1.

0 CONSUMER DEMAND THEORY/ CONSUMER BEHAVIOR

CONSUMER EQUILIBRIUM (OPTIMAL CHOICE)
(a) Graphical analysis
A Consumer is in equilibrium when maximizing utility given market commodity prices and income.
This is achieved where the budget line is tangent to the highest possible indifference curve. That is, at the
DY MU X P
optimal choice, - = = MRS X ,Y = - 1
DX MU Y P2

The optimal choice of (X0Y0) at the set prices (P1P2) and income (M) is called consumer’s demanded bundle.
The tangency condition however does not hold at all cases at the optimal choice.
There are exceptional cases
a. Kinky tastes where two commodities are perfect implement.

b. boundary optimum- perfect substitutes: x1 = m/p1 if p1 < p2;

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The tangency condition of consumer equilibrium is a necessary but not a sufficient condition. Consider the
following case where tangency condition is satisfied,

To ensure that there is only one optimal choice on each budget line, IC must be strictly convex to the origin.

(b) mathematical/formal analysis

Consider a consumer consuming commodities X and Y whose utility function is given by,
U ( X , Y ) = XY
The prices of X and Y are P1 and P2 respectively and income M.
In equilibrium IC is tangent to the budget line hence their slope are equal
DU dU
MU X = = =Y
DX dX
Conversely,
DU dU
MU Y = = =X
DY dY
MU X Y P
= = 1
MU Y X P2
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If P1 and P2 equals 20 and 40 respectively and M=800
Y 20 1
= =
X 40 2
2Y = X
X = 2Y
OR ………………….………………………………………………. {1}
1
Y= X
2
But,
P1 . X + P2 .Y = M
20 X + 40Y = 800 ………………………………………………………… {2}
From {1} and {2},
20 X + 40Y = 800
20(2Y ) + 40Y = 800
40Y + 40Y = 800
80Y = 800
Y = 10 …………………………………………………………………….. {3}
Substituting {3} into {2},
X = 20 ………………………………………………………………… {4}

OPTIMAL CHOICE AND DEMAND

1. Effects of changes in price

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If X is giffen good,

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2. The effect of changes in income

If good Y is a normal good while good X is an inferior good

ENGELS CURVE

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Since the quantity demanded of X increases as income increases, commodity X is a normal good.
DEMAND FUNCTION
Demand function depends on both prices and income.
X = (P1 P2 M ) Demand function for good X
Y = (P1 P2 M ) Demand function for good X
Different preferences will lead to different demand functions.
DERIVATION OF DEMAND CURVE
a. Ordinary / uncompensated demand curve.

This analysis assumes that

D X = ( P1 P2 M )
b. Compensated/Hicksian demand curve
It derived on the assumption that price of the other good and utility is held constant.
hX = ( P1 P2 U )

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SUBSTITUTION AND INCOME EFFECR OF PRICE CHANGE (SLUTSKY EQUATION)
Changes in price of a good has two sorts of effects,
a. The rate of exchange of one good for other changes. For example if X becomes cheaper, more of it and less
of Y is bought (Substitution effect)
b. Purchasing power/real income changes e.g. if X becomes cheaper, a given money income can now buy more
of both X and Y than before (Income effect)
GRAPHICAL ANALYSIS OF SLUTSKY EQUATION
a. Substitution effect
Let price of X decreases and adjust money income so as to hold purchasing power constant.

As a result of the decrease in price of X, the budget line rotates around the original demanded bundle (X1Y1).
The increase in real income due to decrease in price of X is compensated by reducing money income so that the
consumer remains on the same IC.
b. Income effect
Let price of X decrease and allow purchasing power to vary.

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The movement from E1 to E3 is the income effect. The consumer is at equilibrium at E3.
In this case, good X is a normal good.
If good X is an inferior good,

Substitution effect=x1-x0=Positive
Income effect=x2-x1=negative
Total price effect=x2-x0=Positive
If good X is a Giffen good,

Substitution effect=x1-x0=Positive
Income effect=x2-x1=negative
Total price effect=x2-x0=Negative
DX = DX s + DX n
X 2 - X 0 = (X1 - X 0 ) + (X 2 - X1 )

X 2 - X 0 = X1 - X 0 + X 2 - X1

X2 - X0 = -X0 + X2

X2 - X0 = X2 - X0

FORMAL/MATHEMATICAL ANALYSIS OF SLUTSKY EQUATION

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Since the original bundle (X1Y1) lies on the rotated B.L. that bundle is just affordable. To keep (X1Y1) just
affordable, money income (M) must be adjusted.
Let,
M 1 =Income that will just let the original consumption bundle affordable.
( )
Since (X1Y1) is affordable at both (P1 P2 M ) and P11 P2 M 1 , we have,

M 1 = P11 X 1 + P2Y …………………………. {1}

M = P1 X 1 + P2Y1 ……………………………. {2}
The necessary change in money income so that the original bundle (X1Y1) is just affordable is given by,
{1}− {2}
M 1 - M = P11 X 1 + P2Y1 - P1 X 1 - P2Y1

M 1 - M = P11 X 1 - P1 X 1

M 1 - M = X 1 ( P11 - P1 )
DM = DPX 1 ……………………………. {3}.
DM and DP Must always move in the same direction

SUBSTITUTION EFFECT DX S ( )
( )
DX S = X 1 P11 M 1 - X (P1 M )
Where,
( )
X 1 P11 M 1 = New demand for X after price change and the consumer has been compensated for changes in real
income
X (P1 M ) = Original demand for X before the price change.
Numerical Example II
Suppose the consumer demand for good X is,
M
X = 10 +
10 P1
If M=120 and P1=3
120
X = 10 +
10(3)
120
X = 10 + = 10 + 4 = 14 Demand for X at X (P1 M )
30
If P1 falls to 2 i.e. P11 = 2 , demand at P11 will be
M
X 1 = 10 +
10 P1

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X 1 = 10 +
120
10(2)
= 10 +
120
20
= 10 + 6 = 16 Demand for X at X 1 P11 M( )
The change in money income necessary to make the original bundle just affordable when price decreases to 2
is,
DM = DPX 1
DM = (2 - 3)14 = -1914) = -14
Money income must be reduced by Sh14 in order to make the original bundle just affordable.
Thus the level of income necessary to keep real/purchasing power constant is,
M 1 = M + DM
M 1 = 120 + (-14) = 120 - 14 = 106

The consumer demand for X at price P11 and income M 1 is,

( )
X 1 P11 M 1 = X (2,106 )

M1
X 1 = 10 +
10 P11

X 1 = 10 +
106
10(2)
( )
= 10 + 5.3 = 15.3 .Demand for X at X 1 P11 M 1 = X (2,106 )

But,
( )
DX S = X 1 P11 M 1 - X (P1 M )

DX S = 15.3 - 14 = 1.3 [Substitution effect]

Income Effect
( )
DX n = X 1 P11 M - X 1 P11 M 1 ( )
Where,
( )
X 1 P11 M = Demand at new price and original money income
Increase in real income will increase the demand for good X if it’s a normal good and decrease its demand if
it’s an inferior good and vise versa.

( )
X 1 P11 M = X 1 (2,120 ) = 10 +
120
10(2)
= 10 + 6 = 16

( )
X 1 P11 M 1 = X 1 (2,106 ) = 10 +
106
10(2)
= 10 + 5.3 = 15.3

Thus,
( )
DX n = X 1 P11 M - X 1 P11 M 1 ( )
DX n = 16 - 15.3 = 0.7 > 0 hence good X is a normal good.

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TOTAL CHANGE IN DEMAND
( )
DX = X 1 P11 M - X (P1 M ) …………………………………… {1}

DX = DX S + DX n
( )
DX = X 1 P11 M - X (P1 M ) = [ X 1 ( P11 M 1 ) - X ( P1 M )] + [ X ( P11 M ) - X 1 ( P11 M 1 )] …………………….. {2}
$!!! !#!!!!
1

" $!!!!#!!!! "

DX S DX n

It can be re-written as follows,

( )
DX = X 1 P11 M - X (P1 M ) = X 1 ( P11 M 1 ) - X ( P1 M ) + X 1 ( P11 M ) - X 1 ( P11 M 1 )

( )
X 1 P11 M - X (P1 M ) = - X ( P1 M ) + X 1 ( P11 M )

X (P M ) - X (P M ) = X (P M ) - X (P M ) ………………………………………….. {3}
1
1
1
1
1
1
1
1

Equation {3} is the Slutsky Identity.

R. QN

1) a. A consumer has a demand function given as,

Q = 0.02M - 2 P .
Where,
P=commodity’s price
M=Consumers income
Currently price equals sh30 and income equals sh7500. If price increases to sh40, decompose the substitution
and income effect of price change and comment on the nature of the good in question

GOODS, BADS AND NEUTERS

i. Goods
‘Goods’ are goods and services which yields satisfaction.
ii. Bads
These are commodities, which yield disutility
iii. Neuters
Are commodities that yield neither utility nor disutility to the consumer
INDIFFERENCE MAPS FOR ‘GOODS’, ‘BADS’ AND NEUTERE
Consumers have to make their consumption basket/bundle of,
i. ‘Goods’ and ‘Goods’
ii. ‘Goods’ and ‘Bads’
iii. ‘Goods’ and Neuter
a. Indifference map for a ‘Good’ and a ‘Bad’
More of a ‘Good’ is always preferred to less of it and less of ‘Bad’ is preferred to more of it.

Since ‘Bads’ are often inseparable from ‘Goods’ if the society wants to have more of such goods, it will have to
accept more of ‘Bads’ as well.

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b. Indifference map for a ‘Good’ and a ‘Good’ turning ‘Bad’
Most consumer goods retain the property of a ‘Good’ only up to a certain point.
Thus beyond satiety point, less of such goods is preferred to more.

c. Indifference map for a ‘Good’ and a Neuter

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