HARAMAYA UNIVERSITY

FACULTY OF CONTINUING AND DISTANCE EDUCATION

MICROECONOMICS-I
MODULE-I

October, 2006
 Haramaya University
Faculty of Continuing and Distance Education

Microeconomics I
Module I

October, 2006
 Table of Contents

Course Introduction .......................................................................................................... V

Module Introduction ...................................................................................................... VII

Unit One: The Nature of Economics ................................................................................. 1

INTRODUCTION ................................................................................................................. 1
SECTION 1: BASIC CONCEPTS IN ECONOMICS ..................................................................... 2
1.1.1. Definitions .......................................................................................................... 2
1.1.2. Scarcity and Opportunity Cost ............................................................................ 3
1.1.3. Production Possibilities ...................................................................................... 4
SECTION 2: ECONOMIC QUESTIONS.................................................................................... 6
1.2.1. Economic Systems .............................................................................................. 7
1.2.2. The Circular Flow .............................................................................................. 9
SUMMARY ...................................................................................................................... 10
SELF-TEST EXERCISES ..................................................................................................... 11
SUGGESTED READING MATERIALS .................................................................................. 12

Unit Two: Theory of Demand and Supply ...................................................................... 13

INTRODUCTION ............................................................................................................... 13
SECTION 1: THEORY OF DEMAND ...................................................................................... 14

2.1.1. Definitions ........................................................................................................ 14

2.1.2. The Law of Demand .......................................................................................... 17
2.1.3. Individuals’ Demand for a Product ................................................................... 17
2.1.4. Market demand................................................................................................. 17
2.1.5. Demand Function ............................................................................................. 19
2.1.6. Movement along the Demand Curve and Shift in the Demand Curve ................ 19
SECTION 2: THEORY OF SUPPLY ...................................................................................... 23
2.2.1. Definitions ........................................................................................................ 24
2.2.2. The Law of Supply ............................................................................................ 25
2.2.3. Individual Firm’s Supply .................................................................................. 26
2.2.4. Market (Industry) Supply .................................................................................. 26
2.2.5. Supply Function................................................................................................ 28
2.2.6. Movement along the Supply Curve and Shifts in the Supply Curve .................... 28
SECTION 3: MARKET EQUILIBRIUM.................................................................................. 31
2.3.1. Definition ......................................................................................................... 32
2.3.2. Graphic Approach to Equilibrium .................................................................... 32
2.3.3. Numerical Approach to Equilibrium ................................................................. 34
2.3.4. Effects of Change in Demand ............................................................................ 36

iii
 2.3.5. Effects of Change in Supply .............................................................................. 40
2.3.6. Simultaneous Shift in Demand and Supply........................................................ 44
SECTION 4: ELASTICITY .................................................................................................. 49
2.4.1 Concept of Elasticity ......................................................................................... 50
2.4.2. Elasticity of Demand ........................................................................................ 51
2.4.3. Elasticity of Supply........................................................................................... 70
SUMMARY...................................................................................................................... 72
SELF-TEST EXERCISES .................................................................................................... 74
ANSWERS TO EXERCISES ................................................................................................ 76
SUGGESTED READING MATERIALS .................................................................................. 78

Unit Three: Theory of Utility and Preferences ............................................................... 79

INTRODUCTION............................................................................................................... 79
SECTION 1: CARDINAL UTILITY APPROACH ..................................................................... 81
3.1.1. Assumptions of Cardinal Utility Theory ............................................................ 81
3.1.2. Total Utility and Marginal Utility..................................................................... 82
3.1.3. Utility and Consumer Behavior ........................................................................ 85
3.1.4. Equilibrium of the Consumer ........................................................................... 86
3.1.5. Derivation of the Demand Curve of the Consumer ........................................... 91
3.1.6. Consumers’ Surplus ......................................................................................... 92
SECTION 2: ORDINAL UTILITY APPROACH ....................................................................... 94
3.2.1. Assumptions of Ordinal Utility Theory ............................................................. 95
3.2.2. Preference Ranking .......................................................................................... 95
3.2.3. The Indifference Curve ..................................................................................... 98
3.2.4. Marginal Rate of Substitution......................................................................... 103
3.2.5. The Budget Constraint ................................................................................... 106
3.2.6. The Equilibrium of the Consumer ................................................................... 115
SUMMARY.................................................................................................................... 132
SELF-TEST EXERCISES .................................................................................................. 133
ANSWERS TO EXERCISES .............................................................................................. 136
SUGGESTED READING MATERIALS ................................................................................ 139

Answers to Self-Test Questions ..................................................................................... 140

iv
 COURSE INTRODUCTION

There are two broad approaches to the study of economic science: Microeconomics and
Macroeconomics. Because of their broadness these approaches can be split into two courses
each, for instructional purpose. The first part of microeconomics is covered by
Microeconomics-I and the second part with Microeconomics-II. The materials designed for
the course Microeconomics-I consist of two modules prepared in a coherent manner.

Regarding the organization, there are seven units to be covered in this course: Three in
Module-I and the remaining four in Module-II. The first is an introductory unit presenting an
overview of basic concepts in economics; unit two explains the theory of demand and
supply; the third unit dwells on utility and preferences; unit four presents the details of
theory of production; unit five explains theory of costs; and Units six and seven are
exclusively devoted to product market structures emphasizing on perfectly competitive
market and pure monopoly market, respectively.

All possible efforts have been made to enhance the usefulness of the material. In both of the
modules, it has been tried to discuss the main principles of economics and to make the
science of economics understandable. Further, the explanation of various economic theories
has been supported by appropriate tables, figures, and examples. In addition, adequate
number of activities and exercises are included for further thought of the distance learner.

v
COURSE OBJECTIVES

The objectives of this course are:

 To provide an insight into the economic way of thinking through exposure to the
theories and methods of economics.

 To enable students to have a deeper understanding of microeconomics and be more

confident in its applications.

 To allow learners to understand and predict the economic choices that individual
consumers and profit-oriented producers encounter and their effects on society.

 To help learners understand supply and demand relationships, utility concepts, and
cost and revenue curves as they relate to price theory in various forms of market
structures.

vi
 MODULE-I

Introduction

In this module three units are included. All units of this module are designed in a way that
we have introduction of the chapter at the beginning followed by chapter objectives. Then
brief introductions and objectives of sections are presented. Topics and subtopics are, then,
discussed in detail by including relevant examples and questions in the forms of activities
and exercises that the learner is expected to think about. Then we have unit summary to help
the reader capture important concepts of the chapter followed by self-test exercises, answers
for exercises in the unit, and suggested reading materials. At the end of the module, answers
to self-test exercises are included.

Objectives

At the end of this module, you will be able to:

 Explain the basic concepts and definitions in economics.

 Describe the role of demand and supply forces in determining price and output in a
free market economic system.

 Discuss how the theory of indifference curves is used to show consumers‟ decision
making behavior.

vii
 UNIT ONE: THE NATURE OF ECONOMICS

UNIT ONE

THE NATURE OF ECONOMICS

Introduction

Dear learner, are you familiar with the word „economics‟? If so, can you remember the
major concerns of economics? If not, don‟t worry. This unit will introduce you briefly about
these issues.

Economics as a course sheds light to many of the problems that we face, the current issues
that we come across, etc. Though not all problems are necessarily economic, most of them
have economic dimensions. Therefore, studying economics provides us with a better
understanding of how the world functions.

In this world of finite resources, we have to face the fact of scarcity. Our wants and desires
for economic goods (those goods which are not available for free) are very great compared
to our ability to satisfy them. This forces us to make choice among different desirable things
according to their importance.

Objectives

After studying this unit, you will be able to:

 Define economics and be able to make basic distinctions between microeconomics

and macroeconomics;

 Define and explain opportunity cost;

 Define the production possibility curve; and

 Define and explain free market system, mixed economic system and command
economics system.

1 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

Section 1: Basic Concepts in Economics

Introduction

Colleague, let us start our discussion with the concept of resources in the definition of
economic science. In this section, we will first define economics; then we will look in to the
concept of scarcity and opportunity cost; and finally we will discuss production possibilities.

The world is endowed with various resources. Some are free and others are available with
cost. Economics concerns itself with the latter type of resources. Economic resources are
available in limited quantity. The problem, therefore, is finding the best way of allocating
these scarce resources.

Objectives

At the end of this section, you should be able to:

 Define economics;

 Define and distinguish between microeconomics and macroeconomics;

 Define scarcity and opportunity cost; and

 Define the production possibility curve.

1.1.1. Definitions

How do you define economics? Ok! Economics has been defined in different ways by
different authors. Let you compare your definition with the following more general
definition:

Definition: Economics is the scientific study of how people and their institutions go about
producing and consuming goods and services and how they face the problem of making
choices in the world of scarce resources.

The study of economics is often divided into microeconomics and macroeconomics.

Before you read the following, can you say something about the difference between
microeconomics and macroeconomics? Good! Read the following carefully.

HARAMAYA UNIVERSITY 2
 UNIT ONE: THE NATURE OF ECONOMICS

Microeconomics looks at the interactions of producers and consumers in individual

marketssay, the market for shoesand the interactions between different marketssay, the
market for coffee and the market for tea.

Macroeconomics studies the behavior of economy-wide measures such as the Gross

National Productthe value of final output that the economy produces in a given time
periodas well as categories that cut across many markets, such as total employment in
manufacturing industries or total exports.

In both microeconomics and macroeconomics, the most important tools are the ideas of
demand and supply. They help explain price and output in individual markets and how
prices and output in different markets are related.

Colleague, did you understand the difference between microeconomics and

macroeconomics? Good! Microeconomics actually deals with the aspects like individual
demand, individual supply, individual income, individual employment, individual savings,
and individual investment. Macro-economics, on the other hand, is a study of broad
economic events that are largely beyond the control of individual decision makers and yet
affect nearly all firms, households and other institutions in the economy.

1.1.2. Scarcity and Opportunity Cost

Dear colleague, now, we will turn to the discussion of scarcity and opportunity cost. Do you
know the different types of resources? Ok. A society‟s resources consist of natural
endowments such as land, forests, and minerals; human resources, both mental and physical;
and manufactured aids to production such as tools, machinery, and buildings. Such resources
are called factors of production in economics, because they are used to produce output that
people desire. These outputs could be goods or services. Goods are tangible (e.g., shoes,
bread), and services are intangible (e.g., education, entertainment).

People use these goods and services to satisfy their wants. The act of making goods and
services is called production and the act of using them is called consumption.

The quantity of factors of production and the goods and services they help produce is not
infinite. The existing resources are inadequate to satisfy the unlimited desires of people.
Wants are insatiable, because no matter how much people have, they always want more of

3 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

them. Since not all wants can be satisfied, individuals have to pick and choose among the
possibilities open to them. Every society is faced with the same problems of scarcity and
choice.

Colleague, what types of measures do individuals take while they are facing scarcity of
resources? Ok! Let us see it together. Scarcity forces individuals to economize on their use
of resources. Every decision to produce or to consume something means that we must forego
producing or consuming something else. The cost of engaging in certain activity, say, going
to cinema, includes cost of the ticket and the value of what is given up in order to participate
in that activity. The time spent watching movie could have been spent in other activities,
such as work. You are therefore giving up the opportunity of working in order to watch
movie. The value of this foregone opportunity is called opportunity cost.

Definition: opportunity cost is the value of the next best opportunity given up in order to
enjoy a particular good or service.

Colleague, let us make the concept of opportunity cost clear. Suppose the person in the
above example could have earned an hourly wage of Birr 20 had he decided to work rather
than go to the cinema. For the individual, the opportunity cost of enjoying a 1 hour and 45
minutes movie is Birr 35.

1.1.3. Production Possibilities

Dear learner, let us classify factors of production discussed earlier. In their production
process, firms use factors of production. These factors of production are often divided into
four categories: entrepreneurship, labor, land, and capital. Can you differentiate among these
factors of production? Don‟t worry. You can differentiate among these factors after careful
reading of the following.

Entrepreneurship entrepreneurs combine the other factors of production by buying these

factors to produce a saleable product. When they put money into their production process,
entrepreneurs are taking risks. The return for entrepreneurship is called profit.

Labor labor is defined as the physical and intellectual exertion of human beings. The
efforts of a teacher, factory worker, clerk, and a carpenter are all called labor. For its

HARAMAYA UNIVERSITY 4
 UNIT ONE: THE NATURE OF ECONOMICS

contribution in production, labor is remunerated in the form of wages; i.e., the resource
payments that entrepreneurs make for the use of labor.

Land land refers to all natural resources that can be used as inputs to production, for
example, minerals, water, air, forests, oil, and even such intangibles as rainfall, temperature,
and soil quality. The key distinction between land and certain kinds of capital is that land
consists of natural resources or conditions unimproved by labor or capital expenditure. For
example, land in Afar region that has been irrigated represents more than land. It also
represents capital. The income payment to land is called rent.

Capital capital is defined as all man-made aids to production. Capital includes tools,
factories, warehouses, stocks of inventories, and the like. We should be clear to distinguish
capital from money. Capital, as a factor of production, refers to physical things. In essence,
capital goods are the tools of production. Capital, like other factors of production, receives
income. The payment to capital is called interest. Investment is the act of adding to capital
stock. Money, on the other hand, is any asset that is generally acceptable in transactions and
in settlement of debts.

Did you understand the difference now? Good. Let us discuss about production possibilities.
To see the production possibilities open to a firm (or any production unit), consider the
choice between the production of food and clothing. It is possible to increase the production
of both only if there are some unused resources. That is, if there is some unemployed labor,
unused land, idle capital etc., the production of both food and clothing could be increased.
But if factors of production are fully employed, it is not possible to have more of both.

Assuming that factors of production are fully employed, there are only two goods, food and
clothing, and factors of production are homogenous; the production possibility open to a
production unit can be presented using the production possibility curve (PPC).

The assumption of homogenous factors of production implies that all units of labor, capital
and land are identical. This assumption, in fact, contrasts with reality. Do you think that the
productivity of two pieces of land, one in a highland area and one in a desert, can be the
same? Definitely no.

5 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

Food

10 a
8  b Production Possibility Curve
4 c

0 7 10 Clothing
Figure 1.1: Production Possibility Curve

There are three important regions in Figure 1.1 above. Can you identify them? If yes, good.
If no, don‟t worry. We will see it together. If resources are fully employed, the firm will be
able to produce combinations of food and clothing on the PPC such as point a. If there are
some unused resources (if there is underutilization) the firm will produce combinations to
the left of the PPC such points like b. Production above the PPC at points like c is
impossible for any given quantity of factors of production, and therefore is called
unattainable region. For any given quantity of factors of production, the attainable region of
production is that on and below the PPC.

The production possibility curve illustrates three concepts: scarcity, choice, and opportunity
cost. Scarcity is indicated by the unattainable combinations above the PPC; choice, by the
need to choose among the alternative attainable points along the PPC; and opportunity cost,
by the negative slope of the PPC.

Section 2: Economic Questions

Introduction

Dear learner, in the previous section, we have seen the basic concepts in economics. In this
section, we will differentiate among the different economic systems and then discuss how
firms and households interact using the concept of circular flow.

Over the course of the world, different economic ideas were dominant in different time
periods. Even in today‟s world, different economic ideologies are adopted in different
economies. During the cold war USSR, Eastern European countries and some African

HARAMAYA UNIVERSITY 6
 UNIT ONE: THE NATURE OF ECONOMICS

(Ethiopia for example), Asian and Latin American countries followed communist ideologies
while capitalist ideologies dominated most of the west. The ideology followed by an
economy affect the allocation of resources in that economy to a larger extent.

Objectives

At the end of this lesson you will be able to

 Define traditional, market, command, and mixed economic systems.

 Explain how the product market interacts with the factor market.

1.2.1. Economic Systems

Colleague, the production possibilities curve discussed above sets the stage for identifying
the major microeconomic and macroeconomic problems.

The major economic questions can take many forms, but they can be reduced to three basic
ones:

1. What combination of goods and services is to be produced?

2. How or in what manner are the goods and services to be produced?

3. For whom will the goods and services be produced, and how much will each person
receive?

Each of these questions is addressed in every society, and microeconomic theory

concentrates on the ways different types of economic organizations formulate answers to
these questions.

Do you know the different economic systems prevailing in the world? Can you answer the
above basic economic questions from the point of view of these systems? Anyway,
economists divide economic systems into four major groupsthe traditional economy, the
planned (command) economy, the market economy, and the mixed economy. Just read
attentively so as to understand how the basic questions are answered in these four systems.

1) The Traditional Economy: The traditional economy answers the fundamental

microeconomic questions by appeal to tradition. What is produced is what the young have
been taught by their parents to hunt, to gather, or to plant. The techniques of production of

7 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

how to produce are also passed on, often without change, from generation to generation. The
amount of production is, of course, highly dependent on good fortune. The last question,
concerning distribution, is also traditionally determined. In fact, traditional societies may
have rules on how output is to be divided.

2) The Planned Economy: It answers the fundamental microeconomic questions through

planning or through central command and control. The decisions regarding what, how, and
how much to produce are spelled out and documented. Detailed plans and orders are sent to
producers, and these instructions carry the weight of the law. A large part of the question of
who gets what is determined in the same way, because planners determine wage rates and
the amount of production of consumer goods. Of course, in any economy, people plan; that
is, they think about the future and make preparations for it. Economists use the term planned
economy to refer to one in which the government plays a large role in answering the
production and consumption questions of the society.

3) The Market Economy: The organizing principles, here, are the forces of demand and
supply. The determination of what to produce is made by consumers, and the force of
demand causes prices to go up for certain products when consumers desire more of them.

In a sense, consumers vote with their money. The result of this voting process determines
what will be produced. Suppliers combine resources, determining how things are to be
produced. Assuming suppliers are self-interested and seek to maximize their profits, they
tend to combine inputs to produce any good or service at the lowest possible cost. This
determination depends on the prices of resources. Suppliers will use more of relatively
abundant resources because they are relatively cheap. This, in turn, helps conserve the
scarcer (more expensive) resources. The goods are then distributed to consumers who have
the purchasing power to buy them. Those who have more purchasing power receive more
goods and services.

4) The Mixed Economic System: In the real world we find that economies are the blend of
traditional, planned and market economic systems. In practice every economy is a mixed
economy in the sense that it combines significant elements of all three systems.

Furthermore, within any economy, the degree of the mix will vary from sector to sector. For
example, in some planned economies the command principle was used more often to

HARAMAYA UNIVERSITY 8
 UNIT ONE: THE NATURE OF ECONOMICS

determine behavior in heavy goods industries, such as steel, than in agriculture. Farmers
were often given substantial freedom to produce to varying market prices.

When we speak of a particular economy as being a centrally planned economy, we mean

only that the degree of the mix is weighted heavily toward the command principle. When we
speak of an economy as being a market economy, we mean only that the degree of the mix is
weighted heavily toward decentralized decision making in response to market signals. It is
important to realize that such distinctions are always matters of degree, and that almost
every conceivable mix can be found across the world‟s economies.

1.2.2. The Circular Flow

Dear colleague, did you know the difference between factor market and product market? If
no, don‟t worry. We will see it together.

In a pure market economy, there are two distinct markets in which firms interact with
households. Households are purchasers of goods and services that firms produce, and there
is a flow of money to firms in payment for these goods and services. The market in which
these exchanges take place is referred to as the product market. Firms buy factors of
production from households in order to produce the goods and services they sell to the
households. The market in which these transactions take place is called the factor market.

Assuming that all factors of production are owned by households and all goods are produced
by firms, the circular flow model is given in Figure 1.2.

Product market
Payment for goods and services
Goods and services

Firms Households

Factors of production
Income to households
Factor market

Figure 1.2: The Circular Flow

9 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

The lower segment of the circular flow shows the flow factors of production such as labor
and capital from households to firms. In return, households receive factor payments, which
then they use for the purchase of goods and services from firms as shown in the upper
segment of the diagram. This flow of money represents the income of firms.

Summary

 Economics is the scientific study of people and institutions from the point of view of
how they produce and consume goods and services and face the problem of scarcity.

 Microeconomics looks at the interactions of producers and consumers in individual

markets.

 Macroeconomics is the study of the economy as a whole and is concerned with

aggregates.

 Scarcity is a fundamental problem faced by all economies. The resources available

are not enough to produce all the goods and services that people would like to
consume. Scarcity makes it necessary to choose.

 Opportunity cost measures the value of foregone opportunities in order to enjoy a

unit of a commodity. It emphasizes the problem of scarcity and choice by measuring
the cost of obtaining one commodity in terms of the number of units of other
commodities that could have been obtained instead.

 Three basic questions must be answered in all economies: what commodities are to
be produced? How are these commodities going to be produced? And to whom are
the commodities to be produced?

 Different economic systems resolve these problems in different ways. There are
three pure economic systems: traditional, command and free market economic
systems. In traditional systems these questions are answered through tradition and
norm. In a command system answers to the above questions are given through
government direction. In a free market system the forces of demand and supply give
answer to the questions.

HARAMAYA UNIVERSITY 10
 UNIT ONE: THE NATURE OF ECONOMICS

 The production possibility curve (PPF) shows the different possible ways of
producing goods and services. Production on the PPF indicates full utilization of
existing resources. Production below the PPF indicates underutilization of resources,
while production outside the PPF is impossible.

Self-test Exercises

i) Review your understanding of the following terms

Microeconomics Macroeconomics

Scarcity Opportunity cost

Factors of production Production

Consumption Production Possibility Curve

Traditional economic system Planned economic system

Market economic system Mixed economic system

ii) Multiple Choice Questions

1. What do economists mean when they state that a good is scarce?

a) There is a shortage or insufficient demand of the good at the existing price.

b) It is possible to expand the availability of the good.

c) People will want to buy more of the good regardless of price.

d) The amount of the good that people would like to have exceeds the supply that is
freely available from nature.

e) None

2. Economic choice and competitive behavior are the result of

a) Absence of alternative uses for resources.

b) Abundance of resources.

c) Limited wants.

d) Scarcity.

11 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

3. The expression, "There's no such thing as a free lunch" implies that

a) Everyone has to pay for his own lunch.

b) The person consuming a good must always pay for it.

c) Costs are incurred when resources are used to produce goods and services.

d) No one has time for a good lunch anymore.

e) None

4. The basic difference between macroeconomics and microeconomics is that

a) Macroeconomics looks at the forest (aggregate markets), while microeconomics is

concerned with the individual trees (subcomponents).

b) Macroeconomics is concerned with policy decisions, while microeconomics applies

only to theory.

c) Microeconomics is concerned with the forest (aggregate markets), while

macroeconomics is concerned with the trees (components).

d) Macroeconomics is more concerned with households and microeconomics with the

national economy.

e) None

iii) Discussion Questions

1. What do you think is the economic system that prevails in Ethiopia?

2. Wants are insatiable compared to the means available to satisfy them. Discuss.

Suggested Reading Materials

Lipsey R. G., Courant P. N., Purvis D. D., and Steiner P. O., Microeconomics, 10th ed. New
York: Harper Collins College Publishers, Inc., 1993.

Amacher R. C., and Ulbrich H. H., Principles of Microeconomics, 3rd ed. Ohio: South-
Western Publishing Co., 1986.

Stanlake G. F., and Grant S. J., Introductory Economics, 6th ed., Singapore, Longman, 1995.

HARAMAYA UNIVERSITY 12
 UNIT TWO: THEORY OF DEMAND AND SUPPLY

UNIT TWO

THEORY OF DEMAND AND SUPPLY

Introduction

Dear learner, in unit one, we have briefly discussed about the nature of economics. In this
second unit, we will see the details of theory of demand and supply under different sections.

The subject matter of this unit is basic to the understanding of economics. The theories of
demand and supply are the building blocks of how the economic system at large operates.

From the outset, it is important to understand what determines demand for and supply of
particular goods or services. Then it becomes possible to see how demand and supply
together determine the prices of goods and services and the quantities that are bought and
sold. Demand and supply help understand how the price system responds to various changes
that affect it.

As factors that affect demand and supply change, they cause change in demand and supply.
It is important to know the direction of change as well as the magnitude of change in
demand and supply before any policy recommendation can be made. Elasticity is an
important mechanism in measuring and describing the extent of responsiveness of quantities
to changes in prices and other variables.

Objectives

At the end of this unit, you are expected to:

 Define and demonstrate the concepts of supply and demand using words, numbers or
functions, and graphs;

 Define equilibrium and explain how equilibrium is reached;

 Show how changes in demand and supply affect the equilibrium condition; and

 Define elasticity and explain the difference among price, income, and cross
elasticities.

13 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

Section 1: Theory of Demand

Introduction

Colleague, have you heard of demand for a given product affecting price of that product?
We hope so. Anyway let us continue. In this section, emphasis will be given to the
derivation of individual and market demand curves. The determinants of demand and supply
and the effects of their change, thereof, will be covered.

Objectives

At the end of this section, you will be able to:

 Define demand and list the factors that influence it;

 Demonstrate the concept of demand using words, numbers or functions, and graphs;

 Identify on a graph the differences between changes in demand and changes in

quantity demanded; and

 Show how changes in ceteris paribus conditions affect demand.

2.1.1. Definitions

Can you define demand? Ok. Just compare the definition you provide with the following
definition.

Definition: demand refers to the desire and ability to consume certain quantities at certain
prices.

Demand schedule: a tabular listing that shows the quantity demanded at various prices,
ceteris paribus. The phrase ceteris paribus means other things remain the same. The
importance of this assumption will be clear from the discussions in subsequent sections.

So as to derive the demand schedule of an individual (say Mr. Abebe) what is required is
just asking him what quantity of the good (say bread) he would buy at different prices of the
good, ceteris paribus. Look at the following table for illustration.

HARAMAYA UNIVERSITY 14
 UNIT TWO: THEORY OF DEMAND AND SUPPLY

Table 2.1: Demand schedule

Price Quantity
0 250
5 200
10 150
15 100
20 50
25 0

Dear learner, try to draw a curve using price as a vertical axis and quantity as a horizontal
axis based on the figures in the above table. Did you try? Good. The curve that you tried to
draw is called demand curve.

Demand curve: a graphical representation of a demand schedule showing the quantity

demanded at various prices, ceteris paribus. Plotting the price-quantity relationships from
the demand schedule on a two-axis plane derives the demand curve for a good or service
given in figure 2.1 below.

Price
25
20 Demand curve
15
10
5

0 50 100 150 200 250 Quantity

Figure 2.1: The Demand Curve
Dear colleague, let you think about factors affecting demand for a given product and write
these factors. Have you written? Ok. Now, let you compare your list with the lists indicated
below.

Demand for goods and services is affected by several factors. These factors include:

1. The price of the goods and services.

2. The tastes of the group demanding the good.

3. The size of the group (population size).

15 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

4. The income and wealth of the group.

5. The prices of other related goods and services.

6. Expectations about future prices or income.

7. Others (such as religion, weather, …)

Demand is, therefore, a multivariate function:

Qd = f(P, Po T, S, I, E,Z)

Where: P is output price

Po is the price of other goods and services.

T is the taste of consumers toward the good.

S is the size of the population in the market.

I is the income of consumers.

E is the expectation of consumers about future market conditions.

Z is other factors.

All things that affect demand work through one of these factors. When studying demand all
factors that affect demand, except one, are kept constant (ceteris paribus) and we determine
what happens to demand when the factor under consideration changes.

Activity 2.1

a) Identify the factors that affect the demand for bread in your locality.

__________________________________________________________________________
__________________________________________________________________________
__________________________________________________________________________

b) How do you relate these factors to the factors that affect demand as listed above?

__________________________________________________________________________
__________________________________________________________________________
__________________________________________________________________________

HARAMAYA UNIVERSITY 16
 UNIT TWO: THEORY OF DEMAND AND SUPPLY

2.1.2. The Law of Demand

Can you think of the relationship between price and quantity demanded for a given product?
Good. Now, let us discuss the law of demand in order to understand it.

The law of demand states that the quantity demanded of a good or service is negatively
related to its price, ceteris paribus. Holding other things the same, consumers will buy more
of a good or service at a lower price than at a higher price. As price rises, consumers will
demand a smaller quantity of a good or service.

At this point, it is important to make distinction between demand and quantity demanded of
a good or service. Demand refers to the whole set of price-quantity combinations, i.e.,
demand defines the whole set of relationship between price and quantity. Quantity
demanded, on the other hand, is the amount consumers want to buy at a particular price, i.e.,
the quantity of a good or service that consumers demand at price Birr 1, the quantity they
demand at price Birr 2 etc.

2.1.3. Individuals’ Demand for a Product

Dear colleague, think of your own demand for a given product and compare it with
following concept. An individual‟s demand for a product is the quantity of the good that the
consumer would buy at various prices. Suppose we ask individual A how many units of a
good he/she would buy at alternative prices. The individual‟s response would reflect his/her
demand for the good. If the different price-quantity combinations are plotted on a two-axis
plane, the result would be the individual‟s demand curve. For instance, the demand schedule
above could show individual A‟s demand for the good under consideration at different
prices. Plotting the individual demand schedule on a two-axis plane yields the demand curve
of the individual. (See Table 2.1)

2.1.4. Market demand

Dear learner, let us discuss the broader concept: market demand. The market demand for a
given product is obtained by horizontal summation of individual demands of all consumers
for that particular good. Suppose there are just two individuals (A and B) in a market. In this
particular case, the market demand for the product is simply the horizontal summation of the

17 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

quantities the two individuals buy at alternative prices. Consider the demand schedules of
the two individuals indicated in the following table:

Table 2.2: Individual Demand Schedules

Demand schedule of A Price 0 1 2 3 4 5

Quantity 50 40 30 20 10 0
Demand schedule of B Price 0 1 2 3 4 5
Quantity 30 20 25 20 15 10

Colleague, can you derive market demand based on the above individuals demand? Good. It
is as simple as the following. The market demand schedule is obtained from the horizontal
summation of the quantity demanded by individuals A and B at different prices.

Table 2.3: Market Demand Schedule

Price 0 1 2 3 4 5
Quantity 80 60 55 40 25 10

At price 0, A is willing to buy 50 units of the product, while B is willing to buy 30 units.
Therefore, the market quantity demanded at price 0 is 80 (30 + 50 = 80). Similarly, the
market quantity demanded at price 1 is 60: the sum of A‟s demand (40 units) and B‟s
demand (20 units). As price rises the quantity demanded in the market decreases. This
conforms to the law of demand.

The market demand curves are similarly obtained from simple horizontal summation of
individual demand curves as given below:

Price
6
5 Market demand curve
4
3
2
1

0 10 25 40 55 60 80 Quantity
Figure 2.2: Market Demand Curve

HARAMAYA UNIVERSITY 18
 UNIT TWO: THEORY OF DEMAND AND SUPPLY

2.1.5. Demand Function

Dear colleague, can you indicate the functional relationship between price and quantity
using the concept discussed under the theory of demand? Ok. Let us continue.

Demand function shows the functional relationship between the quantity demanded of a
good and its price, ceteris paribus. It is defined as:

Q = f(P)

The demand function gives quantity demanded as a negative function of price. The most
widely used functional form is a linear demand curve, which is given as:

Q  a  bP

What do you think is the slope of this demand function? Ok. It is –b.

In a more general case, in which the market consists of n consumers with individual demand
functions for goods X is defined as:

Xi = f (PX)

where Xi represents the quantity demanded of good X by individual i.

The market demand for good X (Xm) is given as:

n
Xm   Xi
i 1

The market demand curve (see Figure 2.2), therefore, could be considered to show the
relationship between market demand (Xm) and price PX , other things remaining constant.

2.1.6. Movement along the Demand Curve and Shift in the Demand Curve

Colleague, let us look at the effects of the different determinants of demand on demand
curve.

As stated above demand is a multivariate function. Changes in the determinants of demand

cause changes in demand. These changes in demand which result from changes in its

19 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

determinants can be classified into movement along the demand curve and shift of the
demand curve.

2.1.6.1. Movement along the Demand Curve

Colleague, think of the determinants of demand we discussed earlier. Which of these

determinants do you think is responsible for movement along the demand curve? We will
see it together. Just follow attentively.

Movement along the demand curve refers to that change in the quantity demanded of a good
because of changes in the prices of that good while other factors affecting demand (such as
price of other goods, income etc.) remaining the same (unchanged).

The consumer buys larger quantities at lower prices and lower quantities at higher prices.
Therefore, such movements take the consumer from one point on the demand curve to
another point on the same demand curve. In Figure 2.3 below, reduction of price from P1 to
P2 increases quantity demanded from Q1 to Q2. This represents what is called change in
quantity demanded.

P D
P1 a

P2 b
D

0 Q1 Q2 Q
Figure 2.3: Movement along the Demand Curve

Example 2.1
Suppose a demand function for a theater ticket is given as Q  100  2P . If now price
changes from Birr 2 to Birr 2.50, its effect will be a decline in quantity demanded from 96
tickets to 95 tickets. On a demand curve this can be shown by a movement from coordinate
(2, 96) to coordinate (2.50, 95).

HARAMAYA UNIVERSITY 20
 UNIT TWO: THEORY OF DEMAND AND SUPPLY

2.1.6.2. Shift in the demand curve

Let us consider the second change: shift in demand curve. The demand curve is drawn on
the assumption that other things remain the same. If, however, the factors assumed constant
change, their effect would be shifting the demand curve. In other words, shift in the demand
curve for a good result from changes in one or more of the factors that affect demand except
the price of own good. Increase in demand is shown by outward shift of the demand curve
whereas inward shift of the demand curve represents decrease in demand.

When the tastes of the people change in favor of bread, it would be reflected by an increase
in demand for bread. At every price, consumers demand a larger amount than before. This,
as shown in Figure 2.4, shifts the demand curve from D to D1. The opposite would have
occurred if tastes change against bread, in which case there would be decrease in demand,
represented by a shift from D to D2. Look at the following figure for illustration.

P1

D D1
D2
0 Q2 Q Q1 Q
Figure 2.4: Shift of the Demand Curve

An increase in the size of the population has an effect of shifting the demand curve from D
to D1. Suppose the government reduces the minimum driving age from 18 to17. Following
this reduction, the population of driving age increases. This, in turn, will have the effect of
increasing the demand for cars. Decrease in the size of population, on the other hand, shifts
the demand curve from D to D2. This would be the case if the minimum driving age were,
for example, raised to 20.

Colleague, what do you think is the effect of an increase in income of consumers on quantity
demanded? The answer may not be simple. Please read carefully. An increase in income
leads to an increase or a decrease in demand depending on the nature of the good.
Depending on the effect of change in income on their quantity demanded, there are two

21 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

types of goods: normal goods and inferior goods. Demand increases with increase in income
if the good is normal. As an example, consider meat whose demand is directly related with
income. On the other hand, inferior good is a good whose demand decreases with increase in
income. If, for example, you decrease your consumption of „shiro wet‟ as your income
increases in order to shift to say meat, then „shiro wet‟ is going to an inferior good for you.

The price of related goods and services also has effect on demand depending on the nature
of the other goods. There are two classes of such goods:

 Substitute goods- such goods are substitute to one another. As a result, an increase in
the price of such related goods leads to increase in demand for the other good. Consider
Pepsi Cola and Coca Cola. If the price of Coca Cola increases consumers will shift from
the consumption of Coca Cola to Pepsi Cola. This implies increase in the price of Coca
Cola results in the increase of the demand for Pepsi Cola.

 Complementary goods- these are goods that are jointly consumed. As a result, a rise in
the price of one such good results in decline in demand of the other good. Consider the
case of sugar and coffee. Coffee is consumed together with sugar. Thus, increase in the
price of sugar causes decline in demand for coffee. The converse is true for decrease in
the price of sugar.

Colleague, can you explain the effect of future expectations on demand curve? Anyhow,
expectations also have influence on demand. If individuals expect prices to change in the
future for any reason, they may take action that they otherwise might postpone. Suppose
consumers expect prices to fall in the future. In this case they reduce current consumption
hoping to buy more of the good when price falls in the future. If, on the other hand, they
expect prices to rise in the future, they will consume more of the goods at present so as to
avoid buying the good at a higher price in the future.

Similarly, change in expectation about the future income influences the decision of
consumers. If consumers expect their income to increase in the future, they would increase
their current consumption through current borrowing. On the other hand, if they expect
income to decrease in the future they will reduce current consumption.

HARAMAYA UNIVERSITY 22
 UNIT TWO: THEORY OF DEMAND AND SUPPLY

Activity 2.2

a) Suppose disaster caused inflow of people from neighboring areas to your locality. What
do you think is the effect of such migration on demand in your locality?

__________________________________________________________________________
__________________________________________________________________________
__________________________________________________________________________

b) How do you think will a decrease in price of camera affect demand for a film?

__________________________________________________________________________
__________________________________________________________________________
__________________________________________________________________________

Exercise 2.1
?
The demand function of a consumer is given as Qd  100  2P . If demand changes
P
to Qd  100  4P , find the effect of this change on quantity demanded at price Birr 10.
1

Section 2: Theory of Supply

Introduction

Dear learner, in the previous section, we have seen the theory of demand focusing on the
behavior of buyers. In the current section, however, we will discuss price-quantity
relationship from the point of view of the sellers using theory of supply.

This section deals mainly with the derivation of individual and market supply curves and the
identification of their determinants. Once the factors that affect supply are identified, the
effect of changes in these factors will, accordingly, be considered.

Objectives
At the end of this section, you will be able to:

 Define supply and list the factors that affect it;

23 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

 Demonstrate the concept of supply using words, numbers or functions, and graphs;

 Identify on a graph the differences between changes in supply and changes in

quantity supplied; and

 Show how changes in ceteris paribus conditions affect supply.

2.2.1. Definitions

Colleague, can you define supply with your own words? Look at the following definition.

Definition: supply refers to the quantity of goods offered for sale at a particular time or a
particular place at alternative prices.

Supply defines the whole set of price-quantity relationship. It shows the quantities that
producers are willing and able to supply at alternative prices, ceteris paribus. It is different
from quantity supplied, which represents the actual quantity that producers supply at each
price.

Supply schedule: is a tabular listing that shows quantity supplied at various prices, ceteris
paribus. Look at the table below.

Table 2.4: Supply Schedule

Price 5 10 15 20 25

Quantity 10 20 30 40 50

Supply curve: is a graphical representation of a supply schedule showing the quantity

supplied at various prices, ceteris paribus (see Figure 2.5 below).

P
25 Supply curve
20
15
10
5

0 10 20 30 40 Q
Figure 2.5: Supply Curve

HARAMAYA UNIVERSITY 24
 UNIT TWO: THEORY OF DEMAND AND SUPPLY

Colleague, can you list the factors that affect supply? Ok. Anyway let us continue.

The supply of goods or services is affected by several factors. The factors that influence
supply include:

1. The price of the good (P).

2. The level of technology (T).

3. The price of factors of production (Pf).

4. The number of suppliers (S).

5. Expectations (E).

6. Others (Z)

Everything that affects supply works through one of these determinants. Supply function is,
then, defined as

Qs = f (P, T, Pf, S, E, Z)

Activity 2.3

a) Identify the factors that affect the supply of fertilizer by unions in your locality.
____________________________________________________________________
____________________________________________________________________
____________________________________________________________________

b) How do you relate these factors to the factors that affect supply as listed above?
____________________________________________________________________
____________________________________________________________________
___________________________________________________________________

2.2.2. The Law of Supply

Dear colleague, do you think that the price-quantity relationship in supply theory is the same
as that in demand theory? Good. The answer is definitely no. Let us proceed.

The supply curve shows the relationship between the quantity supplied of a good and its
price. Therefore, in order to see what happens when the price of the good under

25 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

considerations changes, everything but the price of the good must be held constant. Given
these conditions, the law of supply states that the quantity supplied of a good or service is
usually a positive function of price, ceteris paribus.

However, this positive relationship between price and quantity supplied fails in two
exceptional cases:

 The supply will not be upward sloping if there is no enough time to produce more
units of the good because production techniques are not flexible in the very short run.
Suppose a given firm is operating at full capacity in the short run. Under such
circumstances, the firm will not be able to positively respond to increase in price of
any magnitude. The law is not applicable in the immediate short-run.

 When a unique supplier no longer exists, quantity supplied will not exhibit positive
relationship with price. In such cases, though prices rise to very high levels, the
producers no longer exist to supply more of the products. Consider, as an example,
the paintings of a famous painter such as Picasso.

In these unusual cases, quantity supplied does not respond to price at all. Accordingly the
supply curve will be horizontal parallel to the quantity axis.

2.2.3. Individual Firm’s Supply

Colleague, let us start our discussion with the concept of individual supply. An individual
firm‟s supply shows the different quantities that the firm would supply at various prices. So
as to derive an individual firm‟s supply schedule, just ask the firm the quantities it would
supply at alternative prices, and if it is able to state, then the different price-quantity supplied
combinations define the individual firm‟s supply.

The supply schedule above could be considered to represent an individual firm‟s supply
schedule. Plotting these combinations on a two axis plane gives the individual firm‟s supply
curve, which is upward sloping under normal circumstances.

2.2.4. Market (Industry) Supply

Can you derive market supply from individuals supply as we did for market demand? Good.
We can use similar as follows. The market supply curve is obtained by horizontal

HARAMAYA UNIVERSITY 26
 UNIT TWO: THEORY OF DEMAND AND SUPPLY

summation of the individual (firm) supply curves. This curve represents the sum of the
quantities supplied by each firm at different prices. If there are just two firms in the market,
for example, the market supply schedule can be derived from the simple horizontal
summation of the quantity supplied by the two firms at each price.

Table 2.5: Individual Supply Schedules

Supply schedule Price 0 1 2 3 4

of firm 1 Quantity 0 10 20 30 40
Supply schedule Price 0 1 2 3 4
of firm 2 Quantity 0 15 30 45 60

Table 2.6: Market Supply Schedule

Price 0 1 2 3 4
Quantity 0 25 50 75 100

Suppose in the above example, firm 1 has a larger market share and firm 2 has a relatively
lower market share. Accordingly, firm 1 has larger supply curve while firm 2 has a lower
supply curve. In this case, the industry (market) supply curve is given in Figure2.6 below.

P S2 S1

(S1+S2)=market supply

P2
P1

0 Y
Figure 2.6: Market Supply Curve

The market supply is the horizontal summation of individual supply curves. For price level
less than P2 firm 2 supplies no output at all. As a result the market supply curve coincides
with firm 1‟s supply curve. For price level less than P1 since firm 1‟s level of output is zero,
market supply will also be zero. Such market supply curve is a graphical depiction of how
much will be offered for sale in the market at various prices.

27 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

In a more general case with n number of firms in the industry (market), the market supply
function S(p) is given as:
n
S ( p)   S i ( p)
i 1

where Si is the supply function of individual firms.

2.2.5. Supply Function

Now, we can explain supply function as we did for demand. Supply function shows the
functional relationship between price and quantity supplied, ceteris paribus. And it is
generally defined as:

Q = f (P)

The most widely used functional form is the linear supply curve, which is given as:

Q  c  dP

The slope of the supply function is d.

2.2.6. Movement along the Supply Curve and Shifts in the Supply Curve

Colleague, it is very important to look into the effect of changes in determinants of supply
on the supply curve. So, let us discuss these effects.

As is stated above supply decision by an individual firm is affected by several factors.

Change in the factor determining supply cause either movement along the supply curve or
shift of the supply curve.

2.2.6.1. Movement along the Supply Curve

Colleague, movement along any supply curve occurs because of changes of the price of the
good or service under study while holding other factors constant. These changes in quantity
supplied result as a positive function of changes in price. Because producers are willing to
sell more units if the price rises to cover the additional costs of production, we observe
movement along the same curve.

HARAMAYA UNIVERSITY 28
 UNIT TWO: THEORY OF DEMAND AND SUPPLY

Graphically, the effect of change in the price of the product concerned is shown by
movement from one point on the supply curve to another point on the same curve. In the
figure below fall in price from P1 to P2 leads to increase in quantity supplied from Q1 to Q2.

Price
Supply
P1 b

P2 a

0 Q1 Q2 Quantity

Figure 2.7 Movement along the supply curve

Example 2.2

Suppose the supply function of a grocery is given as Q  20  5P . The effect of rise in
price from Birr 6 to Birr 7 would be rise of quantity supplied from Birr 10 to Birr 15. On a
supply curve, this would be shown by movement from coordinate (6, 10) to coordinate (7,
15).

2.2.6.2. Shifts in the Supply Curve

Shifts in the supply curve occur as any one of the ceteris paribus factors (factors kept
constant earlier) is altered. These constitute what is called change in supply (not change in
quantity supplied). Change in quantity demanded results from change in the price of the
good with other things remaining the same.

Suppose technology changes, and this change has a positive effect. For instance, assume we
are looking at the supply of beef and that agricultural researchers develop a very inexpensive
pill that causes a young steer to double in weight rapidly. This technological advance means
that more beef will be supplied at each price. There will be increase in supply. Such an
increase in supply is represented by a rightward shift of the supply curve. In the figure below
such effects are shown by shift of the supply curve from S to S1 (see Figure 2.8).

29 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

A negative technological change will have the opposite effect. Suppose the government
discovers that this drug, now in use for steer fattening, has harmful side effects on humans
and farmers are, therefore, prohibited from giving it to steers. This will mean that less beef
will be supplied at each price. There will be a decrease in supply, which is depicted as a
leftward shift of the supply curve. This is shown by shift of the supply curve from S to S2
(see Figure 2.8).

P
S2 S
S1
P2
P1

0 Q2 Q1 Q
Figure 2.8 Shift of the supply curve

Now consider changes in the prices of factors of production. A rise in the price of a factor of
production, ceteris paribus, causes a decrease in supply. This happens because the producer
now will find that the cost of supplying any quantity has increased. We will, thus, find that
after a price rise in the price of a factor of production, less will be supplied at the old price or
the same amount will be supplied only at a higher price. This is graphically represented by a
shift in the curve from S to S2. The opposite is also true: any decrease in the price of a factor
of production will cause an increase in supply.

A change in the number of suppliers similarly will have a predictable effect on supply. For
instance, if the number of beef ranchers declines, the total supply of beef at each price will
be reduced. Thus, the supply curve will shift to the left from S to S2. Conversely, an increase
in the number of ranchers will cause increase in total supply of beef, and hence, the supply
curve to shift to the right from S to S1.

As in the case of demand, expectations about any of the ceteris paribus conditions or about
price can have an effect on supply. Assume that ranchers expect that the price of beef will
fall next year because they anticipate a poor harvest, which would make it more expensive

HARAMAYA UNIVERSITY 30
 UNIT TWO: THEORY OF DEMAND AND SUPPLY

to keep beef on feedlots. Under such expectations, they would bring more cattle to market
now before price falls. If enough farmers follow suit, the supply for this year will increase as
shown in the figure above, by a rightward shift of the supply curve.

Activity 2.4

Suppose the government distributes pesticides to all farmers in your locality for free.

a) What do you think is the effect of such change in the level of output of farmers?
____________________________________________________________________
____________________________________________________________________
____________________________________________________________________

b) To what factor that affects supply do you relate such changes?

____________________________________________________________________
____________________________________________________________________
____________________________________________________________________

Exercise 2.2
? The supply function of a firm is given as Qs  10  4P . If supply changes

toPQs  10  1.5P , find the effect of the change on quantity supplied at price Birr 10.
1

Section 3: Market Equilibrium

Introduction

Dear learner, in the earlier two sections, we have independently seen about the theory of
demand and the theory of supply. In this section, however, we will bring the two theories
together and discuss their interaction in determining market price and quantity.

In a free market system output price as well as the level of output in a market are determined
by the forces of demand and supply. The condition of equality of demand and supply is

31 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

called equilibrium. In this section we will consider the derivation of the equilibrium
condition.

The equilibrium condition is affected by changes in the factors that affect demand and
supply. Due attention, accordingly, will be given to see the effects of such changes on
equilibrium.

Objectives:

At the end of this section, you must be able to:

 Define equilibrium;

 Explain how equilibrium is reached; and

 Show how changes in demand and supply affect the equilibrium condition.

2.3.1. Definition

Dear colleague, as shown in previous sections, demand is a negative function of price while
supply is a positive function of price. Coexistence of buyers and sellers in a given market
implies that if there is to be any exchange, there must be a price at which the quantity that
sellers are willing and able to sell must be equal to the quantity that buyers are willing and
able to buy.

Market equilibrium is a price-quantity combination that results from the interaction of the
supply curve and the demand curve such that at the indicated price, the quantity demanded
equals the quantity supplied.

The equilibrium has the property that once the market settles on that point it stays there
unless either supply or demand shifts. Additionally, a market that is not at the equilibrium
position moves toward that point. These two points can be made clear by considering the
graphic representation of equilibrium discussed below.

2.3.2. Graphic Approach to Equilibrium

Colleague, let us see the determination of equilibrium using graphic approach. To see how
equilibrium comes about, consider the following hypothetical demand and supply of coffee
in a given market given by Table 2.7 and its corresponding figure (Figure 2.9).

HARAMAYA UNIVERSITY 32
 UNIT TWO: THEORY OF DEMAND AND SUPPLY

At a price of Birr 2.00, suppliers want to supply 4 thousand kg of coffee and demanders
want to purchase 8 thousand kg. The quantity demanded exceeds quantity supplied by
4 thousand kg. This means that some consumers do not get the desired amount at price Birr
2.00. Some of these consumers will offer more and bid the price up. As the price rises, the
quantity supplied, being a positive function of price will rise and the quantity demanded,
being a negative function of price, will fall. This will continue until the price reaches Birr
3.00. At Birr 3.00, the amount consumers wish to purchase is exactly equal to the amount
suppliers wish to sell. This is the equilibrium price (market clearing price). The output
which corresponds to the equilibrium price is called the equilibrium quantity.

Table 2.7: Supply of and Demand for Coffee

Price per Kg Kg supplied Kg demanded Difference

per month per month
Br 1.00 2 thousand 10 thousand 8 thousand excess quantity demanded
Br 2.00 4 thousand 8 thousand 4 thousand excess quantity demanded
Br 3.00 6 thousand 6 thousand Equilibrium (no excess )
Br 4.00 8 thousand 4 thousand 4 thousand excess quantity supplied
Br 5.00 10 thousand 2 thousand 8 thousand excess quantity supplied

Price/kg

5.00 4 thousand excess supply S

4.00
3.00
2.00
1.00 4 thousand excess demand D
0 1 2 3 4 5 6 7 8 9 10 Thousand Kg
Figure 2.9 Market Equilibrium
It is important to note that the point representing equilibrium price and equilibrium quantity
is not the same thing as the point where the amount sold equals the amount bought.
Quantities bought and quantities sold are always equal. But at equilibrium the quantity that
suppliers wish to sell is exactly equal to the quantity demanders wish to purchase, i.e., the
equilibrium represents coincidence of wishes on the part of consumers and producers.

33 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

 Excess demand causes an upward pressure on price. Thus price converges to the
equilibrium price.

 Excess supply causes a downward pressure on price. Thus, price follows a path
towards the equilibrium.

Once equilibrium is reached at the point of equality of the demand curve with the supply
curve, it remains there as long as demand and supply remain unchanged.

2.3.3. Numerical Approach to Equilibrium

Dear learner, did you understand how equilibrium levels of price and quantity can be
determined? Ok. Let us proceed with the same analysis but using numerical approach.

At the equilibrium position, the demand function is exactly equal to the supply function.

If demand is given as Qd  a  bP and supply is given as Qs  c  dP , the equilibrium

condition is

Supply = Demand

a  bP  c  dP

Rearranging gives:

bP  dP  a  c

P(b  d )  a  c

The equilibrium price is, therefore:

ac
P
bd

The equilibrium quantity is obtained by substituting the equilibrium price into the demand or
supply function.

ac
Substituting P  in the demand function Q  a  bP
bd

ac
Q  a  b( ) or,
bd

HARAMAYA UNIVERSITY 34
 UNIT TWO: THEORY OF DEMAND AND SUPPLY

ac
Substituting P  in the supply function Q  c  dP
bd

ac
Q  c  d( ),
bd

ac ac
where a  b( ) = c  d( ).
bd bd

Example 2.3

Suppose the demand and supply functions in a particular market are given as:

Qd  100  2P

Qs  10  4P

At equilibrium Qd = Qs

100  2P  10  4P

Rearranging

6P  90

The equilibrium Price is, therefore, P = 15.

The equilibrium quantity is obtained by substitution.

Qd  100  2(15)  70  Qs

Exercise 2.3
? Given Qd  50  3P and Qs  15  2P , find equilibrium levels of price and quantity.
P
1

35 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

Dear colleague, we have discussed that market equilibrium condition is determined by the
interaction of demand and supply forces. This means, any change on one of the two or on
both will affect the equilibrium condition. Now, let us discuss how the equilibrium condition
is affected by changes in demand or in supply or in both.

2.3.4. Effects of Change in Demand

Colleague, do you remember the ceteris paribus conditions? Good. Now, we are going to
see the effect of these conditions. When the ceteris paribus conditions (price of other goods,
consumers‟ income, taste, population size, expectation etc.) change, there will be a shift in
the demand curve. Such changes (shifts) in demand result in a shift of the equilibrium
position.

Assume first, there is increase in demand, for any one reason, represented by an upward
(rightward) shift in the demand curve. Such rise in demand, with supply constant, creates
shortage at the initial equilibrium price, and the unsatisfied buyers bid up the price. This
causes a larger quantity to be produced, with the result that at the new equilibrium more is
bought and sold at a higher price. This change, with supply remaining the same, shifts the
equilibrium position from e0 to e1. The equilibrium price rises from P0 to P1 and equilibrium
quantity rises from Q0 to Q1. That means, consumers are now demanding larger quantities of
the good at every price than before (See the figure below).

P
S0
P1 e1
P0 e0
P2 e2 D1
D0
D2
0 Q2 Q0 Q1 Q
Figure 2.10 effects of change in demand

On the other hand, fall in demand, ceteris paribus, creates surplus, and the unsuccessful
sellers bid the price downwards to clear the surplus. As a result, less of the commodity is

HARAMAYA UNIVERSITY 36
 UNIT TWO: THEORY OF DEMAND AND SUPPLY

produced and offered for sale. At the new equilibrium, both price and quantity bought and
sold are lower than they were originally.

Such fall in demand is represented by a leftward (downward) shift of the demand curve, and
causes the equilibrium position to shift from e0 to e2. Accordingly, equilibrium price falls
from P0 to P2 and equilibrium quantity falls from Q0 to Q2.

With regard to change in demand the equilibrium price and quantity change in the same
direction. The magnitude of the change in price and quantity demanded depends on:

 The size (magnitude) of demand change

 The slope (elasticity) of supply

For any given supply curve, the higher the size of change in demand the higher the change
in equilibrium price and quantity (See Figure 2.11 below). The size of change in demand is
high in panel (b) than in panel (a). Therefore, the changes in equilibrium price and quantity
are high in the former than in the later.

P S P S
P1 e1
P1 e1
P0 e0 P0 e0
D1 D1
D0 D0
0 Q0 Q1 Q 0 Q0 Q1 Q
(a) (b)
Figure 2.11: Shifts in demand in Different Magnitudes

Example 2.4

With the supply function in example 2.3 remaining the same at Qs  10  4P , suppose the

demand function changes to Qd  130  2P .

At equilibrium 130  2P  10  4P 6P  120 P  20

Qd  130  2(20)  90  Qs

The effect of such rise in demand would be rise in price and quantity demanded.

37 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

Exercise 2.4
?
The supply function of a firm is given as Qs  10  4P . Compare the effects on
P
equilibrium
1 price and quantity of change in demand

a. From Qd  100  2P to Qd  130  2P .

b. From Qd  100  2P to Qd  160  2P .

How do you explain the differences, if any?

For any given change in demand, the change in equilibrium price is higher and the change in
equilibrium quantity is lower the steeper the supply curve (the higher the slope of the supply
curve). The converse would be true if supply curve is flatter.

P S P
P1 e1 S
P0 e0 P1 e1
P0 e0
D1
D0 D0 D1
0 Q0 Q1 Q 0 Q0 Q1 Q

(a) (b)

Figure 2.12: Effects of Difference in the Slope of Supply

In the figure above, the supply curve in (a) is much steeper than the supply curve in (b).
Accordingly, the resulting changes in equilibrium price and quantity for any given shift of
the demand curve are different.

Assume the changes in demand in the two cases are equal. As demand shifts from D0 to D1,
the changes in equilibrium price and quantity are given by (P1-P0) and (Q1-Q0) respectively.
Yet (P1-P0) is higher in (a) than in (b), and (Q1-Q0) is higher in (b) than in (a).

Example 2.5

HARAMAYA UNIVERSITY 38
 UNIT TWO: THEORY OF DEMAND AND SUPPLY

Suppose the demand function has shifted from Qd  100  2P to Qd  130  2P , consider

the change in the equilibrium price and quantity for supply functions Qs  10  4P

and Qs  10  P . Here the first supply function is flatter than the latter.

The initial equilibrium under the two supply functions

Case 1 Case 2

100  2P  10  4P 100  2P  10  P

6P  90 P  15 3P  90 P  30

Qd  100  2(15)  70  Qs Qd  100  2(30)  40  Qs

The new equilibrium after the shift in demand

Case 1 Case 2

130  2P  10  4P 130  2P  10  P

6P  120 3P  120

P  20 P  40

Qd  130  2(20)  90  Qs Qd  130  2(40)  50  Qs

Colleague, as the demand curve shifts, the change in equilibrium price is higher and the
change in equilibrium quantity is lower for the steeper supply curve than for the flatter one.

This implies, therefore, that for any given change in demand, change in price will be higher
and change in quantity lower the steeper the supply curve.

Exercise 2.5
?
Suppose the demand functions of two markets, A and B are given as: QdA  100  2P
P
1 Qd 100  P . If the two markets have the same supply condition and the supply
B
and

functions shift from Qs  10  4P to Qs  40  4P , compare the resulting changes in the two

markets.

How do you explain the differences in the two markets, if any?

39 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

2.3.5. Effects of Change in Supply

Dear colleague, can you explain the effect of change in supply? Ok. Let us discuss it
together. Shift in the supply curve resulting from changes in the ceteris paribus conditions,
causes shift of the equilibrium position (point). An increase in supply for one or the other
reason would shift the supply curve rightward from s0 to s1. With demand remaining the
same, this shift causes shift of the equilibrium point from e0 to e1. Accordingly, there will be
shifts in equilibrium price and quantity.

The effect of such shift in supply would be decline in equilibrium price because the increase
in supply exerts downward pressure on price, and increase in equilibrium quantity because
now that the total supply at each price is higher compared to the initial condition, producers
wish to sell off their products at lower prices.

Accordingly, the equilibrium price and quantity change from P0 to P1 and from Q0 to Q1
respectively.

P D S2 S0
S1
P2 e2
P0 e0
P1 e1

0 Q2 Q0 Q1 Q
Figure 2.13: Effects of Shift in Supply

If, on the other hand, supply decreases as given by the leftward shift of the supply curve
from S0 to S2, there will be consequent shift of the equilibrium point from e0 to e2. The effect
of such change in supply is increase in equilibrium price and fall in equilibrium quantity
because, with demand remaining the same, producers are willing to sell lower quantities at
each price. The equilibrium price and quantity change from P0 to P2 and from Q0 to Q2
respectively.

HARAMAYA UNIVERSITY 40
 UNIT TWO: THEORY OF DEMAND AND SUPPLY

The magnitude (size) of the changes in equilibrium price and equilibrium quantity due to
change in supply depend on:

 The size (magnitude) of supply change

 The slope (elasticity) of demand

First, let us consider changes in supply of different magnitude for any given demand curve.
Large change in supply causes large changes in equilibrium price and quantity than a small
change in supply (See the Figure below).

41 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

P (a) S0 P (b) S0
S1 S1
P0 e0 P0 e0

P1 e1 P1 e1

0 Q0 Q1 Q 0 Q0 Q1 Q
Figure 2.14: Shifts in Supply in Different Magnitude

In Figure 2.14, the change in supply is large in panel (b) than in (a). Accordingly, the
changes in equilibrium price and equilibrium quantity are larger in (b) than in (a).

Example 2.6

With the demand function in example 2.3 remaining the same at Qd  100  2P , suppose the

supply function changes to Qs  40  4P .

At equilibrium

100  2P  40  4P

6P  60  P  10

Qd  100  2(10)  80  Qs

The effect of such rise in supply would be fall in price and rise in quantity demanded.

Exercise 2.6
?
The demand function of consumers is given as Qd  100  2P . Compare the effects
P
on1 equilibrium price and quantity of change in supply

a) From Qs  10  4P to Qs  16  4P .

b) From Qs  10  4P to Qs  40  4P .

How do you explain the differences, if any?

HARAMAYA UNIVERSITY 42
 UNIT TWO: THEORY OF DEMAND AND SUPPLY

Dear colleague, now consider the effect of difference in the slope of the demand curve on
the changes in equilibrium price and quantity.

P P S0
S0 S1 S1
P0 e0 P0 e0
P1 e1 P1 e1
D D

0 Q0 Q1 Q 0 Q0 Q1 Q
(a) (b)
Figure 2.15: Effects of Difference in the Slope of Demand

Suppose the shifts in supply in the above two diagrams are equal. For any given shift in
supply, therefore, the higher the change in equilibrium price and the lower the change in
equilibrium quantity will be, the steeper the demand curve. Demand is steeper in (b) than in
(a). Accordingly, the change in price is higher in (b) than in (a), while change in quantity is
higher in (a) than in (b).

Example 2.7

Suppose the supply function has shifted from Qs  10  4P to Qs  28  4P , consider the

equilibrium conditions for demand functions Qd  100  2P and Qd  100  5P .

The former demand function represents a steeper demand curve than the later.

The initial equilibrium condition under the two demand functions is

Case 1 Case 2

10  4P = 100  2P 10  4P = 100  5P

6P  90 9P  90

P  15 P  10

Qd  100  2(15) Qd  100  5(10)

Qd  70  Qs Qd  50  Qs

43 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

Case 1 Case 2

28  4P = 100  2P 28  4P = 100  5P

6P  72 9P  72

P  12 P 8

Qd  100  2(12) Qd  100  5(8)

Qd  76  Qs Qd  60  Qs

The change in price is higher and the change in quantity is lower for the former demand
function (which is steeper) than the latter (which is flatter). Therefore, for any given change
in supply, the effect on price is higher and the effect on quantity is lower the steeper the
demand curve.

Exercise 2.7
?
Suppose the supply functions in two markets, A and B are given as: QsA  10  4P
P
and QsB  10  2P .The two markets have the same demand function Qd  100  2P . Now if
1

the demand function shifts from Qd  100  2P to Qd  118  2P , compare the resulting
changes in the two markets.

How do you explain the differences in the two markets, if any?

2.3.6. Simultaneous Shift in Demand and Supply

Dear learner, in the above two sections, we have seen how price and quantity change as
demand shifts and supply shifts under the ceteris paribus assumption. Under normal
conditions, however, both may change simultaneously. Such types of changes are analyzed
below.
2.3.5.1. Change in Demand and Supply in a Same Direction
Increase in demand shifts the demand curve to the right and exerts an upward pressure both
on price and quantity. Increase in supply, similarly, shifts the supply curve to the right and
exerts a downward pressure on price and an upward pressure on quantity (See the Figure
below).

HARAMAYA UNIVERSITY 44
 UNIT TWO: THEORY OF DEMAND AND SUPPLY

P S1 S2 P S1
S2

P2 e2
P1 e1 P1 e1
P2 e2

D1 D2 D1 D2

0 Q1 Q2 Q 0 Q1 Q2 Q
(a) (b)
Figure 2.16: Increase in Demand and Supply
Dear colleague, look at the above figure very carefully.
In panel (a), the initial equilibrium is defined at e1. As both demand and supply rise, the
equilibrium point shifts from e1 to e2. Since the rise in demand is greater than the rise in
supply, the net effect will be rise in both price and quantity.
In panel (b), the initial equilibrium position occurs at e1. The shift demand and supply moves
the equilibrium from e1 to e2. Yet, the rise in supply is greater than the rise in demand
resulting in net increase in supply. This reduces the equilibrium price and increases the
equilibrium quantity.

Activity 2.5
Suppose in a particular locality, due to drought, there has been migration of the people to
other areas and thus, population size has decreased. At the same time, suppose there was exit
of producers from the locality, which has reduced the number of producers. Show the effect
of such developments on equilibrium price and quantity assuming
a) Larger reduction in demand than supply. (use appropriate diagram)
_______________________________________________________________________
_______________________________________________________________________
______________________________________________________________________
b) Larger reduction in supply than demand. (use appropriate diagram)
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________

45 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

The magnitude by which price and quantity change depends on two factors: the size of
change in demand and supply and the slope of the demand and supply curves. If demand and
supply increase by an equal percentage, price will remain unchanged. The effect of slope
differential will be considered in the next section.

Example 2.8

Suppose the supply function has shifted from Qs  10  4P to Qs  28  4P , and the

demand function has shifted from Qd  100  2P to Qd  100  2P .

Case one below shows the equilibrium before the shift in demand and supply curves and
case two shows the equilibrium after the shift in demand and supply curves.

Case one Case two

Qd1  Qs1 Qd2  QS2

100  2P  10  4P 100  2P  28  4P

6P  90 6P  72

P  15 P  12

Qd  100  2(15)  70  Qs Qd  100  2(12)  76  QS

The effect of the change in demand and supply is fall in price and rise in quantity. This
indicates that the rise in supply is greater than the rise in demand.

Exercise 2.8
?
Suppose the demand function that a firm faces shifted from Qd  120  3P to
P
Q1d  90  3P and the supply function has shifted from QS  20  2P to QS  10  2P .

a) Find the effect of this change on price and quantity.

b) Which of the changes in demand and supply is higher?

HARAMAYA UNIVERSITY 46
 UNIT TWO: THEORY OF DEMAND AND SUPPLY

2.3.6.2. Change in Demand and Supply in an Opposite Direction

Now, let us look at the effect of opposite changes in demand and supply on equilibrium.
Follow attentively.

Suppose demand increases while supply decreases. The rise in demand shifts the demand
curve to the right and the fall in supply shifts the supply curve to the left (See the following
Figure).

P S2 S1 P S2 S1

P2 e2 P2 e2

P1 e1 P1 e1
D2

D1 D2 D1

0 Q2 Q1 Q 0 Q1Q2 Q
(a) (b)
Figure 2.17: Increase in Demand and Decrease in Supply

In Figure 2.17 above, two forces are operating against the equilibrium position. The rise in
demand pushes price up. If supply remained the same, the equilibrium would occur at the
intersection of D2 and S1. This raises the price level. On the other hand, if supply falls with
demand constant, equilibrium occurs at the intersection of D1 and S2. This pushes price up.
Both rise in demand and fall in supply act to raise price. As demand rises and supply falls
simultaneously, price rises to an even higher level (P2).

The effect on quantity, however, depends on the magnitude of the change in demand and the
slope of demand and supply curves. In panel (a) the rise in demand is less than the fall in
supply, therefore, quantity decreases. In panel (b) the rise in demand is greater than the fall
in supply, therefore, quantity increases. If the rise in demand is equal to the fall in supply
quantity will remain unchanged.

47 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

Activity 2.6
Suppose in a particular locality, due to drought, there has been migration of the people to
other areas and thus, population size has decreased. At the same time, suppose there was
influx of producers from other area to the locality, which has increased the number of
producers. Show the effect of such developments on equilibrium price and quantity
assuming
a) The fall in demand is greater than the rise in supply. (Use appropriate diagram)
__________________________________________________________________________
__________________________________________________________________________
________________________________________________________
b) The fall in demand is less than the rise in supply. (Use appropriate diagram)
__________________________________________________________________________
__________________________________________________________________________
________________________________________________________

Example 2.9

Suppose the supply function of a firm has shifted from Qs  10  4P to Qs  5  4P , and the

demand function has shifted from Qd  100  2P to Qd  155  2P .

Case one below shows the equilibrium before the shift in demand and supply curves and
case two shows the equilibrium after the shift in demand and supply curves.

Case one Case two

Qd1  Qs1 Qd2  QS2

100  2P  10  4P 155  2P  5  4P

6P  90 6P  150

P  15 P  25

Qd  100  2(15)  70  Qs Qd  100  2(25)  50  QS

The changes in demand and supply have increased price and reduced quantity. This
indicates that the change in supply is greater than the change in demand.

HARAMAYA UNIVERSITY 48
 UNIT TWO: THEORY OF DEMAND AND SUPPLY

Exercise 2.9
? Suppose the demand function that a firm faces shifted from Qd  100  2P to

d  80  3P and the supply function has shifted from QS  10  4 P to QS  20  4 P .

QP
1
a) Find the effect of this change on price and quantity.

b) Which of the changes in demand and supply is higher?

Dear colleague, did you understand how equilibrium is affected because of changes in
demand, supply, or both? Good. Now, try to memorize what you have studied up to now,
and then we will continue with the next section.

Section 4: Elasticity

Introduction

Dear colleague, in the previous section, we have discussed the concept of market
equilibrium and factors contributing to changes in equilibrium. In this section, however, we
will emphasis on the responsiveness of demand and supply to changes in their major
determinants.

Both demand and supply are multivariate functions. Any change in their determinants causes
either movement along the curve or shift of the curve. It is often of interest to be able to
measure how demand and supply respond to changes in their determinants. There are
various measures of such responsiveness of demand and supply. The most widely used of
these measures is called elasticity.

Elasticity measures the percentage point responsiveness of demand and supply to a

percentage point in any of their determinants.

Objectives

At the end of this section you should be able to:

 Define and calculate price elasticity of demand;

 Define and calculate price elasticity of supply;

 Define and calculate income elasticity of demand; and

49 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

 Define and calculate cross elasticity of demand.

2.4.1 Concept of Elasticity

Dear learner, have you ever heard about elasticity? Ok. Let us discuss the concept of
elasticity: another important concept in the theory of demand and supply. The determinants
of demand and supply may change for a host of reasons. In studying the effects of factors
that affect demand and supply, we are interested not only in the direction of change but also
in the magnitude of the change. With regard to price, the slope of the demand and supply
functions could be considered.

Slope = dQ/dP,

Where, dQ is the change in output and dP is the change in price.

Slope measures by how much output changes for a very small (say a unit) change in price.
In this sense, slope is a measure of responsiveness but it presents some problems. The most
important one is that the slopes of demand or supply functions depend on the units in which
price and quantity are measured. Output could be measured in units, kilograms, litres,
gallons etc while price is measured in currency units such as Birr, Dollars etc. Therefore,
slope measures certain kg per Birr, some liters per Dollar etc. This, in turn, creates problem
of comparison where responsiveness is measured in different units. It is not possible to
compare responsiveness measured as X kg/Birr with one measured as Y pounds/Dollar.

Rather than specify units all the time, it is convenient to consider a unit free measure of
responsiveness for this purpose, thus, a measure known as elasticity is often used.

Definition: Elasticity is a measure of the sensitivity or responsiveness of quantity demanded

or quantity supplied to changes in price (or other factors).

Elasticity measures the way one variable (dependent variable) responds to changes in other
variables (independent variables). We express the dependent variable (Y) as a function of the
independent variables (Xi) as in the following function:

Y = f(X1, X2, X3,…, Xn)

In this function, Y is given as a function of n variables. As any one of these variables (Xi)
changes, there will be consequent change in the value of Y.

HARAMAYA UNIVERSITY 50
 UNIT TWO: THEORY OF DEMAND AND SUPPLY

The formula to determine the responsiveness of Y to changes in the Xi can be expressed as

%Y %Y %Y

1  , 2  , ……….., n 
%X 1 %X 2 %X n

This formula states that elasticity is the percentage change in the dependent variable divided
by the percentage change in the particular independent variable whose effect is being
examined.

Now, let us look at the elasticity of demand and elasticity of supply separately.

2.4.2. Elasticity of Demand

Colleague, in examining demand, it would be interesting to measure how quantity demanded

responds to changes in price and changes in other factors that affect demand such as price of
other goods and income.

Depending on the variables involved, three measures of elasticity of demand could be

considered:

 Price elasticity of demand measures the responsiveness of quantity demanded to

changes in output price, ceteris paribus.

 Cross elasticity of demand measures the responsiveness of quantity demanded to

changes in the price of other goods, ceteris paribus.

 Income elasticity of demand measures the responsiveness of quantity demanded to

changes in consumers‟ income, ceteris paribus.

2.4.2.1. Price Elasticity of Demand

Colleague, can you indicate the formula for calculating price elasticity of demand based on
the general formula of elasticity we discussed earlier? We hope so. The price elasticity of
demand () is defined to be the percentage change in quantity demanded divided by the
percentage change in price.

Percentage change in quantity demanded


Percentage change in price

Q / Q
 , where Q is change in quantity and P is change in price.
P / P

51 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

Rearranging

Q P
 
P Q

The sign of the elasticity of demand is generally negative, since demand curves invariably
have a negative slope. Accordingly price elasticity of demand can be stated as:

P
  slope 
Q

In elasticity, we consider the absolute value of the coefficients. The negative sign in front of
an elasticity coefficient indicates only that the relationship between price and quantity
demanded is negative. A demand with –2 elasticity coefficient is said to be „more elastic‟
than the one with –1.

If a good has an elasticity of demand greater than 1 in absolute value, it is said to have an
elastic demand. Such values imply that a given percentage fall in price causes more than
proportionate rise in price.

Example 2.10

Assume that a consumer purchases 10 units of a good when price is Birr 4 and 18 units
when price falls to Birr 2. Compute price elasticity of demand.

18  10
Percentage change in quantity demanded is  100  80% and,
10

24
Percentage change in price is  100  50%
4

80%
Elasticity, therefore, is given as    1.6
 50%

This implies that for one percent fall in price quantity demanded rises by 1.6 percent. Here,
since E is greater than one, demand is said to be elastic.

If the elasticity is less than 1 in absolute value, on the other hand, it would be the case of
inelastic demand. This indicates that a given percentage fall in price causes a less than
proportionate rise in quantity demanded.

HARAMAYA UNIVERSITY 52
 UNIT TWO: THEORY OF DEMAND AND SUPPLY

Example 2.11

Again, assume that a consumer purchases 10 units of a good when price is Birr 4 and 14
units when price falls to Birr 2. Compute price elasticity of demand.

14  10
Percentage change in quantity demanded is  100  40% and
10

24
Percentage change in price is  100  50%
4

40%
Price elasticity of demand is    0.8
 50%

This implies that a one percent fall in price causes a 0.8 percent rise in quantity demanded.
Since elasticity is less than one, therefore, demand is said to be inelastic.

If, however, a given percentage change in price causes a proportionate percentage change in
quantity demanded the elasticity coefficient will be -1; and hence demand is referred to as
unitary elastic.

Example 2.12

Assume now a consumer purchases 10 units of a good when price is Birr 4 and 15 units
when price falls to Birr 2. Compute price elasticity of demand.

15  10
Percentage change in quantity demanded is 100  50%
10

24
Percentage change in price is 100  50%
4

50%
Price elasticity of demand is, therefore,    1
50%

With most demand curves, the elasticity coefficient varies along the curve. In this regard, a
good example is a linear demand curve. The coefficients of elasticity of such demand curves
range from perfectly elastic (at the intercept of y-axis) to perfectly inelastic (at the x-axis
intercept).

53 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

Consider a linear demand function of the form, Q = a – bP, depicted in the figure below.
The slope of this demand curve is a constant -b.

The formula for price elasticity of demand is given as

dQ P
 
dP Q

P
 slope 
Q

Substituting this into the formula for elasticity, we have

P  bP
  b  
Q Q

But Q=a - bP

 bP

a  bP

The horizontal intercept of the demand curve will be obtained by setting P=0. Accordingly
it occurs at Q=a. The vertical intercept, on the other hand, is obtained by setting Q=0. It is
defined at P= a/b.

P
a/b e = 
e >1
a/2b e = 1
e<1
e = 0
0 a/2 a Q
Figure 2.18: Elasticity along a Linear Demand Curve

At the horizontal intercept the price elasticity of demand is zero.

 b(0) 0
  0
a  b(0) a

When q = 0 at the vertical intercept, the elasticity of demand is infinity.

HARAMAYA UNIVERSITY 54
 UNIT TWO: THEORY OF DEMAND AND SUPPLY

 bp
 
0

In between these two points, there must be a price-quantity combination at which price
a
elasticity of demand is unity or one. This point occurs at P  .
2b

Proof

The point at which elasticity is unity is defined as

 bP
  1
a  bP

By cross multiplication

 bP  bP  a
a  2bP
a 2bp a
 P
2b 2b 2b

a
At P  the quantity demanded will be obtained by substitution into the demand function
2b
Q = a – bP.

a
Q  a b
2b

a a
Qa Q
2 2

a a
The price-quantity combination that yields unitary elasticity of demand is ( p  ,Q  )
2b 2

This result implies, therefore, that elasticity of demand for this linear demand function
becomes unitary just half way down the demand curve.

Numerical Coefficients of Price Elasticity of Demand

Colleague, depending on the magnitude (size) of the elasticity coefficient, five types of price
elasticity could be traced along a linear demand curve. Each of these is given in Table 2.8
below.

55 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

Table 2.8: Elasticity Coefficients

Numerical Responsiveness of quantity demanded to Terminology

coefficients changes in price
e=0 none Perfectly inelastic
0<e<1 Quantity demanded changes by a smaller Inelastic
percentage than the percentage change in price
e=1 Quantity demanded changes by a percentage equal Unit elastic
to the percentage change in price
1<e< Quantity demanded changes by larger percentage Elastic
than the percentage change in price
e= Quantity demanded goes to zero or to all that is perfectly elastic
available

Exercise 2.10
?
The price elasticity of demand for a 10 percent decrease in price of a commodity is
P
–5. If the quantity demanded of a commodity by a consumer before price change is 8 units,
1
what will be the quantity of a commodity demanded by a consumer after a price change in
units?

Determinants of Price Elasticity of Demand

Can you list the major determinants of elasticity? Price elasticity of demand depends, in
large part, on the number of substitutes a product has. If a good has many close substitutes,
it is generally held that its quantity demanded would be very responsive to price changes.
On the other hand, if there are a few close substitutes for a good, it will exhibit a quite
inelastic demand.

The elasticity coefficients for general groups of commodities will be lower than for specific
commodities. For example, the elasticity of demand for detergent soap will be higher than
the elasticity of demand for soap in general.

Another determinant of elasticity is time. The longer the period of time consumers have to
adjust, the more elastic the demand becomes. This is because there are more opportunities to
modify behavior and substitute different products over a longer time period.

HARAMAYA UNIVERSITY 56
 UNIT TWO: THEORY OF DEMAND AND SUPPLY

A fourth determinant of price elasticity of demand is the nature of the need that the
commodity satisfies. Generally luxury goods are price elastic and necessities are price
inelastic.

The proportion of income spent on the particular commodity also affects price elasticity.
Goods like car which take up a large proportion of income tend to have more elastic demand
than goods like salt which take up only small proportion of income.

Activity 2.7

Try to assess the price elasticity of demand for different products in a market in your
locality. Is there any difference in price elasticity of demand for different products? If yes,
what do you think explains this difference in relation to the determinants of price elasticity
of demand listed above?
__________________________________________________________________________
__________________________________________________________________________
_________________________________________________________________________

2.4.2.2. Constant Elasticity Demands

Along a linear demand curve, as shown above, price elasticity of demand ranges between 0
and ∞. In some exceptional cases, the demand curve may exhibit constant price elasticity
throughout.

A demand curve given by a vertical line indicates a case in which the quantity demanded of
a good is totally unresponsive to changes in price. Consequently, the elasticity coefficient is
zero. Such demand curve is called perfectly inelastic demand curve. This is a limiting case,
which violates the law of demand.

dQ P P
   0  0
dP Q Q

57 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

P D
P2

P1

0 Q1 Q
Figure 2.19: Vertical Demand Curve

If a demand curve is given by a horizontal line, which is also a limiting case, a very small
decrease in price would cause an infinite quantity of the good to be demanded. If price rises,
in contrary, the quantity of the good falls to zero. Such a curve is referred to as a perfectly
elastic demand curve.

P1 D

0 Q1 Q2 Q
Figure 2.20: Horizontal Demand Curve

A general way to characterize demand curves with constant elasticity is

Q  AP 

where A is an arbitrary positive constant and  is a measure of price elasticity of demand. 

being a measure of elasticity, it will typically take a negative value.

It can be shown that  represents price elasticity of demand.

Proof

 = elasticity

Q P
 
P Q

HARAMAYA UNIVERSITY 58
 UNIT TWO: THEORY OF DEMAND AND SUPPLY

Q
 AP  1
P
Q
Q  AP e  A 
P
Q Q P
  
P P P
Q P
 
P Q

A more convenient way to express a constant elasticity demand function is to take the
logarithm of both sides and write

ln Q = ln A +  ln P

In this expression, the logarithm of Q depends in a linear way on the logarithm of P.

An interesting case of such constant elasticity demand curves is a unit elastic demand curve.
The demand curve is a rectangular hyperbola. The demand function will, thus, be:

A
Q  AP 1 or Q 
P

In its logarithmic form, it is stated as

ln q = ln A – ln P

P
P1

P2 D

0 Q1 Q2 Q
Figure 2.21: Rectangular Hyperbola Demand Curve
The price elasticity of demand of a rectangular hyperbola is unitary throughout the demand
curve.

59 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

2.4.2.3. Price Elasticity of Demand and Total Revenue

Dear colleague, here, we are going to discuss about the concept of revenue and its
relationship with elasticity. Try to follow carefully.

When dealing with demand curves, the concern is with price and quantity relationships.
Quantity, or the number of items sold multiplied by price equals the total revenue generated.

TR  P  Q

In order to see how firms set and change prices, the relationship between total revenue and
elasticity could be considered.

It is important to recognize that a price change has two opposite effects on total revenue.
The first is that a price decrease, by itself, will decrease total revenue. The other is that with
a price decrease, quantity demanded increases, thus increasing total revenue. The net effect
on total revenue depends on whether the relative price decrease exceeds the relative increase
in quantity demanded or vice versa.

If demand is elastic, fall in price causes increase in total revenue. If, on the other hand,
demand is inelastic, the effect of fall in price would be decrease in total revenue. To see the
principle, consider the figure below.

Price Price

P1 P1

P2 P2 D

0 Q1 Q2 Quantity 0 Q1 Q2 Quantity

(a) Relatively inelastic demand (b) Relatively elastic demand

Figure 2.22: Elasticity and Total Revenue

HARAMAYA UNIVERSITY 60
 UNIT TWO: THEORY OF DEMAND AND SUPPLY

On both demand curves, the price falls from P1 to P2 and output increases from Q1 to Q2.
This change causes the total revenue to change. Some revenue is lost and some revenue is
gained due to the price change. In Figure 2.22 above, the lightly shaded areas represent the
revenue that has been lost and the darkly shaded areas represent revenue that has been
gained. In the case of the relatively elastic curve, panel (b) of the figure, the decrease in
price has brought about an increase in total revenue; in panel (a), the decrease in price has
brought about a decrease in total revenue.

These relationships are summarized in the table below.

Table 2.9: Relationship between Elasticity and Revenue

Price change Quantity demanded change elasticity total revenue
Rise Decrease >1 Decrease
Rise Decrease =1 Unchanged
Rise Decrease <1 Increase
Fall Increase >1 Increase
Fall Increase =1 Unchanged
Fall Increase <1 Decrease

Example 2.13

Price .50 1.00 1.20 1.40 1.60 1.80 2.00 2.20 2.40 2.60 2.80 3.00

Quantity 25 20 18 16 14 12 10 8 6 4 2 0
demanded

In the table above, at a price of Birr 2.00, the total revenue (TR) is Birr 20.00. An increase in
price form Birr 2.00 to Birr 2.20 causes TR to fall from Birr 20.00 to Birr 17.60. This is
because the 10 percent increase in price caused an even greater percentage decrease in
quantity demanded. The elasticity is greater than one. Conversely, if price rises from Birr
1.00 to Birr 1.20, TR increases from Birr 20.00 to Birr 21.60 because the percentage
increase in price is greater than the percentage decrease in quantity demanded. The elasticity
is less than one.

61 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

Total revenue, being the product of price and quantity, its function can be obtained by
multiplying the inverse demand function by the quantity.

A demand function that gives quantity as a function of price (Q = f (P)) is called direct
demand function. If the demand function gives price as function of quantity (P = f (Q)), it is
called inverse demand function.

An inverse demand function is given as P  a  bQ

TR  P  Q

TR  (a  bQ)Q

TR  aQ  bQ 2

Here, total revenue is a quadratic function. At the maximum point of the function its slope is
zero.

The slope of any function is the first derivative of that function.

dTR
Slope of TR =  a  2bQ
dQ

At the maximum point of TR, a  2bQ  0

a
Q
2b

Let‟s show the relationship between TR and price mathematically.

TR  P  Q

TR P Q
 Q  P
P P P

TR Q
Q P
P P

TR  Q P 
 Q1   
P  P Q 

HARAMAYA UNIVERSITY 62
 UNIT TWO: THEORY OF DEMAND AND SUPPLY

Q P
But   
P Q

TR
 Q(1  e )
P

TR
If e  1 ,  0 . This implies that rise in price leads to fall in TR.
P

TR
If e  1 ,  0 . This implies that rise in price leads to rise in TR.
P

TR
If e  1 ,  0 . This implies that rise in price will not affect TR.
P

Example 2.14

1
Suppose a demand function is given as Qd  50  P . Let‟s show that total revenue is
2
maximum when  = -1.

The inverse demand function is P  100  2Qd .

TR  100Qd  2Qd2

dTR
Slope of TR =  100  4Qd
dQd

At the maximum point of TR:

100  4Qd  0

Qd  25

At Qd  25 price obtained by substitution into the inverse demand function.

P  100  2(25)  50

Price elasticity of demand is defined as:

P
  slope 
Q

63 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

1 50
    1
2 25

Therefore,  = -1 when TR is maximum

Exercise 2.11
? Given the demand function Qd  100  2P
P a) What is price elasticity of demand when TR reaches maximum. Prove your result
1
mathematically.
b) Find the price and quantity which correspond to this maximum total revenue.

2.4.2.4. Approaches to Elasticity Measurement

Colleague, let us look at the different approaches for measuring elasticity. There are two
main approaches to elasticity computation: the arc elasticity and point elasticity. If we are
measuring the elasticity between points, we are actually calculating the average elasticity
over the space between the points. This is called arc elasticity.

Elasticity between two points:

Q
(Q  Q2 ) / 2 Q P1  P2
 1  
P P Q1  Q2
( P1  P2 ) / 2

P1 a

P2 b
D
0 Q1 Q2 Q
Figure 2.23: Arc Elasticity

Suppose you wish to measure price elasticity of demand as price falls from P1 and P2. In this
case you are, in a way, measuring the average elasticity between point a and point b.

HARAMAYA UNIVERSITY 64
 UNIT TWO: THEORY OF DEMAND AND SUPPLY

Exercise 2.12
? Find the price elasticity of demand for the demand curve in Example 2.14 if price
changes
P from Birr 10 to Birr 20. Is demand elastic or inelastic? Explain.
1

When measuring the responsiveness of quantity demanded to changes in price at a particular

point on a curve, you are actually measuring point elasticity.

Elasticity at a point is measured by assuming infinitesimally small changes in price and

quantity demanded. When dealing with the concept of arc elasticity, however, we are
working with sizable, discrete changes.

Elasticity at a particular point:

Q P
 
P Q

P1 a

D
0 Q1 Q

Figure 2.24: Point Elasticity

Price elasticity of demand at a particular point, such as point a, can be obtained by

multiplying the slope of the demand curve at that point by the corresponding price/output
ratio.

P
  slope 
Q

Exercise 2.13
? For the demand function in Example 2.14, find elasticity at price Birr 30.
P
1

65 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

2.4.2.5. Cross Elasticity of Demand

Dear learner, if you remember, we have said that price of other commodities will affect
quantity demanded of a given product. Now, let us discuss the responsiveness of quantity
demanded to changes in prices of other commodities.

The responsiveness of quantity demanded for one commodity to the changes in the prices of
other commodities, ceteris paribus, is called cross elasticity of demand. It is denoted as:

Percentage change in quantity demanded of one commodity (X)

 XY 
Percentage change in the price of another commodity (Y)

In this case (where the demand of a given good does not depend solely on its price), the
demand function is modified in such a way it includes the prices of related goods.

QX = f(PX, PY)

The cross elasticity formula is given as:

Q X PY
 XY   ‟
PY Q X

Where QX is the quantity demanded of good X and PY is the price of good Y.

The cross elasticity of demand coefficient may take different values depending on the type
of relationship between the two goods. If cross elasticity demand coefficient is equal to zero,
it would mean the two goods under consideration are unrelated. In this case, any increase or
decrease in price of one of the two goods has no effect on the quantity demanded of the
other good.

On the other hand, if the goods have a relationship of some sort, this value would be
different from zero. The two goods could be substitutes or complements depending on
whether the cross elasticity coefficient is positive or negative.

Definition: two goods are said to be substitutes if one good can be consumed in place of the
other. Complementary goods, in contrast, are goods that are consumed together so that fall
in consumption of one implies reduction in consumption of the other.

If the cross elasticity of demand coefficient has a positive sign it indicates that a rise in the
price of one of the two goods results in rise in the quantity demanded of the other good. As a

HARAMAYA UNIVERSITY 66
 UNIT TWO: THEORY OF DEMAND AND SUPPLY

result the two goods are substitutes. If, however, the cross elasticity of demand coefficient
has a negative sign, it reflects that a rise in the price of one of the goods results in decline in
the demand for the other indicating that the goods are complements.

The size (magnitude) of the cross elasticity of demand coefficient shows strength of the
substitution or complementary relationship between the goods under consideration. i.e., the
higher the value of cross elasticity, the stronger will be the degree of substitutability or
complementarity, depending on the sign.

Example 2.15

The quantity demanded of good X before change in the price of good Y was 25 units. As
good Y‟s price changes from Birr 5 to Birr 10, the quantity demanded of good X has
increased to 75 units.

Q X PY
 XY  
PY Q X

50 5
 XY   2
5 25

The two goods, therefore, are substitute products.

Exercise 2.14
? Use the information in the table below to answer the questions thereof.
P
1 Price of Y Quantity of X

Birr 5 50 units

Birr 10 25 units

Find the cross elasticity of demand and explain the relationship between the goods.

2.4.2.6. Income Elasticity of Demand

Dear colleague, let us turn our discussion to the responsiveness of quantity demanded to
changes in income of the buyer.

67 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

Income elasticity of demand is a measure of the responsiveness of quantity demanded to

changes in income assuming all other things, including price, constant.

Percentage change in quantity demanded

I 
Percentage change in income

Q I
I  
I Q

Where, Q represents output and I represents consumers‟ income.

In measuring income elasticity of demand, the sign of the elasticity coefficient is important.
The sign of the coefficient indicates the nature of the products; whether the products are
normal or inferior.

Definition: normal goods are goods whose quantity demanded increases with rise in
consumers‟ income, while inferior goods are those goods whose quantity demanded
decreases with rise in income.

The income elasticity of normal goods is positive reflecting the positive relationship
between income and quantity demanded. For inferior goods, however, income elasticity is
negative.

For normal goods, the same designation for the elasticity coefficients that is used for price
elasticity of demand can be used. If the coefficient is greater than one, I >1, the good is
income elastic, whereas if I <1, the good is said to be income inelastic.

Example 2.16

When the income of the consumer is Birr 1000, the consumer buys 100 units of a good. If
income increases to Birr 1200, the resulting quantity demanded would be 130 units.

The income elasticity demand of the consumer is given as:

Q I
I  
I Q

30 1000
I    1.5
200 100

The consumer‟s demand is income elastic.

HARAMAYA UNIVERSITY 68
 UNIT TWO: THEORY OF DEMAND AND SUPPLY

Goods with high positive income elasticity are considered as luxury goods. Necessities in
contrast have low income elasticity. It is important to note at this point that there is no clear
cut range of the income elasticity of demand coefficient for distinguishing between
necessities and luxury goods.

Definition: Luxury goods are normal goods for which quantity demanded changes by a very
high magnitude for a given change in income. Necessities are normal goods whose quantity
demanded changes by a smaller percentage for any given change in income.

Activity 2.8

How do you categorize jewelries and salt in relation to income elasticity of demand?
Explain.
__________________________________________________________________________
__________________________________________________________________________
_________________________________________________________________________

Colleague, look at the following diagrammatical presentation of the difference in income

elasticity across commodities.
Quantity demanded

Quantity demanded

Quantity demanded

D D
D

0 Income 0 M Income 0 M Income

(a) Normal good: (b) Normal good: (c) Inferior good
Income inelastic Income elastic beyond M

Figure 2.25: Income Elasticity of Demand

Look at the above figures carefully. In panel a, as income increases, quantity demanded
increases at a decreasing rate. This is reflected by the increasingly flatter demand curve as
the income level increases. In panel b, as the level of income increases, the demand curve
becomes steeper and steeper implying increase in quantity demanded at an increasing rate.

69 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

In panel c, however, the demand curve has two segments, a rising segment and a falling
segment. At its rising segment, the demand curve represents the case of income inelastic
normal good. Beyond point M, further increase in income causes fall in quantity demanded
representing a case of inferior goods.

Income elasticity of demand of a good depends mainly on the importance of the product to a
consumer. The more basic a good is in the consumption pattern of a consumer, such as food
stuff, the lower is its income elasticity. The more luxury a good is, the higher its income
elasticity will be. Income elasticity also depends on the time period; because consumption
patterns adjust with time-lag to changes in income.

2.4.3. Elasticity of Supply

Dear colleague, as we did for demand, let us now discuss the responsiveness of quantity
supplied to changes in its price.

Price elasticity of Supply

Price elasticity of supply measures the responsiveness of the quantity supplied to a change in
the commodity‟s price, ceteris paribus. It is defined as:

Percentage change in quantity supplied

S 
Percentage change in price

Q s P
s  
P Q s
Where, QS is quantity supplied of a good and P is price.
As with price elasticity of demand, if s = 1, supply is unit elastic. If s > 1, it is elastic; and
if s < 1, it is inelastic.

The coefficients of price elasticity of supply are often positive because normally supply
curves are positively sloped. But there are exceptions in which the supply curve is either
vertical or horizontal. If the supply curve is verticalthe quantity supplied does not change
as price changesthen elasticity is zero. This is the case in the very short run where it is
difficult to produce more of a good regardless of what happens to price. Similarly, a
horizontal supply curve has an infinitely high elasticity of supply: a small drop in price
would reduce the quantity producers are willing to supply from an indefinitely large amount

HARAMAYA UNIVERSITY 70
 UNIT TWO: THEORY OF DEMAND AND SUPPLY

to zero. Between these extremes the elasticity of supply varies with the shape of the supply
curve.

Example 2.17

A firm produces 100 units of output and sells each unit for Birr 20 at equilibrium. Suppose
the demand for the firm‟s product has increased and caused a rise in price to Birr 25 a unit.
After the rise in price the quantity that the firm sells has increased to 120 units.

Q s P
s  
P Q s

20 20
s    0.8
5 100

This implies that the supply of the firm is price inelastic.

Exercise 2.15
?
The price elasticity of supply of a firm is 0.5. A rise in price to Birr 6 has induced a
10Ppercent rise in quantity supplied by the firm. Find the initial level of price.
1

Determinants of Price Elasticity of Supply

The elasticity of supply depends on:

 How costs behave as output is varied. If the costs of producing a unit of output rise
rapidly as output rises, then the stimulus to expand production in response to rise in
price will quickly be obstructed by increases in costs. In this case, supply will tend
to be rather inelastic. If, however, the costs of producing a unit of output rise only
slowly as production increases, a rise in price that raises profits will bring forth a
large increase in quantity supplied before the rise in costs puts a halt to the expansion
of output. In this case, supply will tend to be rather elastic.

 Time involved. Since as the time period increases, the possibility of obtaining new
and different inputs to increase the supply increases, elasticity of supply tends to be
more elastic over longer periods than over shorter periods.

71 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

 Excess capacity and unsold stocks. It may be possible to increase supplies if there is
a pool of unemployed labor and unused machinery. Again, if the industry has
accumulated a large stock of unsold goods, supplies can quickly be increased. These
mean, it is possible to quickly respond to an increase in price by increasing quantity
supplied and hence, supply becomes more elastic.

Activity 2.9

Suppose you were the manager of a particular firm. What factors do you think will affect
your decision of how much to produce? How do you relate these to the determinants of
supply discussed above?

__________________________________________________________________________
__________________________________________________________________________
__________________________________________________________________________

Summary

 The amount of a commodity that households wish to purchase is called the quantity
demanded. It is determined by commodity‟s own price, the price of related
commodities, consumers‟ income, tastes, and size of population.

 Quantity demanded is negatively related to price, ceteris paribus. The relationship

between price and quantity demanded is graphically shown by the demand curve.
The effect of change in price is given by movement along the demand curve.

 Any change in all factors that affect demand except commodity‟s own price cause
shift of the demand curve. This represents a change in demand. The demand curve of
a normal good shifts to the right (an increase in demand) if income rises, population
size rises, if price of substitutes rises, if price of complements falls, or if there is a
change in tastes in favor of the product. The opposite changes shift the demand curve
to the left (a decrease in demand).

HARAMAYA UNIVERSITY 72
 UNIT TWO: THEORY OF DEMAND AND SUPPLY

 The amount of a commodity that firms wish to sell is called the quantity supplied. It
depends on the commodity‟s own price, the costs of inputs, the number of firms, and
the state of technology.

 Quantity supplied is positively related to price, ceteris paribus. The relationship

between price and quantity supplied is graphically shown by the supply curve. The
effect of change in price is given by movement along the supply curve.

 A shift in supply curve indicates a change in the quantity supplied at each price and
is referred to as a change in supply. The supply curve shifts to the right (an increase
in supply) if the costs of producing the commodity fall or if, for any reason,
producers become more willing to produce the commodity.

 The equilibrium price is the one at which the quantity demanded equals the quantity
supplied. Graphically, it is shown by the point of equality of the demand curve with
the supply curve.

 At any price below the equilibrium price, there will be excess demand and at any
price above the equilibrium price, there will be excess supply.

 With supply remaining the same, increase in demand causes rise in equilibrium
price. Fall in demand, on the contrary, causes fall in equilibrium price.

 With demand remaining the same, increase in supply causes fall in equilibrium price
while decrease in supply brings forth rise in equilibrium price.

 Price elasticity of demand measures the extent to which the quantity demanded of a
commodity responds to a change in its price. It is defined as the percentage change in
quantity demanded divided by the percentage change in price. It ranges between zero
and infinity.

 The main determinants of price elasticity of demand are the availability of substitutes
for the commodity and the time period involved for adjustment. A commodity that
has close substitutes will have elastic demand. Similarly, the longer the time for
adjustment, the higher will be elasticity.

73 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

 Cross elasticity of demand is the percentage change in quantity demanded divided by

the percentage change in the price of some other commodity. Positive cross elasticity
implies that the products are substitutes while a negative cross elasticity indicates
that the products are complementary.

 Income elasticity of demand measures the percentage change in quantity demanded

due to a given percentage change in consumers‟ income. If a commodity has positive
income elasticity, it is referred to as a normal good. If income elasticity is negative,
then, the commodity is inferior.

Self-test Exercises

i) Review your understanding of the following terms

Demand function Supply curve

Demand curve Market supply

Market demand Price elasticity of supply

Price elasticity of demand Market equilibrium

Income elasticity of demand Excess demand

Cross elasticity of demand Excess supply

Supply function

ii) Multiple Choice Questions

1. Choose the correct statement.

a) An increase in input prices will increase the supply of a good, ceteris paribus.
b) The supply for a good will not change as a result of changes in the price of the good
itself, ceteris paribus.
c) Other things constant, supply of a good will increase as sellers expect lower price for
their commodity in the future.
d) Fall in the number of producers increases the supply of a good.
e) None
2. Availability of substitutes

HARAMAYA UNIVERSITY 74
 UNIT TWO: THEORY OF DEMAND AND SUPPLY

a) Increases with the broadness of the definition of the good.

b) Increases with the narrowness of the definition of the good.
c) Is not affected by such definitions.
d) May increase or decrease even with the narrowness of the definition.
e) None
3. In Harar stadium, the number of people watching a given football match is usually less
than the capacity it can accommodate. Which of the following means enable to increase
the number of people and simultaneously generate more revenue?
a) Lowering the price of tickets if the demand for tickets is inelastic.
b) Lowering the price of tickets if the demand for tickets is elastic.
c) Raising the price of tickets if the demand for tickets is elastic.
d) Raising the price of tickets if the demand for tickets is inelastic.
e) None
4. If good X and Y are substitutes, a decrease in the price of good Y would cause,
a) The demand curve for good Y to shift to the right.
b) The demand curve for good X to shift to the left.
c) The demand curve for good Y to shift to the left.
d) The demand curve for good X to shift to the right.
e) B and C
5. If a firm‟s demand increases and its supply decreases, one of the following is necessarily
true.
a) The equilibrium price and quantity will both rise.
b) The equilibrium price will rise.
c) The equilibrium output will rise.
d) Equilibrium output will fall.
e) None.

iii) Workout Questions

1. The demand and supply functions that a firm faces are given by:
Qd = 40 – 2P
Qs = 10 + P
a) Find the equilibrium price and quantity.

75 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

b) Show the effect on equilibrium if the supply curve shifts to Qs  15  3P .

2. Find the equilibrium price and quantity if demand and supply functions are given as
P  32  Q 2 and P  Q 2  4Q  16 respectively.
3. Find the price elasticity of supply at price of Birr 8 if the supply function is:
Q = 25 – 4P + P2
What is elasticity at Birr 4 and at Birr 5? Interpret the result.
4. Suppose that Q  200  2P 2 units of a commodity are demanded when Birr P per unit is
charged.
a) Calculate the elasticity of demand when the price is P = 6. Interpret the result.
b) At what price is elasticity of demand equal to -1?
5. The demand function is given by Q = 10 – P near the point Q = 4 and P = 6. If the price
increases by 5%; determine the percentage decrease in demand and hence an
approximation to the elasticity of demand.
Compare the result with the correct value of elasticity of demand corresponding to Q=4.

iv) Discussion Questions

1. Would the elasticity of demand for Coca Cola be higher or lower than the elasticity of
demand for soft drinks? Why?

2. If the government wants to place a tax on a certain commodity for the purpose of
generating revenue, should it look for goods that have relatively inelastic or relatively
elastic demand curves?

Answers to Exercises

2.1) Quantity demanded decreases from 80 units to 60 units.

2.2) Quantity supplied decreases from 50 units to 25 units.

2.3) P=7 and Q=29

2.4) a. Price rises from Birr 15 to Birr 20 and Quantity increases from 70 to 90 units.

b. Price rises from Birr 15 to Birr 25 and Quantity rises from 70 to 110.

HARAMAYA UNIVERSITY 76
 UNIT TWO: THEORY OF DEMAND AND SUPPLY

2.5) Market A: price decreases from Birr 15 to Birr 10 and quantity increases from 70 units
to 80 units.

Market B: price decreases from Birr 18 to Birr 12 and quantity increases from 82 units to
88 units.

2.6) a. Price decreases from Birr 15 to Birr 14 and quantity increases from 70 units to 72
units.

b. Price decreases from Birr 15 to Birr 10 and quantity increases from 70 units to 80
units.

2.7) a. Price increases from Birr 15 to Birr 18 and quantity increases from 70 units to 82
units.

b. Price increases from Birr 22.5 to Birr 27 and quantity increases from 55 units to 64
units.

2.8) a. Price decreases from Birr 20 to Birr 16 and quantity decreases from 60 units to 42
units.

b. The fall in demand is greater than the fall in supply.

2.9) a. Price decreases from Birr 15 to Birr 10 and quantity decreases from 70 units to 60
units.

b. The fall in demand is greater than the rise in supply.

2.10) Q = 12

2.11) a.  = -1

b. Price = Birr 50 and Quantity= 100 units.

2.12)  = -3/17, inelastic.

2.13)  = -3/7

2.14)  = -1/2, complementary.

2.15) P = 5

77 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

Suggested Reading Materials

Lipsey R. G., Courant P. N., Purvis D. D., and Steiner P. O., Microeconomics, 10th ed. New
York: Harper Collins College Publishers, Inc., 1993.

Amacher R. C., and Ulbrich H. H., Principles of Microeconomics, 3rd ed. Ohio: South-
Western Publishing Co., 1986.

Stanlake G. F., and Grant S. J., Introductory Economics, 6th ed., Singapore, Longman, 1995.

Gould J. P. and Lazear E. P., Microeconomic Theory, 6 th ed., Homewood, Richard D. Irwin,
Inc., 1998.

Koutsoyiannis A., Modern Microeconomics, 2nd ed., English Language Book Society,
Macmillan, 1985.

HARAMAYA UNIVERSITY 78
 UNIT THREE: THEORY OF UTILITY AND PREFERENCES

UNIT THREE

THEORY OF UTILITY AND PREFERENCES

Introduction

Dear colleague, in the previous unit considerable time was spent using demand and supply
curves to develop predictions about the outcome of market processes. Most of the analysis
made use of market demand curves, which are derived by aggregating individual demand
curves. Since these individual demand curves are the basis of our analysis, it is important to
consider the factors that underlie the individual consumer‟s demand curve. In this unit,
therefore, we will discuss utility and preferences which are very important in consumer‟s
decision making.

In analyzing an individual consumer‟s decision making process, economists use two

approaches. The first approach, the cardinal utility approach, involved the concept of
measurable utility. The second approach, the ordinal utility approach, requires only the
ranking of preferences as a basis of making decisions using indifference curves.

Objectives

After studying this unit, you should be able to:

 Define utility and consumer‟s surplus;

 State the assumptions of cardinal utility approach and ordinal utility approach;

 Derive marginal utility curve from total utility curve;

 Define an indifference curve and budget line;

 Derive an income-consumption curve and price-consumption curve using

indifference curve analysis;

 Determine an individual‟s utility maximizing consumption bundle;

 Derive an individual‟s demand curve both under cardinal utility approach and ordinal
utility approach; and

 Define and graphically show income effect and substitution effect of price change.

79 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

Definition and Approaches to Utility

Dear colleague, let us start our discussion with the very concept of 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.

Definition: Utility is the satisfaction that an individual receives from consuming goods or
services.

Utility is strictly an ex ante concept; that is, it measures the way an individual feels about a
commodity before the individual buys or consumes it. Utility is the satisfaction that an
individual expects to get, not what he actually gets. You may want to take a bottle of Beer
and enjoy yourself. When you decide to buy that bottle of Beer, what matters the most is the
satisfaction you expect to derive from its consumption. In fact, the consumption may make
you feel uncomfortable – that is irrelevant economically.

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:

 Knowledge of the goods and services available.

 Knowledge of their technical capacity to satisfy his wants.

 Knowledge of market prices.

 Knowledge of his money income.

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.

In relation to the comparison of the utility from different consumption bundles, cardinal
approach and ordinal approach take different views.

HARAMAYA UNIVERSITY 80
 UNIT THREE: THEORY OF UTILITY AND PREFERENCES

Section 1: Cardinal Utility Approach

Introduction

Initially, this approach took the view that utility is measurable and additive. In this regard a
measure called util can be employed. On the basis of the amount of utility consumers derive
from consumption of commodities; comparison of the number of utils of different people
and addition of the utility of different people is, therefore, possible. By comparing different
bundles according to the number of utils they yield, a consumer will choose that bundle
which gives him the highest possible number of utils.

Later, however, the assumption of additive nature of utility was relaxed. This section
considers the later development of cardinal utility approach.

Objectives

At the end of this section you are expected to:

 State the assumptions of cardinal utility approach;

 Calculate marginal utility from total utility;

 Derive marginal utility curve from total utility curve;

 Determine an individual‟s utility maximizing consumption bundle;

 Derive an individual‟s demand curve under cardinal utility approach.

 Define consumer‟s surplus; and

 Calculate consumer‟s surplus from a linear demand curve.

3.1.1. Assumptions of Cardinal Utility Theory

Colleague, the Cardinal utility approach builds on certain assumptions. The basic
assumptions of the approach are given below.

1. The total utility of a „basket of goods‟ depends on the quantities of the individual
commodities. If there are n commodities in the bundle with quantities X 1 , X 2 ,..., X n

the total utility is

U  f ( X 1 , X 2 ,..., X n ) .

81 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

This assumption implies that as the quantity of goods consumed increases the total
utility of the consumer accordingly increases.

2. 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.

3. Utility is cardinal: the utility derived from each commodity is measurable. The most
convenient measure is money: the monetary units that a consumer is prepared to pay
for another unit of the commodity measure utility.

4. Constant marginal utility of money: this assumption is necessary if monetary units

are to be used as the measure of utility. If the 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.

5. Diminishing marginal utility: the extra satisfaction gained from successive units of a
commodity diminishes. In other words, the marginal utility of a commodity
diminishes as the consumer acquires larger quantities of it.

3.1.2. Total Utility and Marginal Utility

Colleague, let us look at the following important definitions in the theory of utility.

Definition: Total utility is the total amount of utility that consumers receive from
consumption of commodities. Utility being measurable, it is given as the sum of the utilities
obtained from consumption of each unit of the commodity consumed.

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.

Definition: Marginal utility is the amount of satisfaction added by an additional unit of

consumption.

HARAMAYA UNIVERSITY 82
 UNIT THREE: THEORY OF UTILITY AND PREFERENCES

The formula for marginal utility (MU) is

Change in total utility U  U n1

MU   n .
Change in quantity consumed Qn  Qn1

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 the nth unit.

Though total utility increases as the consumption increases, the additions to total utility from
each additional unit consumed become smaller. This feature–the fact that additional, or
marginal utility declines as consumption increases–is called diminishing marginal utility
(Consider the following table for more clarification).

Table 3.1: Utility Schedule for Coca Cola

Quantity of Total Utility Marginal Utility

Coca Cola
0 0 –
1 20 20
2 38 18
3 54 16
4 67 13
5 77 10
6 84 7
7 88 4
8 89 1
9 87 -2
10 82 -5

In Table 3.1 above, marginal utility is determined by calculating how much each additional
bottle of Coca Cola adds to total utility. For example, the first bottle adds 20 units to total
utility. The fourth bottle adds 13 units to total utility. This is found by subtracting the total
utility of consuming n-1 bottles from the total utility of consuming n bottles of Coca Cola.

Principle of Diminishing Marginal Utility

The principle of diminishing marginal utility holds that for a given time period, the greater
the level of consumption of a particular commodity, the lower the marginal utility. For
instance, the seventh bottle is expected to provide less additional pleasure than the sixth

83 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

bottle. This principle is reflected in table 3.1 and figure 3.1 below. In table 3.1 marginal
utility falls from 20 units for the first bottle to 18 units for the second bottle. The seventh
bottle adds only four units to total utility.

Panel (a) of figure 3.1 shows the total utility curve derived from the utility schedule in table
3.1. Panel (b) shows the marginal utility curve that corresponds to the total utility curve.

Total
Utility
100
80
60 Total Utility
40
20
0 1 2 3 4 5 6 7 8 9 10 Quantity of
Coca Cola
Marginal
Utility
20
16
12
8
4
0 1 2 3 4 5 6 7 8 9 10 Quantity of
-4 Coca Cola
-8 Marginal Utility

Figure 3.1: Total and Marginal Utility

Colleague, based on the above figures, what is the value of marginal utility when total utility
is zero? Good. Marginal utility is zero when total utility reaches its maximum. The
additional utility (marginal utility) from the consumption of the eighth bottle of Coca Cola is
zero. Total utility, accordingly, reaches its maximum at the eighth bottle of Coca Cola. To
the left of this point marginal utility is positive and total revenue rises. To the right of this
point marginal utility is negative and total revenue falls.

HARAMAYA UNIVERSITY 84
 UNIT THREE: THEORY OF UTILITY AND PREFERENCES

Graphically, MU is the slope of the total utility curve. The slope of total utility curve
decreases until it reaches its maximum point at 8 bottles of Coca Cola. MU, therefore, falls
in this range. At the maximum point of the total utility curve slope is zero, and hence MU
will be zero. Beyond the eighth unit, however, since the total utility curve is falling MU is
negative.

Mathematically, MU is given as

dU
MU  , where dU is change in total utility and dQ is change in the quantity of
dQ
the commodity.

Activity 3.1

Consider an arbitrary measure of utility such as a util, and try if you can measure your
satisfaction from consuming a loaf of bread. Is this possible? If not, why do you think is so?
__________________________________________________________________________
__________________________________________________________________________
__________________________________________________________________________

3.1.3. Utility and Consumer Behavior

Colleague, the concepts of utility and price can now be combined to show how consumers
make choices in the marketplace. When choosing, consumers are confronted with a range of
items and also a range of prices. A consumer may not choose the item which has the greatest
utility because price and income are also important factors. In other words, consumers don‟t
always buy their first choice. Such behavior is common. You may prefer Teff to Sorghum,
but you may purchase the Sorghum. This is rational behavior, and we can see the reason by
looking at price and utility.

Suppose, for example, you are considering purchasing a soft drink. You are presented with
three possibilities given in table 3.2. Coca Cola is your first choice because it yields the most
utility. But the relevant question is not which soft drink has the most utility, but which has
the most utility per Birr. Therefore, you choose to buy a Pepsi. This choice implies that the
extra satisfaction of Coca Cola over Pepsi is not worth 75 cents, but the extra satisfaction of
Pepsi over Sprite is worth the extra 25 cents it costs. Thus, in deciding how to spend your

85 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

money, you look at marginal utility per Birr rather than marginal utility alone. By buying the
commodity with the highest marginal utility per Birr, you economize on your money.

Table 3.2: Hypothetical Utility per Birr Comparisons

Choice Marginal Utility Price MU per Birr

Coca Cola 30 3.00 10

Pepsi 27 2.25 12

Sprite 20 2.00 10

Activity 3.2

Try to see what happens to the additional satisfaction you derive from consumption of a
good as you have more and more of the good. Does the additional good give you more
satisfaction than the units consumed immediately before it? If no, why do you think this is
so?
__________________________________________________________________________
__________________________________________________________________________
__________________________________________________________________________

3.1.4. Equilibrium of the Consumer

Dear learner, let us consider consumer‟s equilibrium condition.

A consumer is said to be at equilibrium when he/she maximizes his/her utility from the
consumption of commodities for a given price and income. In the simplest case, where the
consumer buys just a single commodity X, he/she is faced with the choice of either spending
his income on the purchase of good X or retaining his/her income. The decision of the
consumer depends on the satisfaction he/she derives from consuming additional unit of the
commodity and the satisfaction he/she derives from keeping his/her income. If consumption
gives him/her more satisfaction than saving, he/she would buy the commodity. If
consumption yields relatively lower satisfaction to the consumer compared to the
satisfaction from saving, then the consumer would keep his/her income. The equilibrium
quantity of the commodity is, then, defined at the equality of the additional utility (marginal

HARAMAYA UNIVERSITY 86
 UNIT THREE: THEORY OF UTILITY AND PREFERENCES

utility) of the commodity and the marginal utility of money (which is assumed to be
constant).

Table 3.3: Utility Schedule for a Single Commodity

Quantity Total Marginal Marginal utility per Marginal

utility utility Birr (P = Birr 2) utility of
money

1 10 - - 1

2 36 26 13 1

3 56 20 10 1

4 70 14 7 1

5 78 8 4 1

6 80 2 1 1

7 76 -4 -2 1

8 68 -8 -4 1

Table 3.3 above presents the utility schedule of a consumer that makes decision on
consumption of beer. Initially each consumed Bottle of beer gives the consumer higher
satisfaction. As the quantity of beer consumed increases, the additional satisfaction received
falls.

For consumption level higher than six bottles, since MU per Birr is higher than the MU of a
unit of Birr, the consumer can increase his/her welfare by consuming more bottles of beer.
For consumption level higher than six bottles, the consumer can improve welfare by
reducing consumption because MU per Birr is less than the MU of a unit of Birr. The
equality of the marginal utility of beer and that of money occurs at the sixth bottle of beer.
This represents the equilibrium of the consumer.

Mathematically, the equilibrium condition of a firm that consumes a single good X occurs
when the marginal utility of X is equal to its market price Px.

MUx = Px

87 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

Proof

The utility function is

U  f (X )

If utility is measured in monetary terms and the consumer buys Qx quantity of the
commodity, his expenditure is Qx.Px. The consumer wishes to maximize his utility for any
Birr spent. In a way, therefore, the consumer wishes to maximize the difference between his
utility and his expenditure:

Max (U  Qx .PX )

The necessary condition for maximum is that the partial derivative with respect to Qx be
zero. This is because, at the maximum point, the slope of the total utility function is equal to
zero.

dU d (Qx Px )
 0
dQx dQx

Rearranging we obtain

dU
 Px or MUx = Px
dQx

Exercise 3.1
?
Suppose the marginal utility of a consumer from consuming additional bottle of beer
P
is 6 units. If the price of a bottle of beer is Birr 3, is the consumer maximizing utility? If not,
1
what do you think he has to do in order to move towards utility maximizing position?

If MUx is greater than Px, the consumer can increase his welfare by purchasing more units of
X. If, on the other hand, MUx is less than Px, the consumer can increase its welfare by
reducing the quantity of x he purchases. Utility is maximized when the condition MUx = Px
is satisfied.

HARAMAYA UNIVERSITY 88
 UNIT THREE: THEORY OF UTILITY AND PREFERENCES

Suppose now the consumer faces two commodities in his utility function, Pepsi and Pizza.
The price of Pepsi is Birr 2 a unit and that of Pizza is Birr 3 a unit. The utility schedule of
the consumer is given below (See Table 3.4).

Table 3.4: Utility Schedule for Two Commodities

Pepsi Pizza

Quantity TU MU MU/P Quantity TU MU MU/P

(P = 2) (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

Budget Constraint

Dear colleague, can you buy whatever quantity of a product want to buy? Why? Did you say
I have limited money? Good. That means you have a budget constraint. The consumer has a
given amount of income and hence we call he has a budget constraint.

Definition: budget constraint shows the given level of income that determines the maximum
amount of goods that may be purchased by an individual.

For example, let‟s consider the consumer with Birr 28 worth of purchasing power, and see
how that income will be allocated between the two goods so as to achieve maximum utility.

The consumer first buys a unit of Pepsi, because the first unit of Pepsi 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 Pepsi. The third commodity purchased

89 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

will be pizza, because it yields higher satisfaction per Birr than the second unit of Pepsi.
This process continues until the income of Birr 28 is spent. In maximizing utility, the
consumer will buy 5 units of Pepsi (spends Birr 10 on Pepsi) 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.

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:

MU Pepsi MU pizza

PPepsi Ppizza

Thus, the marginal utility of a bottle of Pepsi, when 5 bottles of Pepsi are consumed is 8
units, and the price of Pepsi is Birr 2, so

MU Pepsi 8
  4,
PPepsi 2

or 4 units per Birr. For pizza, at the optimum consumption rate MU is 12 units and the price
is Birr 3, so

MU pizza 12
  4.
Ppizza 3

This can be generalized to show the consumption decision involving n commodities. In this
case, the condition for the consumer‟s equilibrium is defined by the equality of the ratios of
marginal utilities of individual commodities to their prices.

MU x MU y MU z
  ... 
Px Py Pz

The utility derived from spending an additional unit of money must be the same for all
commodities. If the consumer derives greater utility from any one commodity, he/she can
increase his welfare by spending more on that commodity and less on others.

HARAMAYA UNIVERSITY 90
 UNIT THREE: THEORY OF UTILITY AND PREFERENCES

Exercise 3.2
?
Suppose that the prices of good A and good B are Birr 3 and Birr 2 respectively.
P
Suppose a consumer is spending his entire income for buying 4 units of A and 6 units of B,
1
and the marginal utility of both the 4th unit of A and the 6th unit of B is 6. Is the consumer at
his optimal position? Explain your answers?

3.1.5. Derivation of the Demand Curve of the Consumer

Colleague, let us derive demand curve using the concept of utility. The derivation of demand
is based on the axiom of diminishing marginal utility. The marginal utility of commodity X
may be depicted by a line with a negative slope. Geometrically, marginal utility is the slope
of the total utility function U = f (Qx). The total utility increases, but increases at a
decreasing rate up to quantity X*, and starts declining. Accordingly, MU will take different
values at different points on the TU curve (Look at the figure below).

Ux MUx

TU

0 X* Qx 0 X* Qx
MUx
Figure 3.2: Total Utility and Marginal Utility

The marginal utility of X declines continuously, and becomes negative beyond quantity X*.
If marginal utility is measured in monetary units, the demand curve for X is identical to the
positive segment of the marginal utility curve. At X1 the marginal utility is MU1, which at
equilibrium is equal to P1 and at X2 marginal utility is MU2, which in turn is equal to P2 at
equilibrium. The negative section of the MU curve does not form part of the demand curve,
since negative quantities do not make sense in economics (Consider the following figure for
more illustration).

91 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

MUx Px

Demand curve
MU1 P1
MU2 P2
MU3 P3

0 X1 X2 X3 X Qx 0 X1 X2 X3 X Qx
MUx
Figure 3.3: MU and Demand Curve

Weaknesses of Cardinal Utility Approach:

The cardinal approach involves two serious weaknesses, namely:

 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 utility of money is also unrealistic. The utility derived
from a unit of money varies with the level of income of the consumer. The additional
satisfaction that a poor person derives from a unit of money is by far higher than the
marginal utility of a rich person. Thus, money cannot be used as a measuring rod
since its own utility changes.

3.1.6. Consumers’ Surplus

Colleague, do you know what a consumers‟ surplus is? Ok. We will see it together. A
demand curve shows the price consumers are willing to pay for an additional unit of a
commodity. The negative slope of the demand curve reflects the law of diminishing
marginal utility. Consumers wish to pay less and less to additional units of commodity
because the additional utility that extra units of a commodity yield tend to be lower as the
quantity of the commodity consumed increases.

HARAMAYA UNIVERSITY 92
 UNIT THREE: THEORY OF UTILITY AND PREFERENCES

In a market economy, consumers pay the same price to all units of a commodity purchased,
though they are willing to pay different units. The difference of the price that consumers are
willing to pay and the price they actually pay constitutes consumer‟s surplus.

Definition: Consumer’s surplus is the extra utility gained from the fact that some consumers
pay less for an item than they would be willing to pay for the item.

Consider the demand curve in Figure 3.4 below. At price P1, the consumer will consume Q1
units of the commodity. From the discussion of utility maximizing behavior, the marginal
utility of the last unit purchased is equal to the price of the unit. This means that the
marginal utility of each previous unit purchased was grater than price P 1. The consumer
would have been willing to pay higher prices for those previous units. So at the market price
of P1, the consumer receives extra utility on all units but the last one. The total purchase is
worth more to the consumer than the total amount that is paid. This extra utility gained is
called consumer‟s surplus and is represented by the area below the demand curve and above
the market price. The shaded area in Figure 3.4 below represents consumer‟s surplus.

Consumer
surplus
P1

0 Q1 Q
Figure 3.4: Consumers‟ Surplus

Geometrically, consumer‟s surplus is given as ½ ( P  P1 )Q1 .

Example 3.1

Suppose demand and supply functions are given as Qd  100  2P and Qs  10  4P .

Equilibrium price is 15 and equilibrium quantity is 70. The vertical intercept of the demand
curve is at P = 50. Consumer‟s surplus at equilibrium is, then,

CS = ½ (50 15)  70  1225

93 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

Exercise 3.3
?
Suppose the supply function of consumers for a particular good in a given market is
P
Q=-9+3P, while the demand function of the firms in that market is Q=16-2P. Find the
1
consumer‟s surplus at the equilibrium point.

Section 2: Ordinal Utility Approach

Introduction

Dear learner, in the previous section, we have seen the concept of cardinal utility approach.
In this section, we will consider the second approach to the study of utility: the ordinal
utility approach.

The ordinal utility approach emphasizes that for decision making it suffices if consumers
can rank their preferences according to their desirability, rather than specify the quantity of
utility they derive from consumption of a commodity. For example, instead of saying that a
unit of Pepsi gives me 30 units of utility and a unit of pizza gives me 20 units of utility,
therefore I prefer Pepsi to pizza; the consumer needs only to be able to say “I prefer a unit of
Pepsi to a unit of Pizza.” Ordinal utility involves a utility ranking that only requires that
choices be ranked, rather than assigned numerical values.

Objectives

At the end of this section, you will be able to:

 State the assumptions of ordinal utility approach;

 Define an indifference curve and a budget line;

 Derive an income-consumption curve and price-consumption curve using

indifference curve analysis;

 Determine an individual‟s utility maximizing consumption bundle;

 Derive an individual‟s demand curve using indifference curve analysis; and

 Derive the income effect and substitution effect.

HARAMAYA UNIVERSITY 94
 UNIT THREE: THEORY OF UTILITY AND PREFERENCES

3.2.1. Assumptions of Ordinal Utility Theory

Colleague, like we did for cardinal utility, here also we will start with the assumptions of
ordinal utility. These assumptions are the following:

1. The consumers are assumed to be rational- they aim at the maximization of their
utility, given their income and market prices.

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. 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 A and B and if he is
indifferent between B and C, then he is indifferent between A and C.

3.2.2. Preference Ranking

The basis of ordinal utility approach is its assumption that objective measurement of utility
is largely impossible and unnecessary as long as people are able to rank one consumption
bundle ahead of another. Table 3.5 below shows the ranking of eight consumption bundles
by a consumer that consumes two goods X and Y. The consumer assigns rank to each bundle
according to the importance of the bundles to his satisfaction. In this example, more
preferred bundles are assigned higher values. A commodity space is obtained by plotting the
table on a two dimensional plane. Each point in the commodity space describes an allocation

95 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

of X and Y. So at point F, the consumer is considering the allocation of one unit of X and
four units of Y. To say that the consumer is indifferent between F and G implies that he is
indifferent between the bundle 1X and 4Y and bundle 2X and 2Y. It does not imply that he is
indifferent between 4Y and 1X (See the table).

Table 3.5: Rank Ordering of Commodity Bundles

Bundle Amount of X Amount of Y Rank order

A 6 6 4
B 3 5 3
C 4 3 3
D 5 2 3
E 3 4 2
F 1 4 1
G 2 2 1
H 3 1 1

From the table, we can see that consumption bundle A has more of both goods X and Y, and
hence, is preferred to all other bundles. The consumer is indifferent among consumption
bundles B, C, and D, indicating that the consumer is willing to take less Y if he gets enough
more X in return. Bundle B is preferred to E (the latter has less Y and the same amount of X).
The consumer is also indifferent between bundles G, H, and F.

7
 A(6, 6)
Quantity of Y

6
5 B(3, 5)
4 F(1, 4) E(3, 4)
3 C(4, 3)
2 G(2, 2) D(5, 2)
1 H(3, 1)
0 1 2 3 4 5 6
Quantity of X
Figure 3.5: Commodity Space

HARAMAYA UNIVERSITY 96
 UNIT THREE: THEORY OF UTILITY AND PREFERENCES

Activity 3.3

Consider alternative consumption bundles that are affordable for a given income, and try to
attach rank according to the satisfaction each bundle gives you. Can you identify that bundle
which gives you the highest satisfaction? Do you think ordinal ranking carries advantages
over cardinal utility? Explain.
__________________________________________________________________________
__________________________________________________________________________
__________________________________________________________________________

Hint: for a given income such as Birr 100, think of the different quantity of Bread, Coca
Cola, and Meat (kg), that you can buy. The different combinations define the alternative
consumption bundles.

Note here, however, that the rank that you attach to each bundle is used only for ranking of
preferences.

Utility Functions

Definition: utility function is a preference function ordering a consumer‟s desire to consume

differing amounts of commodities.

The use of utility functions, that assign numerical value or utility level to consumption
bundles, facilitates the analysis of consumer behavior. Utility functions provide ordinal
measurement of the utility provided by consumption bundles, i.e., the particular values
assigned to consumption bundles do not have significance on their own right. They are
simply used for the purpose of ranking different consumption bundles. If the consumer
prefers bundle A to bundle B, the utility function has to assign a larger numerical value to
bundle A than to bundle B, but the actual numerical values so assigned are themselves
irrelevant. Similarly, if the consumer is indifferent between bundle A and bundle B, the
utility function must assign the same numerical value to each bundle, but the particular value
so assigned is irrelevant. For example, the rank order assigned to consumption bundles A
through H in Table 3.5 can be thought of as the numerical values assigned to these bundles

97 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

by some utility function. Any other set of numbers such as 50, 20, 20, 20, 5, 3, 3, 3, which
preserved this ranking would do equally good.

If a utility function is defined as U  XY , utility is the product of the quantities of X and Y

consumed by consumers. In this case, the consumer derives 100 units of utility from a
bundle consisting of 10 units of X and 10 units of Y. And he/she is indifferent between a
bundle, which consists of 1 unit of X and 100 units of Y and 10 units of X and 10 units of Y.
A bundle with 1 unit of X and 100 units of Y is preferred to a bundle with 8 units of X and 10
units of Y.

3.2.3. The Indifference Curve

Colleague, here, we will discuss about indifference curve which is very important in ordinal
utility theory. Consumers‟ preferences are such that they choose the best things they can
afford. Consumers have consumption bundle which represents the complete list of the goods
they prefer. These consumption bundles are represented by (X, Y), where X represents the
good of our particular interest and Y all other goods. This enables us to focus on the tradeoff
between one good and everything else. Consumers can rank these bundles according to their
desirability.

In a consumer choice problem involving two consumption bundles (X1, Y1) and (X2, Y2), if
the individual

 always prefers the former bundle to the later, we say (X1, Y1) is preferred to (X2, Y2).

 is equally satisfied with both bundles, then the consumer is indifferent between the
two bundles.

Definition: An indifference curve is a locus of points–particular combinations or bundles of

goods–in a commodity space, which yield the same utility to the consumer, so that he is
indifferent between the different consumption bundles. Each point on an indifference curve
yields the same total utility as any other point on that same indifference curve.

If the utility function is given by U(X1, X2,…, Xn), where X1 is the amount of good 1
consumed, X2 the amount of good 2 consumed, and so on, then an indifference curve is
defined as the set of all consumption bundles (X1, …, Xn) that satisfy the equation
U(X1, X2, …, Xn) = C, where C is the constant level of utility for that indifference curve.

HARAMAYA UNIVERSITY 98
 UNIT THREE: THEORY OF UTILITY AND PREFERENCES

If on an indifference curve C is 5, then each point on the same indifference curve will yield
just 5 units of utility. If on another indifference curve C is 20, each point on this indifference
curve yields a higher level of utility to the consumer than any one point on the previous
indifference curve. Therefore, bundles on the later indifference curve will be preferred to
bundles on the former indifference curve. A set of indifference curves is called indifference
map.

Definition: An indifference map is a set of indifference curves each corresponding to a

different level of satisfaction for the consumers.

The indifference curves in an indifference map rank the preferences of the consumer.
Combinations of goods situated on an indifference curve yield the same utility.
Combinations of goods lying on a higher indifference curve yield higher level of satisfaction
and are preferred. Combinations of goods on a lower indifference curve yield a lower utility,
and, therefore, are not preferred. An indifference map is generated by choosing different
values for C in the expression U(X1, X2, …, Xn) = C (See the figure below).

Y Y

III
II
I
0 X 0 X
(a) Indifference curve (b) Indifference map

Figure 3.6 Indifference curve and Indifference map

Example 3.2

Assume that a consumer‟s utility function is given as U  XY . A consumption bundle with 6

units of X and 10 units of Y and a bundle with 12 units of X and 5 units of Y yield the same
level of satisfaction (60) to the consumer, therefore, lie on the same indifference curve. A
bundle with 8 units of X and 8 units of Y, however, is preferred to both bundles because it
yields a higher level of satisfaction, therefore lies on a higher indifference curve.

99 HARAMAYA UNIVERSITY
MICROECONOMICS I, MODULE-I

3.2.3.1. Characteristics of Indifference Curves

The following are the major characteristics of an indifference curve:

1. An indifference curve has negative slope, which denotes that if the quantity of one
commodity (Y) decreases, the quantity of the other (X) must increase, if the consumer
is to stay on the same level of satisfaction. If the quantity of one commodity
increases with the quantity of the other remaining the same, the total utility of the
consumer increases. Conversely, if the quantity of one commodity is reduced with
the quantity of the other remaining the same, the total utility of the consumer
decreases. Therefore, in order to keep the utility of the consumer constant, as the
quantity of one commodity is increased, the quantity of the other must be reduced.

2. Consumers can compare any two bundles in the commodity space and decide that he
prefers one of them or is indifferent between them. Therefore, there is an
indifference curve passing through each point in the commodity space. In a
commodity space, there are infinite points that represent consumption bundles. Some
of these bundles yield equal amount of satisfaction to the consumer, and hence are
located on the same indifference curve. Each point gives some amount of satisfaction
to the consumer, therefore, must be located on certain indifference curve.

3. The farther from the origin an indifference curve lies, the higher the level of utility it
denotes: bundles of goods on a higher indifference curve are preferred by the rational
consumer. Consumption bundles on a relatively lower indifference curve, in
contrary, represent lower level of satisfaction and are not preferred by a rational
consumer.

4. Indifference curves do not intersect each other. If they did, the point of their
intersection would imply two different level of satisfaction, which is impossible.

HARAMAYA UNIVERSITY 100

 UNIT THREE: THEORY OF UTILITY AND PREFERENCES

K
a d

b
c I
e II
0 L
Figure 3.7: Intersection of Indifference Curves

Points a, b and c are located on the same indifference curve, therefore must represent
the same level of utility. Similarly, points d, b and e are located on the same
indifference curve, therefore must yield the same level of utility. Bundle b is located
at the intersection of two indifference curves implying two different levels of
satisfaction. Bundle a has equal quantity of Y as bundle d, but it has more of X than
d, therefore represents higher level of utility. Both a and d, however, yield the same
level of satisfaction as bundle b. This implies that a and d yield the same level of
utility, which is not true.

5. Indifference curves are convex to the origin. This implies that the slope of an
indifference curve decreases (in absolute terms) as we move along the curve from the
left downwards to the right.

3.2.3.2. Extreme Indifference Curves

Colleague, we have special cases of indifference curves. The shape of the indifference
curves in Figure 3.6 above is considered to be typical for most goods. A typical indifference
curve has a negative slope and is convex to the origin. To understand why this shape is
typical, let‟s look at two extreme shapes. One extreme is shown in Figure 3.8 below, where
each indifference curve is a straight line. On indifference curve I3, the individual is
indifferent among all combinations between 40 units of Y and no X, and 20 units of X and no
Y. For instance, this person is indifferent between a bundle made up of 20Y and 10X and a
bundle made up of 10Y and 15X. We can generalize and say that the consumer is indifferent

101 HARAMAYA UNIVERSITY

MICROECONOMICS I, MODULE-I

between all combinations offering two units of Y in compensation for the loss of one unit of
X. They all yield the same amount of satisfaction. The tradeoff is always two Y for one X.

Y
40
I3
30
I2
20
I1
10

0 10 15 20 X

Figure 3.8: Linear Indifference Curves

The equation for I3 is Y  40  2 X . In this case, the slope is -2, meaning that two units of Y
will compensate the consumer for the loss of one unit of X. Remember that since this is an
indifference curve, any point on the curve has the same utility as any other point on the
curve. The equation for I2 is Y  30  2 X and for I1, Y  20  2 X . Obviously I3 is preferred
to I2, and I2 is preferred to I1.

Indifference curves like this could happen only if the two commodities, X and Y, are the
same commodity except for the units in which they are expressed. Thus, Y could be a one-kg
bag of sugar and X, a two-kg bag of sugar. This demonstrates that perfect substitutes have
linear indifference curves and that the closer two commodities are to being perfect
substitutes, the closer the indifference curves are to being straight line.

The extreme opposite of the linear indifference curve is the indifference curve with right
angle, as shown in Figure 3.9 below. To see the significance of this, look at I1. I1 indicates
that the consumer is indifferent between having two units of X and two units of Y, and
having two units of X and three units of Y, or indeed, two X and any number of Y, additional
units of only one of them would contribute nothing to additional satisfaction.

Such products are perfect complements, and good examples are left shoe and right shoe.
This is a trivial case since perfect complements are combined and sold as one good. We can

HARAMAYA UNIVERSITY 102

 UNIT THREE: THEORY OF UTILITY AND PREFERENCES

observe from this, however, goods that are complements to each other will have indifference
curves which approach the right-angled ones, being very convex to the origin, and almost
parallel to the axes.

5
4
3 I2
2 I1
1

0 1 2 3 4 5 6 X

Figure 3.9: Right Angled Indifference Curves

The typical indifference curve for two goods, as shown above, will lie between the extremes
of perfect substitutes and perfect complements.

3.2.4. Marginal Rate of Substitution

Colleague, let us see the concept associated with the slope of an indifference curve: marginal
rate of substitution. Marginal rate of substitution is a measure of substitution of two
commodities in consumption.

Definition: Marginal rate of substitution of X for Y is defined as the number of units of

commodity Y that must be given up in exchange for an extra unit of commodity of X so that
the consumer maintains the same level of satisfaction.

Number of units of Y given up

MRS X ,Y 
Number of units of X gained

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 (See the figure below).

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

103 HARAMAYA UNIVERSITY

MICROECONOMICS I, MODULE-I

willing to sacrifice for additional unit of commodity X declines as the quantity of X

increases.

Y
8 a
7
6
5
4
3 b
2
1

0 1 46 25 50 X

Figure 3.10: Marginal Rate of Substitution

At point a in Figure 3.10, 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.

Slope of dY
indifference = = MRS X ,Y
curve dX

Here, it is important to note that MRS X ,Y is different from MRSY , 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.

HARAMAYA UNIVERSITY 104

 UNIT THREE: THEORY OF UTILITY AND PREFERENCES

The concept of marginal utility is implicit in the definition of marginal rate of substitution,
since marginal rate of substitution is defined by the ratio of marginal utilities of the
commodities involved. This reflects the fact that the consumer takes into account the
additional (marginal) utility of the two commodities when making the exchange.

MU X MU Y
MRS X ,Y  or MRS Y , X 
MU Y MU X

Proof:

The utility function involving two commodities X and Y is defined as

U = f (X, Y).

Along an indifference curve utility is constant, therefore

U = f (X, Y) = C

The total differential of the utility function is

U U
dU  dX  dY  0
X Y
MU X  dX  MU Y  dY  0
MU X dY
  MRS X ,Y
MU Y dX

Similarly,

MU Y dX
  MRS Y , X
MU X dY

The ratio of the marginal utilities of the two commodities defines the rate at which one is
substituted for the other in consumption.

Example 3.3

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

105 HARAMAYA UNIVERSITY

MICROECONOMICS I, MODULE-I

dU dU
MU X  , and MU Y 
dX 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

Exercise 3.4
?
Find the MRSX, Y and MRSY, X if a consumer‟s utility function is U  50 X 0.8Y 0.2 . Is
P any difference between the two? Explain your answers.
there
1

3.2.5. The Budget Constraint

Now, let us look at the budget constraint discussed under cardinal utility approach but in a
different way. As seen in the preceding sections, the utility of a consumer depends on the
quantities of the commodities consumed. If so, then, a rational consumer must wish to
acquire as much quantities of the commodities as possible. Yet, the quantity of the
commodities that a consumer can acquire at a given time is limited by his income. Given the
infinite consumption bundles in a commodity space, those bundles that can be afforded by a
consumer for a given money income constitute the affordable consumption bundle of the
consumer. The size of the consumer‟s income, therefore, defines the consumer‟s affordable
consumption bundle.

Suppose the consumer consumes two goods X1 and X2 with their prices given as P1 and P2.
If the total income of the consumer is M, the total expenditure of the consumer cannot
exceed his total income.

P1 X 1  P2 X 2  M

HARAMAYA UNIVERSITY 106

 UNIT THREE: THEORY OF UTILITY AND PREFERENCES

The set of all affordable consumption bundles at a given income M and prices P1 and P2 is
referred to as the budged set of the consumer. The relationship between expenditure and
income above defines the consumer‟s budget set. The boundary of this set is called the
consumer‟s budget constraint.

Definition: budget constraint is the set of consumption bundles that can be purchased if the
entire money income is spent, for a given commodity prices. It is shown by the equality of
expenditure with income.

P1 X 1  P2 X 2  M

Solving for X2 gives the equation of the budget constraint.

P2 X 2  M  P1 X 1
1 P
X2  M  1 X1
P2 P2

The budget constraint establishes the maximum possible combination of goods X1 and X2
that the consumer can acquire for income M and prices P1 and P2. The slope of the budget
P1
line is the negative of the ratio of the prices of the commodities involved ( ) . The
P2
negative sign reflects the downward slope of the budget line, which implies that when the
entire income is used so as to increase the consumption of one commodity, the consumer
must reduce the consumption of the other.

The shaded area in Figure 2.11 shows the different consumption bundles that the consumer
can afford to purchase for a given income M, while the boundary of this region, the budget
constraint, shows the highest possible bundles that can be afforded for the given income M.
The budget line has the following characteristics.

 Points on the budget line, such as point a, indicate consumption bundles that use up the
household‟s entire income. Once a consumer locates himself on any one point on the
budget line, he can only increase the consumption of one commodity by reducing the
consumption of the other, because the entire income has been spent.

107 HARAMAYA UNIVERSITY

MICROECONOMICS I, MODULE-I

X2
M/P2 b
a
Budget constraint
c
Budget set

0 M/P1 X1

Figure 2.11 Budget Set and Budget Line

 Points below the budget line, such as c, indicate combinations of commodities that cost
less than the household‟s income. When an individual consumes a consumption bundle
inside the budget set, since there is income which is not spent, it is possible to improve
utility by increasing consumption.

 Points above the budget line, such as b, indicate combinations of commodities that cost
more than the household‟s income. Points outside the budget set are not attainable for a
given income, and are irrelevant for decision making.

Shifts in the Budget Line

Dear colleague, can you list the factors that are responsible for the shift in the budget line?
Ok. Let us see it together.

The budget constraint sets upper limit to the quantities that a consumer wishes to buy. This
constraint gets relaxed or tightened as certain conditions change. Such changes are reflected
by shift of the budget constraint. These shifts may result from two sources, namely:

 Changes in the consumer‟s income. As the income of the consumer changes, the
consumer can buy more of or less of both commodities depending on the direction of
the change.

HARAMAYA UNIVERSITY 108

 UNIT THREE: THEORY OF UTILITY AND PREFERENCES

 Changes in the prices of the commodities. Such changes have the effect of making
the commodity whose price has fallen relatively attractive and at the same time
raising the real income of the consumer.

3.2.5.1. Changes in Money Income

With two goods, X1 and X2 involved, increase in income enables the consumer to purchase
more of good 1, more of good 2 or more of both goods. Given the budget equation:

1 P
X2 = M  1 X1
P2 P2

The vertical intercept is M/P2 and the horizontal intercept is M/P1. The intercepts show the
quantity of one of the commodities that would be bought by the consumer if the entire
income is spent on the purchase of a single commodity. For example, if the entire income is
spent on the consumption of X2, the total quantity purchased of X2 would be M/P2.

Increase in income changes the vertical intercept and the horizontal intercept. It does not
affect the slope of the budget line (the ratio of prices). As a result, change in consumer‟s
income causes an outward shift of the budget line in a parallel fashion.

X2
M*/P2
M/P2
X 22 b

X 21 a

0 X 11 X 12 M/P1 M*/P1 X1
Figure 2.12: Change in Money Income

Suppose initially the consumer‟s income is defined at M. The budget constraint of the
consumer is given by the line with vertical intercept and horizontal intercept M/P1 and M/P2
respectively as in Figure 2.12. At point a on the initial budget constraint, the consumer can
buy X 11 of X1 and X 21 of X2. If now the consumer‟s income rises to M*, the consumer will

109 HARAMAYA UNIVERSITY

MICROECONOMICS I, MODULE-I

be able to buy more of both goods at the new income condition. In the figure above, the
budget constraint with intercepts M*/P1 and M*/P2 represents the new income condition. At
point b on the new budget line the consumer can buy X 12 of X1 and X 22 of X2. Bundle b has
more of both commodities than bundle a, therefore the consumer‟s position is improved
after the rise in income. A decrease in income, on the other hand, causes a parallel shift to
the left of the budget line. When such changes exist the consumer will be forced to a lower
utility position, because he will have to buy less of one of or both of the commodities at the
lower income.

Example 3.4

Suppose a consumer‟s income is Birr 280 and uses this income to buy two goods X and Y. If
the price of X is Birr 2 a unit and that of Y is Birr 5 a unit, the budget equation can be stated
as

2 X  5Y  280

Solving for Y,

Y  56  0.4 X

The slope of the budget line is, then -0.4. The vertical intercept is obtained by setting X = 0,
and it is defined at Y = 56. The horizontal intercept, similarly, is obtained by setting Y = 0,
and it is X = 140. Now if the consumer‟s income increases to Birr 350, with commodity
prices remaining the same, the new budget equation is given as

2 X  5Y  350 .

Solving for Y,

Y  70  0.4 X

The slope of the budget line is unchanged, but the vertical intercept has increased to Y = 70
and the horizontal intercept has increased to X = 175. Here both the vertical intercept and the
horizontal intercept have risen by 25 percent. Therefore, the budget line must have shifted in
a parallel fashion.

HARAMAYA UNIVERSITY 110

 UNIT THREE: THEORY OF UTILITY AND PREFERENCES

Exercise 3.5
? A consumer‟s income is Birr 400. The consumer uses his entire income to buy two
P X and Y. If the price of X is Birr 2 and the price of Y is Birr 4, derive the consumer‟s
goods
1
budget equation. Find the effect of fall in income to Birr 300 on the vertical intercept,
horizontal intercept and slope of the budget line.

3.2.5.2. Changes in Price

Colleague, we have discussed that the prices of the commodities determine the quantities of
the commodities purchased for a given money income. This fact is reflected in the budget
constraint. The slope and intercepts of the budget line are affected by changes in the prices
of the commodities. The changes in price could be of two types: proportional change in
price, in which the prices of the two commodities rise or fall by the same percentage such as
by change in the general price level, or relative change in price, in which the prices of the
two commodities change by different percentages.

Proportional Change in Prices

Proportional rise in the prices of both goods (good 1 and good 2), with income remaining
unchanged, will reduce the total quantity of the two goods that the consumer can buy for a
given income. For example, if the prices of the two goods under consideration double, this
would halve the quantities of the two goods purchased to be reduced by half. Before the rise
in price, if the consumer decides to spend his entire income on X1, the total quantity
purchased is M/P1. But after the doubling of prices, the new quantity will be M/2P1. The
new quantity is half that of the pre change quantity. Its effect is the same as that of reducing
the consumer‟s income by half. This causes a parallel shift in the budget line towards the
origin.

Proportional rise in the prices of the two commodities, X1 and X2 causes fall in the intercepts
but leaves the slope of the budget line unchanged.

111 HARAMAYA UNIVERSITY

MICROECONOMICS I, MODULE-I

X2

M / P2''
M/P2
M / P2'

0 M / P1' M/P1 M / P1'' X1

Figure 3.13: Proportional Changes in Price

Suppose the initial budget constraint is the one with intercepts M/P1 and M/P2. Proportional
fall in price shifts the budget line to the right to the one with intercepts M / P1'' and M / P2'' .
On the other hand, a proportionate fall in price is shown by shift of the budget line to the
right. In this case, with income remaining the same, the intercepts increase but the slope
remains unchanged. In Figure 3.13, a proportional rise in price is shown by shift of the
budget line from the one with intercepts M/P2 and M/P1 to the one with intercepts M / P1' and

M / P2' .

Example 3.5

Suppose a consumer‟s income is Birr 300. The consumer spends his income in the
consumption of two goods X and Y with prices Birr 5 and birr 10 respectively. Assume
further that the consumer buys equal quantity of both goods. In this case, by exhausting his
entire income the consumer can buy 20 units of X and 20 units of Y.

5(20) + 10(20) = 300

If the price of both goods doubles; i.e., Px = 10 and Py = 20, the quantity that the consumer is
able to buy when the entire income is spent is reduced to 10 units of X and 10 units of Y.

10(10) + 20(10) = 300

HARAMAYA UNIVERSITY 112

 UNIT THREE: THEORY OF UTILITY AND PREFERENCES

Exercise 3.6
?
Suppose a consumer uses his entire income, which is Birr 180, for the purchase of
P
two goods X and Y. The prices of the two goods X and Y are Birr 6 and Birr 12 respectively.
1
If the two goods are complementary and are used in the proportion of one-to-one, find the
effect of fall in price of the two goods to Birr 2 and birr 4, respectively, on the budget
constraint.

Changes in Relative Prices

Colleague, a change in relative price can occur, and often does, as a result of changes in only
one of the prices or changes in both prices in different proportions.

First, assume that the price of good 1 changes (increases) with price of good 2 and income
remaining fixed. Slope being the ratio of prices, this would make the budget line steeper.
The vertical intercept does not change, but the horizontal intercept will change. The
'
P1
resulting new slope would be  where P1' is the new price of good 1.
P2

X2
M/P2
Slope= -P1/P2

Slope=  P1' /P2

0 M / P1' M/P1 X1
Figure 3.14: Relative Changes in Price

In Figure 3.14 above, the initial budget constraint is the one with intercepts M/P1 and M/P2
and slope -P1/P2. With the price of X2 and income (M) remaining unchanged, if the price of
X1 rises, the budget line rotates towards the origin. The horizontal intercept of the budget
line decreases, reflecting the fact that as the price of X1 rises the quantity of X1 that can be
bought by the consumer declines if he decides to spend the entire income on X1. Thus, the

113 HARAMAYA UNIVERSITY

MICROECONOMICS I, MODULE-I

new horizontal intercept is M / P1' . Similarly slope decreases to  P1' /P2. The vertical
intercept remains unchanged, however.

Exercise 3.7
?
Graphically show the effect of rise and fall in price of X2, with the price of X1 and
P
money income remaining the same.
1

The effect of simultaneous change in the prices of the two goods in different proportions can
be shown in the same way as the previous case. In this case, however, both the vertical and
horizontal intercepts change.

In Figure 3.15 below, the initial budget constraint is given by steeper budget line. Given this
initial condition, if the price of X1 rises and the price of X2 falls, the position of the budget
constraint changes. That is, the vertical intercept increases from M / P2' to M/P2 and the

vertical intercept decreases from M / P1' to M/P1.

X2
M/P2

M / P2'

0 M/P1 M / P1' X1

Figure 3.15: Relative Changes in Price

A proportional change in money income and in the prices of all commodities leaves the
consumer neither better off nor worse off. In relation to rise in income and in the prices of
commodities, the rise in income shifts the budget constraint outward, while the rise in the
prices of commodities shifts the budget line inward, the net effect leaves the budget line at
its original position. In the case of fall in income and commodity prices, the fall in income

HARAMAYA UNIVERSITY 114

 UNIT THREE: THEORY OF UTILITY AND PREFERENCES

shifts the budget line in a parallel manner towards the origin, while the fall in the commodity
prices shifts the budget line to the right, the net effect still leaves the budget line unchanged.

3.2.6. The Equilibrium of the Consumer

Dear colleague, we have discussed how an indifference curve and the budget line are
derived. Now, we are going to use these lines in order to determine consumer‟s equilibrium.
Let us continue.

The consumer is in equilibrium when he maximizes his utility, given his income and the
commodity prices. The maximization of utility can now be shown by combining a set of
indifference curves with the budget line. For the consumer to maximize his utility two
conditions must be satisfied.

1. The marginal rate of substitution (the slope of indifference curve) must be equal to
the ratio of commodity prices (the slope of budget constraint).

MU x Px
MRS x , y  
MU y Py

This is necessary but not sufficient condition for equilibrium.

2. The indifference curve must be convex to the origin. This condition is satisfied by
the axiom of diminishing marginal rate of substitution, which states that the slope of
the indifference curve declines as we move from left to right.

Given an indifference map and the consumer‟s budget constraint, the consumer‟s
equilibrium is defined by the tangency of the budget line with the highest possible
indifference curve. As can be seen in the Figure 3.16 below, at point e on indifference curve
II, the budget line and indifference curve II are tangent. Any point on III such as point d, is
preferred to point e, because higher indifference curves represent higher levels of utility.
However, point d is not attainable because it is outside the budget line. Point c on I is
attainable, and point e on indifference curve II also is attainable, and any point on II
represents more satisfaction than any point on I.

115 HARAMAYA UNIVERSITY

MICROECONOMICS I, MODULE-I

A d
c

Y* e
III
I II

0 X* B X

Figure 3.16: Consumer‟s Equilibrium

The consumer wants to reach the highest attainable indifference curve. The highest
attainable curve is the one which is tangent to the budget line because no higher indifference
curve can be reached with the given income and prices. In Figure 3.16 above, the consumer
maximizes his utility at point e. At the point of tangency (point e), the slope of the budget
line, the ratio of the price of X to the price Y, is equal to the slope of indifference curve II,
marginal rate of substitution.

Px
MRS x , y 
Py

This equality satisfies the first order condition for equilibrium. The second order condition is
also satisfied since the indifference curve is convex at the tangency. Anywhere to the left of
the tangency, MRSx, y is higher than at the tangency; and anywhere to the right of the
tangency, MRSx, y is lower than at the tangency. In Figure 3.16, the consumer maximizes his
utility by consuming X* amount of good X and Y* amount of good Y.

The marginal rate of substitution expresses the willingness of the consumer to trade a certain
amount of X for a certain amount of Y, and the slope of the budget line reflects the market‟s
willingness to trade a certain amount of X for a certain amount of Y. The impersonal forces
of the market impose the relative price on the consumer, so the consumer adjusts
consumption amounts in such a way that his tradeoff is the same as that of the market.

HARAMAYA UNIVERSITY 116

 UNIT THREE: THEORY OF UTILITY AND PREFERENCES

The consumer‟s utility maximizing behavior can be generalized to n goods case. With n
goods involved in a consumer‟s decision, the equilibrium condition is defined by the
equality of the ratio of marginal utility to price of all commodities.

MU1 MU 2 MU n
   
P1 P2 Pn

Mathematical derivation of equilibrium:

Assume there are n commodities with pricesP1, P2, …, Pn, and the consumer‟s money
income is M. In this case, the problem to the consumer is maximizing his utility subject to
his limited income and market prices. In maximization, the function which represents the
objective that the consumer tries to achieve (in our case utility function) is called the
objective function and the constraint that the consumer faces is represented by the constraint
function (here the budget constraint).

Maximize: U = f (Q1, Q2, …, Qn)

Subject to: M = P1Q1 + P2Q2 + … + PnQn

Rewriting the constraint

M - P1Q1 - P2Q2 - … - PnQn = 0

Multiplying the constraint by Lagrange multiplier 

(M - P1Q1 - P2Q2 - … - PnQn) = 0

Forming a composite function (also called Lagrange function)

 = U + (M - P1Q1 - P2Q2 - … - PnQn)

Since the rewritten constraint function is zero, adding zero to U makes no difference at all.
Now given the composite function which is obtained by combining the objective function
and the constraint function, the process of utility maximization requires that two conditions
be satisfied:

The first order condition requires that the partial derivatives of the Lagrange function with
respect to all quantities and the Langrage multiplier () be zero.

117 HARAMAYA UNIVERSITY

MICROECONOMICS I, MODULE-I

 U
  P1  0
Q1 Q1
 U
  P2  0
Q2 Q2

 U
  Pn  0
Qn Qn


 (M - P1Q1 - P2Q2 - … - PnQn) = 0


From these equations, we obtain

U
 P1
Q1
U
 P2
Q2

U
 Pn
Qn

U U U
 MU1 ,  MU 2 , …,  MU n .
Q1 Q2 Qn

Substituting and solving for , we obtain the equilibrium condition:

MU 1 MU 2 MU n
   ...  .
p1 p2 pn

In a case where there are only two goods, this means

MU x MU y
 .
Px Py

Rearranging,

MU x Px
  MRS x , y
MU y Py

HARAMAYA UNIVERSITY 118

 UNIT THREE: THEORY OF UTILITY AND PREFERENCES

The second order condition for maximum requires that the second order partial derivatives
of the Lagrange function with respect to all quantities be negative.

 2  2U
 0
Q12 Q12

 2  2U
 0
Qn2 Qn2

The second order conditions imply that the indifference curves be convex to the origin. It is
necessary that the second order condition be satisfied because for indifference curves with
different shapes, tangency may not necessarily represent equilibrium. Suppose the relevant
indifference curve were linear. In this case, the budget line will lie totally on the indifference
curve, in which case any one point on the indifference curve represents equilibrium. If the
indifference curve were rather concave equilibrium would be defined by corner solution.

Example 3.6

Suppose the utility function of a person consuming two commodities X and Y with income
Birr 600 is given by U  2 X 0.6Y 0.4 . If the per unit price of X is Birr 20 and per unit price of
Y is Birr 40.
a) Calculate the utility maximizing level of consumption of X1 and X2.
b) Find the MRSX, Y at the optimum.
Solution
The consumer‟s objective is the maximization of his utility. Therefore, the utility function is
referred to as an objective function. However, the consumer‟s utility maximizing behavior is
constrained by his limited income; accordingly, the budget constraint is referred to as
constraint function.
Objective function: U  2 X 0.6Y 0.4
Constraint function: 20 X  40Y  600
The consumer‟s problem is then;
Max U  2 X 0.6Y 0.4
Subject to 20 X  40Y  600

119 HARAMAYA UNIVERSITY

MICROECONOMICS I, MODULE-I

Rewriting the constraint function

600  20 X  40Y  0
Multiplying the constraint by a Lagrange multiplier
 (600  20 X  40Y )  0
Forming a composite function
  2 X 0.6Y 0.4   (600  20 X  40Y )
The first order condition for utility maximization requires that all the first order derivatives
of the composite function with respect to X, Y and λ be zero.
First order condition:
 1.2 X 0.4Y 0.4
 1.2 X 0.4Y 0.4  20  0    (1)
X 20
 0.8 X 0.6Y 0.6
 0.8 X 0.6Y 0.6  40  0    (2)
Y 40


 600  20 X  40Y  0 (3)


From equations (1) and (2) we have

1.2 X 0.4Y 0.4 0.8 X 0.6Y 0.6

 
20 40

Rearranging (by cross multiplication)

2.4 X 0.4Y 0.4

1
0.8 X 0.6Y 0.6

3Y  X

Substituting this result in equation (3)

600  20(3Y )  40Y  0

60Y  600
Y 6

X  3Y
X  3(6)  18

Second order condition:

HARAMAYA UNIVERSITY 120

 UNIT THREE: THEORY OF UTILITY AND PREFERENCES

 2
 0.4(1.2 X ( 0.41)Y 0.4 )  0.48 X 1.4Y 0.4  0
X 2

 2
 0.6(0.8 X 0.6Y ( 0.61) )  0.48 X 0.6Y 1.6  0
Y 2

The second order condition is satisfied, therefore, the consumer should buy 30 units of X and
10 units of Y in order to maximize his utility.

The MRSX, Y at the optimal point is obtained by substituting the optimal quantities of the two
goods in the ratio of marginal utilities that defines MRSX, Y.

MU X
MRS X ,Y 
MU Y

U U
MU X   1.2 X 0.4Y 0.4 and MU Y   0.8 X 0.6Y 0.6
X Y

Y 6
MRS X ,Y  1.5  1.5  0.5
X 18

Exercise 3.8
?
Utility function of a person consuming two commodities X and Y with income Birr
P is given by; U  30 X 0.2Y 0.8 . If per unit price of X is Birr 2 and per unit price of Y is
1000
1
Birr 8,
a) Calculate the utility maximizing level of consumption of X and Y.
b) The MRSX, Y at the utility maximizing position.
c) Find the maximum utility.

3.2.6.1. Consumers’ Reaction to Income Changes

Colleague, using an indifference map and the budget line, let‟s now trace through the
adjustment process that takes place when a household experiences change in income.
Increase in income leads to a parallel shift of the budget line. With each shift of the budget
line following the rise in income, a new equilibrium position is defined at a higher position.
The new equilibrium represents a higher utility to the consumer, because with commodity
prices remaining the same, the consumer can now buy larger quantity of at least one of the

121 HARAMAYA UNIVERSITY

MICROECONOMICS I, MODULE-I

commodities. By joining the different optimal points associated with different level of
income, we obtain the income-consumption curve.

Definition: income-consumption curve is a curve that shows how the consumption of two
commodities changes as income changes with commodity prices unchanged.
Income
Y Y
Income consumption
M3/Py consumption M3/Py curve
M2/Py curve M2/Py c
M1/Py c M1/Py
b b
a a

0 M1/Px M2/Px M3/Px X 0 M1/Px M2/Px M3/Px X

(a) (b)

Figure 3.17: Income-Consumption Curve

In Figure 3.17, if the consumer‟s income is M2, and prices of X and Y are Px and Py, the
optimum utility is at point b. A decrease in income is represented by M1, and an increase in
income is shown by M3. The respective optimum positions representing tangencies of a
budget line and an indifference curve are points a and c. If we connect these points, we get
what is called an income-consumption curve. This curve shows how consumption of two
goods changes as income changes.

In panel (b) of Figure 3.17, good Y is a normal good, good X, however, is a normal good for
this person until the individual‟s income reaches M2. But when income increases above M2,
less X is bought as income increases. So X is a normal good up to point A, and then becomes
inferior as the income-consumption curve bends backward.

The Engle Curve

The Engle Curve is a curve that relates the equilibrium quantity purchased of a good to the
level of income it corresponds. Joining the different optimal points that correspond to
different levels of income and then relating the optimal quantity of one of the goods under
consideration to the levels of income generates the Engel curve.

HARAMAYA UNIVERSITY 122

 UNIT THREE: THEORY OF UTILITY AND PREFERENCES

Y M
Income-consumption curve
Engel curve
Y3 c M3
Y2 b M2
Y1 a M1

0 X1 X2 X3 X 0 X1 X2 X3 X

Figure 3.18: Engel Curve

For each level of income, there will be some optimal choice for each of the goods. If we
keep the prices of the two goods constant (fixed) and focus on what happens to the demand
for good 1 as the level of income changes, we obtain what is known as the Engel Curve.

At point a in Figure 3.18, the consumer‟s income is M1 and the quantities of X and Y are X1
and Y1. At points b and c, the levels of income are M2 and M3 are the respective quantities
are X2 and Y2, and X3 and Y3. By plotting the different quantities of X at different income
levels against their corresponding income, we trace out the Engel curve for X.

The Engel curve presents the demand for one good as a function of income, with prices
remaining constant. It may take different shapes depending on the income elasticity of the
good under consideration.

M M
Engel curve Engel curve
M3 M3
M2 M2
M1 M1

0 X 1 X2 X3 X 0 X1 X2 X3 X
(a) (b)
Figure 3.19 Income Elasticity and Engel Curves

123 HARAMAYA UNIVERSITY

MICROECONOMICS I, MODULE-I

In panel (a) of Figure 3.19 above, the Engel curve becomes flatter as the consumer‟s income
increases, therefore, represents income elastic demand. In panel (b), however, as income
increase, the resulting change in demand becomes lower and lower. Hence, it represents the
case of income inelastic demand.

3.2.6.2. Consumers’ Reaction to Price Changes

Colleague, in Figure 3.14, we have seen how a change in price affects the budget line. Now,
we will see how the optimum consumption combination is affected by price changes.
Initially, the consumer is at the point of maximum utility (point a in Figure 3.20 below). If
price of X falls from P1 to P2, the budget line rotates out to intersect the x-axis at M/P2, and
the consumer now has a new optimum at point b on indifference curve I2. Another decrease
in price to P3 allows the consumer reach still higher indifference curve I3 and a new
optimum at point c. Connecting the points produces a price-consumption curve, which
shows how consumption changes when relative prices change.
Definition: Price-consumption curve is a locus of points in the commodity space showing
the equilibrium consumption bundles resulting from variations in the price ratio, money
income remaining constant. It shows how the household‟s purchases react to a change in the
price of one of the goods with money income and the price of the other good being held
constant.

Y
M/Py
Price-consumption curve
c
b
a I3
I2
I1

0 M/P1 M/P2 M/P3 X

Figure 3.20 Price-consumption curve

Derivation of Demand Curve

When studying demand, all factors that affect demand except the price of the good or
service under study, are kept constant. With all the ceteris paribus factors kept constant, a

HARAMAYA UNIVERSITY 124

 UNIT THREE: THEORY OF UTILITY AND PREFERENCES

demand curve shows the total quantity of goods or services that the consumer is willing and
able to buy at alternative prices.

In a situation involving two goods X and Y, we derive the demand curve for good X from the
tangencies of indifference curves and budget lines in such a way that the price of X, Px
changes while Py and income M remaining the same.

If the price of X declines while the price of Y and income (M) remaining the same, the
budget line will rotate out. As the budget line rotates, a new optimal position is defined at a
different position.

Y PX

Y3 c P1 a
Y2 b P2 b
Y1 a P3 c
Demand
Curve
0 X1X2X3 M/P1 M/P2 M/P3 X 0 X1 X2 X3 X

Figure 3.21: Derivation of Demand Curve

In figure 3.21 above, initially price of X is P1 and the optimum point is at a. At the optimum
point, the consumer buys X1 units of X. If now price falls to P2, at equilibrium the consumer
will buy a relatively larger quantity of X, X2. If the price of X further falls to P3, the quantity
of X purchased accordingly rises to X3. If these price-quantity combinations are plotted on a
separate plane, we obtain the demand curve for good X. The demand curve gives the optimal
amount of good X as a function of its own price, ceteris paribus. The demand for Y can
similarly be derived.

3.2.6.3. Substitution and Income Effects

We have seen that a change in price of one good, with the price of other goods and money
income remaining the same, results in change in quantity demanded of the good. This effect
on quantity demanded of one good due to change in its price with the price of the other good
and income being held constant can be decomposed into substitution effect and income

125 HARAMAYA UNIVERSITY

MICROECONOMICS I, MODULE-I

effect. As a basis to the discussion on substitution and income effects, let‟s try to distinguish
between nominal income and real income.

If an individual‟s salary in the year 2000 was Birr 1000 and his salary remains the same, say,
up to year 2006, the individual in year 2006 would say “My salary has been constant for five
years.” Is he right? This makes sense only in monetary terms, because Birr 1000 in 2006
cannot buy equal quantity of real goods and services as Birr 1000 in 2000. Therefore, the
individual‟s income is constant only in nominal terms. This monetary (nominal) value of
money is what we call nominal income. On the other hand, the quantity of goods and
services that a constant amount of nominal income can buy represents real income. If the
nominal price of one good falls, money income and other nominal prices remaining
constant, real income rises because the consumer can now buy more of the goods (more of
the good whose price declined or more of the other good) . But, if the nominal price of one
good rises, money income and other nominal prices remaining constant, real income falls
because the consumer can now buy less of the goods.

Nominal income – is income measured in Birr; the money value of income.

Real income – is income expressed in terms of the purchasing power of money income; i.e.,
the quantity of goods and services that can be purchased with the money income.

When the price of one good changes, with the price of the other good and nominal income
remaining the same, the consumer moves from one equilibrium position to the other. This
movement of the consumer due to change in price of one good is called the total effect of
price change. This total effect can be divided in to two effects: substitution effect and
income effect. i.e., Total effect = substitution effect + income effect.

First, when the price of a given good falls, the market trade-off between this good and other
goods (or the rate of substitution) changes. This is the substitution effect. Second, the
individual has a larger real income, meaning that with the same money income, more of both
commodities can be purchased. This is the income effect.

Definition: substitution effect is the change in consumption of a commodity by a consumer

because of change in the price of that commodity, price of other commodities and real
income remaining the same. Income effect, on the other hand, is the change in consumption

HARAMAYA UNIVERSITY 126

 UNIT THREE: THEORY OF UTILITY AND PREFERENCES

of a commodity because of change in real income, commodity prices and money income
assumed constant.

The substitution and income effects of price change are different for different products.

The Normal Goods (Superior Goods) Case

Normal goods are those goods whose quantity demanded is positively related to income. For
a normal good (and for all goods), a decline in price leads to increase in the quantity
demanded of the good. Decline in price of one good, the price of the other good and income
remaining the same, changes the relative prices and makes the good whose price declined
more attractive than the other. Consumers will substitute the relatively expensive good by
the relatively cheap one.

Y
a

a’

Y3 f
Y1 e II
Y2 g
I

0 X1 X2 X3 b c’ c X

Figure 3.22 Substitution and Income effects

Colleague, look at the above figure very carefully while discussing the following. For
example, if the price of X in Figure 3.22 above declines from P1 to P2, the budget line pivots
from ab to ac. Though the nominal income of the consumer is unchanged, his real income
(purchasing power) has increased because of the decline in price; i.e., he can now buy higher
quantity of X, Y, or both. This would move the equilibrium point from point e on
indifference curve I to point f on indifference curve II. This movement represents the total
effect of price change, and it can be segregated into substitution effect and income effect.

Increase in the real income of the consumer is shown by the shift to a higher indifference
curve. A higher indifference curve represents a higher level of utility, and utility is a
function of quantities consumed, then the quantities on a higher indifference curve must be

127 HARAMAYA UNIVERSITY

MICROECONOMICS I, MODULE-I

higher than the quantities on a lower indifference curve. To isolate the substitution effect
from income effect, we can consider what would happen if we also reduce the household‟s
money income to restore its original purchasing power. To do this, we can reduce money
income until the original bundle of the two goods can just be bought at the new prices. The
consumption bundle that the consumer chooses in this hypothetical situation with the new
prices and the reduced money income reflects the effect of the change in relative prices
when the purchasing power of income is held constant. The resulting change in the
consumer‟s choice compared to its initial preferred combination is called the substitution
effect.

The new hypothetical budget line in Figure 3.22 above is given by the broken line a’c’. The
substitution effect is, thus, represented by a movement from the original equilibrium
position at e to the hypothetical equilibrium at g. The consumer reduces his consumption of
the relatively expensive good Y by the relatively cheap good X.

In the case of substitution effect, change in relative price makes the consumer move along
the original indifference curve. The income effect, however, moves the consumer from one
indifference curve to the other. To measure the income effect, we restore the consumer‟s
income, which shifts the budget line outward, parallel to itself. Since the goods involved are
assumed normal, the consumer increases his consumption of both goods. The change in
quantity demanded of X as a result of the consumer‟s reaction to this shift of his budget line
is called income effect.

In Figure 3.22 above, with real income remaining constant, fall in the price of X increased
the quantity demanded of X from X1 to X2. This is represented by movement from point e to
point g. Now if we let the consumer‟s real income to increase because of the fall in price of
X, the budget line would shift from the hypothetical budget line a’c’ to ac. The movement
from the hypothetical equilibrium g to f represents income effect.

Based on the above analyses, we can say that for normal goods, quantity demanded varies
directly with real income and inversely with price. In the case of normal goods, both
substitution effect and income effect are positive.

HARAMAYA UNIVERSITY 128

 UNIT THREE: THEORY OF UTILITY AND PREFERENCES

Example 3.7

To understand the substitutions and income effects for a normal good consider the table
below.

Table 3.6: Substitution and Income Effect

Prices Consumption Total

expenditure
Food (F) Clothing (C) Food (F) Clothing (C)
Initial position Birr 12 Birr 6 15 30 Birr 360
Price of food falls; cost of Birr 6 Birr 6 15 30 Birr 270
initial bundle at new prices
Intermediate position Birr 6 Birr 6 21 24 Birr 270
Final position Birr 6 Birr 6 25 35 Birr 360

In the initial position, a consumer with income of Birr 360 faces prices of Birr 12 per unit
for food and Birr 6 for clothing, and chooses to purchase 15F and 30C. The money price of
food then falls to Birr 6 per unit. As shown in line 2, the consumer‟s initial bundle of 15F
and 30C now costs only Birr 270.

Line 3 shows the consumer‟s choice at the new prices when his/her income is reduced to
Birr 270. Although the initial bundle can still be bought at the new prices, the consumer
does not choose to do so. Instead, he increases his consumption of (the now cheaper) food
and reduces his consumption of clothing; he now purchases 21F and 24C.

Line 4 shows what happens when money income is returned to its original level of Birr 360–
the consumption of food and clothing both rise, to 25F and 35C.

Similarly, it is possible to illustrate the effect of increment in price of the commodity. A rise
in the price of the commodity will have effects which are opposite to effects of reduction in
prices.

The Inferior goods case

Colleague, what are inferior goods? Ok. Inferior goods are those goods whose quantity
demanded decreases with rise in income. If now the price of one commodity falls, the price
of the other commodity and income remaining constant, the budget line rotates to the right.
Accordingly, the equilibrium position shifts outward as indicated in the following figure.

129 HARAMAYA UNIVERSITY

MICROECONOMICS I, MODULE-I

Y
a

a’
Y3 f
II
Y1 e
Y2 g
I

0 X1 X3 X2 b c c X
Figure 3.23 Substitution and Income effects

Suppose the initial budget line is given by line ab. If the price of good X decreases, the
budget line rotates to ac. As the budget line rotates, the equilibrium position shifts form e to
f. This movement constitutes the total effect of price change, and it can be decomposed to
substitution and income effects.

As the price of one product decreases, consumers substitute it for relatively expensive
products. In Figure 3.23 above, substitution effect can be shown by assuming that the
consumer‟s income remains the same after the change in price. In order to keep real income
constant, we imagine reduction in the consumer‟s nominal income so that the consumer is
able to buy bundles only on his original indifference curve (I). The resulting hypothetical
budget line is ac’. If the price of the other good and income remain the same, the consumer
will move along the original indifference curve from point e to point g. This movement is,
then, called substitution effect.

The income effect of the price change is obtained by restoring the nominal income of the
consumer to its original position. As real income increases, the consumer moves to point f
on a higher indifference curve. The movement from g to f represents income effect. The new
optimal point, however, has less quantity of X, implying that the quantity of X decreases as
the consumer‟s income increases. Thus, X must be an inferior good. In this case, the
substitution effect, like the case with normal goods, is positive. Income effect, however, is
negative.

HARAMAYA UNIVERSITY 130

 UNIT THREE: THEORY OF UTILITY AND PREFERENCES

Example 3.8

Consider Table 3.7 below to clearly see substitution and income effects of a price change of
an inferior good.

Table 3.7: Substitution and Income Effects of an Inferior Good

Prices Consumption Total

expenditure
Cabbage Meat Cabbage (C) Meat (M)

Initial position Birr 6 Birr 8 20 10 Birr 200

Price of cabbage falls; cost of Birr 4 Birr 8 20 10 Birr 160

initial bundle at new prices

Intermediate position Birr 4 Birr 8 24 8 Birr 160

Final position Birr 4 Birr 8 22 14 Birr 200

Here, it is assumed that cabbage is an inferior good and meat is a normal good. In the initial
position, a consumer with a money income of Birr 200 faces prices of Birr 6 per unit for
cabbage and Birr 8 for a unit of meat, and chooses to purchase 20C and 10M. Then, the price
of cabbage falls to Birr 4 per unit. After the change in price, the initial bundle costs only Birr
160. This is shown in line 2 of the table above. Line 3 shows the consumer‟s choice at the
new prices when his/her income is reduced to Birr 160. Although the initial bundle can still
be bought at the new prices, the consumer does not choose to do so. Instead, he increases his
consumption of the cheaper good (cabbage) and reduces his consumption of meat; he now
purchases 22C and 9M. This constitutes substitution effect.

Line 4 shows what happens when money income is returned to its original level of Birr 200–
the consumption of cabbage now decreases to 16 units and consumption of meat increases to
17 units. This represents income effect.

131 HARAMAYA UNIVERSITY

MICROECONOMICS I, MODULE-I

Exercise 3.9
?
Suppose a consumer buys two goods X and Y. The initial price of X is Birr 3 per unit
P that of Y is Birr 4 per unit. The consumer bought 20 units of X and 10 units of Y. The
while
1
price of X has fallen to Birr 2 per unit with the price of Y unchanged. This change has
resulted in increase in consumption of both X and Y to 21 and 12 units respectively.
a. Show the substitution and income effects in a tabular form as shown in the above
examples.
b. Is the good a normal good or an inferior good?

Generally, in the case of inferior goods, the positive substitution effect of a price change is
great enough to offset a negative income effect and hence total effect becomes positive. But
sometimes, the negative income effect is so strong that it more than offsets the positive
substitution effect. Goods exhibiting these characteristics are called Giffen goods. For these
goods, a decline in price leads to a decline in quantity demanded and a rise in price leads to
a rise in quantity demanded.

Summary

 Total utility is the total amount of satisfaction expected from consuming an item.

 Marginal utility is the addition to total utility from consuming one more unit of a
good.

 Consumers, in deciding among items, choose those items with the highest marginal
utility per a unit of money (Birr).

 An individual maximizes total utility by consuming all items so that the marginal
utilities per Birr spent are equal.

 Consumer surplus is a measure of the benefits derived from a purchase in excess of

the price that is paid.

 Indifference curve shows combinations of goods that yield equal amounts of

satisfaction. The slope an indifference curve shows the marginal rate of substitution
between goods.

HARAMAYA UNIVERSITY 132

 UNIT THREE: THEORY OF UTILITY AND PREFERENCES

 Diminishing marginal rate of substitution means that as more of one good is

substituted for another, its value in terms of the other good declines.

 A budget constraint is represented by a budget line which shows the combinations on

consumption bundles that are attainable at a given level of income and a given set of
prices.

 The position of a budget line changes as income or prices change. A change in

income is represented by a parallel shift of the budget line. A price change is
represented by moving the intercept of the goods whose price has changed; this
changes the slope of the budget line.

 When price falls, the quantity demanded increases because of income effects and
substitution effects. The substitution effect is a result of the change in relative prices.
The income effect comes about because real income changes as prices change.

Self-test Exercises

i) Review your understanding of the following terms:

Utility Marginal rate of substitution

Cardinal utility approach Budget constraint

Ordinal utility approach Income consumption curve

Marginal utility Engel curve

Principles of diminishing marginal utility Price consumption curve

Indifference curve Substitution effect of a price change

Consumer‟s surplus Income effect of a price change

ii) Multiple Choice Questions

1. Which one of the following is not a characteristic of an indifference curve?

a) Indifference curves are invariably negatively sloped.
b) Indifference curves for complementary goods tend to be right angled.
c) The rationality assumption entails that indifference curves located far away from the
origin are superior compared to those located closer to the origin.

133 HARAMAYA UNIVERSITY

MICROECONOMICS I, MODULE-I

d) Perfect substitute goods tend to have a linear indifference curve.

e) None

2. Which one of the following is a consumer optimum of perfect complement goods X1 and
X2, when they are consumed in one to one ratio? Assume income of the individual is
equal to M.
M M X2
a) X 1  2 b) X 1  c) X 1 
P1 P1  P2 M

1
d) X  e) None.
P1  P2

3. Identify the correct statement if the prices of good A and good B that a consumer faces
are Birr 3 and Birr 2, respectively. The consumer is spending his entire income for
buying 4 units of A and 6 units of B, and the marginal utility of both the 4th unit of A and
the 6th unit of B is 6.

a) The consumer is in equilibrium.

b) The consumer should buy more of A and less of B to maximize his total utility.
c) The consumer should buy less of A and more of B to maximize his total utility.
d) The consumer should buy less of both A and B to maximize his total utility.

e) None

4. Suppose a consumer has an income of Birr 8, the price of good X is Birr 1and the price
of good Y is 0.50 Cents. Then, which one of the following is a wrong statement?

a) The quantity combination of 5 units of X and 6 units of Y is on the consumer‟s

budget line.

b) The slope of the budget line is 1/2 when good X is measured on the horizontal axis.

c) The slope of the indifference curve at the consumer‟s equilibrium point is 2.

d) The consumer can buy 8 units of X if the entire income is spent on X.

e) None

5. Which one is wrong about income and substitution effects of a price change?
a) Both are positive in the case of normal goods.

HARAMAYA UNIVERSITY 134

 UNIT THREE: THEORY OF UTILITY AND PREFERENCES

b) Income effect is negative and substitution effect is positive for inferior goods but the
negative income effect is more than offsets the positive substitution effect.
c) Substitution effect is positive for all goods while income effect varies depending on
the nature of the good.
d) Substitution effect can never lead a household to purchase less of a good whose price
has fallen.
e) None.

iii) Workout Questions

1. Suppose a consumer‟s utility schedule is given in the table below. The price of Coke is
Birr 4 per unit and the price of Burger is Birr 6 per unit.
a) Fill in the missing values in the table.
b) Find the utility maximizing consumption bundle.
Coke Burger
Quantity TU MU Quantity TU MU
1 100 1 108
2 180 2 198
3 240 3 258
4 280 4 306
5 312 5 336
6 336 6 354
7 344 7 360
8 344 8 348
9 340 9 324
10 328 10 294

2. A utility maximizing consumer faces the utility function

U=2XY
The consumer‟s income is Birr100, and the price of the two goods are Px=2 and Py=3.
Find the utility maximizing levels of the two goods, X and Y.

3. Suppose a consumer‟s budget equation is given by 2 X  5Y  300 . Now if price of X

rises to Birr 4 and that of Y decreases to Birr 4, show the effect of such change on the
vertical intercept, horizontal intercept, and slope of the budget line both graphically and
mathematically.

135 HARAMAYA UNIVERSITY

 MICROECONOMICS I, MODULE-I

4. Suppose a consumer‟s utility function is given as U  20 X 0.5Y 0.5 . If the consumer‟s

income is Birr 800 and the price of X is Birr 2 per unit and the price of Y is Birr 5 per
unit.
a) Find the utility maximizing quantity of X and Y.
b) Find the MRSX, Y at the equilibrium position.
5. Suppose a consumer‟s utility function is given as U  100 X 0.25Y 0.75 . The prices of the
two commodities X and Y are Birr 2 and Birr 5 per unit respectively. If the consumer‟s
income is Birr 280, how many units of each commodity should the consumer buy to
maximize utility?

iv) Discussion Questions

i. Suppose the equation of a given budget line is given as 5 X  7Y  350 . What do you
think is the effect of rise in prices of X and Y to Birr 7.5 and Birr 10.5 respectively, and a
rise in income to Birr 525 on the consumer‟s position. Discuss, in relation to the
consumer‟s ability to buy of the two goods.

Answers to Exercises

Ex. 3.1: No, the consumer is not maximizing utility. In order to maximize utility, the
consumer has to consume more bottles of beer until his marginal utility becomes 3.
Ex. 3.2: No. The reason is that marginal utility to price ratios of the two goods are not equal.
Ex. 3.3: Consumers‟ surplus is 33 units.
MU X
Ex. 3.4: MRS X ,Y 
MU Y

dU dU
MU X  , and MU Y 
dX dY

MU X  0.8(50 X (0.81)Y 0.2 ) , and MU Y  0.2(50 X 0.8Y ( 0.21) )

MU X  0.8(50 X 0.2Y 0.2 ) , and MU Y  0.2(50 X 0.8Y 0.8 )

MU X 0.8(50 X 0.2Y 0.2 )

MRS X ,Y  
MU Y 0.2(50 X 0.8Y 0.8 )

HARAMAYA UNIVERSITY 136

 UNIT THREE: THEORY OF UTILITY AND PREFERENCES

4Y
MRS X ,Y 
X

MU Y X
But, MRS X ,Y   . It is the reciprocal of MRS X ,Y
MU X 4Y

Ex. 3.5: Budget equation: Y=100-0.5X

After increase in income, the budget equation is Y=75-0.5X
The effect of change in price:
-Reduction of Y intercept from 100 to 75;
-Reduction of X intercept from 200 to 150; and
-No change on slope.
Ex. 3.6: Initial budget constraint is Y=15-0.5X. After proportional change (reduction) of
prices of the two goods, the new budget constraint will be Y=45-0.5X. This means there
is no change on slope; there is a change in intercepts; and hence we have a parallel shift
of the budget line to the right.
Ex. 3.7: Assume the budget line before price change is AB as indicated in the following
figure. But for a change in price of X2, the line will pivot around the X1 axis. For
reduction in price of X2, it pivots clockwise direction and for increase in price of
X2, it pivots anti-clockwise direction as it is indicated in the figure below.

X2

X1
B

Ex. 3.8:
a) Objective function: U  30 X 0.2Y 0.8
Constraint function: 2 X  8Y  1000
Max U  30 X 0.2Y 0.8 subject to 2 X  8Y  1000

137 HARAMAYA UNIVERSITY

MICROECONOMICS I, MODULE-I

Rewriting the constraint function

1000  2 X  8Y  0
Multiplying the constraint by a Lagrange multiplier
 (1000  2 X  8Y )  0
Forming a composite function
  30 X 0.2Y 0.8   (1000  2 X  8Y )
First order condition:
 6 X 0.8Y 0.8
 6 X Y  2  0   
0.8 0.8
……………….. (1)
X 2
 24 X 0.2Y 0.2
0.2 0.2
 24 X Y  8  0    ………………. (2)
Y 8


 1000  2 X  8Y  0 ……………………….. (3)


From equations (1) and (2) we have

6 X 0.8Y 0.8 24 X 0.2Y 0.2

 
2 8

YX

Substituting this result in equation (3)

1000  2(Y )  8Y  0
10Y  1000
Y  100

X  Y  100

Second order condition:

 2
 4.8 X 1.8Y 0.8  0
X 2

 2
 4.8 X 0.2Y 1.2  0
Y 2

HARAMAYA UNIVERSITY 138

 UNIT THREE: THEORY OF UTILITY AND PREFERENCES

The second order condition is satisfied, therefore, the consumer should buy 100 units of X
and 100 units of Y in order to maximize his utility.

b) The MRSX, Y at the optimal point is obtained by substituting the optimal quantities of the
two goods in the ratio of marginal utilities that defines MRSX, Y.

MU X
MRS X ,Y 
MU Y

6 X 0.8Y 0.8 Y 100

MRS X ,Y  0.2 0.2
=   0.25
24 X Y 4 X 4(100)

c) Maximum utility is U  30 X 0.2Y 0.8  30(1000.2 )(1000.8 )  3000

Ex. 3.9: One possibility can be in the following way. We may have other possibilities as
well. At the intermediate position, the new combination must be such that the quantity of X
increases while that of Y decreases with total cost of Birr 80

Prices Consumption Total

expenditure
X Y X Y

Initial position Birr 3 Birr 4 20 10 Birr 100

Price of X falls; cost of initial Birr 2 Birr 4 20 10 Birr 80

bundle at new prices

Intermediate position Birr 2 Birr 4 20.5 9.75 Birr 80

Final position Birr 2 Birr 4 21 12 Birr 100

The good is normal.

Suggested Reading Materials

Gould J. P. and Lazear E. P., Microeconomic Theory, 6th ed., Homewood, Richard D. Irwin,
Inc., 1998.

Koutsoyiannis A., Modern Microeconomics, 2nd ed., English Language Book Society,
Macmillan, 1985.

Varian H. R., Intermediate Microeconomics, 3rd ed., New York, Norton & Company, 1993.

139 HARAMAYA UNIVERSITY

MICROECONOMICS I, MODULE-I

Answers to Self-test Questions

Unit One:

ii) 1. D 2. D 3. C 4.A

Unit Two:

ii) 1. C 2. B 3. B 4. B 5.B

iii) 1. a) P=10 and Q=20

b) P=5 and Q=30 (A decreases in price and increase in quantity)

2. P=28 and Q=2

3. At P=8,  p =1.68 (elastic); at P=4,  p =0.64 (inelastic); and at P=5,  p =1 (unitary)

4. a)  p =1.125 (elastic)

b) P= P  100 3

5. Initial price is 6. After 5% increment it will be 6.3. At this price level, the new
quantity is going to be 3.7 given the demand equation of Q=10-P. This means, we
have 7.5% reduction in quantity. Using percentage increment in price and percentage
dQ P
reduction in quantity, elasticity will be -1.5. If we use the formula of , we will
dP Q
have the same value of -1.5.

HARAMAYA UNIVERSITY 140

 ANSWERS TO SELF-TEST EXERCISES

Unit Three:

ii) 1.A 2. B 3. C 4. B 5. B

iii) 1.a)
Coke Burger
Quantity TU MU Quantity TU MU
1 100 - 1 108 -
2 180 80 2 198 90
3 240 60 3 258 60
4 280 40 4 306 48
5 312 32 5 336 30
6 336 24 6 354 18
7 344 8 7 360 6
8 344 0 8 348 -12
9 340 -4 9 324 -24
10 328 -12 10 294 -30
MU Coke MU Burger
b) Consumer‟s equilibrium is when  . Given the two prices (Birr 4 for
PCoke PBurger

Coke and birr 6 for Burger), utility maximizing levels are 5 units of Coke and 4 units of
Burger. This is because marginal utility to price ratios of the two commodities are equal
(which is 8) at these levels.

2. Maximize U  2 XY Subject to 2X+3Y=100

Composite function is   2 XY   (100  2 X  3Y )
  
 2Y  2  0  2 X  3  0  100  2 X  3Y  0
X Y 

2
 Y   X  100  2 X  3Y  0
3
2
This means Y  X
3
2 50
Therefore, 100  2 X  3( X )  0  X  25 and Y 
3 3
2
3. Initial budget line is Y  60  X and budget line after change in prices of the two goods
5
is Y  75  X .
2
The effects are: Slope changes from  to -1
5

141 HARAMAYA UNIVERSITY

MICROECONOMICS I, MODULE-I

Y-intercept increases from 60 to 75

X-intercept decreases from 150 to 75
Graphically, it looks like the following:
Y

75

60

75 150 X
4. a) Composite function is   20 X Y 0.5 0.5
  (800  2 X  5Y )
  
 10 X 0.5Y 0.5  2  0  10 X 0.5Y 0.5  5  0  800  2 X  5Y  0
X Y 
   5 X 0.5Y 0.5    2 X 0.5Y 0.5  800  2 X  5Y  0

This means    5 X 0.5Y 0.5  2 X 0.5Y 0.5

5Y 5Y
After rearranging, we have X   800  2( )  5Y  0
2 2

Y  80 and hence X  200

MU X 10 X 0.5Y 0.5 Y 80 2
b) MRS X ,Y   0.5 0.5
  
MU Y 10 X Y X 200 5

5. Composite function is   100 X 0.25Y 0.75   (280  2 X  5Y )

  
 25 X 0.75Y 0.75  2  0  75 X 0.25Y 0.25  5  0  280  2 X  5Y  0
X Y 

25 X 0.75Y 0.75 75 X 0.25Y 0.25

   
2 5

5Y
Equating the two and rearranging, we have X 
6

5Y 5(42)
Substituting this, we have 280  2( )  5Y  0 . This means Y=42 and X   35 .
6 6

HARAMAYA UNIVERSITY 142

REFERENCES

Lipsey R. G., Courant P. N., Purvis D. D., and Steiner P. O., Microeconomics, 10th ed. New
York: Harper Collins College Publishers, Inc., 1993.

Amacher R. C., and Ulbrich H. H., Principles of Microeconomics, 3rd ed. Ohio: South-
Western Publishing Co., 1986.

Stanlake G. F., and Grant S. J., Introductory Economics, 6th ed., Singapore, Longman, 1995.

Gould J. P. and Lazear E. P., Microeconomic Theory, 6th ed., Homewood, Richard D. Irwin,
Inc., 1998.

Koutsoyiannis A., Modern Microeconomics, 2nd ed., English Language Book Society,
Macmillan, 1985.

Varian H. R., Intermediate Microeconomics, 3rd ed., New York, Norton & Company, 1993.

143 HARAMAYA UNIVERSITY