Micro Cha 2-P1

HOPE ENTERPRISE UNIVERSITY COLLEGE
Faculty of Business
COURSE TITLE: Microeconomics I
COURSE CODE: Econ – 201
DEPARTMENT:
Accounting/Marketing/Management
LEVEL: Undergraduate
CREDIT HOURS: 3
ACADEMIC YEAR: 2024 G.C
Instructor Name: H . A
Phone Number:
SEMESTER II Feb 2024
Hope Enterprise University College
Hope Enterprise University
College
Theory of Consumer Behavior?
 Explains how consumers allocate their income
among d/t G+S to maximize their well-being
 Consumer behavior can

be best understood in 3
steps.
1. Consumer‘s preference
2. Budget constraints
3. Consumer choice.

 A consumer makes choices by comparing bundle of
goods.
 Given any two consumption bundles:
✓ The consumer either decides that one of the
consumption bundles is strictly better than the other,
or
✓ Decides that she is indifferent between the two
bundles.
 The symbol ≻ to mean that one bundle is strictly
preferred to another
 X≻Y interpreted as the consumer strictly prefers X
to Y Hope Enterprise University College
 If the consumer is indifferent between two bundles
of goods, use the symbol ∼ and write X~Y.
 Indifference means that the consumer would be just

as satisfied
 If the consumer prefers or is indifferent between the

two bundles we say that she weakly prefers X to Y
and write X ⪰ Y.

 Some Basic Assumptions about Preferences
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:-
I. A to B,
II. B to A, or
III. will be indifferent
between the two. Hope Enterprise University College
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.
Transitivity is normally
regarded as necessary
for consumer
consistency.

3. More is better than
less (Non-satiety):
 Goods are assumed
to be desirable (i.e.
to be good).
 Consumers always
prefer more of any
good to less.
 Consumers are never satisfied

 More is always better, even if just a little better.
Utility:
 Satisfaction/pleasure derived from the consumption
of a good or service.
 The power of the
product to satisfy
human wants.
 The consumer
definitely wants the
X-bundle than the Y-
bundle iff the utility
of X is better than the
utility of Y. Hope Enterprise University College
Utility’ Versus ‘Usefulness
 Utility’ and ‘Usefulness’ are not synonymous.
 Usefulness is product centric but utility is consumer
centric.
 Utility is subjective
The utility of a product will vary from person to
person.
 Utility can be d/t at d/t places and time
The utility that we get from drinking coffee early in
the morning may be d/t from the utility we get during
lunch time.
 Two major approaches to measure consumer‘s utility
1. Cardinal- The cardinalist school postulated utility
can be measured objectively
2. Ordinal: The ordinalist school, utility is not
measurable in cardinal numbers
 The ordinalist
school assumes
that consumer can
rank or order the
utility he derives
from d/t G+S
2.3.1 The cardinal utility theory
 Utility is measurable by arbitrary unit of
measurement called utils in the form of 1, 2, 3
etc.
 Example:
➢ We may say that consumption of an orange gives
Bilen 10 utils and a banana gives her 8 utils, and
so on.
➢ From this, we can assert that Bilen gets more
satisfaction from orange than from banana.
2.3.1.1 Assumptions of cardinal utility theory
1. Rationality of consumers: Maximize satisfaction
2. Utility is cardinally measurable:- utils
3. Constant marginal utility of money:
4. Diminishing marginal utility (DMU):
5. The total utility of a basket of goods depends on

the quantities of the individual commodities:

2.3.1.2 Total and Marginal utility
Total Utility (TU): Is the total satisfaction a consumer gets from
consuming some specific quantities of a commodity at a
particular time.
Marginal Utility (MU): Is
the extra satisfaction a
consumer realizes from an
additional unit of the Total utility = Sum of marginal utilities
product.
 It is the TU that results
from the consumption of
one more unit of a product.
Graphically:
 MU is the slope of TU
Mathematically, MU is:
 MU= ∆TU
∆Q
Where,
 ∆TU is the change in total utility, and
 ∆Q is the change in the amount of product
consumed.
 Hypothetical example:
➢ The relationship between TU and MU is shown as

follows:- Hope Enterprise University College
Quantity Total utility Marginal utility
(TU) (MU)
0 0 -
1 10 10
2 18 8
3 24 6
4 28 4
5 30 2
6 30 0
7 28 -2
Table: Total and marginal utility Hope Enterprise University College
 The total utility first increases, reaches the maximum
(when the consumer consumes 6 units)
 Then declines as the quantity consumed increases.
 The MU continuously declines (even becomes zero
or negative) as quantity consumed increases.

 Graphically, the above data can be depicted as below
TU The figure shows:
➢ When TU is increasing,
30 MU is positive.
Figure: Total and marginal utility curves
➢ When TU is maximized,
TU
MU is zero.
18 ➢ When TU is decreasing,
MU is negative.
0
MU 2 6 Quantity
Consumed
0 2 6 Quantity
Consumed
2.3.1.3 Law of diminishing marginal utility (LDMU)
 States that as the quantity consumed of a
commodity increases per unit of time, the utility
derived from each successive unit decreases,
consumption of all other commodities remaining
constant.
 The extra satisfaction that a consumer derives
declines as he/she consumes more and more of the
product in a given period of time.
 The 1st banana a person consumes gives him more
MU than the 2nd & the 2nd banana also gives him
higher MU than the 3rd & . . .(see the previous figure )
1 Hope Enterprise University
28 College
30
2
 The LDMU is based on the following assumptions.
1. The consumer is rational
2. The consumer consumes identical or homogenous

product.
3. The commodity to be consumed should have

similar quality, color, design, etc.
4. There is no time gap in consumption of the good
5. The consumer taste/preferences remain

Hope Enterprise unchanged
University College
2.3.1.4 Equilibrium of a consumer
 The objective of a rational consumer is to maximize
total utility.
 As long as the additional unit consumed brings a

positive MU, the consumer wants to consumer more
of the product because TU increases.
 However, given his limited income and the price

level of G+S, what combination of G+S should he
consume so as to get the maximum total utility?

a) The case of one commodity
 The equilibrium condition of a consumer that
consumes a single good X occurs when the MU of X
is equal to its market price.
MUx = Px
Proof
 Given the utility function:
U = f (X)
 If the consumer buys commodity X, then his
expenditure will be QxPx Hope Enterprise University College
 The consumer maximizes the difference
between his utility and expenditure.
Max (U-QxPx)
 The necessary condition for maximization is
equating the derivative of a function to zero.
 Thus,
dU dQxPx
= =0
dQx dQx
dU
-Px = 0 MUx = Px
dQx
Figure: Equilibrium condition of
MUx
.A consumer with only one commodity
Px .C
. B
MUx
Qx
• At any point above point C (like point A) where MUX

> PX, it pays the consumer to consume more.
• When MUX < PX (like point B), the consumer should
consume less of X.
• At point C where MUx = Px the consumer is at
equilibrium. Hope Enterprise University College
b) The case of two or more commodities:
 The consumer‘s equilibrium is achieved when the
MU per money spent is equal for each good
purchased and his money income available for the
purchase of the goods is exhausted.
MUx MUy MUN

= = ...
Px Py PN
and
PxQx+PyQy + . . . PNQN =M
Where,
M is the income
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Enterprise University consumer
College
Example:
❑Suppose Saron has 7 Birr to be spent on two

goods: Banana and Bread.
❑The unit price of Banana is 1 Birr and the unit

price of a loaf of Bread is 4 Birr.
❑The total utility she obtains from consumption

of each good is given below.
Income = 7br, Price of banana = 1brrr, Price of
bread = 4 Birr
Banana Bread
Quantity TU MU MU/P Quantity TU MU MU/P
0 0 - - 0 0 - -
1 6 6 6 1 12 12 3
2 11 5 5 2 20 8 2
3 14 3 3 3 26 6 1.5
4 16 2 2 4 29 3 0.75
5 16 0 0 5 31 2 0.5
6 14 -2 -2 6 32 1 0.25
Table: Utility schedule for two commodities
Q. Which combination of the 2 goods will maximize Saron’s
TU?
Solution
MU1 MU2
1). Utility is maximized at: =
P1 P2
 In the table, there are 2 d/t combinations of the 2

goods where the MU of the last birr spent on each
commodity is equal.
 But, only one of the two combinations is consistent
with the prices of the goods & her income.
 Saron will be at equilibrium when she consumes 3
units of banana and 1 loaf of bread.
 At this equilibrium:-
MU1 MU2 MUBanana 12
= MUBread 3
= = =3
P1 P2 PBanana 1 4
PBread
II). P1Q1+P2Q2 = M 1*3 + 4*1 = 7

 The total utility that Saron derives from this
combination can be given by:-
TU = 14 + 12 = 26
 Given her fixed income and the price level of the two
goods, no combination of the two goods will give her
higher TU than this level of utility.
Limitation of the cardinal approach
I. The assumption of cardinal utility is
doubtful because utility may not be
quantified. Utility cannot be measured
absolutely (objectively).
II. The assumption of constant MU of money is

unrealistic because as income increases, the
marginal utility of money changes.

2.3.2 The Ordinal Utility Theory/Approach:
 It is not possible for consumers to express the utility
of various commodities they consume in absolute
terms, like 1 util, 2 utils, or 3 utils
 The consumer express the utility in relative terms.
 The consumers can rank commodities in the order of
their preferences as 1st, 2nd, 3rd and so on.
 The consumer need not know in specific units the
utility of various commodities to make his choice.
 Consumers rank the various baskets of goods
according to the satisfaction that each bundle gives
him Hope Enterprise University College
2.3.2.1 Assumptions of ordinal utility theory
➢ Consumers are rational - they maximize their
satisfaction or utility.
➢ Utility is ordinal-utility is not absolutely
(cardinally) measurable. Ordered or ranked.
➢ Diminishing MRS - DMRS:
✓ The MRS is the rate at which a consumer is willing
to substitute one commodity for another commodity
so that his total satisfaction remains the same.
✓ The rate at which one good can be substituted for
another in consumer‘s basket of goods diminishes as
the consumer consumes more and more of the good.
➢ The total utility of a consumer is measured by the
amount (quantities) of all items he/she consumes
from his/her consumption basket.
➢ Consumer’s preferences are consistent.
▪ Ex: If there are three goods in a given consumer‘s
basket, say, X, Y, Z and if he prefers X to Y and Y to
Z, then the consumer is expected to prefer X to Z.
▪ This property is known as axioms of transitivity.
 The ordinal utility approach is explained with the
help of indifference curves.
 This theory is also known as the indifference curve
approach. Hope Enterprise University College
2.3.2.2 Indifference set, curve and map
a). Indifference set/ schedule:
 Is a combination of goods for which the consumer is
indifferent.
 The various combinations of goods from which the
consumer derives the same level of satisfaction.
 Consider a consumer who consumes two goods X
and Y (see the following table). Table: Indifference schedule
Bundle A B C D
(Combination)
Orange – X 1 2 4 4
Banana - Y 10 6 3University College 1
Hope Enterprise
 Each combination of good X and Y gives the
consumer equal level of total utility.
 The individual is indifferent whether he consumes
combination A, B, C or D.
b). Indifference curve:
 It is the graphical representation of indifference
set/schedule
 An indifference curve shows different combinations
of two goods which yield the same utility (level of
satisfaction) to the consumer.
c). Indifference map:
 A set of indifference curves-indifference map.
Banana Banana
10 A
B
6
C IC3
3
D
1 IC2
IC1
0
1 2 4 7 Orange
Orange
I) Indifference curve II) Indifference map
Figure: Indifference curve and indifference mapUniversity College

Hope Enterprise
2.3.2.3 Properties of indifference curves
1. Indifference curves have negative slope (downward
sloping to the right). B/s as the quantity of one commodity
is increased the quantity of the other must be decreased.
2. Indifference curves are convex to the origin. The slope of
an indifference curve decreases as we move along the curve
from the left downwards to the right. The convexity of
indifference curves is the reflection of the DMRS.
3. A higher indifference curve is always preferred to a
lower one. The further away from the origin an indifferent
curve lies, the higher the level of utility it denotes.
4. Indifference curves never cross each other (cannot
intersect). The assumptions of consistency and transitivity
will rule out the intersection of indifference curves.
 Intersection of indifference curves violates the assumptions of
preferences.
➢ The consumer prefers bundle B to bundle C.
➢ The consumer is indifferent between bundle A & C at IC1
Good Y
➢ The consumer is indifferent between

bundle A & B at IC2
A
B ➢ By transitivity, this implies that the
IC2 consumer is indifferent between
C
bundle B and C which is
IC1
contradictory or inconsistent with the
initial statement where the consumer
prefers bundle B to C.
Good X
➢ Therefore, indifference curves never
Figure: Intersection of indifference curves crossHope
each other.
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2.3.2.4 Marginal rate of substitution (MRS)
 A rate at which consumers are willing to substitute

one commodity for another.
 It is the amount of one good that a consumer requires

as compensation to give up one unit of the other
good.
 A consumer‘s willingness to substitute one good for

another while he/she is indifferent b/n the bundles.
 The slope at any point on an indifference curve is the
MRS
 MRS of X for Y is defined as the number of units of
commodity Y that must be given up in exchange for
an extra unit of commodity X so that the consumer
maintains the same level of satisfaction.
 Since one of the goods is reduced to obtain more of

the other good, the MRS is negative.
 We usually take the absolute value of the slope.

Number of units of Y given up ∆Y
MRSX,Y = =
Number of units of X gained ∆X
 Consider the below indifference curve (Example 1):-
Movement MRSX,Y =
Good Y
from A to D ∆Y/∆X
30 A A to B 2.0
20 B B to C 1.6
C C to D 0.8
12
D
8 IC
0
5 10 15 20
Good X
Figure: Indifference curve for 2 products X & Y
❖ For the same increase in the consumption of good X, the
amount of good Y the consumer is willing to scarify
diminishes.
❖ This principle of MRS is reflected by the convex shape of the
indifference curve and is called diminishing MRS.
Movement MRSX,Y
A to D = ∆Y/∆X
A to B 2.0
B to C 1.6
C to D 0.8
Figure: Indifference curve for 2 products X & Y Hope Enterprise University College
 Possible to derive MRS using MU concept
 MRSX,Y related to MUx and MUy as follows
MUx
MRSX,Y = MUy
Proof: Suppose the utility function for two
commodities X and Y is defined as: U = f (X,Y)
 Since utility is constant along an indifference curve,
the total differential of the utility function = zero.
∂U ∂U
du = dx + dy = 0 Muxdx + Muydy = 0
∂x ∂y
MUx dy Similarly, MUy dx
=- = MRSX,Y = -University
dy
= MRSy,x
MUy dx MUx
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Example: Suppose a consumer‘s utility function is
given by U (x,y) = (X4Y2). Find MRSX,Y
Solution:
∂U
MUx= = 4X3Y2
∂x
∂U
and MUy= = 2X4Y
∂y
4X3Y2 2Y
MUx =
Hence, MRSX,Y =
MUy
=
X
2X4Y
Example of MRS- for Coffee & Cigarette
Commodities Case
Figure: MRS of Commodity X (Cigarette) and Commodity

Hope Enterprise Y (Coffee)
University College
2.3.2.5 The budget line or the price line
Why the budget line?
 Indifference curves:
✓ only tell us about consumer preferences for any two
goods
✓ cannot show which combinations of the two goods
will be bought.
✓ not tell us whether a given combination of goods is
affordable to the consumer
 In reality, the consumer is constrained by his/her
income and prices of the two commodities.
 This constraint is captured by the budget
Hope Enterprise line/price
University College line
The budget line: Definition?
✓ Is a set of the commodity bundles that can be
purchased if the entire income is spent.
✓ A graph which shows the various combinations of
two goods that a consumer can purchase given
his/her limited income & the prices of the two goods.
 People consume less than
they desire because their
spending is constrained,
or limited, by their
income.
 Assumptions to draw a budget line:
1. Only 2 goods bought in quantities (X & Y).
2. Each consumer is confronted with market
determined prices, Px and Py
3. The consumer has a known & fixed money income
(M).
 Assuming that the consumer spends all his/her
income on the two goods (X and Y)
 The budget constraint can be express the as:
M = Px X + Py Y
 Hence,
➢the general equation of a budget line is:-
M Px
Y= - X
Py Py
Graphically: Note that:
Good Y • The slope of the budget line
is given is by – Px Py
M/Py
.B (the ratio of the prices of the
.A two goods)
• Any combination of
the two goods
Figure: The budget line M/P Good X
x
within the budget
• Any combination of the two line (such as point
goods outside the budget line A) or along the
(such as point B) is budget line is
unattainable (unaffordable). Hopeattainable.
Enterprise University College
Example:
 A consumer has ETB 100 to spend on two goods X
and Y with prices ETB 3 and ETB 5 respectively.
a) Derive the equation of the budget line and
b) Sketch the graph.
Solution:
a). The equation of the budget line can be derived as
follows. M = P xX + Py Y 100 = 3X + 5Y
100-3X = 5Y
Y= (100/5)-(3x/5)
Y= 20-(3/5)x
b). Graphically:-  Sketch the graph of
 When the consumer
the budget line using
spends all of her income
on good Y, we get the Y- these two points
intercept (0, 20).
Y
M/Py
 When the consumer = 20
spends all of her income
on good X, we obtain the
X- intercept (33.3,0).
X
33.3
= M/Px
Factors Affecting the Budget Line
1. Change in income
affect the budget line

2. Change in prices

1. Change in income:
 If the income of the consumer changes (keeping
prices of the commodities unchanged), the budget
line also shifts (changes).
Good Y
M/Py
M/Px Good X
Hope
Fig: Effects of increase (right) and decrease (left) in income Enterprise
on the University College
budget line
 Increase in income causes an upward/outward shift
in the budget line that allows the consumer to buy
more G+S
 Decreases in income causes a downward/inward
shift in the budget line that leads the consumer to
buy less quantity of the two goods.
Figure: Effects of increase (right) and
Good Y decrease (left) in income on the budget line
 The slope of the

budget line (the M/Py
ratio of the two

prices) does not
change when
income rises or falls. M/Px
Hope Enterprise University College Good X
2. Change in prices:
 An equal increase in the prices of the two goods shifts the
budget line inward.
 Since the two goods become expensive, the consumer can
purchase the lesser amount of the two goods.
Good Y
M2/Py
 An equal decrease in the M2 > M > M1
prices of the two goods
M/Py
shifts the budget line out B2
ward.
M1/Py
B
 Since the two goods
become cheaper, the B1
Good X
consumer can purchase the
M1/Px M/Px M2/Px
more amounts of the two
Figure: Effect of proportionate increase (inward)
goods. Hope Enterprise
and decrease (outUniversity
ward) inCollege
the prices of both goods
2. Change in prices . . .
 An increase or decrease in the price of one of the two
goods, keeping the price of the other good and
income constant, changes the slope of the budget line
by affecting only the intercept of the commodity
that records the change in the price.

2. Change in prices . . . Good Y
 Ex: If the price of good X decreases
while both the price of good Y and
consumer‘s income remain unchanged,
the horizontal intercept moves outward
Good X
and makes the budget line flatter. Figure: Effect of decrease in the price
of only good X on the budget line
 The reverse is true if the price of good X

increases. Good Y
 If the price of good Y decreases while

both the price of good X and consumer‘s
income remain unchanged, the vertical
intercept moves upward and makes the
budget line steeper.
Good X
 The reverse is true for an increase in the Figure: Effect of decrease in the price
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University
only good College
price of good Y. Y on the budget line
Optimum/Equilibrium of the consumer
 The preferences of a consumer are indicated by the
indifference curve.
 The budget line specifies
d/t combinations of 2
goods the consumer can
purchase with the limited
income.
 A rational consumer tries
to attain the highest
possible indifference
curve, given the budget Figure: Consumer equilibrium under
line. indifference curve approach
Optimum/Equilibrium of the consumer . . .
 This occurs at the point where:
✓ the indifference curve is tangent to the budget line
✓ so that the slope of the indifference curve (MRSxy)
is equal to the slope of the budget line (Px/Py).
 The equilibrium of the
consumer is at point E
where the budget line
is tangent to the
highest attainable IC2.

Optimum/Equilibrium of the consumer . . .
 Mathematically:-
➢ Consumer optimum (equilibrium) is attained at the
point where:
Slope of indifference curve = Slope of the budget

Px
line=
MRSX,Y
Py
MUx
= Px
MUy
P
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y University College
Example:
 A consumer consuming two commodities X and Y
has the utility function U(X,Y) = XY +2X.
 The prices of the two commodities are 4 birr and 2
birr respectively.
 The consumer has a total income of 60 birr to be
spent on the two goods.
 Find the
a) utility maximizing quantities of good X and Y.
b) MRSx,y at equilibrium.

Solution
a) The budget constraint of the consumer is given by:
M = PxX + PyY 60 = 4X + 2Y. . . . . . . . . (1)
• Moreover, at equilibrium
MUx Y+2 4 Y+2 =2

Px
= =
MUy Py X 2 X
Y=2X-2 . . . . . . . . . . (2)
Substituting equation (2) into (1), we obtain Y=14 and

X = 8. Hope Enterprise University College
b) MRSx,y: has two options
Option 1)
MUx Y+2 14+2
MRSx,y = = = =2
MUy X 8
Option 2):
 At the equilibrium MRS is the ratio of the prices of

the two goods
Px 4
MRSx,y = = =2
Py 2
Effects of Changes in Income and Prices on
Consumer
A. Changes In Income: ICC and the Engel Curve
 An increase in the consumer’s income (all other

things held constant) results in an upward parallel
shift of the budget line.
 This allows the consumer to buy more of the two

goods.
 When the consumer’s income falls, ceteris paribus,

the budget line shifts downward, remaining parallel
to the original one.
Effects of Changes in Income & Prices on Consumer…
 Connect all of the points representing equilibrium
market baskets corresponding to all possible levels of
money income
➢Income consumption curve (ICC) or
➢Income expansion curve (IEC)
 The ICC is a curve joining the points of consumer

optimum (equilibrium) as income changes (ceteris
paribus).
or
 It is the locus of consumer equilibrium points
resulting when only the consumer’s income varies.
Figure: the income –consumption and the Engle curves

The Engle Curve:
 The Engle Curve: derived from the ICC
 It is the r/ship between the equilibrium quantity

purchased of a good and the level of income.
 It shows the equilibrium (utility maximizing)

quantities of a commodity, which a consumer will
purchase at various levels of income; (celeries
paribus) per unit of time.
Good
Normal/Superior Inferior
 If normal commodities:
✓ the income consumption curve and its Engle curve

are positively sloped
✓ meaning that more of the goods are purchased at

higher levels of income.
 If commodities are inferior:
✓ the ICC and Engle curve is negatively sloped
✓ I.e. their purchase decreases when income increases.

M3/Py
M3/Py
M2/Py
M2/Py
M1/Py
M1/Py
M1/Px M2/Px M3/Px M1/Px M2/Px M3/Px
Figure: income consumption curve
• Ex: in the above figure good Y is a normal good while good X is a normal
good until the person’s level of income reaches M2
• When income increases beyond M2, the person will buy less of good X as
his income increases.
• Good X is a normal good Up to point A and becomes an inferior good as
the ICC bends backward
A. Changes in Price: Price Consumption Curve
(PCC) and Individual Demand Curve
 The change in the price of x will result in out ward
shift of the budget line that makes the consumer to
buy more of good x.
 Connect all the points representing equilibrium
market baskets corresponding to each price of good
X we get a curve called PCC.
 PCC is the locus of the utility-maximizing
combinations of products that result from variations
in the price of one commodity when other product
prices, the money income- other factors are held constant
.
 The demand curve of an individual derived for a
commodity from the PCC.
Px1 to Px2 to Px3
 Below is an illustration of deriving the demand curve
when price of commodity X decreases from
Figure: the PPC and derivation of the demand curve

Mathematical derivation of equilibrium

 Suppose that the consumer consumes two
commodities X and Y given their prices by spending
level of money income M.
 The objective of the consumer is:
➢maximizing his utility function
➢subject to his limited income and market prices
 Objective function: The function that the consumer

tries to achieve in maximizing utility
 Constraint function: Represents the constraint that

the consumer faces
 The maximization problem will be formulated as

follows:
MaximizeU = f ( X , Y )
Subject to PX X + PY Y = M
• Multiplying the constraint by Lagrange multiplier 
• Forming a composite function gives as the Lagrange function:
 = U ( X , Y ) +  ( M − PX X + PY Y )
 The first order condition requires that the partial

derivatives of the Lagrange function with respect to
the two goods and the langrage multiplier be zero.
 U  U 
= − PX = 0 ; = − PY = 0 and = −( PX X + PY Y − M ) = 0
X X Y Y 
 From the above equations we obtain:

U U
= P and = P and U
= MU and
U
= MU Y
X Y
X Y
X Y
X
 Therefore, substituting and solving for we get the

equilibrium condition:
MU X MU Y
= =
PX PY
 By rearranging we get:
MU X P
= X
MU Y PY
 The second order condition for maximum requires

that the second order partial derivatives of the
Lagrange function with respect to the two goods
must be negative.
 2 U 2  2 U 2
=  0 and = 0
X 2
X 2
Y 2
Y 2
Example:
 A consumer consuming two commodities X and Y

has the following utility function U = XY + 2 X
 If the price of the two commodities are 4 and 2

respectively and his/her budget is birr 60.
a) Find the quantities of good X and Y which will

maximize utility
b) What will the consumer’s optimal utility level be?
c) Find the MRS X ,Y at optimum.

Solution
 The Lagrange equation will be written as follows:
 = XY + 2 X +  (60 − 4 X − 2Y )

= Y + 2 −  4 = 0 …...... (1)
X

= X −  2 = 0 …..…...... (2)
Y
 ………...... (3)
= 60 − 4 X − 2Y = 0

 From equation (1) we get Y + 2 = 4
 And from equation (2) we get X = 2

Y +2
 Thus, we can get that X =
2
 And equation (2) gives as  = 1 X

2
 By substituting X = Y + 2 into equation (2) we get:
2
MU X
MRS X ,Y =
MU Y
Y +2
=
X
 After inserting the optimum value of Y=14 and X=8
b). The optimal value of U is where Y=14 and X=8
= (8)(14) + 2(8) = 112+16 = 128
U = XY + 2 X
c). The MRS at optimum equals to the price ratio of the
X ,Y
P 4
two goods P 2 = 2)
( = X
Y

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HOPE ENTERPRISE UNIVERSITY COLLEGE

 Consumer behavior can

Hope Enterprise University College

 Indifference means that the consumer would be just

 If the consumer prefers or is indifferent between the

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Hope Enterprise University College

 Consumers are never satisfied

2. Utility is cardinally measurable:- utils

3. Constant marginal utility of money:

4. Diminishing marginal utility (DMU):

5. The total utility of a basket of goods depends on

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➢ The relationship between TU and MU is shown as

(when the consumer consumes 6 units)

 Then declines as the quantity consumed increases.

 The MU continuously declines (even becomes zero

or negative) as quantity consumed increases.

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1. The consumer is rational

2. The consumer consumes identical or homogenous

3. The commodity to be consumed should have

4. There is no time gap in consumption of the good

5. The consumer taste/preferences remain

 As long as the additional unit consumed brings a

 However, given his limited income and the price

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• At any point above point C (like point A) where MUX

MUx MUy MUN

❑Suppose Saron has 7 Birr to be spent on two

❑The unit price of Banana is 1 Birr and the unit

❑The total utility she obtains from consumption

 In the table, there are 2 d/t combinations of the 2

II). P1Q1+P2Q2 = M 1*3 + 4*1 = 7

II. The assumption of constant MU of money is

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I) Indifference curve II) Indifference map

Figure: Indifference curve and indifference mapUniversity College

➢ The consumer is indifferent between

 A rate at which consumers are willing to substitute

 It is the amount of one good that a consumer requires

 A consumer‘s willingness to substitute one good for

 Since one of the goods is reduced to obtain more of

 We usually take the absolute value of the slope.

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Figure: MRS of Commodity X (Cigarette) and Commodity

affect the budget line

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 The slope of the

ratio of the two

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 The reverse is true if the price of good X

 If the price of good Y decreases while

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➢ Consumer optimum (equilibrium) is attained at the

Slope of indifference curve = Slope of the budget

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M = PxX + PyY 60 = 4X + 2Y. . . . . . . . . (1)

MUx Y+2 4 Y+2 =2

Substituting equation (2) into (1), we obtain Y=14 and

 At the equilibrium MRS is the ratio of the prices of

 An increase in the consumer’s income (all other

 This allows the consumer to buy more of the two

 When the consumer’s income falls, ceteris paribus,

II). P1Q1+P2Q2 = M 13 + 41 = 7