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Adigrat University Department of Economics Microeconomics 2016
1. Theory of Consumer Behavior

1.1. Basic Concepts of Consumer Behavior
The theory of consumer behavior is based on the assumption of the consumer being
rational to maximize level of satisfaction. The consumer makes the buying decision by
comparing available bundle of goods. The study of consumer behavior is done by the two
approaches which are different in their assumptions about measurability of utility or
satisfaction. The two approaches are called cardinal and ordinal utility approaches.
1.2. Consumer Preferences and Utility
In this section we will see how consumers allocate their limited income among different
number of goods and services so as to maximize their satisfaction. Moreover, we will learn
how consumer’s allocation decisions determine quantity demand of goods and services.
1.2.1. Consumer Preference
Given any two consumption bundles, the consumer can either decide that one of
consumption bundles is strictly better than the other, or decide that he is indifferent
between the two bundles. Commodities are desired because of their ability to satisfy wants.
Goods and services, however, differ in their ability to satisfy a want. An individual may
prefer coffee to tea. Another person may prefer tea to coffee but both consumers will derive
some level of satisfaction by consuming the good they have chosen.
Strict Preference: Given any two consumption bundles(X1, X2) and (Y1, Y2), if(X1, X2) >
(Y1, Y2) or if he chooses (X1, X2) when (Y1, Y2) is available the consumer definitely wants
the X-bundle than Y. The consumer prefers the X bundles than the Y bundles.
Weak Preference: Given any two consumption bundles(X1, X2) and (Y1, Y2), if the
consumer is indifferent between the two commodity bundles or if (X1, X2)  (Y1, Y2), the
consumer would be equally satisfied if he consumes (X1, X2) or (Y1, Y2).
Completeness: Completeness of preference assumption implies that the consumer can
compare two or more goods and can easily indicate his preference. For any two commodity
bundles X and Y, a consumer will prefer X to Y, Y to X or will be indifferent between the
two.
Transitivity: According to this rule, if a consumer prefers basket A to basket B and basket
B to C, then the consumer also prefers basket A to basket C. Or if the consumer is
indifferent between basket A and basket B and basket B and basket C, then he will be
indifferent between basket A and basket C.
More is better than less: Consumers always prefer more of any good to less and they are
never satisfied or satiated. In any two consumption bundles A and B, A is preferred to B if
A contains at least more of one commodity than B. However, bad goods are not desirable
and consumers will always prefer less of them.
Chapter I Consumer Behavior Page 1 of 31

1.2.2. Utility and Approaches to Measure Utility

Economists use the term utility to describe the satisfaction or enjoyment derived from the
consumption of a good or service. Utility is the level of satisfaction that is obtained by
consuming a commodity or undertaking an activity.
In defining strict preference, we said that given any two consumption bundles (X 1, X2) and
(Y1, Y2), the consumer definitely wants the X bundle than the Y bundle if (X 1, X2) > (Y1,
Y2).This means, the consumer prefers bundle (X1, X2) to bundle (Y1, Y2) if and only if the
utility (X1, X2) is larger than the utility of (Y1, Y2). There are two major approaches of
measuring utility:
I. Cardinal Utility Approach
Utility maximization theories are important to deal with consumer behavior. Neo classical
economists argued that utility is measurable like weight, height, temperature and they
suggested a unit of measurement of satisfaction called utils. A util is a cardinal number like
1, 2, 3 etc simply attached to utility. Hence, according to cardinal utility approach, utility
can be quantitatively measured.
Assumptions of Cardinal Utility theory
The major difference between the two approaches of utility lies in their assumptions and
implications of those assumptions. The basic assumptions of cardinal utility theory are
given below.
a. Rationality of Consumers: The main objective of the consumer is to maximize his/her
satisfaction given his/her limited budget or income. Thus, in order to maximize his/her
satisfaction, the consumer has to be rational.
b. Utility is Cardinally Measurable: According to this approach, the utility or
satisfaction of each commodity is measurable in cardinal numbers. Money is the most
convenient measurement of utility. In other words, the monetary unit that the consumer
is prepared to pay for another unit of commodity measures utility or satisfaction.
c. Constant Marginal Utility of Money: According to assumption number two, money is
the most convenient measurement of utility. However, if the marginal utility of money
changes with the level of income (wealth) of the consumer, then money can not be
considered as a measurement of utility. The essential feature of a standard unit of
measurement is that it is constant.

d. Limited Money Income: The consumer has limited money income to spend on the
goods and services he/she chooses to consume making choice mandatory for the
consumer.
e. Diminishing Marginal Utility DMU: The utility derived from each successive units of
a commodity diminishes. Generally, the utility of the last unit consumed is less than the
utility of the previous item consumed of the same good. In other words, the marginal
utility of a commodity diminishes as the consumer acquires larger quantities of it.
f. The total utility of a basket of goods depends on the quantities of the individual
commodities consumed: If there are n commodities in the bundle with quantities,
X 1 , X 2 ,... X n the total utility is :
TU=f ( X 1 , X 2 ...... X n ) ………………………….. 1.0
This implies total utility is a positive function of the quantities of goods consumed.
Total and Marginal Utility
Total Utility TU refers to the total amount of satisfaction a consumer gets from consuming
or possessing some specific quantities of a commodity at a particular time. As the consumer
consumes more of a good per time period his total utility increases. However, total utility
can not be increased indefinitely. There is a point in which the consumer will not be
capable of enjoying any greater satisfaction from it. There is a point at which total
satisfaction reaches maximum and this point is called saturation point.
Marginal Utility MU refers to the additional utility obtained from consuming an additional
unit of a commodity. In other words, marginal utility is the change in total utility resulting
from the consumption of one or more unit of a product per unit of time. In short, it is the
slope of the total utility function. Mathematically:
TU
MU  …………………………………….. 1.1
Q
Law of Diminishing Marginal Utility LDMU
The utility that a consumer gets by consuming a commodity for the first time is not the
same as the consumption of the good for the second, third, fourth, etc. The 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 LDMU is best explained by the MU curve that is derived from the relationship
between TU and total quantity consumed.
Table1.0: TU and MU of Oranges (X)
Quantity of 1st nd
X consumed 0 U 2 4th 5th 6th
un 3rd unit
Unit ni it
unit Unit Unit
t
TUX 0 util 10 utils 16 utils 20 utils 22 utils 22 utils 20 utils
MUX - 10 6 4 2 0 -2
Figure 1.0: Derivation of MU TU
A
20
TUX
15
Total Utility
10
Quantity X
Marginal Utility
10 B
Quantity X
1 2 3 4 5
MUX
As the consumer consumes more of a good over time period, the total utility increases, at
an increasing rate and then increases at a decreasing rate when the marginal utility starts to
decrease and reaches maximum; the marginal utility becomes zero (see figure 1.0).
The total utility curve reaches its pick point (Saturation point) at point A. This saturation
point indicates that by consuming 5 units of X, the consumer attains its highest satisfaction
of 22 utils. However, Consumption beyond this point results in dissatisfaction because
consuming the 6th and more units of X brings a negative utility than the previous orange.

Equilibrium of the Consumer

A. One Commodity Case
Suppose the consumer’s utility function is giver as U  f ( X ) and his/her total income
spent (expenditure) on commodity X would be: Total Expenditure TE  Q X PX where Qx is
amount of commodity and Px is price of good X. The consumer would like to maximize the
difference between the utility (satisfaction) and expenditure (sacrifice).The problem is
simple maximization of the function. That is:
MaxU  TE
U  Q X PX
………………………………………….. 1.2
According to the Necessary Condition (First Order Condition) for Optimization, for utility
to reach maximum, the derivative of the function with respect to Qx must be equal to zero:
dU d (Q X PX )
  0  MUx - PX =0
dQ X dQ X
MUx
MU X  PX  1
Px
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 the whole income has been consumed
(Total Expenditure =Total Income).
B. n-Commodity Case (General Case)
A consumer that maximizes utility reaches his/her equilibrium position when allocation of
his/her expenditure is such that the last birr spent on each commodity yields the same
utility.
For example: If the consumer consumes a bundle of n commodities i.e X 1, X2 X3, …, Xn he
would be in equilibrium or utility is maximized if and only if:
MU X 1 MU X 2 MU X n
  .........   MU m ………………… 1.3
PX 1 PX 2 PX n
Where: Mum = Marginal Utility of Money

1.1: Marginal Utility of a Consumer
P
A

C
PX 
 B
MUX
Quantity X
Note that: at any point above point C like point A where MUX> Px, it pays the consumer to
consume more. At any point below point C like point B where MUX< Px the consumer
consumes less of X. However, at point C where MUx=Px the consumer is at equilibrium.
Table1.1: Utility Schedule for a Single Commodity
Marginal utility
Quantity of Marginal utility
Total utility Marginal utility per Birr(price=2
Orange of money
birr)
0 0 - - 1
1 6 6 3 1
2 10 4 2 1
3 12 2 1 1
4 13 1 0.5 1
5 13 0 0 1
6 11 -2 -1 1
For consumption level lower than three quantities of oranges, since the marginal utility of
orange is higher than the price, the consumer can increase his/her utility by consuming
more quantities of oranges. On the other hand, for quantities higher than three, since the
marginal utility of orange is lower than the price, the consumer can increase his/her utility
by reducing its consumption of oranges.
Suppose that a consumer consumes two commodities, Orange and Banana. The total
income of the consumer is Birr 20.If price of Orange is Birr 2 per unit and Birr 4 per unit
for Banana. If the utility schedule of the consumer is as indicated below the optimum
combination of the two goods can be calculated as follows.

Table1.2: Utility Schedule for Two Commodities
Orange, Price=2birr Banana, Price=4birr

Quantity TU MU MU/P Quantity TU MU MU/P
0 0 - - 0 0 - -
1 6 6 3 1 6 6 6
2 10 4 2 2 22 16 4
3 12 2 1 3 32 12 3
4 13 1 0.5 4 40 8 2
5 13 0 0 5 45 5 1.85
6 11 -2 -1 6 48 3 0.75
Utility is maximized when the condition of marginal utility of one commodity divided by
its market price is equal to the marginal utility of the other commodity divided by its
MU 1 MU 2
market price (  ) and income equals expenditure.
P1 P2
Thus, the consumer will be at equilibrium when he consumes 2 quantities of Orange and 4
MU orange MU banana 4 8
quantities of banana because     2 and his total income of
Porange Pbanana 2 4
birr 20 equals to the total expenditure on 2 units of orange (2X2= birr 4) and 4 units of
banana (4x4=birr16)
Derivation of the Demand Curve under Cardinalist Approach
The derivation of demand curve is based on the concept of diminishing marginal utility. If
the marginal utility is measured using monetary units the demand curve for a commodity is
the same as the positive segment of the marginal utility curve.

Figure 1.3: Derivation of Demand Curve
a
P1
b
P
Price
c
P2
MUX
O Quantity
P1
Price
P
Demand
P2 Curve
O Quantity
Q1 Q Q2
II. Ordinal Utility Approach
In the ordinal utility approach, utility cannot be measured in cardinal numbers or

absolutely. The consumer is expected to rank different consumption bundles according to
his preferences. The ordinal utility concept is based on the fact that it may not be possible
for consumers to express the utility of various commodities they consume in absolute
terms, like, 1 util, 2 utils, or 3 utils but it is always possible for the consumers to express
the utility in relative terms. It is practically possible for the consumers to rank commodities
st nd rd
in the order of their preference as 1 2 3 and so on.
Assumptions of Ordinal Utility Theory
i. The Consumers are rational: They aim at maximizing their satisfaction or utility given
their income and market prices.
ii. Utility is ordinal: Utility is not absolutely (cardinally) measurable. Consumers are
required only to order or rank their preference for various bundles of commodities.
iii. Diminishing Marginal Rate of Substitution MRS: The 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. It is the slope of the Indifference curve. When a

consumer continues to substitute X for Y the rate goes on decreasing as the two goods
are assumed to be imperfect substitutes in a standard case.
iv. The total utility of the consumer depends on the quantities of the commodities
consumed, i.e., U=f (X1 ,X2, X3,--- Xn,)
v. Preferences are transitive or consistent: It is transitive in the senses that if the
consumer prefers market basket X to market basket Y, and prefers Y to Z, and then the
consumer also prefers X to Z. Consistency of preference implies that If market basket X
is preferred to market basket Y (X>Y) then Y can not be preferred to X at another
time(Y not >X).
vi. Limited Money Income: The consumer is confronted with limited money income so
that optimization is mandatory.
vii. Non – satiation assumption: Consumers always prefer more of any good to less and
they are never satisfied or satiated. In any two consumption bundles A and B, A is
preferred to B if A contains at least more of one commodity. However, bad goods are
not desirable and consumers will always prefer less of them.
The ordinal utility approach is expressed or explained with the help of indifference curves.
An indifference curve is a concept used to represent an ordinal measure of the tastes and
preferences of the consumer and to show how he maximizes utility in spending income.
Since it uses ICs to study the consumer’s behavior, the ordinal utility theory is also known
as the Indifference Curve Analysis.
Indifference Set, Indifference Curve and Indifference Map
Indifference Set/Schedule: It is a combination of goods for which the consumer is
indifferent, preferring none of the consumption bundles. It is a tabular presentation of the
various combinations of goods from which the consumer derives the same level of utility.
Table 1.3: Indifference Schedule
Bundle (Combination) A B C D
Orange(X) 1 3 5 7
Banana (Y) 23 15 9 6
Each combination of good X and Y gives the consumer equal level of total utility. Thus,
the individual is indifferent whether he consumes combination A, B, C or D.

Indifference Curves: An indifference curve shows the various combinations of two goods
that provide the consumer the same level of utility or satisfaction. It is the
locus of points (particular combinations or bundles of good), which yield the
same utility (level of satisfaction) to the consumer, so that the consumer is
indifferent as to the particular combination he/she consumes. An
indifference curve is an iso or equal utility curve. By transforming the above
indifference schedule into graphical representation, we get an indifference
curve.
Figure 1.3: Indifference Curves and Indifference Map
Banana (Y)
10 A
Good B
Indifferenc
B
6 e
Curve (IC)
Indifference Curve
C Indifference Map
2 IC3
D IC2
Indifference
1 Map: It is a set of indifference curves with different levels of satisfaction. It
IC1
is the entire set of indifference curves which reflects the complete set of tastes and
preferences
1 2of the 4consumer.7 A higher indifference curve refers to a higher level of
Good A
satisfaction and aOrangeX
lower indifference curve shows lesser satisfaction. IC 2 reflects higher
)) that
level of utility than (X) of IC1.
Properties of Indifference Curves

Indifference curves have certain unique characteristics with which their foundation is
based:
a. Indifference curves have negative slope (downward sloping to the right):
Indifference curves are negatively sloped because the consumption level of one
commodity can be increased only by reducing the consumption level of the other

commodity for a movement along an indifference curve. That means, if the quantity of
one commodity increases with the quantity of the other remaining constant, the total
utility of the consumer increases. On the other hand, if the quantity of one commodity
decreases with the quantity of the other remaining constant, the total utility of the
consumer reduces. Hence, in order to keep the utility of the consumer constant, as the
quantity of one commodity is increased, the quantity of the other must be decreased.
b. Indifference curves do not intersect each other: Intersection between two
indifference curves is inconsistent with the reflection of indifference curves. If they do
intersect, the point of their intersection would mean two different levels of satisfaction
from a single combination of goods, which is impossible.
c. 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:
baskets of goods on a higher indifference curve are preferred by the rational consumer,
because they contain more of the two commodities than the lower ones.
d. Indifference curves are convex to the origin: This implies that the slope of an
indifference curve decreases (in absolute terms) as we move along the curve from the
left downwards to the right. This assumption implies that the commodities can
substitute one another at any point on an indifference curve but are not perfect
substitutes.
1.4: Positively Sloped and Intersected Indifference Curves
X
Banana
Banana
Indifference curves cannot intersect

B each other. If they did, the consumer would be
indifferent between C and E, (Right panel of figure 2.5) since both Eare on indifference

curve one (IC1). Similarly, the consumer would be indifferent between points D D andIC E,2
C
A
IC1
Orange Orange
since they are on the same indifference curve, IC 2.By transitivity, the consumer must also
be indifferent between C and D. However, a rational consumer would prefer D to C
because he/she can have more Orange at point D (more Orange by an amount of X).
The left panel of figure 1.4 summarizes the implication of an upward sloping indifference
curve. Point A and B are two points on the same indifference curve which must give the
consumer the same satisfaction. But the consumer is not indifferent between the two
consumption bundles since consumption bundle B contains more of both orange and
banana.
Marginal rate of substitution MRS
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. It is the rate at which one commodity
can be substituted for another while keeping the level of satisfaction the same.
Number of units of Y given up

MRS X ,Y  ………………….. 1.4
Number of units of X gained
It is the negative of the slope of an indifference curve at any point for any two commodities
such as X and Y, and is given by the slope of the tangent line at that point:
y
 MRS X ,Y …………………………………………. 1.5
x
MRS refers to the amount of one commodity that an individual is willing to give up to get
an additional unit of another good while maintaining the same level of satisfaction or
remaining on the same indifference curve. The diminishing slope of the indifference curve
means the willingness to substitute X for Y diminishes as one move down the curve.
MRS X ,Y Measures the downward vertical distance (the amount of y that the individual is
willing to give up) per unit of horizontal distance (i.e. per additional unit of x required) to
Y
remain on the same indifference curve. That is, MRS X ,Y   because of the reduction
X
in Y, MRS is negative. However, we multiply by negative one and express MRS X ,Y as a

positive value. MRS is defined for a movement along the same indifference curve.

The rationale behind the convexity, that is, diminishing MRS, is that a consumer’s
subjective willingness to substitute X for Y (or Y for X) will depend on the amounts of Y
and X he/she possesses.
Table1.4: Level of Consumption of Good X and Y
Bundle (Combination) A B C D
Orange(X) 1 3 5 7
Banana (Y) 23 15 9 6
Y 8
MRS X ,Y (between points A and B )   4
X 2
The consumer is willing to forgo 8 units of Banana to obtain 2 more unit of Orange (see
table 1.4). If the consumer moves from point B to point C, he is willing to give up only 6
units of Banana(Y) to obtain 2 unit of Orange (X), so the MRS is 3(∆Y/∆X =6/2). Having
still less of Banana and more of Orange at point D, the consumer is willing to give up only
3 unit of Banana so as to obtain the same 2 units of Orange. In this case, the MRS falls to
3/2. In general, as the amount of Y increases, the marginal utility of additional units of Y
decreases. Similarly, as the quantity of X decreases, its marginal utility increases. In
addition, the MRS decreases as one move downwards to the right.
Marginal Utility and Marginal Rate of Substitution
It is also possible to show the derivation of the MRS using MU concepts. The MRS X ,Y is
related to the MUx and the MUy:
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 )
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 because there is no change in utility for any
X Y
movement along the same indifference curve.
U U
MU X dX  MU Y dY  0 , = MUX and = MUy
X Y

MU X dY
  MRS X ,Y
MU Y dX
MU Y dX
Or,   MRS Y , X
MU X dY
Example 1.0: Suppose a consumer’s utility function is given by U  10 X 2Y
.Compute MRS X ,Y .
MU X
MRS X ,Y 
MU Y
dU dU
MU X  and MU Y 
dX dY
Therefore, MU X  20( X 21Y )  20 XY and MU Y  10( X 2Y 11 )  10 X 2
MU X 20 XY 2Y
MRS X ,Y   
MU Y 10 X 2 X
Exceptional Indifference Curves

In a standard case indifference curves are convex to the origin and downward sloping as we
have seen earlier and this shape of indifference curve is true for most goods. In this
situation, we assume that the two commodities such as X and Y can substitute one another
to a certain extent but are not perfect substitutes. However, the shape of the indifference
curve will be different if commodities have some other unique relationship such as perfect
substitution or complementary. Here, are some of the ways in which indifference
curves/maps might be used to reflect preferences for three special cases:
1. Perfect substitutes: perfect substitutes are goods which can be replaced for one another
at a constant rate. If two commodities are perfect substitutes (if they are essentially the
same), the indifference curve becomes a straight line with a negative slope. MRS for
perfect substitutes is constant (see figure 1.5 Panel a)
2. 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. Suppose that an individual prefers to consume left shoes (on the
horizontal axis) and right shoes on the vertical axis in pairs. If an individual has two pairs

of shoes, additional right or left shoes provide no more utility for him. MRS for perfect
complements is zero i.e. there is no substitution between the two goods (see figure 1.5
Panel b ).
3. A useless good: Figure 1.5 Panel c shows an individual’s indifference curve for food (on
the horizontal axis) and an out-dated book, a useless good, (on the vertical axis). Since they
are totally useless, increasing purchases of out-dated books does not increase utility. This
person enjoys a higher level of utility only by getting additional food consumption. For
example, the vertical indifference curve shows that utility will be the same as long as this
person has same units of food no matter how many out dated books he has.
Figure 1.5: Special cases of indifference curves
Out dated books

IC3 IC1 IC2 IC3
IC2
IC1
Right shoe
IC3
Total
IC2
IC1
Panel a Panel b Panel c
Mobile
Budget Line or Price LineLeft shoe Food
Indifference curves show how the rate at which the consumer is willing to substitute one
good for another utility remaining the same. It only tells us the consumer’s preferences for
any two goods but they can not tell us which combinations of the two goods will be chosen
or bought.
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. Therefore, in addition to consumer preferences,
we need to know the consumer’s income and prices of the goods. In other words, individual
choices are also affected by budget constraints that limit people’s ability to consume in
light of prices they must pay for various goods and services. Whether or not a particular
indifference curve is attainable depends on the consumer’s money income and on
commodity prices. A consumer while maximizing utility is constrained by the amount of
income and prices of goods that must be paid. This constraint is often presented with the

help of the budget line constructed by possible alternative purchases of any two goods.
Therefore, before we discuss consumer’s equilibrium, it is better to understand his/ her
budget line.
The budget line is a line or a graph indicating different combinations of two goods that a
consumer can buy with a given income at a given prices. In other words, the budget line
shows the market basket that the consumer can purchase, given the consumer’s income and
prevailing market prices.
Assumptions for the use of Budget Line
1. There are only two goods, X and Y, bought in quantities X and Y;
2. Each consumer is confronted with market determined prices, Px and Py, of good X and good
Y respectivley; and
3. The consumer has a known and fixed money income M.
By assuming that the consumer spends all his income on two goods (X and Y), we can
express the budget constraint as:
M  PX X  PY Y …………………….. 1. 6
Where: PX=price of good X, PY=price of good Y, X=quantity of good X,Y=quantity of
good Y and M=consumer’s money income.
According to the above budget equation, the amount of money spent on X plus the amount
spent on Y equals the consumer’s money income.
Suppose for example a household with 60 Birr per day to spend on banana(X) at Birr 2
each and Orange(Y) at Birr 4 each. That is, PX  2, PY  4, M  60birr .
Therefore, our budget line equation will be:
2 X  4Y  60
Table1.5: Alternative Purchase Possibilities of the Two Goods
Consumption Alternatives A B C D E F
banana (X) in (kgs) 0 1 2 3 4 5
Orange(Y) in (kgs) 15 14.5 14 13.5 13 12.5
Total Expenditure 60 60 60 60 60 60
At alternative A, the consumer is using all of his /her income for good Y. Mathematically; it
is the y-intercept (0, 15). And at alternative F, the consumer is spending all his income for
good X. Mathematically it is the X-intercept (5, 0). We may present the income constraint
graphically by the budget line whose equation is derived from the budget equation.

M  PX X  PY Y
M  XPX  YPY
By rearranging the above equation we can derive the general equation of a budget line:
M PX
Y  X
PY PY
M
= Vertical Intercept (Y-intercept), when X=0.
PY
PX
 = slope of the budget line (the ratio of the prices of the two goods)
PY
The horizontal intercept (i.e., the maximum amount of X the individual can consume or
purchase given his income) is:
M PX
 X 0
PY PY
M PX
 X
PY PY
M
X
PX
Figure 1.6: Derivation of the Budget Line
M/PY
B

A

M/PX

Therefore, the budget line is the locus of combinations or bundle of goods that can be
purchased if the entire money income is spent. Given any budget line, there are two
possible areas indicated by point A and point B. The area outside the budget line represents
non- feasible (un-attainable) area because it is beyond the reach of the consumer. On the
other hand, the area inside or on the budget line denotes feasible or achievable area.
Factors Affecting the Budget Line
Budget line depends on the price of the two goods and the income of the consumer. Any
change in the income of the goods or the income of the consumer results in a shift in the
budget line. Let us examine the impact of these changes one by one.
a. Effects of Changes in Income
If the income of the consumer changes (keeping the prices of the commodities unchanged)
the budget line also shifts (changes). Increase in income causes an upward shift of the
budget line that allows the consumer to buy more goods and services and decreases in
income causes a downward shift of the budget line that leads the consumer to buy less
quantity of the two goods. It is important to note that the slope of the budget line (the ratio
of the two prices) does not change when income rises or falls. The budget line shifts from
Bo to B1 when income decreases and to B2 when income rises.
Figure2 1.7: Effects of Change in Income
M /Py
Where M2>Mo>M1
Mo/Py
M1/Py
Bo B2
B1
M1/PX Mo/PX M2/PX
b. Effects of Changes in Price of the Commodities

Changes in the prices of X and Y is reflected in the shift of the budget lines. In the figures
below (panel a), a price decline of good X results in the shift from B to B 1.A fall in the
price of good Y in panel b is reflected by the shift of the budget line from B to B 1.We can

notice that changes in the prices of the commodities change the position and the slope of
the budget line. But, proportional increases or decreases in the price of the two
commodities (keeping income unchanged) do not change the slope of the budget line if it is
in the same direction.
Figure 1.8: Effects of Change in Price
Y Y
B1 B1
B
B
X X
Panel a Panel b
Let us now consider the effects of each price changes on the budget line:
1. What would happen if price of x falls, while the price of good Y and money incme
remaining constant?
Figure 1.9: Effect of a Decrease in Price of x on Budget Line
Y
A
M/py
Here PX1, < Pxo, hence M/Pxo <M/Px1
B B’
M/PX0 M/Px1 X
Since the Y-intercept (M/Py) is constant, the consumer can purchase the same amount of Y
by spending the entire money income on Y regardless of the price of X. We can see from

the above figure that a decrease in the price of X, money income and price of Y held
constant, pivots the budget line out-ward, as from AB to AB’.
2. What would happen if price of X rises, while the price of good Y and money incme
remaining constant?
Since the Y-intercept (M/Py) is constant, the consumer can purchase the same amount of Y
by spending the entire money income on Y regardless of the price of X. We can see from
the figure below that an increase in the price of X, money income and price of Y held
constant, pivots the budget line in-ward, as from AB to AB’.
Figure 1.10: Effect of an Increase in Price of x on Budget Line
A
M/Py
B
B’
M/Px1 M/Px2
3. What would happen if price of Y rises, while the price of good X and money incme
remaining constant?
Figure1.11: Effect of a Raise in Price of Y on Budget Line
YA
M/py
A’
M/py'
B
M/Px X
Since the X-intercept (M/Py) is constant, the consumer can purchase the same amount of X
by spending the entire money income on X regardless of the price of Y. We can see from
the above figure that an increase in the price of Y, money income and price of X held
constant, pivots the budget line in-ward, as from AB to A’B.

4. What would happen if price of Y falls, while the price of good X and money incme
remaining constant?
Figure 1.12: Effect of a fall in Price of Y on Budget Line

Y
M/py' A’
M/py A
B
M/Px X
The above figure shows what happens to the budget line when the price of Y increases while the
price of good X and money income held constant. Since P y decreases, M/Py increases thereby the
budget line shifts outward.
Some times the price of the two commodities may change proportionally in the same direction and
this will have a shifting impact on the budget line.
Proportional increase in the prices of both goods (X and Y), income remaining the same, reduces
the total quantity of the two goods that the consumer can buy with the given income. For example
if the price of the two goods doubles, the quantity of the two goods bought decreases by half. Since
the slope of the budget line which is the ratio of the prices of the two goods remains the same,
there will be a parallel inward shift of the budget line.
When there is proportional (equal) decrease in price of the two goods income remaining the same,
the quantity bought of the two goods increases which leads o a parallel out ward shift in the budget
line M/Py 2
Figure 1.13: Effect of Proportional Price Change on Budget Line
M/Pyo
Where PX1>PXo > PX2 and
Bo B2
M/Py
Chapter
1 I Consumer Behavior Page 21 of 31
B1
Where PY1>PYo > PT2
M/PX1 M/PXo M/PX2

Example 1.1: A person has Birr 60 to spend on two goods(X, Y) whose respective prices
are Birr 3 and Birr 6.
a) Draw the budget line.
b) What happens to the original budget line if the budget increases by 50%?
c) What happens to the original budget line if the price of Y doubles?
d) What happens to the original budget line if the price of X falls to Birr 2?
e) What happens to the original budget line if price of both X and Y is doubled?
Solution:
PX X  PY Y  M
3 X  6Y  60
6Y  60  3 X
60 3
Y   X
6 6
1
Y  10  X
2
Y  10  0.5 X
When the person spends all of his income only on the consumption of good Y, we can get
the Y intercept that is (0, 10). However, when the consumer spends all of his income on the
Consumption of only good X, then we get the X intercept that is (20, 0). Using these two
points we can draw the budget line. Thus, the budget line will be:
A’
B’ B
20 X

If the budget decreases by 50%, then the budget will be reduced to 30.As a result, the
budget line will be shifted in-ward as indicated by (A’B’).This forces the person to buy less
quantity of the two goods. The equation for the new budget line can be solved as:
3 X  6Y  30
6Y  30  3 X
30 3
Y   X
6 6
1
Y  5 X
2
Y  5  0 .5 X
Therefore, the Y-intercept decreases to 5 units while the X-intercept is only 10 units.
However, since the ratio of the prices does not change the slope of the budget line remains
constant.
If the price of good Y doubles the equation of the budget line will be 3 X  12Y  60 and if
the price of good X falls to Birr 2, the equation for the new budget line is 2 X  6Y  60 .
If price of both X and Y is doubled, the new budget line equation will be 6X+12Y=60.The
X-intercept and Y-intercept decreases to 10 units and 5 unity respectively. The slope
remaining the same (-0.5), the budget line shifts inward in a parallel way.
Equilibrium of the Consumer
A rational consumer seeks to maximize his utility or satisfaction by spending his or her
income. It maximizes the utility by trying to attain the highest possible indifference curve,
given the budget line. This occurs where an indifference curve is tangent to the budget line
so that the slope of the indifference curve ( MRS X ,Y ) is equal to the slope of the budget
line ( PX / PY ).
Thus, the condition for utility maximization, consumer optimization, or consumer
equilibrium occurs where the consumer spends all income (i.e. he/she is on the budget line)
and the slope of the indifference curve equals to the slope of the budget line
MRS X ,Y  PX / PY .
The preferences of the consumer (what he/she wishes) are indicated by the indifference
curve and the budget line specifies the different combinations of X and Y the consumer can
purchase with the limited income. Therefore, the consumer tries to obtain the highest
possible satisfaction with in his budget line.

However, the consumer cannot purchase any bundle lying above and to the right of the
budget line. Because, Indifference curves above the region of the budget line are beyond
the reach of the consumer and are irrelevant for equilibrium consideration. The question
then arises as to which combinations of X and Y the rational consumer will purchase.
Figure 1.14: Consumer Equilibrium
Y
A
B
E
IC4
C IC3
IC2
D
IC1
At point ‘A’ on the budget line, the consumer gets IC 1 level of satisfaction. When he/she
moves down to point ‘B’ by reallocating his/her total income inXfavor of X he/she derives
greater level of satisfaction that is indicated by IC2. Thus, point ‘B’ is preferred to point ‘A’.
Moving further down to point ‘E’, the consumer obtains the greatest level of satisfaction
(IC3) relative to other indifference curves.
Therefore, point ‘E’ (which represents combination X and Y) is the most preferred position
by the consumer since he/she attains the highest level of satisfaction within his/her reach
and point ’E’ is known as the point of consumer equilibrium (or consumer optimum). This
equilibrium occurs at the point of tangency between the highest possible indifference curve
and the budget line. Put differently, equilibrium is established at the point where the slope
of the budget line is equal to the slope of the indifference curve.

Mathematically, consumer optimum (equilibrium) is attained at the point where:
PX MU X
MRS X ,Y  , But we know MRS X ,Y 
PY MU Y
MU X P MU X MU X
  X , or  
MU Y PY Px Py
Mathematical Derivation of Equilibrium

Suppose that the consumer consumes two commodities X and Y given their prices and level
of money income M. Thus, the objective of the consumer is maximizing his utility function
subject to his limited income and market prices. In utility maximization, the function that
represents the objective that the consumer tries too achieve is called the objective function
and the constraint that the consumer faces is called constraint function. The maximization
problem is formulated as:
MaximizeU  f ( X , Y ) ……………………….. 1. 7
Subject to PX X  PY Y  M
To solve the constrained problem; we use the Lagrange Multiplier Method. The steps
involved are:
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 ,  will have positive value
  ( PX X  PY Y  M )  0 ,  will have negative value
C) Form a composite function or the Lagrange function:
  U ( X , Y )   ( M  PX X  PY Y )
Or,   U ( X , Y )   ( PX X  PY Y  M )

D) 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
 PX and  PY
X Y
U U
 MU X and  MU Y
X Y
Therefore, substituting and solving for  we get the equilibrium condition:
MU X MU Y
 
PX PY
By rearranging we get:
MU X P
 X = MRS x,y
MU Y PY
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 U 2 2 U 2
  0 and  0
X 2 X 2 Y 2 Y 2
Example 1.3: A consumer consuming two commodities X and Y has the following utility
function U  X 1.5Y .If the price of the two commodities are 3 and 4 respectively and
his/her budget is birr 100.
a) Find the quantities of good X and Y which will maximize utility.
b) Total utility at equilibrium.
c) Find the MRS X ,Y at optimum point
Solution:
A) The Lagrange equation will be written as follows:
  X 1.5Y   (3 X  4Y  100)

 1.5 X 0.5Y  3  0 ……………………………………… (1)
X


 X 1.5  4  0 …………………………………………. (2)
Y

 100  3 X  4Y  0 …………………………… (3)

From equation (1) we get 1.5 X 0.5Y  3 and from equation (2) we get X 1.5  4 .By
1.5 X 0.5Y
1.5
further simplification, we can get that   and equation (2) gives as X .
3 4
Equating  with 
1.5 X 0.5Y
1.5
  X By rearranging and solving for X, we get


3 4
X=2Y………………………………………………………… (4)
Substituting Equation (4) in equation (3) or the constraint function,
3X +4Y=100 Since X= 2Y from equation (4)
3(2Y) +4Y=100 X=2(10)

10Y=100 X= 20units
Y=10units and;
Therefore, optimum combination of the two goods is 10 units of Y and 20 units of X
B) The total utility at equilibrium is calculated by inserting the corresponding quantities of
X and Y in the total utility function
U  X 1 .5 Y When X= 20 and Y= 10,
U  (20)1.5 10
U= 894
MU X
C) MRS X ,Y  ,
MU Y
U U
MU X   1.5 X 0.5Y and MU Y   X 1.5
X Y
1.5(20) 0.5 (10)

MRS X ,Y  , at optimum point
201.5
67
=
89.4
=0.75
After inserting the optimum value of Y=10 and X=20 we get 0.75 which equals to the price
PX 3
ratio of the two goods (   0.75) .
PY 4
Example 1.4: A consumer consuming two commodities X and Y has the following utility
function U  X 2Y 2 .If the price of the two commodities are Birr 1 and 4 respectively and
his/her budget is birr 10.
A) Find the quantities of good X and Y which will maximize utility.
B) Find the MRS X ,Y at optimum.
C) Total utility at optimum point
D) The amount by which optimum utility changes when quantity of X or Y changes by
one unit (  ).
Solution:
A) The Lagrange equation will be written as follows:
  X 2Y 2   ( X  4Y  10)

 2 XY 2    0 …………………………….. (1)
X

 2YX 2  4  0 …………………………… (2)
Y

 X  4Y  10  0 …………………………. (3)

YX 2
From equation (1) we get   2 XY 2 and from equation (2) we get   .
2
Since  equals to  , we can solve for either X or Y
 =
2
YX
2 XY 2
=
2
YX 2 = 4 XY 2
X = 4Y……………………………………….. (4)
By substituting equation (4) in to equation (3) we get,
X+4Y=10
4Y+4Y=10, since X= 4Y
8Y=10
Y= 1.25 and X=4Y, X=4(1.25) =5
Thus optimum combination of the two goods is 5 for X and 1.25 for Y.
B) MRS X ,Y at optimum.
MU X
MRS X ,Y  , MU X = 2 XY 2 and MUy = 2YX 2
MU Y
 2 XY 2
2YX 2
Y
=
X
After inserting the optimum value of Y=1.25 and X=5 we get 0.25 which equals to the
PX 1
price ratio of the two goods (   0.25) .
PY 4
C) TU  5 2 (1.25) 2
=25(1.56)
=39
D)   2 XY 2 ,x= 5& Y=1.25
 2(5)(1.25) 2
=15.625

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Adigrat University Department of Economics Microeconomics 2016

1. Theory of Consumer Behavior

Chapter I Consumer Behavior Page 1 of 31

1.2.2. Utility and Approaches to Measure Utility

Chapter I Consumer Behavior Page 2 of 31

TU=f ( X 1 , X 2 ...... X n ) ………………………….. 1.0

Chapter I Consumer Behavior Page 3 of 31

Chapter I Consumer Behavior Page 4 of 31

Equilibrium of the Consumer

Chapter I Consumer Behavior Page 5 of 31

1.1: Marginal Utility of a Consumer

Chapter I Consumer Behavior Page 6 of 31

Table1.2: Utility Schedule for Two Commodities

Orange, Price=2birr Banana, Price=4birr

Chapter I Consumer Behavior Page 7 of 31

Figure 1.3: Derivation of Demand Curve

In the ordinal utility approach, utility cannot be measured in cardinal numbers or

Chapter I Consumer Behavior Page 8 of 31

Chapter I Consumer Behavior Page 9 of 31

Properties of Indifference Curves

Chapter I Consumer Behavior Page 10 of 31

Indifference curves cannot intersect

Number of units of Y given up

in Y, MRS is negative. However, we multiply by negative one and express MRS X ,Y as a

Chapter I Consumer Behavior Page 12 of 31

Chapter I Consumer Behavior Page 13 of 31

Therefore, MU X  20( X 21Y )  20 XY and MU Y  10( X 2Y 11 )  10 X 2

Exceptional Indifference Curves

Chapter I Consumer Behavior Page 14 of 31

Out dated books

Chapter I Consumer Behavior Page 15 of 31

Chapter I Consumer Behavior Page 16 of 31

Chapter I Consumer Behavior Page 17 of 31

M1/PX Mo/PX M2/PX

b. Effects of Changes in Price of the Commodities

Chapter I Consumer Behavior Page 18 of 31

Figure 1.8: Effects of Change in Price

Here PX1, < Pxo, hence M/Pxo <M/Px1

Chapter I Consumer Behavior Page 19 of 31

Chapter I Consumer Behavior Page 20 of 31

Figure 1.12: Effect of a fall in Price of Y on Budget Line

Where PY1>PYo > PT2

M/PX1 M/PXo M/PX2

Chapter I Consumer Behavior Page 22 of 31

Chapter I Consumer Behavior Page 23 of 31

Chapter I Consumer Behavior Page 24 of 31

Mathematically, consumer optimum (equilibrium) is attained at the point where:

Mathematical Derivation of Equilibrium

A) Rewrite the constraint function as follows:

B) Multiply the constraint by Lagrange multiplier 

 ( M  PX X  PY Y )  0 ,  will have positive value

  ( PX X  PY Y  M )  0 ,  will have negative value

C) Form a composite function or the Lagrange function:

Chapter I Consumer Behavior Page 25 of 31

Chapter I Consumer Behavior Page 26 of 31

  X By rearranging and solving for X, we get

Chapter I Consumer Behavior Page 27 of 31

1.5(20) 0.5 (10)

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