Recall The Definition of - Demand and - The Law of Demand
Recall The Definition of - Demand and - The Law of Demand
Total 0 3 8 10 11 11
Utility (TU)
Marginal Utility 0 3 5 2 1 0
(MU)
Utility
Marginal utility
0 5
Quantity
06/09/2022 Microeconomics I Slides 2013/14 9
Basic rules
• Differential calculus measures a marginal change in the dependent variable
due to a marginal (unit change) in the independent variable
• Marginal Utility measures a marginal change in total utility due to a unit
change in commodity consumed.
dU
• TU/ Q =
dQ X
• The consumer would like to maximize the difference between the utility (satisfaction)
and expenditure (sacrifice).
• The problem is a simple maximization of the function.
• Max (U – TE) or
• U – PxQx
• Two conditions must be fulfilled
– Necessary Condition (F.O.C)....................MU=Px
– Sufficient Condition (S.O.C)....................M=E
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
E Px (Mum)
MUx
X Quantity of X
Attempt the above questions assuming income of birr 12, ceteris paribus.
Quantity Deriving Cardinalist Demand
of Y E3 P3
E2
P2
E1 P1
X3 X2
X1
MU X Quantity of X
Price
P3 a
P2 b
P1 c
Demand Curve
X3 X2 X1 Quantity of X
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..
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.
06/09/2022 Microeconomics I Slides 2013/14 18
1.2 Ordinal Utility Approach
The ordinals 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
• A market basket is just a collection of one or
more commodities.
• The modern theory of consumer’s behavior is
on the basis of consumers preference
06/09/2022 Microeconomics I Slides 2013/14 19
Ordinal Utility (Cont…)
What is preference?
• It shows choice of the consumer
• 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.
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.
• if quantity of one-commodity decreases, quantity of the other
commodity must increase if the consumer has to stay at the same
level of satisfaction.
b) Indifference curves are convex to the Origin:
The convexity of indifference curves implies
– The two commodities are not perfectly substitute one for another
– 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 preference.
06/09/2022 Microeconomics I Slides 2013/14 27
Banana
C
B IC2
IC1
Orange
Y 8
MRS X ,Y (between point s A and B ) 4
X 2
U f ( X ,Y )
MRS ( Cont…)
Since utility is constant on the same indifference curve:
U f ( X ,Y ) C
Total
IC3
IC2
IC1
Mobile
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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.
Right shoe
IC3
(3,3)
IC2
(2,2)
IC1
(1,1)
06/09/2022
Left shoe
Microeconomics I Slides 2013/14 36
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
06/09/2022 Food
Microeconomics I Slides 2013/14 38
Indifference curve of a bad commodity
Bad Good(Y)
IC
Y2
Y1
X1 X2 Good Commodity(X)
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
Consumption
A B C D E F
Alternatives
banana (X)
in (kgs)… 0 1 2 3 4 5
PX=2
Orange (Y)
15 14.5 14 13.5 13 12.5
in (kgs).Py= 4
Total
60 60 60 60 60 60
Expenditure
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Three areas of a budget line
• The Budget Line
A
M/PX
M2/Py
Mo/Py
M1/Py Bo B2
B1
Where M2>Mo>M1
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 indifference curve 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
06/09/2022 Microeconomics I Slides 2013/14 49
Consumer’s Optimum (Cont…)
Consumer
Y
optimum
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.
• The objective of the consumer is
maximizing his utility subject to his
limited income and market prices.
• State the problem
• The maximization problem may be
formulated as follows:
MaximizeU f ( X , Y )
Subject to PX X PY Y M
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Consumer’s Optimum (Cont…)
( PX X PY Y M ) 0
06/09/2022 Microeconomics I Slides 2013/14 52
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
get the equilibrium condition:
MU X MU Y
PX PY
MU X PX
By rearranging we get:
MU Y PY
2 2 2 2
U U
2
2
0 and 2
2
0
X X Y Y
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
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
PCC
E3
E2
E1
M M’ M’’ X
PCC
Commodity X
Price of
X Px 1
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:
• Substitution
• Income
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;
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.
C
P R IC2
Point Q represents imaginary
equilibrium
Q IC1 The movement from P to Q and a
resulting increase in demand by X1X2 is
substitution effect.
SE
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
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.
IE
The TE can be split into SE and IE by drawing imaginary budget line CC’
P1
CS
E
Pe
Q1 Q
Price Elasticity of Demand
• Consider the law of demand,
– when the price of a good goes up people will
buy less of it and
– if the price falls then people will buy more
of it
• Consumer responds to any change in the
determinants of demand like,
– Commodities own price
– Prices of related goods
– Consumers Income
– Taste and preferences
– And other factors
06/09/2022 Microeconomics I Slides 2013/14 87
• The question however is that what is the
magnitude of the responsiveness of
consumers for these change?
• Economists have developed a tool that
measure responsiveness of consumers demand
for the change in the determinants of
demand.
• This measurement is called Elasticity of
demand
• We have as many elasticity of demand as the
number of determinants of demand
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The most common types of elasticity of
demand are of the following:-
• Price elasticity of demand (own price
elasticity of demand)
• Cross price elasticity of demand
• Income elasticity of demand
1. Own Price Elasticity of demand.
It is a measurement of responsiveness of
quantity demanded to change in the
commodities own price
06/09/2022 Microeconomics I Slides 2013/14 89
• Price elasticity of demand is measured as
a percentage change in quantity
demanded resulting from a percentage
change in price.
• Depending on the magnitude of the
change in price, we have two types of
price elasticity of demand.
– Point price elasticity of demand
– Average or arc price elasticity of
demand
06/09/2022 Microeconomics I Slides 2013/14 90
• Point elasticity of demand:- is used to measure
price elasticity of demand when the change in
price is very small or at a point.
• the point price elasticity coefficient (Ep) can be
determined as,
% change in qunatity demand of X
Ed
% change in price of X
P
Suppose the demand function is Qd a bP
Q
= -b
P
• Price Elasticity of demand is therefore
Ep = - b x P/Q
εp
ΔQ
X
P1 P2
ΔP Q1 Q 2
Example
If price of good X rises from birr 3 to birr 5 and its quantity demand falls from 240 units to
180 units. Calculate the arc price elasticity of demand.
ΔQ X P1Y P 2Y
ε XY
ΔPY Q1X Q 2X
Ep = 1
Ep <1
Q
MR
TR
TR
Q
Total revenue and elasticity