Consumer theory

Utility

Three axioms for consumer choice:

1. Axiom of completeness: Consumer can differentiate among different baskets
2. More is better (Consumers are far away from saturation)
3. Law of transitivity ('a better than b' and 'b better than c' than 'a is better than c')

Iso-Utility curve or Indifference curve (IC)

Law of diminishing marginal utility

Diminishing marginal law of substitution (Slope of IC is decreasing)
Diminishing marginal rate of substitution (Reason of convexity)
2nd item becomes dearer commodity

Slope of IC is marginal rate of substitution (MRS)

Bliss Point
Budget Line(BL)

Slope =-Px/Py
Point where IC curve is tangential to Budget line, maximum utility subjective to budget
constraint(equilibrium point)

Slope of IC = Slope of BL
Equilibrium condition for maximizing utility
Demand Curve (Price and Qty demanded) – price and qty are inversely related if other factors
remain constant (Income M and Py)

With increased income there will be a parallel shift in demand curve to the right
Engel Curve – Relation between income and demand while other factors remain constant

Normal good and Inferior good

Income Consumption Curve (ICC)

Price Effect (PE)

After tax, parallel shift in budget line (B1 to B2). Consumer will still be able to move to higher
Indifference Curve (I1, E1).
Decrease in Px will also result in movement from E0 to E1 or change in consumption from X0 to X1 is
known as Substitution Effect (SE)

After tax amount is returned back to consumer, change from E 1 to E2 is explained by change in real
income, which is known as Income Effect (IE)

Slutsky Equation
PE = IE + SE (https://youtu.be/3hkIktFTlE4)

Inferior Goods – reduce in price results in net increase in demand (income effect is negative)
Substitution effect is larger than income effect hence increased demand
Demand curve is negatively sloped

Giffen Goods – Reduce in price results in decrease in demand (income effect is negative)
Substitution effect is smaller than income effect hence decreased demand (all giffen goods are inferior goods)
Demand curve is positively sloped (Violates law of demand)

Inferior vs Giffen Goods

Elasticity
1. Price Elasticity – percentage change in demand due to 1 percent change in price while other
factors are held constant.

 Elastic – Elasticity greater than 1

 Inelastic – Elasticity less than 1
 Perfectly inelastic – Elasticity = 0 (vertical demand curve)
 Perfectly elastic – Elasticity is infinite. Slightest change in price will lead to huge change in
demand (horizonal demand curve)
 Unitary Elasticity – Elasticity is 1

Elasticity = 1

2. Income Elasticity – percentage change in demand due to 1 percent change in income while
other factors are held constant.
Income elasticity is negative for inferior and giffen goods.
If Income Inelastic, engel curve would be vertical

In a single commodity world,

Income elasticity = 1 (screenshot 1)
Price elasticity = -1 (screenshot 2)

Screenshot 1
Screenshot 2