Consumer Theory

Consumer theory is the study of how people decide to spend their income based on their
individual preferences and budget constraints. This branch of microeconomics shows how an
individual makes choices in an environment constrained by incomes and prices ceteris paribus.
The theory seeks to predict consumer’s purchasing patterns by making the following three basic
assumptions about human behavior:

 Utility maximization: Individuals are said to make calculated decisions when shopping,

purchasing products that bring them the greatest benefit, (maximum utility)
 Non-satiation: People are seldom satisfied with less and always want to consume more
 Decreasing marginal utility: The more of a product one consumes the less satisfaction
they get for an extra unit more in consumption.

Consumer theory is based on the assumptions that:

i) Preferences are complete: the consumer fully understands his or her own preferences,
allowing for a simple but accurate comparison between any two bundles of good presented.
ii) Preferences are reflexive: Means that if A and B are in all respect identical the consumer
will consider A to be at least as good as (i.e. weakly preferred to) B. Alternatively, the axiom can
be modified to read that the consumer is indifferent with regard to A and B.
iii) Preferences are transitive: If A is preferred to B and B is preferred to C then A must be
preferred to C. This also means that if the consumer is indifferent between A and B and is
indifferent between B and C she will be indifferent between A and C. This is the consistency
assumption. This assumption eliminates the possibility of intersecting indifference curves.
iv) Preferences exhibit non-satiation: This is the "more is always better" assumption; that in
general if a consumer is offered two almost identical bundles A and B, but where B includes
more of one particular good, the consumer will choose B.
v) Indifference curves exhibit diminishing marginal rates of substitution: This assumption
assures that indifference curves are smooth and convex to the origin. This assumption also set the
stage for using techniques of constrained optimization. Because the shape of the curve assures
that the first derivative is negative and the second is positive.
vi) Goods are available in all quantities: a consumer may choose to purchase any quantity of a
good (s)he desires. Whilst this makes the model less precise, it is generally acknowledged to
provide a useful simplification to the calculations involved in consumer choice theory, especially
since consumer demand is often examined over a considerable period of time. The more
spending rounds are offered, the better approximation the continuous, differentiable function is
for its discrete counterpart.
vii) Use value: In Marx's critique of political economy, any labor-product has a value and a use
value, and if it is traded as a commodity in markets, it additionally has an exchange value, most
often expressed as a money-price. Marx acknowledges that commodities being traded also have a
general utility, implied by the fact that people want them, but he argued that this by itself tells us
nothing about the specific character of the economy in which they are produced and sold.

1) Cardinal Theory
Utility Function: measures the level of satisfaction from consuming different bundles.
Itrepresents the consumer’s preferences. The unit of measurement is Utils, which does not havea
real life translation. Instead of considering the absolute or numerical value for the level
ofsatisfaction we compare relative values. For example, the consumer receives more utility
fromconsuming an orange than from consuming guava. Different consumers may have
differentutility functions. Thus knowing that Onyangoreceives 5Utils from consuming guava and
Kiokoreceives 6 Utils does not give us any useful information. But again we can only compare
relative values. We can think of Utils as a consumer’s level of happiness in consuming one good.

Diminishing marginal utility: additional units add less utility (ΔU smaller and smaller) but we
will assume that ΔU > 0 always. That is, more is always better, although it is not as good as the
last unit consumed. The marginal utility is the first derivative of the utility function.
MUy= du/dy = change in u/change in y. Each representation is equivalent to: MUy = Δu/Δy =
∂U(y)/∂y
There are three important points in mind when drawing total and marginal utility curves.
1) Total Utility and marginal utility cannot be plotted on the same graph, because the Y-axis
variable differs on each graph.
2) The marginal utility function is the slope of the total utility function.
3) Diminishing marginal utility just tells us that the additional utility we get from consuming
amount of goods is smaller and smaller. The additional utility we get fromconsuming additional
goods is MUx and MUy. So we notice that: MUx is decreasing in x (x is in the denominator)
MUy is decreasing in y (y is in the denominator)
Cardinal Ranking: allows us to answer the intensity at which a consumer prefers onebundle to
another. It is usually hardfor consumers to articulate their intensity but both ranking systems are
important to recognize.Marginal utility: rate at which utility changes as consumption increases.
Often thought of as, howmuch better off we would be if we received one more of something.
Assumptions of Cardinal Utility Analysis:
 
(i) Rationality. The consumer is rational. He seeks to maximize satisfaction from the limited
income which is at his disposal.
 
(ii) Utility is cardinally measurable. The utility can be measured in cardinal numbers such as 1,
3, 10, 15, etc. The utility is expressed in imaginary cardinal numbers tells us a great deal about
the preference of the consumer for a good.
 
(iii) Marginal utility of money remains constant. Another important premise of cardinal utility
of money spent on the purchase of a good or service should remain constant.
 
(iv) Diminishing marginal utility. It is also assumed that the marginal utility obtained from the
consumption of a good diminishes continuously as its consumption is increased.
 
(v) Independent utilities. According to the Cardinalist school, the utility which is derived from
the consumption of a good is a function of the quantity of that good alone. It does not depend at
all upon the quantity consumed of other goods. The goods, we can say, possess independent
utilities and are additive.
 
(vi) Introspection method. The Cardinalist school assumes that the behavior of marginal utility
in the mind of another person can be judged with the help of self-observation. For example, I
know that as I purchase more and more of a good, the less utility I derived from the additional
units of it. By applying the same principle, I can read other people mind and say with confidence
that marginal utility of a good diminishes as they have more units of it.
 
Criticism:
Pareto, an Italian Economist, severely criticized the concept of cardinal utility. He stated that
utility is neither quantifiable nor addible. It can, however be compared. He suggested that the
concept of utility should be replaced by the scale of preference. Hicks and Allen, following the
footsteps of Pareto, introduced the technique of indifference curves. The cardinal utility approach
is thus replaced by ordinal utility function.

2) Ordinal Theory
Ordinal Ranking: allows us to gather information about the order in which a consumerranks a
bundle. We can know that a consumer prefers basket A to B but not how much morethey prefer
it.
Assumptions:
 
The ordinal utility theory or the indifference curve analysis is based on four main assumptions.
 
(i) Rational behavior of the consumer:  individuals are rational in making decisions from their
expenditures on consumer goods.
 
(ii) Utility is ordinal: Utility cannot be measured cardinally. It can however, be expressed
ordinally. In other words, the consumer can rank the basket of goods according to the satisfaction
or utility of each basket.
 
(iii) Diminishing marginal rate of substitution: In the indifference curve analysis, the principle
of diminishing marginal rate of substitution is assumed.
 
(iv) Consistency in choice: The consumer is consistent in his behavior during a period of time.
For insistence, if the consumer prefers combinations of A of good to the combinations B of
goods, he then remains consistent in his choice. His preference, during another period of time
does not change. Symbolically, it can be expressed as:
If A > B, then B > A
 
(iv) Consumer’s preference not self-contradictory: The consumer’s preferences are not self-
contradictory. It means that if combinations A is preferred over combination B which is
preferred over C, then combination A is preferred over combination A which is preferred over
C. Symbolically it can be expressed:
If A > B and B > C, then A > C
 
(v) Goods consumed are substitutable:  The utility can be maintained at the same level by
consuming more of some goods and less of the other. There are many combinations of the two
commodities which are equally preferred by a consumer and he is indifferent as to which of the
two he receives.

Indifference Curve Analysis

Indifference curves: these are curves connecting consumption bundles that yield the same level
of utility.
Properties:
1) When the consumer likes both goods (MUx>0, MUy>0), indifference curves arenegatively
sloped.The slope of the indifference curve measures the marginal rate of substituting one good
for the other. This is known as diminishing MRS. Δy/Δx is the rate at which the consumer is
giving up y in order to get an additional unit of x. MRSx,y = - slope of Indifference curve. =
MUx/MUy
However there are other types of indifference curves based on the substitutability in consumption
between X & Y. a) Perfect substitutes (black or blue pens): they have constant slope equal to
-1, b) Perfect complements (goods that are consumed together, such as left and rightshoes)
these indifference curves are kinked.
2) Indifference curves cannot intersect because if they did, then abundle could create two
different levels of utility which would destroy rational thinking.
3) Every consumption bundle lies on one and only one indifference curve
4) Indifference map is dense meaning that there are very many combinations of good X & Y
from which the consumer could choose from.
5) Indifference curves are convex to the origin

A typical preference relation in this universe can be represented by a set of indifference curves.
Each curve represents a set of bundles that give the consumer the same utility.The consumer will
choose the indifference curve with the highest utility that is attainable within his budget
constraint. Every point on indifference curve is outside his budget constraint so the best that he
can do is the single point on the curve where the latter is tangent to his budget constraint. He will
purchase X* of good X and Y* of good Y.
Figure 1
Indifference curve analysis begins with the utility function. The utility function is treated as an
index of utility. All that is necessary is that the utility index change as more preferred bundles are
consumed.
Indifference curves are typically numbered with the number increasing as more preferred
bundles are consumed. The numbers have no cardinal significance; for example if three
indifference curves are labeled 11,12,and 13 respectively that means nothing more than the
bundles "on" indifference curve 12 are more preferred than the bundles "on" indifference curve
11.
Budget constraint
The budget constraint defines the set of baskets that a consumer can purchase with a
limitedamount of income.
P Q +P Q =M
x x y y Graphically, the budget constraint will be
represented by a specific region on the graph where all bundles in that region are affordable. To
find the limit (outermost edge) of our budget constraint we must construct a budget line which
indicates all combinations of a given set of goods that a consumer can afford to consume if they
spend all their income (M).
Slope of Budget Line

Px X +P y Y =1 ⇒ P y Y =1−P x X Implying Y =1/ P y−(P x /P y )X

Notice that this equation resembles the general equation of a straight line Y =a−bX , where

a= vertical intercept,-b= slope. Hence, the slope of the budget line = −( P x / P y ) and indicates,
when moving from left to right alongthe budget line, how many units of y the consumer must
give up to increase his consumptionof x. An easy way to remember the slope is simply as the
negative of the priceratio. The slope is negative because to get more of good x while staying on
the same budget line one must give up some of good y. If the slope were positive, one would
begetting more of good x by also getting more of good y, which intuitively doesn’t make sense.
If both income and all prices are doubled, the two effects would cancel each other out and
consumer would be left no better or worse off than before the change.
Consumer equilibrium
Putting the indifference curves and the budget line together, the equilibrium is attained.
This occurs where the highest indifference curve is tangential to the budget line i.e
MRS xy =P x /P y
If prices or incomes change cet.par., this equilibrium will change due to a change in relative
prices.Intuitively, an equilibrium consumption bundle will not only maximize a consumer’s
utility, but it will also be affordable. Also note that a consumer would not choose any bundle
inside or outside of the budget line as his optimal bundle. Any point outside the line would be
unaffordable for the consumer, and any point inside the line will not maximize utility because it
would leave income to be spent which would further increase his utility (remember that this
consumer spends all of his income to maximize hisutility).
Corner Points Solutions
So far we have been dealing with optimal bundles where the consumer purchases positive
amounts of all commodities (interior optimum). However, in the real world this is not always the
case. Many times a consumer will not consume a good at all, and thus, we need a way to find
optimal bundles in these situations. This search will take us to what we refer to as corner point
solutions: a solution to the consumer’s optimal choice problem at which some good is not being
consumed at all, in which case the optimal basket lies on an axis.
Corner Points with Perfect Substitutes
What if a consumer is always willing to substitute clothing for food, but in a constant ratio? This
is a case of perfect substitutes. Instead of a curved indifference curve, the curve will be a straight
line, since the slope is constant.
MRSxy = MUx/MUy = 2 (constant MRS because of Perfect substitutes)
px/py>MUx/MUyMUy /py>MUx /px and as a consequence the consumer should only buy x.
Once again, the MU per shilling for both goods is never equal, which will in turn lead the
optimal bundle to a corner point where 0 units of the less preferred good is consumed. In other
words, the consumer only likes y twice as much as x, but y is three times cheaper than y.

What happens if relative prices changes ceteris paribus

Income effect and price effect deal with how the change in price of a commodity changes the
consumption of the good.
Effect of Price Changes
The indifference curves and budget constraint can be used to predict the effect of changes to the
budget constraint. The graph below shows the effect of a price increase for good Y. If the price
of Y increases,cet. Par. the budget constraint will swing from BC2 to BC1. Notice that because
the price of X does not change, the consumer can still buy the same amount of X if he or she
chooses to buy only good X. On the other hand, if the consumer chooses to buy only good Y, he
or she will be able to buy less of good Y because its price has increased.
To maximize the utility with the reduced budget constraint, BC1, the consumer will re-allocate
consumption to reach the highest available indifference curve which BC1 is tangent to. As
shown on the diagram below, that curve is I1, and therefore the amount of good Y bought will
shift from Y2 to Y1, and the amount of good X bought to shift from X2 to X1. The opposite
effect will occur if the price of Y decreases causing the shift from BC2 to BC3, and I2 to I3.

If these curves are plotted for many different prices of good Y, a demand curve for good Y can
be constructed (price consumption curve). The diagram below shows the demand curve for
good Y as its price varies. Alternatively, if the price for good Y is fixed and the price for good X
is varied, a demand curve for good X can be constructed.
Income Effect
Another important item that can change is the money income of the consumer. The income effect
is the phenomenon observed through changes in purchasing power. It reveals the change in
quantity demanded brought by a change in real income. Graphically, as other things remain
constant, changing income will create a parallel shift of the budget line. Increasing the income
will shift the budget line right since more of both can be bought, and decreasing income will shift
it left.
Depending on the indifference curves, as income increases, the amount purchased of a good can
increase, decrease or stay the same. In the diagram below, good Y is a normal good since the
amount purchased increased as the budget constraint shifted from BC1 to the higher income
BC2. Good X is an inferior good since the amount bought decreased as the income increases.

Price effect as the sum total of the substitution and the income effects
Every price change can be decomposed into an income effect and a substitution effect; the price
effect is the sum of substitution and income effects.
The substitution effect is the change in demands resulting from a price change that alters the
slope of the budget constraint but leaves the consumer on the same indifference curve. In other
words, it illustrates the consumer's new consumption basket after the price change while being
compensated as to allow the consumer to be as happy as he or she was previously. By this effect,
the consumer is posited to substitute toward the good that becomes comparatively less
expensive. In the illustration below this corresponds to an imaginary budget constraint denoted
SC being tangent to the indifference curve I1. SC is referred to as compensating variation
(cv).It specifies how much less wealth the consumer needs to achieve the same maximum utility
at the new price as before the price change. That is, it tells us how much the consumer will have
to be compensated so as to stay on the same indifference curve. Conversely, equivalent
variation (EV) tells us how much more money the consumer would have needed yesterday so as
to be as well of as she is today. CV & EV will not be the same as they respond to different
issues. There is however one case where they will coincide, this will be possible if preferences
are quasi-linear.Then the income effect from the rise in purchasing power from a price fall
reinforces the substitution effect. If the good is an inferior good, then the income effect will
offset in some degree the substitution effect. If the income effect for an inferior good is
sufficiently strong, the consumer will buy less of the good when it becomes cheaper, a Giffen
good (commonly believed to be a rarity).

Slutsky Equation

The Slutsky equation (or Slutsky identity) in economics, named after EugenSlutsky relates

changes in Marshallian (uncompensated) demand  to changes in Hichsian (compensated)
demand, which is known as such since it compensates to maintain a fixed level of utility. There
are two parts of the Slutsky equation, namely the substitution effect, and income effect. In
general, the substitution effect is negative, the income effect maybe positive or negative
depending on whether the good is normal or inferior. He designed this formula to explore a
consumer's response as the price changes. When the price increases, the budget set moves
inward, this causes the quantity demanded to decrease. In contrast, when the price decreases, the
budget set moves outward, this leads to an increase in the quantity demanded. The equation
demonstrates that the change in the demand for a good, caused by a price change, is the result of
two effects:

 a substitution effect: the good becomes relatively cheaper, so consumers substitute it for
other goods
 an income effect: the purchasing power of consumer increases as a result of price
decrease, so consumers could now afford better products or more of the same products,
depending on whether the product itself is a normal good or an inferior good.
The Slutsky equation decomposes the change in demand for good i in response to a change in the
price of good j as follows:
∂ x i ( p ,w )/∂ p j=∂ hi ( pi , μ)/∂ p j −{∂ x i ( p ,w )/∂ w} x j ( p ,w )
Where h(p,u) is the Hicksian demand and x(p,w) is the Marshallian demand. The right hand side
of the equation is equal to the change in demand for good  i  holding utility fixed at u minus the
quantity of good  j demanded multiplied by the change in demand for good  i  when wealth
changes. The first term ( ∂h i ( p i , μ )/∂ p j is the substitution effect, while the second term
(∂ x i ( p,w )/∂w ) x j ( p,w ) is the income effect which could be positive or negative depending on
whether it is a nomal or Giffen good. The equations may be written in terms of elasticity as:
h
ε p, ij =ε p , ij−ε w , bj
ε p is the (uncompensated) price elasticity, ε hp is the compensated price elasticity, ε w,i the
b
income elasticity of good  i and i is the budget share of good j.
Giffen Goods
A Giffen good is a product that is in greater demand when the price increases, which are also
special cases of inferior goods. In the extreme case of income inferiority, the size of income
effect overpowered the size of the substitution effect, leading to a positive overall change in
demand responding to an increase in the price. Slutsky's decomposition of the change in demand
into a pure substitution effect and income effect explains why the law of demand doesn't hold for
Giffen goods.
Labor-Leisure Trade off (for diagrammatic representation, refer to class lectures)
The "labor-leisure" tradeoff is the tradeoff faced by wage-earning human beings between the
amounts of time spent engaged in wage-paying work (assumed to be unpleasant) and
satisfaction-generating unpaid time, which allows participation in "leisure" activities and the use
of time to do necessary self-maintenance, such as sleep. The key to the tradeoff is a comparison
between the wage received from each hour of working and the amount of satisfaction generated
by the use of unpaid time.
Such a comparison generally means that a higher wage entices people to spend more time
working for pay; the substitution effect implies a positively sloped labor supply curve. However,
the backward-bending labor supply curve occurs when an even higher wage actually entices
people to work less and consume more leisure or unpaid time.
As wages increase above the subsistence level (discussed below), there are two considerations
affecting a worker's choice of how many hours to work per unit of time (usually day, week, or
month). The first is the substitution or incentive effect. With wages rising, the tradeoff between
working an additional hour for pay and taking one extra hour of unpaid time changes in favor of
working. Thus, more hours of labor-time will be offered at the higher wage than the lower one.
The second and countervailing effect is that the hours worked at the old wage rate now all gain
more income than before, creating an income effect, which encourages more leisure to be chosen
because it is more affordable. Most economists assume that unpaid time (or "leisure") is a normal
good and so people want more of it as their incomes (or wealth) rise. Since a rising wage rate
raises incomes, all else constant, the attraction of unpaid time rises, eventually neutralizing the
substitution effect and causing the backward bend.
Assumptions
It is essential to understand that with the supply curve of labor, there must be assumptions set
which takes the curve's inevitable backward bending form. The assumptions for the theory of
labor supply are listed as follows:

 Workers choose whether they will work, and how many hours they will work. Labor
supply depends on the notion that workers choose how many output of time they will work.
If the workers choose not to work, that is essentially working leisure, in terms of time.
 There are no contractual obligations to work a certain number of hours. This is important
to understand because contractual obligations will involve the labor supply curve to be set,
and not on the basis of time worked.
 Workers are utility-maximizing agents. In terms of the economy, workers always want to
achieve the most amount of money or output they can receive.
 Work provides a disutility, which must be compensated for by paying wages.
 Unpaid leisure time is a normal good. The labor market is competitive, and both firms
and workers are price-takers.
 Wage received is a form of a reservation wage, as workers will have a certain required
amount of wage that can take them away from leisure. This sets an opportunity cost-
minimizing situation for the worker.

NB

1) Higher pay for overtime hours can reduce or negate the effect of a backward bending labor
supply curve, by increasing wages only for hours worked beyond a certain amount. Overtime
maintains the substitution effect at a high labor supply. However, the income effect from the
wages increasing on all the previous hours worked is eliminated. Thus, higher hourly overtime
pay can cause workers to work more hours than if the higher rate is paid on all hours.

2) Workers must have a willingness to want to work. Workers have a certain required amount of
wage that can take them away from leisure. This is known as the reservation wage. This sets an
opportunity cost-minimizing situation for the worker, as the worker will always want to receive
the most output they can. If not enough wage is offered to clear the reservation wage boundary,
the worker will not work and instead consume their utility with leisure.

3) Revealed Preference Theory

Preferences tell us how a consumer ranks some bundle compared to another bundle, and the
utility function representation tells us how much utility a consumer derives from different
bundles. Remember also that from a utility function we can create our indifference map, which
will later be crucial in choosing an optimal bundle. However, the bundles are not equally costly,
and some may be unavailable at the current prices and income. Hence, in order to understand
how a consumer chooses among different goods we need to take into account both – consumer
preferences and budget constraint. Simply put, given that a consumer faces a certain budget
constraint (i.e. he or she only has so many resources by which to attain goods), what bundle is
the affordable and utility maximizing?

In the absence of knowledge on consumer’s preference, the way the consumer makes choices in
different situation will help us understand her preferences. Through revealed preferences we can
establish if a consumer weakly prefers a bundle to another or if she strongly prefers one bundle
to another.
Assumptions of revealed preference theory

The revealed preference theory is based on the following assumptions:

i). Rationality:
The consumer is assumed to behave rationally in the sense that he prefers bundle of goods that
contains more quantities of the commodities. This assumption of rationality underlies all logical
explanations of consumer’s behavior.

ii). Consistency:
The revealed preference theory sets upon this basic assumption, which has been called as
consistency postulate. It can thus be stated, “no two observations of choice behavior are made
which provide conflicting evidence to the individual’s preference”.

In other words, if an individual chooses combination (or bundle) ‘A’ in one situation (given by
his budget constraint) in which bundle ‘B’ was also available to him, he will not choose
combination ‘B’ in any other situation (given by his new budget constraint) in which
combination ‘A’ is also available.

If he chooses combination ‘A’ rather than combination ‘B’ in one particular situation and
chooses combination ‘B’ rather than combination ‘A’ in another situation, when ‘A’ and ‘B’ are
present in both the situations, then he is not behaving consistently. Symbolically, if A > B, then
B > A.

That is, if combination ‘A’ is revealed to be preferred to combination ‘B’ (not expensive than
‘A’) by any individual, then combination ‘B’ cannot be revealed to be preferred to combination
‘A’ by him at any other time, when ‘A’ and ‘B’ are present in both the cases.
The postulate explained above is the exact logical equivalent of Hicks formulation of consistent
behavior in his Revision of Demand Theory. He calls it the ‘two term consistency’, since
comparison here is between two situations.

iii) Transitivity:
The assumption of transitivity is an application of the logical theory of ordering. Suppose, in a
particular situation, three bundles Z1, Z2 and Z3 of two commodities are available to a consumer.
If he prefers bundle Z1 to bundle Z2 and bundle Z2 to bundle Z3, then he must prefer bundle Z1 to
bundle Z3. Symbolically, if ‘A’ > ‘B’ and ‘B’ > ‘C’, then ‘A’ > ‘C’. Thus, the ordering has
always to be unit directional and never circular.

Properties of Preferences

Economic theory makes some fundamental assumptions on preferences. The latter are so
important that they are known as axioms of consumer theory.

1) Completeness. The individual is able to compare any two bundles in the consumption set. In
other words, she can say if she prefers one bundle to the other, or she is indifferent between the
two bundles.

2) Reflexivity. Any bundle is at least as good as itself

3) Transitivity. Taken three bundles, if the first is preferred to the second, and the second to the
third, then the first is preferred to the third.

Coupons vs cash subsidies

Occasionally governments and other institutions want to increase the consumption of aparticular
good. They can do this by issuing coupons, which can only be spent on the good ofinterest, or
through cash subsidies, which are lump sum payments that can be spent on anygood (but which
the issuer hopes will be spent on the good of interest).To isolate the good of interest, say
housing, we lump all other goods into a variable we referto as a composite good. A composite
good is simple a good which represents the collectiveexpenditures on every other good except
the commodity being considered.

Borrowing and Lending

So far we have considered the consumer’s income as fixed within a time period. However,this is
not always the case in the real world. Borrowing and lending is really a tradeoff in
consumption.In borrowing you consuming more today by consuming less tomorrow (loan is
consuming future incomes today). In lending you areconsuming less today so that you can
consume more tomorrow. But how does this affect ouroptimization problem?Without borrowing
and lending consume I1 today and I2 tomorrow (as we have consideredthus far)with borrow and
lending(allowing for)

• If you don’t consume anything today, then you have I2 + I1 (1+r) tomorrow becauseyou lent
some consumption today to be paid back with interest (1+r) tomorrow,where r=interest rate
earned by loaning the money

• If you don’t consume anything tomorrow, then you can consume:I1 + I2/(1+r) today by
borrowing

How to find a slope?

• Our x-axis here will be consumption today while the y-axis will representconsumption
tomorrow

• Intuitively, the price of giving up one unit of consumption tomorrow (y axis) in orderto gain
one more unit of consumption today (x axis) is measured by the opportunity costs of every
shilling, (1+r).

The Concept of Consumer Surplus:

CS= maximum willingness to pay for a good – price paid for good.i.e. how much better off the
consumer will be when he purchases the good.The area under a demand curve measure net
benefits for a consumer only if the consumerexperiences no income effect over the range of price
change.

Q denote quantity and P denote price,

Q = D(P) be the demand function,and the equilibrium quantity and price be Q0 and P0,
respectively.
¿
q

Then, consumer surplus (CS) is:

∫ ¿0 d(q)dq−p¿ q ¿ ¿
¿
q
¿ ¿
p q −∫ ¿ s( q)dq ¿
And the producer surplus (PS) is: 0

The sum of the consumer surplus and the producer surplus is the total gains from trade.
Suppose the demand for a product is given by p=d(q)=−0.8q+150p=d(q)=−0.8q+150 and the
supply for the same product is given by p=s(q)=5.2qp=s(q)=5.2q. For both functions, qq is the
quantity and pp is the price.

a) Find the equilibrium b) Find the consumer surplus at the equilibrium price, c) Find the
producer surplus at the equilibrium price.

Solutions

The equilibrium point is where the supply and demand functions are equal.
Solving −0.8q+150=5.2q−0.8q+150=5.2q gives q=25
25

The consumer surplus is:

∫ ¿0 ¿ (−0.8q+150)dq−(130)(25)=250

25

The producer surplus is:(130)(25)

∫ ¿0 ¿ − 5.2qdq=1625.