Theory of Consumer Demand

Micro Economics I .Chapter 1. Theory of Consumer Demand Mr.
Chandra Sekhar
Introduction to Theory of Consumer Demand
Theory of demand seeks to establish relationship between the quantity demanded of a

commodity and its price. It also explains variations in demand.
The purpose of the theory of demand is to determine the various factors that affect
demand. Demand is a multivariate relationship, that is, it is determined by many
factors simultaneously. Some demand for a particular product are its own price,
consumer’s income, prices of other commodities, consumer’s tastes, income
distribution, total population, consumer’s wealth, credit availability, government
policy, past levels of demand and past levels of income.
There are different approaches known to the economists to the theory of demand. The
oldest among them is the marginal utility approach. The marginal utility analysis
explains consumer’s demand for a commodity and derives a law of demand, which
shows an inverse relationship between the quantity demanded and the price of the
commodities. It should be noted that the traditional theory of demand examines only
the consumer’s demand for durables and non-durables. It is partial in its approach in
that it examines the demand in one market in isolation from the conditions of the
demand in other markets. An important implicit assumption of the theory of demand
is that firms sell their products directly to the final consumers.
All desires of a consumer are not of equal urgency or importance. Since his resources
are limited and he cannot fulfill all his desires, he must pick and choose more
important and more urgent desires for satisfaction. Thus, some desires take
precedence of others. This is how a consumer ranks his desires and builds up a scale
of preferences. Scarcity forces him to choose. Ability to arrange preferences in order
of importance or urgency is inherent in human nature.
A prudent consumer exercises a lot of discrimination in his purchases. We find him

substituting one commodity, partly or wholly, for another. He purchases a certain
quantity of a commodity and no more. All the time, he is aspiring to reach an
equilibrium position, i.e., a position in which he derives maximum satisfaction from
the use of money at his disposal. The consumer’s scale of preferences are independent
of the prices ruling in the market. He builds up his scale of preferences from the
commodities he consumes. Because of this scale of preferences, he knows that one
combination of the goods yields him the same satisfaction as another.
In the following tutorial material of this, we shall learn in detail Consumer

Preferences, Budget Constraints, Utility, Consumer Choice, Offer curve analysis
of price and income, Slutsky’ Equation, Consumer surplus, Derivation of the
Market Demand, and Elasticity of Demand.
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Micro Economics I .Chapter 1. Theory of Consumer Demand Mr. Chandra Sekhar
1.1 BUDGET CONSTRAINTS
The budget constraints are that consumers face because of their limited incomes.
People are compelled to determine their behavior in light of limited financial
resources. For the theory of consumer behavior, this means that each consumer has a
maximum amount that can be spent per period of time. The consumer’s problem is to
spend this amount in the way they yield maximum satisfaction.
The Consumption Basket of a consumer (x 1,x2) is simply a list of two numbers that
tells us how much the consumer is choosing to consume of good 1, x 1, and how much
the consumer is choosing to consume of good 2, x2. Sometimes it is convenient to
denote the consumer’s bundle by a single symbol like X, where X is simply an
abbreviation for the list of two numbers (x1,x2).
We suppose that we can observe the prices of the two goods, (p 1,p2) and the amount of
money the consumer has to spend m, then the budget constraint of the consumer can
be written as
p1x1 + p2x2 < m (1)
Here p1x1 is the amount of money the consumer is spending on good 1, and p 2x2 is the
amount of money the consumer is spending on good 2. The budget constraint of the
consumer requires that the amount of money spent on the two goods be no more than
the total amount the consumer has to spend. The consumer’s affordable consumption
bundles are those that do not cost any more than m.
1. Two Goods Are Often Enough.
The two-goods assumption is more general. Because it is often interpreted as one of

the goods are representing everything else the consumer might want to consume.
For example, if we are interested in studying a consumer’s demand for milk, let x1
measure his or her consumption of milk in quarts per month. Then let x 2 stand for
everything else the consumer might want to consume.
When you adopt this interpretation, it is convenient to think of good 2 as being the
money that the consumer can use to spend on other goods. Under this interpretation,
the price of good 2 will automatically be 1, since the price of one birr is one birr.
Thus, the budget constraint will take the form
p1x1+x2 < m (2)
This expression simply says that the amount of money spent on good 1, p1x1, plus the
amount of money spent on all other goods, x2, must be no more than the total amount
of money the consumer has to spend, m.
Good 2 represents a composite good that stands for everything else that the consumer
might want to consume other than good 1. Such a composite good is invariably
2
measured in birrs to be spent on goods other than good 1. As far as the algebraic form
of the budget constraint is concerned, equation (2) is just a special case of the formula
given in the equation (1)., with p2 = 1, so everything that we have to say about the
budget constraint in general will hold under composite good interpretation.
2. Properties of the Budget Set.
The budget line is the set of bundles that cost exactly m:
p1x1 + p2x2 = m (3)
These are the bundles of goods that just exhaust the consumer’s income. The budget
set is depicted in Fig 1. The heavy line is the budget line – the bundles that cost
exactly m – and the bundles below this line are those that cost strictly less than m.
Figure 1 Budget Line.
X2
Vertical Budget line;
intercept = m/p2 slope = -p1/p2
Budget set
Horizontal Intercept = m/p1 X1

Fig . 1
The budget set consists of all bundles that are affordable at the given prices and
income.
Rearrange the budget line in equation (3) to get the formula
x2 = m/p2 – p1/p2 * x1 (4)
This is the formula for a straight line with a vertical intercept of m/p 2 and a slope of –
p1/p2. The formula tells how many units of good 2 the consumer needs to consume in
order to just satisfy the budget constraint if he or she consuming x1 units of good 1.
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The slope of the budget line measures the rate at which the market is willing to
substitute good 1 for good2. For example that the consumer is going to increase her
consumption of good 1 by ∆x1.
How much will consumption of good 2 have to change in order to satisfy her budget
constraint?
p1x1 + p2x2 = m
and p1(x1+∆x1) + p2(x2+∆x2) = m.
Subtracting the first equation from the second gives
p1∆x1 +p2∆x2 = 0.
This says that the total value of the change in consumption must be zero. Solving for
∆x2/∆x1, the rate at which good 2 can be substituted for good 1 while still satisfying
the budget constraint, gives
x2 p
 1
x1 p2
This is just slope of the budget line. The negative sign is there since ∆x1 and ∆x2 must
always have opposite signs. Because consumption of more of good1 leads to
consumption of less of good 2 and vice versa, as long as the consumer continue to
satisfy the budget constraint.
3. How the Budget Line Changes
When prices and incomes change, the set of goods that a consumer can afford changes
as well. To find out, how these changes affect budget set? First consider changes in
income. It easy to see from equation (4) that all increase in income will increase the
vertical intercept and not affect the slope of the line. Thus an increase in income will
result in a parallel shift outward of the budget line as in the following figure 2.
Similarly, decrease in income will cause a parallel shift inward.
X2
m’/p1
m/p2
m/p1 m’/p1 X1
Fig. 2
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To identify changes in prices? First, consider increasing price 1 while holding price 2
and income fixed. According to equation (4) increase in p1 will not change the
vertical intercept, but it will make the budget line steeper since p1/p2 will become
larger.
X2
m/p2 Budget Lines
Slope = -p1/p2
Slope =
-p1/p2
m/p`1 m/p1 X1
Fig. 3
Increasing Price. If good 1 becomes more expensive, the
budget line becomes steeper.
What happens to the budget line when we change the prices of good 1 and good 2 at
the same time? For example, if the prices of both goods 1 and 2 gets doubled, both the
horizontal and vertical intercepts shift inward by a factor of one-half, and therefore
the budget line shifts inwards by one-half as well. Multiplying both prices by two is
just like dividing income by 2.
To show this algebraically. Suppose our original budget line is
p1x1 + p2x2 = m
Now suppose that both prices become t times as large. Multiplying both prices by t
yields
tp1x1 +t p2x2 = m
However, this equation is same as
p1x1 + p2x2 = m/t.
Thus multiplying both prices by a constant amount t is just like dividing income by
the same constant t. It follows that if we multiply both prices by t and we multiply
income by t. then budget line will not change at all.
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What happens if both prices go up and incomes go down?
If m decreases, p1, and p2 both increase, then the intercepts m/p1 and m/p2 must both
decrease. This means that the budget line will shift inward. How about the slope of
budget line? If price 2 increases more than price 1, so that – p 1/p2 decreases ( in
absolute value) then the budget line will be flatter; if price 2 increases less than 1, the
budget line will be steeper.
The budget line is defined by two prices and one income, but one of these variables is
redundant. We could peg one of the prices, or the income, to some fixed value, and
adjust the other variables to describe exactly the same budget set. Thus the budget line
p1x1 + p2x2 = m
exactly the same budget line as
p1/p2. x1+x2 =m/p2

or
p1/m. x1 +p2/m. x2 = 1.
Since the first budget line results from dividing everything by p2, and the second
budget line results from dividing everything by m. In the first case, we have pegged p2
= 1, and in the second case, we have pegged m = 1. Pegging the price of one of the
goods or income to 1 and adjusting the other prices to 1, as we did above we often
refer to that as the numeraire price. The numeraire price is the price relative to which
we are measuring the other price and income. It will occasionally be convenient to
think of one of the goods and being a numeraire good, since there will then be one
less price to worry about.
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1.2 CONSUMER PREFERENCES
The theory of consumer behavior begins with three basic assumptions about people’s
preferences for one market basket versus another. These assumptions hold for most
people in most situations.
1.2.i. Assumptions:
1. Completeness: Preferences are assumed to be complete. In other words,

consumers can compare and rank all possible baskets. Thus, for any two market
baskets A and B, a consumer will prefer A to B, will prefer B to A, or will be
indifferent between the two. By indifferent we mean that a person will be equally
satisfied with either basket. Note that these preferences ignore costs. A consumer
might prefer steak to hamburger but by hamburger because it is cheaper.
2. Transitivity: Preferences are transitive. Transitivity means that if a consumer

prefers basket A to basket B and basket B to basket C, then the consumer also prefers
A to C. For example, if a Ford is preferred to a Toyota and a Toyota to a Chevrolet,
then Ford is also preferred to a Chevrolet. Transitivity is normally regarded as
necessary for consumer consistency.
3. More is better than less (Nonsatiation): Goods are assumed to be desirable –

i.e., to be good. Consequently, consumers always prefer more of any good to less. In
addition, consumers are never satisfied or satiated; more is always better, even if just a
little better. This assumption is made for academic reasons; namely, it simplifies the
graphical analysis. Of course, some goods such as air pollution may be undesirable,
and consumers will always prefer less.
These three assumptions form the basis of consumer theory. They do not explain
consumer preferences, but they do impose a degree of rationality and reasonableness
on them.
1.2.ii. Indifference Curves
Consumer preferences are graphically shown with the use of indifference curves.
Definition: An indifference curve represents all combinations of market baskets

that provide a consumer with the same level of satisfaction.
Given the three assumptions about preferences, it is known that a consumer can
always indicate either a preference for one market basket over another or indifference
between the two. By using this information, it is possible to rank all potential
consumer choices. In order to appreciate this principle in graphic form, assume that
there are only two goods available for consumption: food F and clothing C. In this
case, all market baskets describe combinations of food and clothing that a person
might wish to consume. The following table provides baskets containing various
amounts of food and clothing.
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Table 1 Alternative Market Baskets for Food and Clothing.
MARKET BASKET UNITS OF FOOD UNITS OF CLOTHING

A 20 30
B 10 50
D 40 20
E 30 40
G 10 20
H 10 40
The following figure shows the same baskets listed in the table above.
Figure 1 Describing Individual Preferences.
Clothing
50 *B
40
*H *E
30
20
*A
10
(Units/week)
10 20 30 40 Food
(Units per Week)
*G *D
The horizontal axis measures the number of units of food purchased each week; the
vertical axis measures the number of units of clothing. Market basket A, with 20 units
of food and 30 units of clothing, is preferred to basket G because A contains more
food and more clothing (third assumption nonsatiation). Similarly, market basket E,
which contains even more food and even more clothing preferred to A. In fact, it is
easy to compare all market baskets in the two shaded areas (such as E and G) to A
because they all contain either more or less of both food and clothing. Note, however,
that B contains more clothing but less food than A. Likewise, D contains more food
but less clothing than A. Therefore, comparisons of market baskets A with baskets B,
D, and H are not possible without more information about the consumer’s ranking.
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The following figure 2 shows an indifference curve, labeled U1, that passes through
points A, B, and D. This curve indicates that the consumer is indifferent among these
three market baskets.
Figure 2 AN INDIFFERENCE CURVE

Clothing
(Units/week)
50
*B
40
*H *E
30
*A
20
*G *D u1
10
10 20 30 40 Food
Food (Units per week)
It shows that in moving from market basket A to market basket B, the consumer feels
neither better nor worse off in giving up 10 units of food to 20 units of clothing.
Likewise, the consumer is indifferent between points A and D. He or she will give up
10 units of clothing to obtain 20 units of food. On the other hand, consumer prefers A
to H, which lies below u1.
Indifference curve in the figure 2 slopes downwards from left to right. To understand
why this must be the case, suppose instead it sloped upward from A to E. This would
violate the assumption that more of any commodity is preferred less. Because market
basket E has more of food and clothing than market basket A, it must be preferred to
A and therefore cannot be on the same indifference curve as A. In fact, any market
basket lying above to the right of indifference curve u 1 in figure 2 is preferred to any
market basket on u1.
1.2.iii. CHARACTERISTICS OF INDIFFERENCE CURVES
Indifference curves have certain characteristics that reflect assumptions about

consumer behavior. In fact, one of the major uses of indifference curves is to examine
the kinds of consumer behavior implied by different preferences, prices, and incomes.
For simplicity, assume there are only two goods, Food and Clothing.
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1. An indifference curve passes through each point in the commodity space.

2. Indifference curves cannot intersect.
3. Indifference curves are negatively sloped.
4. Indifference curves are convex in shape.
5. The higher or further to the right is an indifference curve, the higher the bundles on
that curve are in the consumer’s preference ordering, that is, baskets on higher
indifference curves re preferred to bundles on lower indifference curves.
1.2.iv. THE MARGINAL RATE OF SUBSTITUTION (MRS)
To quantify the amount of one good that a consumer will give up to obtain more of
another, we use a measure called the marginal rate of substitution (MRS). The MRS
of food F for clothing C is the amount of clothing that a person is willing to give up to
obtain one additional unit of food. Suppose, for instance, the MRS is 3. This means
that the consumer will give up 3 units of clothing to obtain 1 additional unit of food. If
the MRS is 1/2, the consumer is willing to give up only ½ unit of clothing. Thus, the
MRS measures the value that the individual places on 1 extra unit of one good in
terms of another.
Figure 3. The Marginal Rate of Substitution
Cloth 16 A
Units/wee
-6
10 B
1
-4
06 D
1
04 -2 E
G
-1
02
0 1 2 3 4 5 Food Units/week
In figure 3 note that clothing appears on the vertical axis and food on the horizontal
axis. When we describe the MRS, we must be clear about which good we are giving
up and which we are getting more of. We define MRS in consistent terms as the
amount of the good on the vertical axis that the consumer is willing to give up to
obtain 1 extra unit of the good on the horizontal axis. In figure 3 the MRS refers to
the amount of clothing that the consumer is willing to give up to obtain an additional
unit of food. If we denote the change in clothing buy ∆C and the change in food by
∆F, the MRS can be written as -∆C/∆F. We add the negative to make the marginal rate
of substitution a positive number (∆C is always negative; the consumer give up
clothing to obtain additional food.)
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Thus, the MRS at any point is equal in magnitude to the slope of the indifference
curve. In Figure 3 for example, the MRS between points A and B is 6: The consumer
is willing to give up 6 units of clothing to obtain 1 additional unit of food. Between
points B and D, however, the MRS is 4: With these quantities of food and clothing,
the consumer is willing to give up only 4 units of clothing to obtain 1 additional unit
of food.
CONVEXITY Also observe in figure 3 that the MRS falls as we move down the
indifference curve. This is not a coincidence. This decline in the MRS reflects an
important characteristic of consumer preferences. To understand this, we will add an
additional assumption regarding consumer preferences to the three that we discussed
earlier in the chapter:
1.2.v Diminishing marginal rate of substitution: (Assumption 4 of Consumer

Preferences) Indifference curves are convex or bowed inward. The term convex means
that the slope of the indifference curve increase (i.e., becomes less negative) as we
move down along the curve. In other words, an indifference curve is convex if the
MRS diminishes along the curve. The indifference curve in Fig 3 is convex. As we
have seen, starting with market basket A in Figure and moving to basket B, the MRS
of Food F for Clothing C is -∆C/∆F = -(-6)/1 = 6. However, when we start at basket
B and move from B to D, the MRS fall to 4. If we start at basket D and move to E, the
MRS is 2. Starting at E and moving to G, we get an MRS of 1. As food consumption
increases, the slope of the indifference curve falls in magnitude. Thus the MRS also
falls. (With nonconvex preferences, the MRS increases as the amount of the good
measured on the horizontal axis increases along any indifference curve. This unlikely
possibility might arise if one or both goods are addictive. For example, the
willingness to substitute an addictive drug for other goods might increase as the use of
the addictive drug increased).
Is it reasonable to expect indifference curves to be convex? Yes, as more and more of

one good is consumed, we can expect that a consumer will prefer to give up fewer and
fewer units of a second good to get additional units of the first one. As we moved
down the indifference curve in figure 3 and consumption of food increases, the
additional satisfaction that a consumer gets from still more food will diminish. Thus,
he will give unless and less clothing to obtain additional food.
Another way of describing this principle is to say that consumers generally prefer
balanced market baskets to market baskets that contain all of one good and none of
another. Note from Figure 3 that a relatively balanced market basket containing 3
units of food and 6 units of clothing (basket D) generates as much satisfaction as
another market basket containing 1 unit of food and 16 units of clothing (Basket A). It
follows that a balanced market basket containing (for example) 6 units of food and 8
units of clothing will generate a higher level of satisfaction.
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1.2.vi PERFECT SUBSTITUTES AND COMPLIMENTS
The shape of an indifference curve describes the willingness of a consumer to

substitute one good for another. An indifference curve with a different shape implies a
different willingness to substitute.
The goods are substitutes when an increase in the price of one leads to an increase in
the quantity demanded of the other. In general, perfect substitutes when the marginal
rate of substitution of one for the other is a constant. The indifference curves
describing the trade-off between the consumption of the goods are straight lines. The
slope of the indifference curves need not be-1 in the case of perfect substitutes. For
more illustration, see the fig 3.a.
Fig. 3.a Perfect substitutes.
Apple Juice
(glasses)
1 2 3 4
Orange Juice (glasses)
This fig 3.a shows preferences of a consumer for apple juice and orange juice. These
two goods are 2 perfect substitutes for a consumer because he is entirely indifferent
between having a glass of one or the other. In this case, the MRS of apple juice for
orange juice is 1: consumer is always willing to trade 1 glass of one for 1 glass of the
other.
1
Goods are compliments when an increase in the price of one leads to a decrease in the
quantity demanded of the other. Two goods are perfect compliments when the
indifference curves for both are shaped as right angles. The following figure 3.b
illustrates a consumer’ preferences for left shoes and right shoes. For a consumer, the
two goods are perfect complements because a left shoe will not increase her
satisfaction unless he/she can obtain the matching right shoe. In this case, the MRS of
left shoes for right shoes is zero whenever there are more right shoes than left shoes;
consumer will not give up any left shoes to get additional right shoes.
Correspondingly, the MRS is infinite whenever there are more left shoes than right
because consumer will give up all but one of his/her excess left shoes than obtain an
additional right shoe.
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3.b. Perfect Compliments.
Apple Juice
(glasses)
3
1 2 3 4
Orange Juice
Bads so (glasses)
far, all the examples mentioned above have involved only commodities that
have been considered as “goods” – i.e., cases in which more of a commodity is
preferred to less. But in the world there are also bad commodities which are preferred
by certain
2 groups of consumers. Bads are those commodities less of them is preferred
to more. Air Pollution and asbestos in housing insulation are some of the examples of
this kind of commodities. To analyze the consumer preferences for these
commodities, they have to be redefined under study so that the consumer tastes are
represented as the preference for less of the bad. This reversal turns the bads into
goods. For instance, instead of preference for air pollution, it can be discussed as the
preference
1
for clean air, which can measure the degree of reduction in air pollution.
Similarly, instead of referring to asbestos as a bad, it can be referred to corresponding
good, the removal of asbestos.
With this simple adaptation, all four of the basic assumptions of consumer theory
continue to hold.
1.3 UTILITY
Consumer theory relies only on the assumption that consumers can provide relative
rankings of market baskets. It is often useful to assign numerical values to individual
baskets. Using this numerical approach, it is possible to describe consumer
preferences by assigning scores to the levels of satisfaction associated with each
indifference curve. Generally, the word utility means “benefit or well-being.”
In the language of economics, the concept of utility refers to the numerical score
representing the satisfaction that a consumer gets from a market basket. In other
words, utility is a device used to simplify the ranking of market baskets. Ex: If buying
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three copies of a textbook gives, you more pleasure than buying one shirt, then it is
said that the books give you more utility than the shirt.
1.3.i UTILITY FUNCTIONS

A utility function is a formula that assigns a level of utility to each market basket. For
example, that a consumer’s utility function for food (F) and clothing (C) is
u(F,C,)=F+2C. In this case, a market basket consisting of 8 units of food and 3 units
of clothing generates a utility of 8 + (2) (3) = 14. Consumer is therefore indifferent
between this market basket and a market basket containing 6 units of food and 4 units
of clothing (6+(2)(4) = 14).
Not all kinds of preferences can be represented by a utility function. For example,
suppose someone had intransitive preferences so that A  B  C  A . Then a utility
function for these preferences would have to consist of numbers u(A), and u(B) and
u(C) such that u(A)>u(B)>u(C)>u(A). However, this is impossible. So such kind of
perverse cases not considered for construction of utility function.
The figure 1 and illustration gives the details of constructing a utility function. A
utility function is a way to label the indifference curves such that higher indifference
curves get larger numbers. To do this, draw the diagonal line illustrated and label each
indifference curve with its distance from the origin measured among the curve.
How do you know this as a utility function? It is not difficult to see that preferences
are monotonic then the line through the origin must intersect every indifference curve
exactly once. Thus, every bundle is getting larger labels – and that is all it takes to be
a utility function. This is one way to find labeling of indifference curves, at least as
long as preferences are monotonic. This at least shows that ordinal utility function is
quite general: nearly any kind of “reasonable” preferences can be represented by a
utility function.
X2 Measures distance
from origin
Indifference
curves
X1
Figure 1: Constructing a utility function from indifference

curves. Draw a diagonal line and label each indifference curve
with how fat it is from the origin measured along the line.
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1.3.ii ORDINAL UTILITY

A utility function that generates ranking in order of most to least preferred of market
baskets is called an ordinal utility function. In fact, numerical values are arbitrary,
interpersonal comparisons of utility are impossible.
The only property of a utility assignment that is important is how it orders the bundles
of goods. The magnitude of the utility function is only important insofar as it ranks
the different consumption bundles; the size of the utility difference between any two
consumption bundles does not matter. Because of this emphasis on ordering bundles
of goods, this kind of utility is referred to as ordinal utility.
Consider the following table 1. where several different ways of assigning utilities to
three bundles of goods is illustrated, all of which order the bundles in the same way.
In this example, the consumer prefers A to B and B to C. All of the way indicated are
valid utility functions that describe the same preferences because they all have the
property that A is assigned a higher number than B, which in turn in assigned a higher
number than C.
Table : 1 Different ways to assign utilities.
Bundle
Bundles U1 U2 U3
A 3 17 -1
B 2 10 -2
C 1 .002 -3
Since only the ranking of the bundles matters, there can be no unique way to assign
utilities to bundles of goods.
1.3. iii CARDINAL UTILITY
A utility function that describes by how much one market basket is preferred to
another is called cardinal utility function. Unlike ordinal utility functions, a cardinal
utility function attaches to market baskets numerical values that cannot arbitrarily be
doubled or tripled without altering the differences between values of various market
baskets.
There are some theories of utility that attach a significance to the magnitude of utility.
These are known as cardinal utility theories. In a theory of cardinal utility, the size of
the utility difference between two bundles of goods is supposed to have some sort of
significance.
In fact, there is no hard and fast rule to measure utility. It is almost not possible to say,
whether a person gets twice as much satisfaction from one market value as from
another. Not it is not known whether one person gets twice as much satisfaction as
another from consuming the same basket. In fact as far as theory is concerned this
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constraint is not important. Because the objective is to understand consumer behavior

all that matters is knowing how consumers rank different baskets.
1.3. iv Marginal Utility
Consider a consumer who is consuming some bundle of goods, (x 1,x2). How does this
consumer’s utility change as we give a little more of good 1? This rate of change is
called the marginal utility with respect to good 1. We write it as MU1 and think of it
as being ratio,
U u ( x1  x1 , x2 )  u ( x1 , x2 )
MU1  
x1 x1
That measures the rate of change in utility (∆U) associated with a small change in the
amount of good 1 (∆x1). Good 2 is held fixed.
This definition implies that to calculate the change in utility associated with a small
change in consumption of good1, just multiply the change in consumption by the
marginal utility of the good.
∆U = MU1∆X1.
The marginal utility with respect to good 2 is defined in a similar manner:
U u ( x1 , x2  x2 )  u ( x1 , x2 )
MU 2  
x2 x2
When computing the marginal utility with respect to good 2 keep the amount of good
1 constant. We can calculate the change in utility associated with a change in the
consumption of good2 by the formula
∆U = MU2∆X2.
Marginal utility depends on the particular utility function that we use to reflect the
preference ordering and its magnitude has no particular significance.
Because of conceptual problems, economists have abandoned the old-fashioned view

of utility as being a measure of happiness. Instead the theory of consumer behavior
has been reformulated entirely in terms of consumer preferences, and utility is seen
only a s a way to describe preferences.
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1.4 CONSUMER CHOICE
Given preferences and budget constraints, it is possible to determine how individual

consumers choose how much of each good to buy. The basic assumption is that
consumers make this choice in a rational way – that they choose goods to maximize
the satisfaction they can achieve, given the limited budget available to them.
The maximizing market basket must satisfy two conditions:
1. It must be located on the budget line.

2. It must give the consumer the most preferred combination of goods and services.
These two conditions reduce the problem of maximizing consumer satisfaction to one
of picking point on the budget line.
We can graphically illustrate the solution to the consumer’s choice problem.
U3
U1
Clothing
D
B
U2
Budget line
Food
Fig 1 Maximizing consumer satisfaction.
The above figure 1 shows how the problem is solved. Here, three indifference curves
describe a consumer’s preferences for food and clothing. Remember that of the three
curves, the outer most curve u3, yields the greatest amount of satisfaction, curve u2the
next greatest amount, and curve u1 the least.
The point B on indifference curve u1 is not the most preferred choice, because a
reallocation of income in which more is spent on food and less on clothing can
increase the consumer’s satisfaction. In particular, by moving to point A, the
consumer spends the same amount of money and achieves the increased level of
satisfaction associated with indifference curve u2 like the basket associated with D on
17
indifference curve u3, achieve a higher level of satisfaction but cannot be purchased
with the available income. Therefore, A maximizes the consumer’s satisfaction.
*If you know the consumer choices that a consumer made, how to determine his
preferences? REVEALED PREFERENCES THEORY
The basic idea is simple. If a consumer chooses one market basket over another, and if
the chosen market basket is more expensive than the alternative, then the consumer
must prefer the chosen market basket.
X2 L1
(X1,X2)
*
*
*
(Y1,Y2)
Figure 2. Revealed Preferences: Two Budget Lines X1

The bundle (x1,x2), that the consumer chooses is revealed preferred to the bundle
(y1,y2), a bundle that he could have chosen.
Consider figure 2 where a consumer’s demanded bundle (x1, x2) and another arbitrary
bundle (y1, y2) i.e., beneath the consumer’s budget line are depicted. The bundle (y1,
y2) is certainly an affordable purchase at the given budget-the consumer could have
bought it, if preferred, and would even have had money left over. Since (x1, x2) is the
optimal bundle, it must be better than anything else that the consumer could afford.
Hence, in particular it must be better than (y1, y2).
The same argument holds for any bundle on or underneath the budget line other than
the demanded bundle. Since it could have been bought at the given budget but was
not, then what was bought must be better. Here is where we use the assumption that
there is a unique demanded bundle for each budget. If preferences are not strictly
convex, so that indifference curves have flat spots, it may be that some bundles that
are on the budget line might be just as good as the demanded bundle.
In figure 2 all of the bundles underneath the budget line are revealed worse than the
demanded bundle (x1, x2). This is because they could have been chose, but were
rejected in favor of (x1, x2).
18
Let (x1, x2) be the bundle purchased at prices (p 1, p2) when the consumer has income
m.
p1 y1  p2 y2  m.
Since (x1, x2) is actually bought at the given budget, it must satisfy the budget
constraint with equality
p1 x1  p2 x2  m .
Putting these two equation together, the fact that (y 1, y2) is affordable at the budget
(p1, p2, m) means that
p1 x1  p2 x2  p1 y1  p2 y2 .
If the above inequality is satisfied and (y 1, y2) is actually a different bundle from (x1,
x2), then (x1, x2) is directly revealed to (y1, y2).
Important point is that the left hand side of this inequality is the expenditure on the
bundle that is actually chosen at prices (p1, p2). Thus, revealed preference is a relation
that holds between the bundle that is actually demanded at some budget and the
bundles that could have been demanded at that budget. When we say that X is
revealed preferred to Y, it means that X is chosen when Y could have been chose; that
is, that
p1 x1  p2 x2  p1 y1  p2 y2
Optimum of the Consumer
A consumer is said to be at optimum when he/she maximizes utility subject to income

constraint.
Consider U = f(x), price of Px.
The consumer can either buy an additional unit of X or keep the income, which was to
be spent on that additional unit of X unspent. Both give some satisfaction to the
consumer. To determine the optimum of the consumer will need to compare the MU x
and Px.
MUx which the consumer will have to pay.
Px What the consumer has to pay.
MUx > Px the consumer can raise his/her satisfaction by purchasing more units of
good of X.
19
MUx <Px The consumer can raise his level of satisfaction by reducing
consumption of x.
MUx = Px Optimum of the consumer. When the utility function of the consumer
contains more than one good. U = f (x 1,x2,….xn). The optimum of the consumer
receives the following conditions to be fulfilled.
The condition.
MU x1 MU 2 MU xn
  .....
Px1 Px 2 Pxn
MU x1
The satisfaction the consumer derives by spending one unit of money x 1.
PX 1
Spending one unit of money should result in the same satisfaction regardless of the
good it is spent on. If spending one unit of money results in higher satisfaction when
it is spent on x1 compared to other goods. The consumer can raise his satisfaction by
spending more on x1 and less on other unit the above condition is fulfilled.
Appendix: Mathematical Derivation of Optimum of Consumer
Though the measurement of marginal utility is unnecessary

the optimality condition. We arrive at through the ordinal
approach is the same that of the cardinal approach.
Mathematically the optimum of the consumer can be derived
by maximizing the utility subject to the budget constraint.
max.u(x1 . x2)
subject to P1X1+P2X2 < m to combine the two use what is called

a Langragean function.
L = U (X1/X2) – λ (P1X1+P2X2 – m)
The Lagrangian theorem states that the optimum of the

consumer should fulfill the following three first order
conditions.
20
L u
  P1 Condition 1.
X x1
L u
  P2  0 Condition 2.
X 2 x2
L
 P1 X 1  P2 X 2  m  0 Condition 3.
L
From (1) MUX1 = λ P1
From (2) MUX2 = λP2
MUX 1 MUX 2
 , 
P1 P2
MUX 1 MUX 2

P1 P2
for the Cobb-Douglas utility function
u (X1.X2) = X1c X2d
 MUX 1  c X 2 MUX 1 c X 2 P1
 .   . 
MUX 2 d X 1 MUX 2 d X 1 P2
P2cX2=P1dX1
P1dX 1 P2 cX 2
X2   X1
P2c P1d
From (condition 3)
P1 X 1  P2 X 2  m  0
( P2cX 2 ) P cX
P1  P2 X 2  m  0 where X 1  2 2
P1d P1d
P2cX 2
 P2 X 2  m  0
d
21
( P2c  P)
.x2  m
d
c m
X1  .
c  d p1
d m
X2  .
c  d p2
The proposition of income spent on x1 at the consumer

optimum.
the % of income which is spent on the X1.
P1 X 1 P1 c m c
 ( . )
m m c  d P1 cd
Proposition of m spent on X1 and
X2 respectively.
P2 . X 2 P2 d m d
 ( . ) the % of income which is spent on X2.
m m c  d p2 cd
a 1 a
U ( X 1. X 2 )  X 1 X 2
a in the proportion of m spent on X1

1-a in the proportion of m spent on X2
U = f (X1,X2,……………..,Xn)
MUX 1 MUX 2 MUX n

  .......... 
P1 P2 Pn
U ( X 1 , X 2 ,.......... X n )   ( P1 X 1  P2 X 2  .......Pn X n )
L
n 1
Example:
Suppose a consumer spends his/ her entire income on food (x 1)

and clothing (x2) and 25% of the total income is spend on food.
22
If price of x1 = 2, prices of X2=3, m = 200, estimate function &

determine the optimum quantity of x1 & x2.
u (x1. x2) = X1 ¼ , X2 ¾
c m
x1  . x1= 0.25*200/2 = 25,
c  d p1
c m
x2  . x = 0.75*200/3=50
c  d p2 2
OFFER CURVES OF INCOME AND PRICE CONSUMPTION
1. Introduction
The consumer’s demand function gives the optimal amounts of each of the goods as
a function of the prices and income faced by the consumer. The demand function is
written as
x1=x1 (p1,p2,m)
x2=x2 (p1,p2,m).
The left hand side of each equation stands for the quantity demanded. The right-hand
side of each equation is the function that relates the prices and income to that quantity.
Studying how a choice responds to changes in the economic environment is known as

comparative statics. “Comparative” means that we want to compare situations:
before and after the change in the economic environment. Statics means that we are
not concerned with any adjustment process may be involved in moving from one
choice to another, others be examined in equilibrium choice. In the case of consumer,
there are two things in the model that affect optimal choice: price and income. Two
comparative statics questions in consumer theory therefore involve investigating how
demand changes when prices and income changes.
2. Normal and Inferior Goods
Normal goods are those goods when their demand for each good would increase when
income increases. If good 1 is a normal good, then the demand for it increases when
income increases, and decreases when income decreases. For a normal good, the
quantity demanded always changes in the same way as income changes. Graphical
representation is shown in the following
Indifference figure 1
curves
x1
 0.
m X2
Optimal choices
Budget lines
23
X1
Fig. 1 Normal Goods: The demand for both goods increases when income
increases.
If something is called normal, there must be possibility of being abnormal. where an

increase of income result in a reduction in the consumption of one of the goods. Such
goods are called as Inferior Goods. There are many goods for which demand
decreases as income increases: example, gruel, bologna, shacks, or nearly any kind of
low quality good.
Whether a good is inferior or not depends on the income level that we examining. It
might very well be that very poor people consume more bologna as their income
increases. But after a point, the consumption of bologna would probably decline as
income continued to increase. Since in real life the consumption of goods can increase
when income increases. Fig 2 shows the graphical presentation of inferior good.
X1
Optimal Budget lines

choices
X2
Fig. 2 An Inferior Good: Good 1 is an inferior good, which means that the demand
for it decreases when income increases.
24
3. Income Offer Curves and Engel Curves
Income offer curve is constructed by shifting the budget line outward. This curve
illustrates the bundles of goods that are demanded at the different levels of income, as
depicted in figure 3.a.
For each level of income, m, there will be some optimal choice for each of the goods.
First focus on good 1 and consider the optimal choice of each set of prices and
income, x1(p1.p2.m). This is simply the demand function for good1. If prices of goods
1 and 2 are held fixed and look at how demand changes because of change income,
for that purpose Engel Curve is generated. The Engel curve is a graph of the demand
for one of the goods as a function of income, with all prices being held constant. See
figure 3.b
X2
m
Income offer curve
Engel Curve
Indifference curves
3.a Income Offer Curve x1 3.b Engel Curve x1
How demand changes as income changes. The income offer curve (or income
expansion path) shown in panel A depicts the optimal choice at different levels
of income and constant prices. When you plot the optimal choice of good 1
against income, m, we get the Engel curve, depicted in panel B.
The income offer (for the consumption) curve is obtained by connecting successive
optimum points arising from increasing income. The curve is sloped positively, when
X1 and X2 are normal goods. But if one of the goods is inferior then the curve is
negatively sloped.
4. The Price Offer Curve and the Demand Curve
Suppose the price of good 1 change while p 2 and income are fixed. Geometrically this
involves pivoting the budget line. To construct price offer curve optimal points be
connected together as illustrated in figure 4.a.This curve represents the bundles that
would be demanded at different prices for good 1.
25
In other words, hold the price of good2 and money income fixed, and for each
different value of p1 plot the optimal level of consumption of good1. The result is the
demand curve depicted in figure 4.b. The demand curve is a plot of the demand
function, x1(p1, p2, m), holding p2 and m fixed at some predetermined values.
Ordinarily, when the price of a good increases, the demand for the good will decrease.
Thus the price and quantity of a good will move in opposite directions, which means
that the demand curve will typically have a negative slope. In terms of rates of
change,
x1
 0 ,which simply says that demand curves usually have a negative slope.
p1
X2 P1
Indifference curves
Demand Curve
Price Offer
Curve
4.a Price Offer Curve X1 4.b Demand Curve X1
The price offer curve and demand curve. Panel A contains a price offer
curve, which depicts the optimal choices as the price of good1, changes. Panel
B contains the associated demand curve, which depicts a plot of the optimal
choice of good 1 as a function of its price.
The price offer curve is obtained as a locus of successive optimum points resulting
from successive changes in price of one of the goods keeping income and prices of
the price offer curve shows you what happens in the optimal of consumer
consumption with respect to the decrease in price of X1.
1.6.1 INCOME AND SUBSTITUTION EFFECTS (Slutsky Equation)
Slutsky equation is the equation showing how the effect on demand for a good of a
change in price can be decomposed into the substitution effect, which shows the effect
26
of a change in relative prices at an unchanged level of real income, and the income
effect, which shows the effect of change in real income holding prices constant.
When the price of a good changes, there are two sorts of effects: the rate at which you
can exchange one good for another changes, and the total purchasing power of your
income is altered. For example, if good1 becomes cheaper, it means that you have to
give up less of good 2 to purchase good1. The change in the price of good 1has
changes the rate at which the market allows you to ‘substitute’ good 2 for good 1. The
trade-off between the two goods that the market presents the consumer has changed.
At the same time, if good1 becomes cheaper it means that your money income will
buy more of good 1. “The purchasing power of your money has gone up although the
number of dollars you have is the same, the amount that they will buy has increased.
The Substitution Effect
The part of the effect of a price change on demand due to the change in relative
prices, assuming that the consumers compensated sufficiently to remain at the same
level of utility.
The change in demand due to the change in the rate of exchange between the two
goods is called substitution effect.
X2 Original Budget Line
Indifference Curves
Original Choice
Final Choice
X2
*
Final Budget line
X1 x1
Figure 1. Pivot and Shift. When the price of good 1 changes and income stays fixed, the
budget line pivots around the vertical axis. We will view this adjustment as occurring in two
Whatfirst
stages: arepivot
the economic meanings
the budget of the
line around thepivoted
originaland shifted
choice, budget
and lines?
then shift this line outward to
the new demanded bundle.
This “pivot-shift” operation gives us a convenient way to decompose the change in
demand into two pieces. The first step- the pivot- is a movement where the slope of
the budget line changes while its purchasing power stays constant, while the second
step is a movement where the slope stays constant and the purchasing power changes.
This decomposition is only a hypothetical construction – the consumer simply
observes a change in price and chooses a new bundle of goods in response. But in
analyzing how the consumer’s choice changes, it is useful to think of budget line
change in two stages – first pivot and then the shift.
27
First, consider the pivoted line. Here is a budget line with the same slope and thus the
same relative prices as the final budget line. However, the money income associated
with this budget line is different. Since the vertical intercept is different. Since the
original consumption bundle (x1,x2) lies on the pivoted budget line, that consumption
bundle is just affordable. The purchasing power of the consumer has remained
constant in the sense that the original bundle of goods is just affordable at the new
pivoted line.
Calculate how much we have to adjust money income in order to keep the old bundle
just affordable. Letm1 be the amount of money income that will just make the original
consumption bundle affordable; this will be the amount of money income associated
with the pivoted budget line. Since (x1, x2) is affordable at both (p1, p2, m|), we have
m1  p11 x1  p2 x2
m  p1 x1  p2 x2
Subtracting the second equation from the first gives

m1  m  x1 p|1  p1 .
This equation says that the change in money income necessary to make the old bundle
affordable at the new prices is just the original amount of consumption of good 1
times the change in prices.
Letting p1  p11  p1 represents the change in price 1, and m  m1  m represents

the change in income necessary to make the old bundle just affordable, we have
m  x1p1
Now we have a formula for the pivoted budget line: it is just the budget line at the
new price with income change by ∆m. Note that if the price of good 1 goes down, a
consumer’s purchasing power goes up, so we will have to decrease the consumer’s
income in order to keep purchasing power fixed. Similarly, when a price goes up,
purchasing power constant must be positive.
The substitution effect x1s is the change in the demand for good1 when the price of
good 1 changes to p|1 and, at the same time, money income changes to m|:
x1s  x1 ( p11 , m1 )  x1 ( p1 , m)
In order to determine the substitution effect, use the consumer’s demand function to
calculate the optimal choices at (p11,m1) and (p1,m). The change in demand for good 1
may be large or small, depending on the shape of the consumer’s indifference curves.
The substitution effect is sometimes called the change in compensated demand. The
idea is that the consumer is being compensated for a price rise by having enough
income given back to him to purchase his old bundle. Of course, if the price goes
down he is compensated by having money taken away from him.
28
The Income Effect

The change in demand due to having more purchasing power is called income effect.
This is the part of the response in the demand for a good to a change in its price which
is due to the rise in the real income of consumer resulting from a price decrease.
A parallel shift of the budget line is the movement that occurs when income changes
while relative prices remain constant. This second stage of price adjustment is called
income effect. Simply change the consumer’s income from m| to m, keeping the prices
constant at (p11, p2). In figure 2 this change moves us from the point Y to Z. It is
natural to call this last movement the income effect because changing the income
while keeping the prices fixed at the new prices.
More precisely, the income effect, x1n , is the change in the demand for good 1 when
we change income from m1, to m, holding the price of good 1 fixed at p`1:
x1n  x1 ( p|1 , m)  x1 ( p|1 , m| ) .
When the price of a good decreases, we need to decrease income in order to keep
purchasing power constant. If the good is a normal good, then this decrease in income
will lead to a decrease in income will lead to a decrease in demand. If the good is an
inferior good, then the decrease in income will lead to an increase in demand.
X2 Indifference Curves
m/p2
m1/P2
z
x y
0 Substitution Income X1
effect effect
Figure 2: Substitution effect and Income effect. The pivot gives the
substitution effect and the shift gives the income effect.
The Total Change in Demand
The total change in demand Δx1, is the change in demand due to the change in price,
holding income constant;
 
x1  x1 p11 , m  x1  p1, m  .
29
This can be broken up into substitution effect and the income effect. In terms of
symbols defined above,
x1  x s1  x n1
x1 ( p 11 , m)  x1 ( p1 , m)  [ x1 ( p |1 , m | )  x1 ( p1 , m)]  [ x1 ( p |1 , m)  x1 ( p | 1 , m | )]
This equation is called Slutsky’s Identity (Named after Russian economist Eugen
Slutskey, 1880-1948). In words, this equation says that the total change in demand
equals the substitution effect plus the income effect. It is called identity because; it is
true for all values of p1, p|1, m and m|. The first and fourth terms on the right hand side
cancel out, so the right hand side is identically equal to the left hand side.
The content comes from the interpretation of two terms on the right hand side:
substitution effect and the income effect. While substitution effect must always be
negative-opposite the change in the price-the income effect can go either way. Thus
the total effect may be positive or negative. However, if we have normal good, then
the substitution effect and the income effect work in the same direction. An increase
in price means that the demand will go down due to the substitution effect. If price
goes up, it is like decrease in income, which, for a normal good, means a decrease in
demand.
The Law of Demand: If the demand for a good increases when income increases,
then the demand for that good must decrease when its price increases.
This follows directly from the Slutsky equation: if the demand increases when income
increases, we have normal good. In addition, if we have a normal good then the
substitution effect and the income effect reinforce each other, and an increase in price
definitely reduce demand.
Some Examples with Perfect compliments and substitutes.
Slutsky’s decomposition is illustrated in the fig 3. When we pivot the budget line
around the chosen point, the optimal choice at the new budget line is the same as at
the old one – this means that the substitution effect is zero. The change in demand is
due entirely to the income effect.
The case of perfect substitutes illustrated in figure 4. When we tilt the budget line, the
demand bundle jumps from the vertical axis to the horizontal axis. This is because of
the entire change in the demand due to the substitution effect.
30
X2 Indifference curves
Original budget
line
Final budget line

Pivot Shift
Income effect = Total effect

X1
Figure 3
Perfect Compliments. Slutsky decomposition with perfect
compliments
X2
Indifference curves
Final budget line
Original Choice
Final Choice
Original budget line
Substitution effect = total effect X1
Figure 4
Perfect substitutes. Slutsky decomposition with perfect substitutes.
To conclude, Slutsky equation says that the total change in demand is the sum of the
substitution effect and the income effect.
A Numerical Example: Calculating the Substitution Effect
m
Suppose that the consumer has a demand function for milk of the form x1  10 
10 p1
.
Originally his income is Br.120 per week and the price of milk is Br.3 per quart. Thus
120
his demand for milk will be 10   14 quarts per week. Now suppose that the
10 * 3
price of milk falls to Br.2 per quart. Then his demand at this new price will be
31
120
10   16 quarts of milk per week. The total change in demand is +2 quarts a
10 * 2
week.
In order to calculate the substitution effect, we must first calculate how much income
would have to change in order to make the original consumption of milk just
affordable when the price of milk is Br.2 a quart. We apply the formula
m  x1p1  14 * (2  3)   Br.14.
Thus the level of income necessary to keep purchasing power constant is

m'  m  m  120  14  106. what is the consumer’s demand for milk at the new
price, Br.2 per quart, and this level of income? Just plug numbers into the demand
function to find.
106
x1 ( p '1 , m' )  x1 ( 2,106)  10   15.3
10 * 2
Thus the substitution effect is x s1  x1 (2,106)  x1 (3,120)  15.3  14  1.3 .
Calculating the Income Effect.
x1 ( p '1 , m)  x1 (2,120)  16
x1 ( p '1 , m' )  x1 (2,106)  15.3
Thus the income effect for this problem is
x n1  x1 (2,120)  x1 (2,106)  16  15.3  0.7 .
Since milk is a normal good for this consumer, the demand for milk increases when
income increases.
DERIVATION OF CONSUMER DEMAND
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 (fig.
2). Geometrically the marginal utility of x is the slope of the total utility function
U=f(qx). The total utility increases, but at a decreasing rate, up to quantity x and then
starts declining (fig. 1).
Ux MUx
TU
0 x qx 0 x qx
Fig. 1 Fig. 2
MUx
32
Accordingly the marginal utility of x declines continuously, and becomes negative

beyond quantity x. If the marginal utility is measured in monetary units, the demand
curve for x is identical to the positive segment of the marginal utility curve. At x t the
marginal utility is MU1 (fig. 3). This is equal to P1, by definition. Hence, at P1 the
consumer demand x1 quantity (fig. 4).
MUx Px
MU1
MU2 P1
MU3
P2
P3
0 atx1 x the
Similarly, x2 marginal
x3 utility 0 x x2 to xP3 2. xHence, qat
2 MUx is MU 2, which is1 equal x P 2 the
Fig. 3
consumer will buy x2, and so on. The negative section of Fig.
MU4 curve does not form part
of the demand curve, since negative quantities do not make sense in economics.
Graphical Presentation of the Equilibrium of the Consumer:
Given the indifference map of the consumer and his budget line, the equilibrium is
defined by the point of tangency of the budget line with the highest possible
indifference curve (point e in fig. 5).
Y* e
0 x* B X
Fig. 5
At the point of tangency the slopes of the budget line (Px/Py) and of the indifference
curve (MRSx,y=MUx/MUy) are equal:
MU x P
 x
MU y Py
33
Thus the first-order condition is denoted graphically by the point of tangency of the
two relevant curves. The second-order condition is implied by the convex shape of
the indifference curves. The consumer maximizes his utility by buying x* and y* of
the two commodities.
Mathematical derivation of the equilibrium:
Given the market prices and his income, the consumer aims at the maximization of his
utility. Assume that there are n commodities available to the consumer, with given
market prices P1,P2,…….Pn. The consumer has a money income (Y) which he spends
on the available commodities.
Formally, the problem may be stated as follows:
Maximise U = f(q1,q2,….,qn)
n
Subject to q P  q P  q P
t 1
1 1 1 1 2 2  ....  qn Pn  Y
We use the ‘Langrangian multipliers’ method for the solution of this constrained
maximum.
The steps involved in this method may be outlined as follows:
(a) Rewrite the constraint in the form
(q1P1+q2P2+…+qnPn - Y) = 0
(b) Multiply the constraint by a constant λ, which is the Lagrangian multiplier.
λ(q1P1+q1P2+…..qnPn – Y) = 0.
(c) Subtract the above constraint from the utility function and obtain the ‘composite
function’.
 = U – λ(q1P1+q2P2+…..qnPn – Y)
It can be shown that maximization of the ‘composite function implies maximization

of the utility function.
The first condition for the maximization of a function is that its partial derivatives be
equal to zero. Differentiating Φ with respect to q1,…qn and λ and equating to zero we
find
 U
   ( P1 )  0
q1 q1
 U
   ( P2 )  0
q2 q2
. . . .
. . . .
34
. . . .
 U
   ( Pn )  0
qn qn

 ( q1 P1  q2 P2  .......qn Pn  Y )  0

From these equation 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 λ we find
MU1 MU 2 MU n
   ..... 
P1 P2 Pn
Alternatively, we may divide the preceding equation corresponding to commodity x,

by the equation which refers to commodity y, and obtain
MU x P
 x  MRS x , y
MU y Py
We observe that the equilibrium conditions are identical in the cardinalist approach
and in the indifference curves approach. In both theories we have
MU1 MU 2 MU x MU y MU n
  ....    .... 
P1 P2 Px Py Pn
Thus, although in the indifference – curves approach cardinality of utility is not

required. The MRS requires knowledge of the ratio of the marginal utilities, given that
the first order condition for any two commodities may be written as
MU x P
 x  MRS x , y
MU y Py
35
Hence, the concept of marginal utility is implicit in the definition of the slope of the
indifference curves, although its measurement is not required by this approach. What
is preceded is a diminishing marginal rate of substitution, which of course does not
require diminishing marginal utilities of the commodities involved in the utility
function.
1.8 THE CONSUMER’S SURPLUS
The consumer’s surplus is a concept introduced by Marshall, who maintained that it

can be measured in monetary units, and is equal to the difference between the amount
of money that a consumer actually pays to buy a certain quantity of commodity x, and
the amount that he would be willing to pay for this quantity rather than do with it.
Graphically the consumer’s surplus may be found by his demand curve for
commodity x and the current market price. Assume that the consumer’s demand for x
is a straight line (AB in Figure 1) and the market price is P. At this price the consumer
buys q units of x and pays an amount (q).(P) for it. However, he would be willing to
pay p1 for q1, P2 for q2, P3 for q3 and so on. The fact that the price in the market is
lower than the price he would be willing to pay for the initial units of x implies that
his actual expenditure is less than he would be willing to spend to acquire the quantity
q. This difference is the consumer’s surplus, and is the area of the triangle PAC in
figure 1.
Px
A
P1
P2
P3
0 q1 q2 q3 q B
Figure 1
36
The Marshallian consumer’s surplus can also be measured by using indifference

curves analysis. In figure 2 the good measured on the horizontal axis is x, while on
the vertical axis we measure the consumer’s money income. The budget line of the
consumer is MM1 and its slope is equal to the price of the commodity x (since the
price of one unit of monetary unit is 1). Given P x, the consumer is in equilibrium at E:
he buys OQ quantity of x and pays AM` of his income for it, being left with OA
amount of money to spend on all other commodities.
Next, find the amount of money which consumer would be willing to pay for OQ
quantity of x rather than do without it.
M
Income
M1
A
E
A|
I1
B
O Q M| X
Fig. 2
This is attainted by drawing an indifference curve passing through M. Under
Marshallian assumption that the MU of money income is constant, this indifference
curve will be vertically parallel to the indifference curve I 1; the indifference curves
will have the same slope at any given quantity of x. for example, at Q the slope of I1 is
the same as the I0
MU x
Slope I1 for Q units of X = MRS x,M =  MU x
1
(Given that MUM = 1)
Similarly
37
MU x
Slope I0 for Q units of X = MRS x,M =  MU x
1
Given that the quantity of x is the same at E and B, the two slopes are equal.
The indifference curve I0 shows that the consumer would be willing to pay A1M for
the quantity OQ, since point B shows indifference of the consumer between having
OQ of x and OA` of income to spend on other goods, or having none of x and
spending all his income M on other goods. In other words A`M is the amount of
money that the consumer would be willing to pay for OQ rather than do without it.
The difference A`M - AM = AA` = EB is the difference between what the consumer
actually pays and what he would be willing to pay for OQ of x. This difference is the
Marshallian Consumer Surplus.
Other Interpretation of Consumer’s Surplus
There is also an other way to think about consumer’s surplus. Suppose that the price
of the discrete goods is p. Then the value that the consumer places on the first unit of
consumption of that good is r1, but he only has to pay p for it. This gives him a
surplus of r1-p on the first unit of consumption. He values the second unit of
consumption of at r2, but again he only has to pay p for it. This gives him a surplus of
r2-p on that unit. If we add this up- over all n units the consumer chooses, we get his
total consumer’s surplus:
CS  r1  p  r2  p  ......rn  p  r1  .....rn  np
Since the sum of the reservation prices just gives us the utility of consumption of
good 1. We can also write this as
CS  v( n)  pn
From Consumer’s surplus to Consumers surplus:
So fare we are considering the case of a single consumer. If several consumers are
involved we can ad up each consumer’s surplus across the consumers to create an
aggregate measure of the consumers’ surplus. Observe carefully the distinction
between the two concepts: consumer’s surplus refers to the surplus of single
consumer: consumers’ surplus refers to the sum of the surpluses across a number of
consumers.
Consumers’ surplus serves as a convenient measure of the aggregate gains from trade,
just as consumer’s surplus serves as a measure of the individual gains from trade.
Interpreting the changes in Consumer’s Surplus
38
Demand Curve
P
R Change in consumer surplus

P11
T
1
P
0 X11 X1 X
Fig. 3 Change in consumer’s surplus. The change in consumer’s surplus will be
the difference between two roughly triangular areas, and thus will have a roughly
trapezoidal shape.
In Figure 3 the change in consumer’s surplus associated with a change in price. The
change in consumer’s surplus is the difference between two roughly triangular regions
and will there has trapezoidal shape. The trapezoid is further composed of two
regions, the rectangle indicated buy R and the roughly triangular region indicated by
T.
The rectangle measures the loss in surplus due to the fact that the consumer is now
paying more for all the units he continues to consume. After the price increases the
consumer continues to consumer x|| units of the good and each unit of the good is now
more expensive by p|| - p1. This means he has to spend (p || - p|) x|| more money than he
did before just to consume x|| units of the good.
This is not entire welfare loss. Due to the increase in the price of the x good, the
consumer has decided to consumer less of it than he was before. The triangle T
measures the value of the lost consumption of the x good. The total loss to the
consumer is the sum of these two effects: R measures the loss from having to pay
more for the units he continues to consume, and T measures the loss from the reduced
consumption.
1.9 THE MARKET DEMAND
1. Derivation of the Market Demand

The market demand for a given commodity is the horizontal summation of the
demand of the individual consumers. In other words, the quantity demanded in the
market at each price is the sum of the individual demands of all consumers at that
price.
Table1 Individual and Market Demand
Price Quantity Quantity Quantity Quantity Market Demand

demanded demanded demanded demanded
by by by by
Consumer A Consumer B Consumer C Consumer D
39
2 40 4 45 18 107
6 24 5 30 13 72
10 14 10 15 11 50
14 08 05 10 06 29
18 04 02 0 0 06
20 03 0 0 0 03
20
*
16
*
*
14
* *
*
10
** *
*
6
Economic theory does not* define
* *any particular form
* of the demand curve. Market
demand is sometimes shown in textbooks* as a straight line (linear demand curve) and
2 convex to the origin. The linear demand curve (Fig 1) may be
sometimes as a curve * * * *
written in the form
Q = b0 – b1P 0 10 20 30 40 50 60 70 80 90 100 110 Q

and implies a constant slope, but a changing
Fig.elasticity
1 at various prices. The most
common form of a non-linear demand curve is the so called constant – elasticity –
demand curve, which implies constant elasticity at all prices; its mathematical form is
Q = b0.pb1
Where b1 is the constant price elasticity.
2. DETERMINANTS OF DEMAND
Traditionally the most important determinants of the market demand are considered to
be the price of the commodity in question, the prices of other commodities,
consumer’s income and tastes. The result of a change in the price of the commodity is
shown by a movement from one point to another on the same demand curve. Thus
these factors are called shift factors, and the demand curve is drawn under the ceteris
paribus assumption, that the shift factors are constant. The distinction between
movements along the curve and shifts of the curve is convenient for the graphical
presentation of the demand function. Conceptually, however, demand should be
thought of as being determined by various factors (is multivariate) and the change in
any one of these factors changes the quantity demanded.
40
Apart from the above determinants, demand is affected by numerous other factors,
such as the distribution of income, total population and its composition, wealth, credit
availability, stocks and habits. The last two factors allow for the influence of past
behavior on the present, thus rendering demand analysis dynamic.
P1
P2
0 x1 x2 Q 0 x1 x2 x3 Q
Fig 3: Shifts of the demand curve as, for example
Fig:2 Movement along the demand curve as the price Income increases.
Of x changes.
1.10 ELASTICITY OF DEMAND
There are as many, elasticities of demand as its determinants. The most important of
these are (i) the price elasticity, (ii) the income elasticity, (iii) the cross-elasticity of
demand.
(i) The Price Elasticity of Demand:
The price elasticity is a measure of the responsiveness of demand to changes in
commodity’s own price. If the changes in price are very small, we use a measure of
the responsiveness of demand the point elasticity of demand. If the changes in price
are not small, we use the arc elasticity of demand as the relevant measure.
dQ
ep  Q
dP
P
or
dq P
ep  *
dP Q
If the demand curve is linear
Q  b0  b1 P
Its slope is dQ / dP  b1 . Substituting in the elasticity formula, we obtain
P
e p  b1 *
Q
Which implies that the elasticity changes at the various points of the linear-demand
curve. Graphically the point elasticity of a linear demand curve is shown by the ratio
41
of the segments of the line to the right and to the left of the particular point. In figure
FD`
1 the elasticity of the linear demand curve at point F is the ratio
FD
P
D F
P1
F1
P2 E
0 Q1 Q2 D| O
Figure 1
From Fig.1 we see that
ΔP = P1P2 = EF ΔQ = Q1Q2 = EF|

P = OP1 Q = OQ1
If we consider very small changes in P and Q, then P  dP Q  dQ
Thus substituting in the formula for the point elasticity, we obtain
dQ P Q1Q2 OP1 EF | OP1

ep  *  *  *
dP Q P1P2 OQ1 EF OQ1
From the figure we can also see that the triangles FEF| and FQ1D| are similar
(because each corresponding angle is equal). Hence
EF | Q1 D| Q1D|
 
EF FQ1 OP1
Q1D| OP1 Q1D|

Thus ep  * 
OP1 OQ1 OQ1
Furthermore the Triangles DP1F and FQ1D| are similar, so that
Q1D| P1F OQ1

 
FD | FD FD
Re Arranging we obtain
Q1D| FD|

OQ1 FD
Q1D| FD!
Thus the price elasticity at point F is ep  
0Q1 FD
42
ep→∞
P
D ep>1
ep=1
M
ep<1
ep=0
0 Fig. 2 D| Q
Given the graphical measurement of point elasticity it is obvious that at the mid-point
of a linear demand curve ep = 1 (Point M in Fig.2)
At any point to the right of M the point elasticity is less than unity (ep < 1);
finally at any point to the left of M, ep > 1.
At point D the e p   , while as point D` the ep = 0. The price elasticity is always
negative because of the inverse relationship between Q and P implied by the ‘law of
demand’. However, traditionally the negative sign is omitted when writing the
formula of the elasticity.
The range of values of elasticity are 0  e p  
If ep = 0 the demand is perfectly inelastic
if ep=1 the demand has unitary elasticity
If e p   , the demand is perfectly elastic.
If 0<e<1, we say that the demand inelastic
if 1<e<  , the demand is elastic.
Figures 3, 4, and 5.
D
P D
0 ep =0 0 ep =1 0 ep  
Fig 3 Fig 4 Fig 5
The basic determinants of the elasticity of demand of a commodity with respect to its
own price are:
(1) The availability of substitutes; the demand for a commodity is more elastic if there
are close substitutes for it.
(2) The nature of the need that the commodity satisfies. In general, luxury goods are
price elastic, while necessities are price inelastic.
43
(3) The time period. Demand is more elastic in the long run.
(4) The number of uses to which a commodity can be put. The more the possible uses
of a commodity the greater its price elasticity will be.
(5) The proportion of income spent on the particular commodity.
The above formula for the price elasticity is applicable only for extremely small
changes in the price. If the price changes appreciably, we use the following formula,
which measures the arc elasticity of demand:
ep = ΔQ P1+P2/2 = ΔQ (P1+P2)
ΔP Q1+Q2/2 ΔP (Q1+Q2)
The arc elasticity is a measure of the average elasticity, i.e., the elasticity at the mid
point of the chord that connects the two points (A and B) on the demand curve defined
by the initial and the new price levels (fig 6). It should be clear that the measure of the
arc elasticity is an approximation of the true elasticity of the section AB or if the
demand curve, which is used when we know only the two points A and B from the
demand curve is, the poorer the liner approximation attained by the arc elasticity
formula.
P D
A Aarc elasticity
P1
B
P2
D
.
O Q1 Q2 Q
Figure 6
(ii) The Income Elasticity of Demand.
The income elasticity is defined as the proportionate change in the quantity demanded
resulting from a proportionate change in Income. Symbolically we may write
ey = dQ/Q = dQ Y
dY/Y dY Q
The income elasticity is positive for normal goods. A commodity is considered to be a
luxury if its income elasticity is greater than unity. A commodity is a necessity if its
income elasticity is small (less than unity, usually).
The main determinants of income elasticity are:
1. The nature of the need that the commodity covers: the percentage of income spent
on food declines as income increases (this is known as ‘Engel’s Law’ and has some
times been used as a measure of welfare and of the development stage of an
economy.)
2. The initial level of income of a country. For example, a TV set is a luxury in an
underdeveloped, poor country while it is a ‘necessity’ in a country with high per
capita income.
3. The Time period, because consumption patterns adjust with a time-lag to changes
in income.
44
(iii) The Cross-Elasticity of Demand

The cross-elasticity of demand is defined as the proportionate change in the quantity
demanded of x resulting from a proportionate change in the price of y. Symbolically
we have
dQx dPy dQx Py

e xy  /  *
Q Py dPy Qx
The sign of the cross elasticity is negative if x and y are complementary goods, and
positive if x and y are substitutes. The higher the value of the cross-elasticity the
stronger will be the substitutability or complemetarity of x and y.
The main determinant of cross-elasticity is the nature of the commodities relative to

their use. If two commodities can satisfy equally well the same need, the cross-
elasticity is high, and vice-versa.
45

Theory of Consumer Demand

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Theory of Consumer Demand

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Micro Economics I .Chapter 1. Theory of Consumer Demand Mr.

Introduction to Theory of Consumer Demand

Theory of demand seeks to establish relationship between the quantity demanded of a

A prudent consumer exercises a lot of discrimination in his purchases. We find him

In the following tutorial material of this, we shall learn in detail Consumer

1.1 BUDGET CONSTRAINTS

p1x1 + p2x2 < m (1)

1. Two Goods Are Often Enough.

The two-goods assumption is more general. Because it is often interpreted as one of

p1x1+x2 < m (2)

2. Properties of the Budget Set.

The budget line is the set of bundles that cost exactly m:

p1x1 + p2x2 = m (3)

Figure 1 Budget Line.

Horizontal Intercept = m/p1 X1

Rearrange the budget line in equation (3) to get the formula

x2 = m/p2 – p1/p2 * x1 (4)

and p1(x1+∆x1) + p2(x2+∆x2) = m.

Subtracting the first equation from the second gives

3. How the Budget Line Changes

To show this algebraically. Suppose our original budget line is

However, this equation is same as

p1x1 + p2x2 = m/t.

What happens if both prices go up and incomes go down?

exactly the same budget line as

p1/p2. x1+x2 =m/p2

1.2 CONSUMER PREFERENCES

1. Completeness: Preferences are assumed to be complete. In other words,

2. Transitivity: Preferences are transitive. Transitivity means that if a consumer

3. More is better than less (Nonsatiation): Goods are assumed to be desirable –

1.2.ii. Indifference Curves

Definition: An indifference curve represents all combinations of market baskets

Table 1 Alternative Market Baskets for Food and Clothing.

MARKET BASKET UNITS OF FOOD UNITS OF CLOTHING

Figure 1 Describing Individual Preferences.

Figure 2 AN INDIFFERENCE CURVE

Indifference curves have certain characteristics that reflect assumptions about

1. An indifference curve passes through each point in the commodity space.

1.2.iv. THE MARGINAL RATE OF SUBSTITUTION (MRS)

1.2.v Diminishing marginal rate of substitution: (Assumption 4 of Consumer

Is it reasonable to expect indifference curves to be convex? Yes, as more and more of

1.2.vi PERFECT SUBSTITUTES AND COMPLIMENTS

The shape of an indifference curve describes the willingness of a consumer to

Fig. 3.a Perfect substitutes.

3.b. Perfect Compliments.

1.3.i UTILITY FUNCTIONS

Figure 1: Constructing a utility function from indifference

1.3.ii ORDINAL UTILITY

1.3. iii CARDINAL UTILITY

constraint is not important. Because the objective is to understand consumer behavior

1.3. iv Marginal Utility

The marginal utility with respect to good 2 is defined in a similar manner:

Because of conceptual problems, economists have abandoned the old-fashioned view

1.4 CONSUMER CHOICE

Given preferences and budget constraints, it is possible to determine how individual

The maximizing market basket must satisfy two conditions:

1. It must be located on the budget line.

We can graphically illustrate the solution to the consumer’s choice problem.

Fig 1 Maximizing consumer satisfaction.

Figure 2. Revealed Preferences: Two Budget Lines X1

Optimum of the Consumer

A consumer is said to be at optimum when he/she maximizes utility subject to income

Consider U = f(x), price of Px.