Lecture one

THEORY OF CONSUMER BEHAVIOR

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 INTRODUCTION
• The theory of consumer behavior is the concern of
how consumers decide on the basket of goods and
services they consume in order to maximize their
satisfaction.

• The theory of demand starts with the examination of

the behavior of the consumer, since the market
demand is assumed to be the summation of the
. 2
 SOME BASIC CONCEPTS of CB

• CONSUMER: - A decision making unit (an

individual or a household) who uses or consumes a
commodity or service.
• RELATIVITY OF UTILITY: - The utility of a
commodity is subjective to a person’s need. It is not
absolute (objectively determined).
• UTILITY AND MORAL VALUES: - Utility is
free from moral values. 3
 Cont…

Eg: eating a food item which may be immoral in a

society yields utility as long as it satisfies hunger.

It is also the case that utility is “ethically neutral”

between good and bad, and harmful and useful. For

example, drug.

UTILITY:-The power of a commodity to satisfy

human wants. . 4
 Cont…
It is the satisfaction or subjective pleasure that one

gets from consuming a good or service.

What is utility?

Utility describe the expected satisfaction or enjoyment

derived from the consumption of a good or service.

. 5
 Cont..
Properties Of Utility
A.‘Utility’ and ‘Usefulness” are not synonymous.
– E.g. Paintings by Picasso may be useless
functionally but offer great utility to art lovers.
– Hence, usefulness is product centric whereas
utility is consumer centric.
B. Utility is subjective: The utility of a product will
vary from person to person.
. 6
 Cont…
– For example, non-smokers do not derive any
utility from cigarettes

C. The utility of a product can be different at

different places and time.
– Utility from eating meat is zero during fasting

7
 Major assumptions of TCB
1. The consumer is rational: - given his/her income and the
market price of the commodities, he/she plans the spending
of his/her income.
2. The goal of the consumer is to maximize his utility
3. The non-satiation assumption (more is better than less)…
Utility decreases as a consumer moves further away from
the best combination
4. The consumer has complete knowledge of all the
information relevant to his/her
.
decision; price, income
 Approaches to consumer optimum

• Two approaches of showing consumer optimum

– Cardinal utility theory

– Ordinal utility theory

• Major difference is the assumption that utility can/

can not be measured in absolute / cardinal numbers.

1. Cardinal Utility Approach

• This school postulates that utility can be
measured in absolute terms.
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 Assumptions CUT
A. Rationality

B. Cardinal Utility: The utility of each commodity is measurable and the most

convenient unit of measurement is money.

C. Constant Marginal Utility of Money.

– The essential feature of a standard unit of measurement is that it is consistent.

D. Limited money income of the consumer and all is income is spent in the

consumption process.

– That is, saving gives no positive utility to the consumer.

E. Diminishing Marginal Utility (DMU).

– The utility derived from each successive units of a commodity diminishes. .

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 Cardinal Utility (cont…)
F. Total utility depends on the quantity of the commodities consumed.
– If there are n commodities in the bundle with quantities X1, X2, X3 …… Xn the total utility is then

– U = f (X1, X2, X3 ……. Xn).

G. Utility is also additive, i.e., Total Utility (TU) = U (X1) + U (X2) +U (X3) ……+U ( Xn )

Total and Marginal Utility

• Total Utility: refers to the total amount of satisfaction a consumer

gets from consuming or possessing some specific quantities of a

commodity at a particular time.

• If a consumer consumes 4 units of a commodity and derives U1, U2,

U3 and U4 from the successive units consumed,

• Then TU = U1+U2+U3+U4. . 11
 Cardinal Utility (cont…)
• Marginal Utility (MU) : Total utility derived from, the last
unit of a commodity consumed.
• It is the change in the total utility resulting from a unit
change in commodity consumed
• It is the slope of total utility function,
• MU = TU/ Q
– TU = Change in Total Utility
– Q = Change in quantity consumed
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Cardinal Utility (cont…)
• Utility Schedule for banana

Quantity of 0 1 2 3 4 5
Banana
Consumed

Total 0 3 8 10 11 11
Utility (TU)

Marginal Utility - 3 5 2 1 0
(MU)

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Graphical representation of total utility

TU
1
2 0
11
8 3

6 5

4
2

O 1 2 3 4 5
.
Quantity 14
Graphical representation of total utility

TU

11
8
TU
6
4
2

O 1 2 3 4 5
.
Quantity 15
 Marginal Utility (cont…)

Utility

Marginal utility

0 5
Quantity
. 16
 The Law Diminishing Marginal Utility:

States that as the quantity consumed of a commodity

increases, the utility derived by the consumer from the
successive units decreases, ceteris paribus.
This law stems from the facts that:-
• The utility derived from a commodity depends on the
intensity of the need for that commodity
• As more and more quantity of a commodity is consumed the
intensity of desire decreases and therefore, the utility
derived at the margin decrease.
.
17
Consumer’s Equilibrium: One Commodity Case

Suppose the consumer’s utility function is given as:

U=f(x) and his/her total income spent (expenditure)
on commodity X –Total Expenditure would be: TE=
Where Qx is amount of commodity x and Px is price
of good X.
• The consumer would like to maximize the
difference b/n the utility and expenditure.
 Cont..
The problem is a simple maximization of the function.
• Max (U – TE) or U – Px Qx

• Two conditions must be fulfilled

– Necessary Condition (F.O.C)....................MU=Px

– Sufficient Condition (S.O.C)....................M=E

• The necessary condition (First Order Condition) for maximum,
require that the derivative of the function with respect to
independent variable (Qx) must be equal to zero.
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 Max (U – TE) or
U – PxQx
dU

d (Q X PX )
0
 MUx - Px =0
dQ X dQ X

MU X  PX MUx
1
Px
At optimal point:
1. the equilibrium condition of a consumer that consumes a single good X
occurs when the marginal utility of X is equal to its market price and
2. the whole income has been spent or Total Expenditure =Total Income

Utility

Px (Mum)
E

MUx

X Quantity of X
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• If MUx > Px, the consumer can increase his/her
welfare by purchasing more unit of X, and
• if the MUx < Px, welfare can be increased by
reducing the consumption of X.

. 21
 Consumers Equilibrium: More Than Two Commodities

• In the case there are more commodities, the

condition for optimality of the consumer is the
equality of the ratios of MU of the individual
commodities to their prices

MU X 1 MU X 2 MU X n
  .........   MU m
PX1 PX 2 PX n
And Total expenditure = total income
22
 cont.…

a. Determine the optimum combinations of three goods consumed by

the consumer when income is 130 also px is 2, py is 6 and pz=10 .

b. Compute total utility

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 Limitations of the Cardinal approach

a) The assumption that utility is a cardinal

concept (utility is objectively measurable) is
doubtful.
– Utility is a subjective concept, which
cannot be measured objectively.

b) The assumption of constant marginal

utility of money is also unrealistic..
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 Cont…
c) The psychological law of diminishing marginal
utility has been established from introspection
d) The cardinal utility approach is on the basis of
Ceteris Paribus assumption.

As a result it ignores the substitution and income

effect.

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 Ordinal Utility Approach

The ordinalist school argue that utility is not

cardinally measurable,
• It is ordinal in magnitude.
• The consumer may not know the specific unit of
utility derived from different commodity.
• He is able to rank or order different basket of goods
• The modern theory of consumer’s behavior is on the
basis of consumers preference
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 Ordinal Utility (Cont…)
What is preference?
• It shows choice of the consumer and it has three types
– Strict preference …..one is preferred over the other

– Weak preference….one is sometimes preferred and

sometimes treated as same
– Indifference ...…the consumer treats them as same
• Given any two consumption bundles, the consumer may
choose or prefer one of the consumption bundles over the
other. Or May be indifferent in choosing one over the other.
27
 Ordinal Utility (Cont…)

a) Strict preference
B) Weak preference

C) Indifference

(Y1 , Y2 )  ( X 1 X 2 ) …………………….. Strict Preference

(Y1 , Y2 )( X 1 X 2 ) …………………….. Weak Preference
(Y1 , Y2 )  ( X 1 X 2 ) ………… …Indifference

28
 Other Properties of preference
• Completeness: any two bundles can be compared by
a consumer

• Transitivity: if A is preferred to B and B is preferred to C

then, A is preferred to C.

• More is better than less: Non satiation assumption

• Reflexive Behavior: Any bundle is at least as

good as itself . 29
 Ordinal Utility approach assumptions(Cont…)

1.Rationality: The consumer is assumed to be

rational aiming at maximizing his utility

2. Utility is Ordinal: The consumer can rank or

order his preferences

3. Consistence of Choice: If he preferred

bundle A to B, he will not choice bundle B
over A another time.
30
 Cont…

4.Diminishing Marginal Rate of Substitution

 MRS is the rate at which a consumer is willing

to substitute one commodity (x) for another
commodity (y), so that his total satisfaction
remains the same.

 MRS diminishes as substitution increases

5.Limited money income: The consumer is

. 31
 Indifference Set, Curve and Map
• IC : The graphical representation of consumer’s preference
is called Indifference Curve (IC) or is the locus of different
combinations of two commodities, which are equally
preferred.
• Indifference Schedule is a tabular presentation of points or a
combinations of same utility
• An indifference curve is an iso or equal utility curve.
• Indifference Map: It is a set of indifference curves with
different levels of satisfaction. 32
Indifference Schedule
Bundle (Combinations) A B C D

Orange (X) 1 3 5 7

Banana (Y) 23 15 9 6

Banana (Y)
10 A
Indifference

6 B Curve (IC)

2 C
D
1

1 2 4 7 Orange(X)
Good B
Indifference map

IC3
IC2
IC1
Good A
Indifference Map: It is a set of indifference curves with different levels of
satisfaction
 Properties of Indifference Curves:

a) Indifference curves have a negative slope:

• The negative slope of indifference curve
implies that the two commodities are
substitute for each other.
b)Indifference curves are convex to the Origin:

The convexity of indifference curves implies :the

two commodities are not perfectly substitute
one for another . 35
 Cont….

The marginal rate of substitution (MRs) between

the two goods decreases as a consumer moves
along the indifference curve
– Averages are preferred to extreme values

c) Indifference curves do not intersect each other.

• What would happen if they cross each other?
• If two different curves cross each other it would be
violation of transitivity assumption in consumer’s
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preference
Banana

A Figure shows the case of

intersecting ICs

C
B IC2
IC1

Orange

Points like, A, B and C represents three different combinations of commodities X

and Y. Not that combination B is common to both indifference curves.
A = B and B = C , then A = C ……..But A # C

D) 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:
 The Marginal Rate of Substitution (MRS)

• The slope of an indifferent curve is called MRS

• MRS has an important economic meaning.

• (MRS) is a rate at which one commodity can be substituted
for another, with out changing the level of satisfaction.
• Marginal rate of substitution 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 of X
– so that the consumer maintains the same level of satisfaction

Number of units of Y given up

MRS X ,Y 
Number. of units of X gained 38
 MRS ( Cont…)

• As a slope of an indifference curve

y
 MRS X ,Y
x
• MRS decreases as a consumer continues to substitute one
commodity for another and Consider the following table
Bundle A B C D
(Combination)

Orange (X) 1 3 5 7

Banana (Y) 23 15 9 6

Y 8
MRS X ,Y (b / n points A and B)   4
X 2
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Marginal Utility and Marginal rate of Substitution
• MRS is also equals to the ratio of MU of
commodities involved in the utility function.

MU X
MRS X ,Y 
MU Y

Proof:
Suppose the utility function for two commodities X and Y is defined as:

U  f ( X ,Y )
 MRS ( Cont…)
• Since utility is constant on the same indifference curve:
U  f ( X ,Y )  C
• The total differential of the utility function is
U U
dU  dX  dY  0
X Y

MU X dX  MU Y dY  0
• Since there is no change in utility for any movement along
the same indifference curve , dU=0
The relationship b/n MRS and MU
MU X dY
  MRS X ,Y
MU Y dX
 Exceptional Indifference Curves
• indifference curves are convex to the origin and
downward sloping
• However, the shape of the indifference curve reflects the
degree of substitution between the two commodity
• The shape of an indifference curve might be different if the
relationship between two commodities is unique
• Perfect substitutes: perfect substitutes are goods which can
be replaced for one another at a constant rate.
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 Exceptional IC (Cont …)
• Perfect substitutes: the indifference curve is a
straight line with negative slope, as shown in
Figure 41 because the MRSXY is constant.

Total
IC3

IC2

IC1

Mobile
. 43
 Exceptional IC (Cont …)
• Perfect complements: perfect complements are
goods which are to be consumed jointly at a
constant rate
• If two commodities are perfect complements the
indifference curve takes the shape of a right angle (L
–shape)
• Graphically it is shown as follows.

. 44
 Exceptional IC (Cont …)
• Perfect complements

Right shoe
IC3

(3,3)

IC2
(2,2)

IC1
(1,1)

Left shoe
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 Exceptional IC (Cont …)
• A useless good: This shows the relationship between
useless good and another normal good.
• A good example is outdated book and food.
• since the outdated books are totally useless, increasing their
purchases does not increase utility.
• The person enjoys a higher level of utility only by getting
additional food consumption
• The indifference curve in this case will have a vertical one
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 Exceptional IC (Cont …)
• IC involving a useless good(Y axis)

IC1 IC2 IC3

Out dated books

Food
. 47
 Indifference curve of a bad and good commodity
•Bad and good Commodity IC( Y-axis):IC a consumer prefer less of bad commodity and more of
good commodity

Bad Good(Y)
IC

Y2

Y1

X1 X2 Good Commodity(X)

In that case, a set of indifference curves is . upward sloping. 48

 The Budget Line or the Price line

A utility maximizing consumer would like to reach the highest

possible indifference curve on his/her indifference map. But

the consumer’s decision is constrained by his/her

 money income and prices of the two

commodities: This limitation is called consumer’s

budget constraint and;

• How a consumer decides how much of a commodity to buy
. 49
at a particular price?
 Cont..

• Why a consumer will buy more of a commodity at lower

price?

• How consumer optimum can be indicated using constrained

optimization approach

– Objective fun…………….Utility function

– Constraint function…….budget constraint

• Level of satisfaction enjoyed by consumer at optimum

consumption point . 50
 Budget Line (Cont…)
• This limitation is called budget constraint

– is represented by the budget line

• The budget line is a line representing different combinations of two goods

that a consumer can buy with a given income at a given prices level

Assumptions

A. There are only two goods, X and Y, bought in quantities X & Y;

B. Each consumer is confronted with market determined prices, Px and

Py, of good X and good Y respectively

C. The consumer has a known and fixed income (I).

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 Budget Line (Cont…)
M  PX X  PY Y
Where, PX=price of good X
PY=price of good Y
X=quantity of good X
Y=quantity of good
M=consumer’s money income

• Suppose a household has 60 Birr to spend

– on banana (X) at Birr 2 each and
– Orange (Y) at Birr 4 each. .
• Therefore, our budget line equation will be:

2 X  4Y  60 . 52
 Three areas of a budget line
• The Budget Line
Three areas of a budget line
• Inside…feasible but
inefficient
M/PY
 B • On the line… feasible and
efficient
• Outside…..not feasible
A


M/PX

. 53
 Factors Affecting the Budget Line

• Budget line depends on the price of the two goods

and the income of the consumer
• A change in the income of the consumer results in a
shift in the budget line
• Where as a change in the price of a commodity will
rotate the budget line.
• The effect of change in income of consumer can be
shown in the following figure.
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 Effect of change in income on BL

M2/Py

Mo/Py

M1/Py Bo B2

B1

M1/PX Mo/PX M2/PX

Where M2>Mo>M1
Effects of Changes in Price of the commodities

Effects of Changes in Price of the commodities

M/Px1 M/Px2 X
Effects of Changes in Price of the commodities

Y
M/Py2

M/Py1

X
M/Py
 Optimum of the Consumer
• A consumer reach at optimum when he chooses the quantity
that maximizes his utility given his income and market
prices of commodities
• This occurs when an IC is tangent to the budget line
• At the point of tangency the slope of the indifference curve
(MRSxy) is equal to the slope of the budget line

MRS X ,Y  PX / PY
. 58
 Consumer’s Optimum (Cont…)

Consumer optimum
Y

E
Y*
IC4
IC3

IC1 IC2

X* X
 Mathematical derivation of equilibrium

• Suppose that the consumer consumes two

commodities X and Y given their prices and level of
money income M.
• objective of the consumer is maximizing his/her
utility subject to his limited income and market
prices. Z maximization problem may be formulated
as follows: MaximizeU  f ( X , Y )
Subject to PX X  PY Y  M
. 60
 Consumer’s Optimum (Cont…)
• To solve the constrained problem; we use the
Lagrange Multiplier Method. The steps involved:
A). Rewrite the constraint function as follows:
M  ( PX X  PY Y )  0  (  will have positive value)
or
PX X  PY Y  M  0 ,   will have negative value
B).Multiply the constraint by Lagrange multiplier
 ( M  PX X  PY Y )  0

  ( PX X  PY Y  M )  0
. 61
 Consumer’s Optimum (Cont…)
C) Form a composite function or the Lagrange function:
  U ( X , Y )   ( M  PX X  PY Y )
  U ( X , Y )   ( PX X  PY Y  M )
D) The first order condition for maximum requires that
the partial derivatives of the Lagrange function with
respect to the two goods and the Lagrangian constraint
be equals to 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
 PX and  PY
X Y
. 62
 Consumer’s Optimum (Cont…)

• Therefore, substituting and solving the equilibrium

condition:

MU X MU Y
 
PX PY

MU X PX
By rearranging we get: 
MU Y PY

. 63
 Consumer’s Optimum (Cont…)
E) 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 2 2 2
 U  U
2
 2
 0 and 2
 2
 0
X X Y Y

. 64
 Consumer’s Optimum (Cont…)
Example 1: A consumer consuming two commodities X
and Y has the following utility function. U =X2Y2 and the
price of the two commodities are Birr 1 and 4
respectively and his/her budget is birr 10.
i. Find the quantities of good X and Y which will maximize
utility.
ii. Total utility at optimum point

iii. Find the MRSxy at optimum point

. 65
 Effects of Changes in Income and Prices on Consumer‘s equilibrium

Changes In Income: depends on the nature of the

good
– Normal Goods are goods whose demand
increases with an increase in income
– Inferior goods are goods whose consumption
decreases as income increase
Income Consumption Curve and the Engel Curve

i. The case of normal goods

• An increase in the consumer’s
.
income (all other
66
 CONT

• things held constant) leads to an upward

parallel shift of the budget line.
• As a result a consumer moves to different
consumption level.
• The following figure shows this condition

. 67
Since both X and Y increased as income increase this shows the case of normal goods

Commodity Y

ICC

E3
Y3
E2

Y1 E1

X1 X3 Commodity X
 Effects of Income Changes (Cont …)

• Income Consumption Curve (ICC): is a locus

of all points that representing various
combinations of the two commodities
purchased by the consumer at different
levels of his income, all other things
remaining the same
• Normal Good is a good whose demand increases with income
increase
• For normal good income effect
.
is positive
69
 Effects of Income Changes (Cont …)

ii. The case of inferior goods

• Inferior good : is a good whose
consumption decreases as income increase
• Engle curve will have a negative slope for
inferior good as indicated in the figure
below

. 70
the income –consumption curve when good X is inferior

Y
ICC
Y3

Y2

Y1

X
X1 X1 X3
 the income –consumption curve when good y is inferior good

Y3
Y1
ICC

X1 X3 X
 Effects of Income Changes (Cont …)

• ICC is used to derive Engle Curve:

• Engle Curve:is a line representing the
relationship between the equilibrium quantity
purchased of a good and the level of income
• For normal goods Engle curve will have
positive slope
• For inferior goods Engle curve will have a
negative slope . 73
 Effects of Price Change

Price Consumption Curve (PCC) & Individual Demand Curve

• When one of the two commodity price changes while

other things remain unchanged the BL will rotate and the
consumer will be at a new equilibrium point

• If we connect such equilibrium points that would occur at

different price level we get a line 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 C.
 The Effect of price change on Consumer’s Equilibrium

Y The case of decrease in price of X

PCC
E3
E2
E1

M M’ M’’ X

• We use the PCC to derive the individual demand curve for a

particular commodity .How ?
• By plotting PCC from commodity space to price and quantity
space as shown below
Commodity Y

PCC

Commodity X
Price of
X Px1
Px2
Individual
Px3
demand curve
X1 X2 X3
Commodity X
 Income and Substitution effects of a price change

• When price of one of the commodity changes, while other

thing remain unchanged, the budget line will rotate
accordingly.
• This price change will brings two major effects:

A) Substitution effect : refers to the change in the quantity

demanded of a Commodity resulting exclusively from a
change in its price when the consumer’s real income is
held constant;
. 77
 Cont..
 If a price of commodity X falls while Price Y and
income of a consumer remain unchanged.

 Commodity X will relatively be cheaper and this

induces consumer to substitute cheaper commodity
(X) for more expensive one.

B) The Income Effect: The change in the price of a

commodity will also have an income effect.
. 78
• When price of commodity X decreases ( other things
remain), the relative purchasing power of consumer will
increase.
• I.e. the real income will increase (meaning a consumer can
afford to buy more of the two commodities with the
existing income depending on the nature of the commodity.
The following figure will depict these two effects

. 79
Suppose the consumer is at equilibrium at point A consuming X1 unit of X

Suppose price of X falls while other

things remain unchanged, in case the
A
budget line will shift from AB to AB’

•A consumer move to a new

C equilibrium point at point B
A B IC2
  consuming X3 units
C IC1
 •The movement from A to B is called
Total Effect or Net effect of price
change
x1 x2 B x3 C’ B’ •The TE consists of SE and IE
SE IE
NE
 TE = Substitution effect + Income Effect , TE = SE + IE

How can we split these two effects?

We can split these two effects by drawing an

A imaginary budget line which is parallel to the new
budget line (AB’) and tangent to the original IC1

C
P R IC2
Point Q represents imaginary
  equilibrium
Q IC1 The movement from P to Q and a
 resulting increase in demand by X1 to X2
is due to substitution effect.

x2 B The movement from Q to R and

x1
SE IE
x3 C’ B’ increase in demand by X2 to X3
NE
is due to income effect
• In the above case income effect and the substitution
effects operate in the same direction – they reinforce
each other.
• This is the case for a good called Normal goods.
• But, not all goods are normal. Some goods are
called inferior goods
• Inferior good: Is a good whose quantity demand
decrease with income increase.
. 82
 Cont..
• Is a good whose demand is negatively related to the income
of a consumer

For an inferior good, a decrease in the price of the commodity,

– causes the consumer to buy more of it (the substitution
effect),
– but at the same time the higher real income tends the
consumer to reduce consumption of the commodity
(negative income effect).
. 83
Suppose the consumer is at equilibrium at point A consuming X1 unit of X

When price of X falls while other

things remain unchanged
Y
The budget line will shift from
A
AB to AB’
R
C
P •A consumer move to a new

Q2 equilibrium point at point R

consuming X2 units
B B’

X1 X2 X3 X •The movement from P to R is

IE
NE Total Effect or Net effect of price

SE change
The TE can be split into SE and IE by drawing imaginary budget line CC’
Where:
X1X3= NE=Net effect Point Q represents imaginary equilibrium
X1X2= SE=Substitution effect
X2 X3= IE=Income effect The movement from P to Q2 and a
Y resulting increase in demand by X1X3
is substitution effect.
A

R The movement from Q to R and

C decrease in demand by X3 to X2 is due
P to income effect. Increased real income
Q2 decreases demand for inferior good
decreases
B B’

X1 X2 X3 X
IE
NE

SE
• In this case we observe that,

– the substitution effect still is more powerful than the

income effect (SE >IE)
– even though the income effect works against the
substitution effect, it does not override it.
– As a result the law of demand hold

– Hence, the demand curve for most inferior goods is

still negatively sloped.
• In very rare occasions, a good may be so strongly inferior that the
income effect actually overrides the
. substitute effect. 86
• As a result the law of demand may be violated. I.e., decline

in the price of a good would lead to a decline in the quantity

demanded

• In other words, price and quantity move in the same

direction which is against the law of demand.

• Such goods are called Giffen Goods

• Giffen goods: are goods whose demand decreases as price

of a commodity decreases.
The f/f graph shows the substitution .and income effect of Giffen goods
87
Suppose the consumer is at equilibrium at point P
consuming X1 unit of X
Y
A
R When price of X falls while other
IC2 things remain unchanged
C The budget line will shift from AB
P to AB’
Q •A consumer move to a new
IC1 equilibrium point at point R
B’
B C’ consuming X3 units
X3 X1 X 2 X •The movement from P to R is
SE
NE Total Effect or Net effect of price
change
IE
The TE can be split into SE and IE by drawing imaginary budget line CC’

Y Point Q represents imaginary equilibrium

A
R The movement from P to Q and a
IC2 resulting increase in demand by X2X3 is
C substitution effect.
The movement from Q to R and
P decrease in demand by X1 to X3 is
Q due to income effect.
IC1 We observe that the income effect
B’
B C’ is greater than substitution effect.
X1 X2 X 3 X The net effect is that as price fall
SE
NE demand for Giffen good will also
decrease
IE
• The strong negative income effect outweighs the
substitution effect ( IE > SE)
• This reduces quantity demanded of a Giffen good
• Which means as price of a Giffen good decreases
quantity demanded will also decrease
• Which is against the law of demand

. 90
The End!!!

. 91