive: we assume that any bundle is at least as good as

itself; (x1, x2) ≥ (x1, x2).

o Transitivity: if (x1, x2) ≥ (y1, y2) and (y1, y2) ≥ (z1, z2), then
we assume that (x1, x2) ≥ (z1, z2).
29
Indifference Curve
• Indifference curve is graphical representation of consumer
preference.

• An indifference curve shows the combination of good 1 and

good 2 that gives the consumer the same level of
satisfaction.

• If we pick a certain consumption bundle (x1, x2) and shade in

all of the consumption bundles that are weakly preferred to
(x1, x2) we will get weakly preferred set.

• The bundles on the boundary of this set – the bundle for

which the consumer is just indifferent to (x1, x2) – forms the
indifference curve
30
Indifference Curve

31
Indifference Map
Indifference map is a set
of indifference curves.

Each successive curve to

the right represents higher
level of utility (i.e. IC3 > IC2
>IC1).

32
Characteristics of Indifference Curve
1) Downward sloping: this is because since they represent
combination of good 1 and good 2 which gives the
consumer the same level of utility; to consume more of
one good s/he has to consume less of the other good so
as to remain on the same level of utility.

2) Convex to the origin: the significance of one product in

terms of the other product diminishes as the consumer
consumes more and more of that same product.

3) Two indifference curves representing distinct level of

reference cannot cross each other.

33
Characteristics of Indifference Curve

34
Types of preferences
• Perfect Substitutes

• Perfect Complements

• Economic Bad

• Neutral

35
Perfect Substitutes
• Two goods are called perfect substitutes if the consumer is willing to
substitute on good for the other at a constant rate.

• Example: x1 – blue pen and x2 – red pen

• Suppose, the consumer does not care about the color of the pens, all he
wants is to consume twenty pens.

• This means, any bundle (x1, x2) such that x1 + x2 = 20 will be on this
consumer’s indifference curve.

• Since the consumer is willing to substitute red pen for blue pen on one-
to-one basis, the slope the indifference curve of perfect substitutes will
be constant (i.e. IC’s will be straight line with a slope -1).

36
Perfect Substitutes

If the consumption of x1
increased by one unit, the
consumption of x2 has to
decrease by one unit to leave
the consumer on the same IC.
Thus, the slope of the IC is -1.

37
Perfect Complements
• These are goods that are always consumed together in
fixed proportions.

• Example: one right shoe and one left shoe

• The use proportion is not necessary one-to-one. The

consumer for example can use two spoons of sugar for
a cup of tea.

• The IC’s of perfect substitutes is L-shaped because

increasingly the amount of only one good say left shoe,
does not increase the satisfaction of the consumer.

38
Perfect Complements
The vertex of the IC
occurs when individuals
consume equal number
of left and right shoes.

If the consumer increases

the number of two goods
simultaneously, utility will
increase.

39
Economic Bad
• A bad is a commodity that the consumer does not
like to consume.

• Example: dirt or too much salt.

• IC’s are positively sloped because if we increase the

amount of “bad”, we should increase the amount
of the “good” to leave the consumer on the same
level of utility.

40
Economic Bad
Salt
Here salt is the “bad” and
egg is the “good” for this
consumer.

The direction of increasing

preference is towards the
direction of egg (the good).

Egg

41
 Neutrals
A neutral is a good about
which the consumer does
Salt not care.

Say egg is good while salt is

neutral for the consumer.

IC’s will be vertical because

the consumer utility
depends only on egg
consumption.

IC’s are increasing towards

the left where egg
consumption increases.
Egg

42
Concave Preferences
• What if the consumer likes x1 and x2 but does not want to consume
them together?

• Utility will increase when he/she consumes less and less of both
goods.

• I3 > I2 > I1

X2
I1
I2

I3

X1

43
Satiation
• It is the maximum level satisfaction/bliss point.

• There is some overall best bundle to the consumer, and

the closer he is to that best bundle; the better off he is
in terms of his own preferences.

• Suppose that the consumer has some most preferred

bundle of goods (𝑥ҧ1 , 𝑥ҧ2 ) and the farther away he is
from that bundle, the worse off he is.

• In this case we say, (𝑥ҧ1 , 𝑥ҧ2 ) is a satiation/ bliss point

44
Satiation
I: x1 and x2 are goods –
negatively sloped IC

II: x1 and x2 are too much (both

III
are bad) – negatively sloped IC
II
III: x1 is good but x2 is bad –
positively sloped IC

IV: x2 is good but x1 is bad –

positively sloped IC

From the view point of

I IV economic choice, the interesting
region is I where you have less
than you want of most goods.

45
Properties of well-behaved preferences

Monotonicity (more is
better)

• The consumer does not

reach the maximum
satisfaction (bliss point).

• This means he/she wants

to consume more of both
goods, consumer is in
region I.

• Implication: IC’s are down

ward sloping.

46
Properties of well-behaved preferences

Averages are preferred to

extremes

• If we take two bundles of

good (x1. x2) and (y1, y2) on the
same IC curve and take the
weighted average of the two
bundles, then the average
bundle will be at least as good
as or strictly preferred to each
of the extreme bundles.

• Implication: IC’s are convex to

the origin.

47
Marginal Rate of Substitution (MRS)
• MRS measures the rate at which the consumer is willing to substitute on
good for the other in such a way that s/he gets the same level of
satisfaction.

• It is the slope of the IC.

• It is also called the marginal willingness to pay of the consumer.

• This because it measures the amount of good 2 that the one is willing to
give for a marginal amount of extra consumption of good 1.

• Note: The MRS for perfect substitutes is constant while the MRS for
perfect complements and neutrals is either infinity or zero.

48
 Marginal Rate of Substitution (MRS)

X2 • The MRS of well-

behaved preferences
decreases as we
increase the amount of
one commodity, i.e.,
the IC exhibits a
diminishing MRS.

• This means the rate at

which the consumer is
willing to substitute
(trade) x1 for x2
decreased as the
amount of x1 increases.

49
III. Utility
• Utility is a way to describe preferences.

• A utility function is a way of assigning a number to a

consumption bundle such that more preferred bundle gets
assigned larger number than less- preferred bundles.

• (x1, x2) > (y1, y2) if and only if U (x1, x2) > U (y1, y2)

• There are two ways of measuring utility.

• The cardinal approach

• The ordinal approach

50
The Cardinal Approach
• This approach states that Unit Total Marginal
utility can be measured in the
form of 1, 2, 3 etc. consumed Utility Utility
0 0 -
• Marginal Utility (MU): the
change in total utility when 1 10 10
consumption of x1 increases
by one unit. 2 18 8
∆𝑇𝑈 𝑑𝑇𝑈
MU = = 3 24 6
∆𝑥1 𝑑𝑥1
4 28 4
• Diminishing Marginal Utility:
as the consumer consumes 5 30 2
more and more of the same
product (x1) the extra 6 30 0
satisfaction (MU) s/he gets
declines. 7 28 -2

51
The Ordinal Utility Approach
• This approach states utility • Example 1
cannot be measurable in the
form of 1, 2, 3 rather it can be Bundles U1 U2 U3
ranked or ordered in the form of
1st, 2nd, 3rd, etc. A 40 4 2
B 30 3 1.5
• Monotonic transformation: is a
way of transforming one set of C 20 2 1
numbers into another set of • Example 2
numbers in such a way that the
original order is preserved.
Bundles U f = 2U f = U3 f = U +10
X 2 4 8 12
• Given U1 > U2, f (U) is considered
to be a monotonic Y 3 6 27 13
transformation if and only if f (u1)
> f (u2). Z 5 10 125 15

52
The Ordinal Utility Approach
• A monotonic transformation of a utility function is a
function that represents the same preference as the original
utility function.

o If U (x1, x2) represents particular preference, if (x1, x2) > (y1,

y2) and if only if U (x1, x2) > U (y1, y2)

o If f (U) is monotonic transformation of U and U (x1, x2) > U

(y1, y2) then f (U (x1, x2)) > f (U (y1, y2))

o Therefore, f (U (x1, x2)) > f (U (y1, y2)) if and only if (x1, x2) >
(y1, y2) and f (U) represents the same preference U.

53
The Ordinal Utility Approach - Utility Functions

54
The Ordinal Utility Approach- Marginal Utility

• Given U = f (x1, x2)

∆𝑈 𝜕𝑈 ∆𝑈 𝜕𝑈
𝑀𝑈𝑥1 = = 𝑀𝑈𝑥2 = =
∆𝑥1 𝜕𝑥1 ∆𝑥2 𝜕𝑥2

• Example 1: U = x1 + x2, find 𝑀𝑈𝑥1 𝑎𝑛𝑑 𝑀𝑈𝑥2

𝜕𝑈 𝜕𝑈
• 𝑀𝑈𝑥1 = =1 𝑀𝑈𝑥2 = =1
𝜕𝑥1 𝜕𝑥2

• Example 2: U = 4x1 + 3x2, find 𝑀𝑈𝑥1 𝑎𝑛𝑑 𝑀𝑈𝑥2

𝜕𝑈 𝜕𝑈
• 𝑀𝑈𝑥1 = =4 𝑀𝑈𝑥2 = =3
𝜕𝑥1 𝜕𝑥2

55
The Relationship between Marginal Utility and MRS
∆𝑈 𝜕𝑈 ∆𝑈 𝜕𝑈
• 𝑀𝑈𝑥1 = = 𝑀𝑈𝑥2 = =
∆𝑥1 𝜕𝑥1 ∆𝑥2 𝜕𝑥2

• ΔU = 𝑀𝑈𝑥1 Δ𝑥1 and ΔU = 𝑀𝑈𝑥2 Δ𝑥2

• Suppose both x1 and x2 changes but the consumer is on the same IC.

• Total change in ΔU = 𝑀𝑈𝑥1 Δ𝑥1 + 𝑀𝑈𝑥2 Δ𝑥2 = 0, because the consumer

is on the same IC.

• 𝑀𝑈𝑥1 Δ𝑥1 = − 𝑀𝑈𝑥2 Δ𝑥2

𝑀𝑈𝑥1 Δ𝑥2
• =−
𝑀𝑈𝑥2 Δ𝑥1

56
The Relationship between Marginal Utility and MRS
𝑴𝑼𝒙𝟏
• MRS𝒙 ,𝒙 =-
𝟏 𝟐 𝑴𝑼𝒙𝟐

• MRS is the ratio of marginal utilities and it also measures the

slope of the indifference curve.

• Note: taking the monotonic transformation of a utility function

does not change MRS.

1/2 1/2
• Example: U = 𝑥1 𝑥2 and U = 𝑥1 𝑥2

• MRS𝒙 ,𝒙 for both utility functions is 𝑥2 Τ𝑥1

𝟏 𝟐

57
Exercise
• Identify the preferences, draw the IC’s and find the
MUX1, MUX2 and MRS.

1. U = 𝑥12 𝑥22 6.U = 𝑥1 + 𝑥2

2. U = 𝑥1𝑚 𝑥2𝑛 7. U = 𝑥1 + 𝑥2
3. U = 𝑥1𝑚 𝑥21−𝑚 8. U= Min (3𝑥1 , 𝑥2 )
4. U = 6𝑥1 + 𝑥2 9. U = 𝑥10.5 𝑥20.5
5. U = ln𝑥1 + 𝑥2 10. U = 2𝑥1 + 𝑥2

58
IV. Optimal Choice
• Given the objective market information contained in the budget
line and the subjective preferences of the consumer embodied in
the indifference curves, we can now determine the consumers
optimum or utility maximizing position.

• The consumer maximizes utility by choosing (preference) the best

bundle that s/he can afford (which is within his/her budget set).

• Objective: to find the bundle in the budget set that is on the

highest indifference curve.

• The consumer utility maximizing point is given by the tangency of

the budget line and the indifference curve (i.e. the point where
the slope of the budget line equals the slope of the indifference
curve).

59
Optimal Choice
• In the left panel, point A gives
The consumer maximizes us the optimum of the
utility at a point consumer.
∆𝒙𝟐 −𝑷𝟏 −𝑴𝑼𝒙𝟏
= = = MRS
∆𝒙𝟏 𝑷𝟐 𝑴𝑼𝑿𝟐
• At point B, the IC is crossing the
budget line from below (i.e. the
budget line is steeper than the
C IC) and hence to reach optimal
point, the consumer should
reduce the consumption of X1
and increase the consumption
A D of X2 .
I3
• At point C, the budget line is
flatter than the indifference
I2 curve and hence to reach
B optimal point, the consumer has
to increase consumption of x1
I1 and reduce consumption of X2.

60
Optimal Choice
• The tangency condition is a
necessary condition but not
sufficient for the bundles to
be optimal.

• At point C, I1 is tangent to the

budget line from below. Even A
if the tangency condition is
satisfied, point C is not c
optimal because we can reach
on a higher IC – I2 by
reallocating x1 and x2. I3
B

• Thus, the necessary and I2

sufficient condition for I1
optimality is that the IC’s
should be tangent to the
budget line from above.

61
Mathematical derivation of the optimal choice and
consumer demand
• The Lagrange Multiplier Method: is a method of finding the maximum
or minimum of a constrained function.

Given U= U (x1, x2) ………………….. Objective function

P1x1 + P2x2 =M ……………….. Budget constraint

• The objective of the consumer is to maximize utility U (x1, x2) subjected

to a budget constraint P1x1 + P2x2 =M. Then the Lagrangian function will
be given as

L = U (x1, x2) + λ (M - P1x1 - P2x2)

• Where, λ is the Lagrangian multiplier which measures the change in the

objective function when the constant of the constraint changes by one
unit – in our case λ measures the marginal utility of income.

62
Mathematical derivation of the optimal choice and
consumer demand

• The first order conditions for optimality states that;

𝜕𝐿 𝜕 𝑈 (𝑥1 ,𝑥2 )
• = - λ𝑃1 = 0 …………………………. (1)
𝜕𝑥1 𝜕𝑥1

𝜕𝐿 𝜕 𝑈 (𝑥1 ,𝑥2 )
• = - λ𝑃2 = 0 …………………………. (2)
𝜕𝑥2 𝜕𝑥2

𝜕𝐿
• = M - P1x1 - P2x2 …………………………….. (3)
𝜕𝜆

• From (1) and (2) we get

𝜕𝑈Τ𝜕𝑥1 𝑀𝑈𝑥1 𝑃1
• = = = 𝑀𝑅𝑆 𝑥2 , 𝑥1
𝜕𝑈Τ𝜕𝑥2 𝑀𝑈𝑥2 𝑃2

63
Mathematical derivation of the optimal choice and
consumer demand

• Example 1: Maximize U = 𝑥1𝑎 𝑥2𝑏 subjected to P1x1 + P2x2 =M

• First order conditions

𝜕𝐿
• = 𝑎𝑥1𝑎−1 𝑥2𝑏 - λ𝑃1 = 0 …………………………. (1)
𝜕𝑥1
𝜕𝐿
• =𝑏𝑥1𝑎 𝑥2𝑏−1 - λ𝑃2 = 0 …………………………. (2)
𝜕𝑥2
𝜕𝐿
• = M - P1x1 - P2x2 …………………………….. (3)
𝜕𝜆
𝑎𝑥1𝑎−1 𝑥2𝑏 𝑏𝑥1𝑎 𝑥2𝑏−1
• From equation 1, λ = and from equation 2, λ =
𝑃1 𝑃2

64
Mathematical derivation of the optimal choice and
consumer demand
𝑎𝑥1𝑎−1 𝑥2𝑏 𝑃1 𝑎𝑥2 𝑃1
• Since λ = λ; we will have 𝑏−1 = → =
𝑏𝑥1𝑎 𝑥2 𝑃2 𝑏𝑥1 𝑃2
𝑏𝑃1 𝑥1
• 𝑥2 = ………………………. (4)
𝑎𝑃2

• From equation (3) P1x1 + P2x2 =M substituting (4) into this: P1x1 +
𝑏𝑃1𝑥1
P2 =M
𝑎𝑃2

𝑴 𝒂 𝑎
• 𝒙𝟏 = ………………… Consumer demand for x1; where is share
𝑷𝟏 𝒂+𝒃 𝑎+𝑏
of income spent on x1

• The demand for x1 = f (P1, M), is positively related with income and
negatively related to its own price.

65
Mathematical derivation of the optimal choice and
consumer demand
𝑏𝑃1𝑥1 𝑏𝑃1 𝑀 𝑎
• From (4) 𝑥2 = =
𝑎𝑃2 𝑎𝑃2 𝑃1 𝑎+𝑏

𝑴 𝒃
• 𝒙𝟐 = ………………… Consumer demand for x2
𝑷𝟐 𝒂+𝒃

𝑏
• Where is share of income spent on x2.
𝑎+𝑏

• The demand for x2 = f (P2, M), is positively related with

income and negatively with price.

• Example 2: Maximize U = 𝑥1 𝑥2 subjected to 2x1 + 4x2 =200

66
Exercise
1. Max U = 𝑥13 𝑥2 subjected to 6x1 + 3x2 =600
2. Max U = 𝑥12 𝑥23 subjected to 2x1 + 4x2 =600
3. Max U = 𝑥1 𝑥2 subjected to 2x1 + 4x2 =300

4. Suppose the consumer’s objective is to Max U = 𝑥12 𝑥23 subjected

to 3x1 + x2 = 50,

a) How much of x1 and x2 should the consumer consume to maximize

utility?

b) If price of x2 increases to 2 birr, how much of x1 and x2 should be

consumed to maximize utility?

c) If the price x2 increases to 2 birr and if the consumer wants to

consume the same level of goods as in (a) by how much should
income increases?

67
Exceptions to Tangency
• Utility maximization may not always be characterized
by tangency.

• Perfect Complements

• Bad/Neutrals

• Perfect Substitutes

• Convex Preferences
68
Exceptions to Tangency - Perfect complements

• At point E, utility is maximized

but I2 is not tangent with the
budget line rather at optimum IC
has a kink at point E.

• At point E the slope of the IC is

not defined and hence the slope
of IC is different from the slope of
the budget line.

• Since the consumer is purchasing E

the same amount of good 1 and
good 2 no matter what price
demand function is given as
follows:

• P1x + P2x =M → M/P1 +P2

69
 Exceptions to Tangency - Bad/Neutrals

Neutrals
Bad
U1 U1 U2 U3
U2
U3

Good
Good

• The above panels represent boundary optimum (until now we were dealing with
interior optimum).

• In this case the consumer spends all of his/her money on the good he/she likes
and does not purchase the neutral/bad at optimum.

• Thus, if x1 is good and x2 is bad/neutral, demand function will be x1 = M/P1, x2 = 0.

70
Exceptions to Tangency - Perfect Substitutes
• In this case, the consumer
will buy the cheapest
commodity.

1. If P1 < P2 then demand for

𝑥1 = 𝑚Τ𝑝1 and x2 = 0

2. If P1 = P2 any point on the

budget line, i.e., any
amount of x1 and x2 that
satisfy the budget line.

3. If P1 > P2 then the demand

for x1 = 0

71
Exceptions to Tangency – Concave Preferences

• In this case since the

consumer does not
want to consume them
together, he/she will
spend all of his/her
money on one or the
other good.

• The optimal choice is

the boundary point, Z,
not the interior
tangency point, X,
because Z lies on a
higher indifference
curve

72
V. Demand
• From the previous section recall that the consumers demand function
gives the optimal amount of each of the goods as a function of price and
income faced by the consumer.

• In this section, we will examine how the demand for goods changes as
prices and income change.

• Studying how choice responds to changes in the economic environment

is known as comparative statics.

• In subsequent sections we will see what happens to consumer

equilibrium (and demand for the goods as well) when:

• Income changes everything else constant

• Price changes everything else constant

73
Normal and Inferior Goods
• 1. Normal Goods: the demand for such goods
increases as income increases and decreases as
∆𝑥
income decreases, i.e. >0
∆𝑀

• 2. Inferior Goods: we would normally think that the

demand for any good increases as income
increases. But there are also situations where
demand for some goods decreases as income
increases and vice versa. Such goods are
∆𝑥
considered as inferior goods i.e. < 0.
∆𝑀

74
Income offer curve and Engle Curve
• In section I, we have seen that an increase in income corresponds
to shifting the budget line outward in a parallel manner.

• If we connect together the demanded bundles on each shifted

budget lines, we can construct the income offer curve.

• The income offer curve (IOC) shows the bundles of goods that
are demanded at different levels of income. If both goods are
normal, IOC will have a positive slope.

• Engle curve shows the relationship between income of the

consumer and quantity demand of x1 and x2. It’s a graph of
demand for one of the goods as a function of income, with all
prices being held constant. Engle curve for normal goods is
positively sloped.

75
Income offer curve and Engle Curve

• Panel A show income offer curve for normal goods (x1 and x2).

• Panel B shows Engle curve for good 1 and it is positively sloped

because x1 is assumed to be normal good.

76
Income offer curve and Engle Curve
X2 Income

𝑀 ′′
𝑃1
𝑀′ ′
𝑒′
𝑃2
𝑀 𝑒′ 𝑀′′
𝑃2
e 𝑀′
M

𝑀′ 𝑀 ′′
X1 X1
𝑀
𝑥1′′ 𝑥1′ 𝑥1
𝑃1 𝑃1 𝑃1

(a) (b)

• Panel (a) shows income offer curve when X1 is an inferior good.

• Panel (b) shows Engle curve for good 1 and it is negatively sloped.

77
Perfect Substitutes
• Here we can consider three cases:

• (1) P1 < P2, X2 = 0 then the horizontal axis will be the IOC
while the Engle curve for X1 will be positive with a slope P1,

• (2) P2 < P1, X1 = 0 then the vertical axis will be the IOC while
the Engle curve for X2 will be positive with a slope P2 and

• (3) P1 = P2, any consumption bundle which is on the budget

line will maximize the consumer utility and hence both the
IOC and Engle curve will be positively sloped.

78
Perfect Substitutes

Income offer curve and Engel curve when P1 < P2

79
Perfect Complements
• In the case of perfect complements, since the consumer will always
consume the same amount of each goods, demand is given by X1 =
X2 = M/ (P1 +P2).

• Thus, the income offer curve is diagonal line through the origin and
also the Engle curve is a straight line with a slope of P1 + P2.

M Engle Curve
X2

IOC
Slope = P1+ P2

X1
X1

80
Cobb – Douglas Preferences
• For the case of Cobb-Douglas preferences, if U = 𝑥1𝑎 𝑥21−𝑎 the demand for
good 1 has the form 𝑎𝑀Τ𝑃1 and the demand for good 2 is
(1 − 𝑎)𝑀Τ𝑃2 .

• Based on the fact that the demand function for both goods are linear
functions, the income offer curve will be straight lines through the origin
and Engle curve for both good 1 and good 2 will be a straight line as well
with a slope 𝑃1 Τ𝑎 and 𝑃2 Τ1 − 𝑎 respectively.

M Engle Curve
X2

IOC Slope = 𝑃1 Τ𝑎

X1
X1

81
Ordinary and Giffen Goods
• 1. Ordinary Goods: the demand for such goods
increases as price decreases and decreases as price
∆𝑥
increases, i.e. < 0
∆𝑃

• 2. Giffen Goods: we would normally think that the

demand for any good decreases as price increases.
But there are also situations where demand for
some goods increases as price increases. Such
∆𝑥
goods are considered as giffen goods i.e. > 0.
∆𝑃

82
Price Offer Curve and Demand Curve
• Let us now consider the effect of price changes on the
consumer’s demand keeping everything else constant.

• The price offer curve (POC) shows the bundles of

goods that are demanded at different levels of prices.

• The demand curve shows the relationship between

price and quantity demand of x1 or x2. It’s a graph of
demand for one of the goods as a function it own price,
with income and all other prices being held constant.

83
Price Offer Curve and Demand Curve

• Panel A contains a price offer curve for a normal good, which depicts the
optimal choices as the price of good 1 changes.

• Panel B contains the associated demand curve, which depicts a plot of the
optimal choice of good 1 as a function of its price.

84
Perfect Substitutes
We can consider three cases:

• If P1 < P2, demand for x2 will be zero and only x1 will be demanded
• If P1 > P2, demand for x1 will be zero and only x2 will be demanded
• If P1 = P2, any combination of x1 and x2 which on the budget line will be
demanded

P1 > P2

P1 < P2

85
Perfect Complements
• The price offer curve in the case of perfect complements is diagonal
line through the origin and the demand curve is downward sloping.

86
Decomposition of Income and Substitution Effects
• Change in price have two effects: (1) the rate at which you can exchange
one good for another changes, and (2) the total purchasing power of
your income is altered.

• For example, if good 1 become cheaper, it means that you have to give
up less of good 2 to purchase good 1, i.e., the rate at which the market
allows you to “substitute” good 2 for good 1 changes.

• At the same time, if good 1 becomes cheaper it means that your money
income will buy more of good 1, i.e., the purchasing power of your
money has gone up.

• The substitution effect – change demand due to change in the rate of

exchange between the two goods.

• The income effect – change demand due to having more purchasing power

88
Slutsky's Decomposition
• Suppose the price of good 1 declined. This means that the budget line
shift along the horizontal axis and becomes flatter.

• This movement of budget line can be break into two steps;

• First pivot the budget line around the original demand bundle (i.e. draw
a new budget line that indicates the same relative price as the final
budget line but has a different income).

• Then, shift the pivoted line out to the new demand bundle.

• The first step – the pivot – is a movement where the slope of the budget
line changes while its purchasing power stays constant, while the
second step is a movement where the slope stays constant and the
purchasing power changes.

89
Slutsky's Decomposition
• Point ‘Y’ is optimal
purchase on the pivoted
budget line.

• Movement from X to Y is
the substitution effect and
it indicates how the
consumer “substitutes”
one good for the other
when price changes but
purchasing power remains
constant.

• Movement from Y to Z is
the income effect which
indicates how demand
changes when income
changes while relative
prices remain constant.

90
Slutsky's Decomposition
• Substitution effect is negative, since the change in demand due to the
substitution effect is opposite to the change in price, i.e., if price
increases, the demand for the good due to the substitution effect
decreases and vice versa.

• The income effect can be negative or positive depending on whether

the good is normal or inferior.

• If the good is normal income effect will be positive while for an inferior
good it is negative.

• The total change in demand is the change in demand due to the change
in price, holding income constant.

• It is the sum of change in demand due to the substitution effect and

the income effect which is given by the Slutsky identity.

91
Slutsky's Decomposition
• We can use what we know about the signs of the income and
substitution effect to determine the sign of the total effect.

• While the substitution effect must always be negative – opposite

to the change in price – the income effect can go either way.

• Thus, the total change in demand will depend on which effect is

dominant.

• If it is a normal good, the substitution effect and the income

effect work in the same direction, i.e., an increase in price will
decrease demand.

92
Slutsky's Decomposition
• If we have inferior good, it might happen that the income effect
outweighs the substitution effect, so that the total change in
demand associated with a price increase is actually positive.

• This would mean that an increase in price could result in an

increase in demand.

• This is the perverse Giffen good case where the increase in price
has reduced the consumer’s purchasing power so much that she
has increased her consumption of the inferior good.

• Thus a Giffen good must be an inferior good but an inferior good

is not necessarily a Giffen good: the income effect not only has to
be of “wrong” sign, it also has to be large enough to outweigh the
sign of the substitution effect.

93
The Law of Demand
• If the demand for a good increases when income
increases, then the demand for that good must
decrease when its price increases.

• This follows from the Slutsky equation: if the demand

increase when income increases, we have a normal
good.

• And if we have a normal good, then the substitution

effect and the income effect reinforce each other, and
an increase in price will unambiguously reduce
demand.

94
Hicksian Decomposition
• For the Hicks substitution effect, instead of pivoting the
budget line around the indifference curve through the
original consumption bundle, we now roll the budget line
around the indifference curve through the original
consumption bundle.

• The purchasing power the consumer has under this budget

line will no longer be sufficient to purchase his original
bundle of goods – but it will be sufficient to purchase a
bundle that is just indifferent to his original bundle.

• Thus, the Hicks substitution effect keeps utility constant

rather than keeping purchasing power constant.

95
Hicksian Decomposition
• The Slutsky substitution
effect gives the consumer
just enough money to get
back to his old level of
consumption, while the
Hicks substitution effect
gives the consumer just
enough money to get
back to his old
indifference curve.

• Despite this difference,

the sign of the Hicks
substitution effect is
negative like the Slutsky
substitution effect.

96
Market Demand
• Market Demand is derived by horizontally adding the quantity
demanded for the product by all buyers at each price.

• The figure below shows individual and market demand curve at price
equal to 3
Required Revision from Econ (1011)
• Elasticity of Demand
o Price elasticity
o Income elasticity
o Cross-price elasticity

98