Microeconomics Chapter-2 utility management

Microeconomic

1. CHAPTER ONE Theory of Consumer Behavior and Demand 10/10/2024 1

2. 1. Consumer Preferences and Choices 1.1 Preference Strict preference Given any two consumption bundles(X 1 , X 2 ) and (Y 1 , Y 2 ), if (X 1 , X 2 )> (Y 1 , Y 2 ) or if he chooses (X 1 , X 2 ) when (Y 1 , Y 2 ) is available the consumer definitely wants the X-bundle than Y.   Weak preference Given any two consumption bundles(X 1 , X 2 ) and (Y 1 , Y 2 ), if the consumer is indifferent between the two commodity bundles or if (X 1 , X 2 ) (Y 1 , Y 2 ), the consumer would be equally satisfied if he consumes (X 1 , X 2 ) or (Y 1 , Y 2 ). 10/10/2024 2

3. Consumer Preferences Count… Completeness 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 It means that if a consumer prefers basket A to basket B and to basket C, then the consumer also prefers A to C. More is better than less Consumers always prefer more of any good to less and they are never satisfied or satiated. However, bad goods are not desirable and consumers will always prefer less of them. 10/10/2024 3

4. Consumer Preferences Count… 1.2 Utility Utility is the power of product to satisfy the human want. It is the expected satisfaction a consumer derives from the consumption of a commodity or using of a services. The concept of utility is characterized by ‘Utility’ and ‘Usefulness” are not synonymous. For example, paintings by Picasso may be useless functionally but offer great utility to art lovers. Utility is subjective. Utility of a product will vary from person to person. Utility is different It can be different at different places and time . 10/10/2024 4

5. Consumer Preferences Count… A Consumer considers the following to get maximum utility : How much satisfaction he gets from buying and then consuming an extra unit of a good or service. The price he pays to get the good. The satisfaction he gets from consuming alternative products The prices of alternative goods and services. 10/10/2024 5

6. Consumer Preferences Count… Assumptions consumer has exact and perfect knowledge of all information relevant to his consumption decisions: Knowledge of the goods and services available Their technical capacity to satisfy his wants Knowledge of market prices and her/his money income Consumer objective is to maximize satisfaction or utility 10/10/2024 6

7. 2. Approaches to Measure Utility There are two approaches to measure utility. Cardinal Approach Ordinal Approach. 10/10/2024 7

8. 2.1 The Cardinal Utility theory Cardinal Utility theory ( 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, utility can be quantitatively measured. 10/10/2024 8

9. Cardinals Count… 2.1.1 Assumptions of Cardinal Utility theory Rationality of Consumers . The main objective of the consumer is to maximize his/her satisfaction given his/her limited budget or income. Utility is Cardinally Measurable: Money is the most convenient measurement of utility. Constant Marginal Utility of Money. Limited Money Income. The consumer has limited money income to spend on the goods and services he/she chooses to consume. Diminishing Marginal Utility (DMU). The utility derived from each from each successive units of a commodity diminishes. The total utility of a basket of goods depends on the quantities of the individual commodities. 10/10/2024 9

10. Cardinals Count… 2.1.2 Total and Marginal Utility Total Utility (TU): It 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/her total utility increases. However, there is a saturation point for that commodity in which the consumer will not be capable of enjoying any greater satisfaction from it.       10/10/2024 10

11. Cardinals Count… Marginal Utility (MU): It refers to the additional utility obtained from consuming an additional unit of a commodity. It is the change in total utility resulting from the consumption of one or more unit of a product per unit of time. Graphically, it is the slope of total utility.  Mathematically, the formula for marginal utility is: Where,  TU is the change in Total Utility, and,  Q is change in the amount of product consumed. 10/10/2024 11

12. Cardinals Count… 2.1.3 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 the TU and total quantity consumed. 10/10/2024 12

13. Cardinals Count… Hypothetical table showing TU and MU of consuming Oranges (X)   10/10/2024 13 Units of Quantity(x) consumed Unit 1 st Unit 2 nd unit 3 rd unit 4 th unit 5 th Unit 6 th Unit TU X 0 util 10 utils 16 utils 20 utils 22 utils 22 utils 20 utils MU X 10 6 4 2 -2

14. Cardinals Count… Derivation of marginal utility from total utility TU TU MU 1 2 3 4 5 MU 10/10/2024 14 20 15 10 10 5 X X

15. Cardinals Count… As the consumer consumes more of a good per time period, TU increases, at an increasing rate when MU is increasing increases at a decreasing rate when MU starts to decrease reaches maximum when MU is Zero. The TU curve reaches its pick point (Saturation point) by consuming 5 oranges, the consumer attains its highest satisfaction of 22 utils. However, Consumption beyond this point results in dissatisfaction, because consuming 6th and more orange brings a lesser additional utility than previous orange. When the MU curve reaches its maximum point is called an inflexion point or the point of Diminishing MU. 10/10/2024 15

16. Cardinals Count… 2.1.4 Equilibrium of a consumer 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 x1,x2,…,xn, he/she would be in equilibrium or utility is maximized if and only if: Where: MUm –marginal utility of money=1 10/10/2024 16

17. Cardinals Count… Utility schedule for a single commodity   10/10/2024 17 Quantity of Total utility Marginal utility Marginal utility per Birr(price=2 birr) Marginal utility of money - - 1 1 6 6 3 1 2 10 4 2 1 3 12 2 1 1 4 13 1 0.5 1 5 13 1 6 11 -2 -1 1

18. Cardinals Count… For consumption level lower than 3 quantities of oranges, since the MU 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 3, since the MU of orange is lower than the price, the consumer can increase his/her utility by reducing its consumption of oranges. Mathematically, the equilibrium condition of a consumer that consumes a single good X occurs when the MU of X is equal to its market price.     10/10/2024 18

19. Cardinals Count… Utility schedule for two commodities with M=20 10/10/2024 19 Orange, Price=2birr Banana, Price=4birr Quantity TU MU MU/P Quantity TU MU MU/P - - - - 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 5 45 5 1.85 6 11 -2 -1 6 48 3 0.75

20. Cardinals Count… 10/10/2024 20 Utility is maximized when the condition of MU of one commodity divided by its market price is equal to the MU of the other commodity divided by its market price i.e. Thus, the consumer will be at equilibrium when he consumes 2 quantities of Orange and 4 quantities of banana, because

21. Cardinals Count… 2.1.5 Derivation of the Cardinalist Demand 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. 10/10/2024 21

22. Cardinals Count… Derivation of Cardinalist Demand Curve 10/10/2024 22 P 1 P P 2 P 1 P P 2 Q 1 Q Q 2 Demand Curve MU X a b c Quantity Quantity Price Price O O

23. Cardinals Count… Limitation of the Cardinalist approach The assumption of cardinal utility is doubtful because utility may not be quantified. Utility can not be measured absolutely (objectively). The satisfaction obtained from different commodities can not be measured objectively. The assumption of constant MU of money is unrealistic because as income increases, the marginal utility of money changes.   10/10/2024 23

24. 2.2 The Ordinal Utility Theory In the ordinal utility approach, utility cannot be measured absolutely but different consumption bundles are ranked according to preferences. The 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 util, or 3 util, 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 in the order of their preference as and so on. 24 10/10/2024

25. The Ordinal Utility Count… 2.2.1 Assumptions of Ordinal Utility theory 1 . The Consumers are rational 2. Utility is ordinal, utility is not absolutely measurable. 3. Diminishing Marginal Rate of Substitution (MRS): 4. The TU of the consumer depends on the quantities of the commodities consumed, i.e., U=f ( ) 5. Preferences are transitive or consistent: 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. Consistent: If market basket X is greater than market basket Y (X>Y) then Y not greater than X (Y not >X). 10/10/2024 25

26. The Ordinal Utility Count… 2.2.2 Indifference Set, Curve and Map 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/she 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. 10/10/2024 26

27. The Ordinal Utility Count… Indifference Set/ Schedule : It is a combination of goods for which the consumer is indifferent, preferring none of any others. It shows the various combinations of goods from which the consumer derives the same level of utility.   Indifference Schedule 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. 10/10/2024 27 Bundle (Combination) A B C D Orange (X) 1 2 4 7 Banana (Y) 10 6 3 1

28. The Ordinal Utility Count… Indifference Curves : it 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. By transforming the above indifference schedule into graphical representation, we get an indifference curve. 10/10/2024 28

29. The Ordinal Utility Count… indifference map 10/10/2024 29 1 2 4 7 1 2 6 10 A B C D OrangeX)) (X) Banana (Y) Indifference Curve (IC) IC 1 IC 2 IC 3 Good A Good B

30. The Ordinal Utility Count… Indifference Map : it is the entire set of indifference curves, which reflects the entire set of tastes and preferences of the consumer. A higher indifference curve refers to a higher level of satisfaction and a lower indifference curve shows lesser satisfaction. IC2 reflects higher level of utility than that of IC1 and IC3 reflects higher level of utility than that of IC2. Any consumer has lots of indifference curves, not just one. 10/10/2024 30

31. The Ordinal Utility Count… 2.2.3 Properties of Indifference Curves : 1. ICs have negative slope (downward to the right). In order to keep the utility of the consumer constant, as the quantity of one commodity is increased, quantity of the other must be decreased. 2. ICs do not intersect each other. If they did, the point of their intersection would mean two different levels of satisfaction, which is impossible. 3. A higher IC is always preferred to a lower one. The further away from the origin an IC lies, the higher the level of utility it denotes 4. ICs are convex to the origin . This implies that the slope of an IC decreases (in absolute terms) as we move along the curve from the left to the right. (the commodities can substitute, but are not perfect). 31 10/10/2024

32. The Ordinal Utility Count… 2.2.4 Marginal rate of substitution (MRS) MRS 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 negative of the slope of an IC at any point of any two commodities such as X and Y, and is given by the slope of the tangent at that point:  Slope of IC= 10/10/2024 32

33. The Ordinal Utility Count… Note that ( ) 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 remain on same IC. That is, because of the reduction in Y, MRS is negative. However, we multiply by negative one and express as a positive value. The rationale behind the convexity, that is, diminishing MRS, is that a consumer’s subjective willingness to substitute A for B (or B for A) will depend on the amounts of B and A he/she possesses. 10/10/2024 33

34. The Ordinal Utility Count… Example: level of consumption of good X and Y 10/10/2024 34 Bundle (Combination) A B C D Orange (X) 1 2 4 7 Banana (Y) 10 6 3 1

35. The Ordinal Utility Count… The relation ship between MU and MRS Suppose the utility function for two commodities X and Y is defined as: Since utility is constant on the same IC: The total differential of the utility function is: Or 10/10/2024 35

36. The Ordinal Utility Count… Example: Suppose a consumer’s utility function is given by . Compute the 10/10/2024 36

37. The Ordinal Utility Count… 2.2.5 Special Indifference Curves We have seen convexity or down ward sloping of IC and this shape of IC is for most goods. Here we assume that two commodities such as x and y can substitute to a certain extent but are not perfect. Perfect substitutes : If two commodities are perfect substitutes (if they are essentially the same), the IC becomes a straight line with a negative slope. MRS for perfect substitutes is constant. (Panel a) Perfect complements: If two commodities are perfect complements the IC takes the shape of a right angle. MRS for perfect complements is zero 10/10/2024 37

38. The Ordinal Utility Count… Special types of indifference curves III.A useless good: Panel C in the above figure shows an individual’s IC 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. 10/10/2024 38 Mobil Total IC 1 IC2 IC 3 Left shoe Right shoe Out dated books Food IC 1 IC2 IC 3 IC 1 IC 2 IC 3

39. 2.3 The Budget Line & Utility maximization ICs only tell us about the consumer’s preferences for any two goods but not which combinations of the two goods will be chosen or bought.. In reality, the consumer is constrained by his/her money income and prices of the two commodities. The budget line is a line or graph indicating different combinations of two goods that a consumer can buy with a given income at a given prices. It shows the market basket that the consumer can purchase, given the consumer’s income and prevailing market prices.   10/10/2024 39

40. The Budget Line Count… 2.3.1 Assumptions for the use of budget line There are only two goods, X and Y, bought in quantities X and Y; Each consumer is confronted with market determined prices, Px and Py , of good X and good Y respectively; and The consumer has a known and fixed money income (M). By assuming that the consumer spends all his/her income on two goods (X and Y), we can express the budget constraint as: 40 10/10/2024

41. The Budget Line Count… x 2 x 1 Budget constraint is p 1 x 1 + p 2 x 2 = m. m /p 2 m /p 1 10/10/2024 41

42. The Budget Line Count… x 2 x 1 Budget constraint is p 1 x 1 + p 2 x 2 = m. m /p 1 Just affordable m /p 2 10/10/2024 42

43. The Budget Line Count… x 2 x 1 Budget constraint is p 1 x 1 + p 2 x 2 = m. m /p 1 Just affordable Not affordable m /p 2 10/10/2024 43

44. The Budget Line Count… x 2 x 1 Budget constraint is p 1 x 1 + p 2 x 2 = m. m /p 1 Affordable but inefficient Just affordable Not affordable m /p 2 10/10/2024 44

45. The Budget Line Count… x 2 x 1 Budget constraint is p 1 x 1 + p 2 x 2 = m. m /p 1 Budget Set the collection of all affordable bundles. m /p 2 10/10/2024 45

46. The Budget Line Count… 10/10/2024 46 Example: Suppose a household with 30 Birr per day to spend on banana(X) at 5 Birr each and Orange(Y) at 2 Birr each. That is, Therefore, our budget line equation will be: Graphical presentation of BL ( 15 ) M=P X X+P Y Y (BL) M/P Y M/P X( 6)

47. The Budget Line Count… 2.3.2 Factors Affecting the Budget Line 1. Changes in consumer income If the income of the consumer changes (keeping the prices of the commodities unchanged) the BL will shifts. An increase in income of the consumer causes an upward shift of the budget line that allows the consumer to buy more the two goods and decreases in income of the consumer causes a downward shift of the budget line that leads the consumer to buy less quantity of the two goods. 10/10/2024 47

48. The Budget Line Count… Original budget set New affordable consumption choices x 2 x 1 Original and new budget constraints are parallel (same slope). 10/10/2024 48

49. The Budget Line Count… x 2 x 1 New, smaller budget set Consumption bundles that are no longer affordable. Old and new constraints are parallel. 10/10/2024 49

50. The Budget Line Count… Example : suppose the consumer income is Birr 280 and uses this income to buy two goods X and Y. If the price of X is Birr 2 per unit and that of Y is Birr 5 per unit then Formulate the budget equation and draw its line What will happen on the budget line if the consumer's income increased to Birr 350 10/10/2024 50

51. The Budget Line Count… 2. Effects of Changes in Price of the commodities M/PY’ M/PY M/P x M/Px ‘ Fig (a) Fig (b) P x ’ <Px, hence M/P x <M/P x1 P Y ’ < PY, hence M/P Y <M/P Y’ In the above figures (a) a price decline of good X results to rotate BL from B to B1. A fall in the price of good Y in figure (b) is reflected by the rotation of the budget line from B to B1. 10/10/2024 51 X X Y Y B B 1 B 1 B

52. The Budget Line Count… We can notice that unproportiona l 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. It simply shift the budget line outward (reduced price) or inward (increased in price). 10/10/2024 52

53. The Budget Line Count… Example: A person has Birr 100 to spend on two goods(X,Y) whose respective prices are Birr 3 and Birr5. Based on this given Draw the budget line. What happens to the original budget line if the budget falls by 25%? What happens to the original budget line if the price of X doubles? What happens to the original budget line if the price of Y falls to 4? 10/10/2024 53

54. The Budget Line Count… Solution First let as fid the BL equation which given as Based on our given When the person spends all of his income only on the consumption of good Y, Y intercept will be is(0,20) when the consumer spends all of his income on the consumption of only good X, X intercept is (33.33,0). 10/10/2024 54

55. The Budget Line Count… The graph of the budget line looks as follow 10/10/2024 55 20 33.33

56. The Budget Line Count… b. When the budget falls by 25% the new income will be 75 birr BL equation given as 3x+5y=75 X intercept will be x=25 Y intercept will be y=15 Y X 10/10/2024 56 20 15 25 33.33

57. The Budget Line Count… When the if the price of X doubles the original budget line will rotate inwards to the x axis BL equation given as 6x+5y=100 X intercept will be x=16.67 Y intercept will be y=20 y X 10/10/2024 57 20 16.67 33.33

58. The Budget Line Count… When the price of Y falls to 4 the budget line shift outward to the y axis BL equation given as 3x+4y=100 X intercept will be x=33.33 Y intercept will be y=25 Y X 10/10/2024 58 25 20 33.33

59. 2.4 Optimum 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 BL is tangent to the maximum possible IC the so that the slope of the BL is equal to the slope of an IC ( ) Thus, the condition for utility maximization, occurs where the consumer spends all income (i.e. he is on his BL) and slope of the IC equals to the slope of BL. 10/10/2024 59

60. Optimum of the Consumer Count… Graphically, the consumer optimum depicted as follows: Point ‘E’ 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). 60 X Y IC 1 IC 2 IC 3 IC 4 B A E C D 10/10/2024

61. Optimum of the Consumer Count… The maximization problem will be formulated as follows: We can rewrite the constraint as follows: Multiplying the constraint by Lagrange multiplier Forming a composite function gives as the Lagrange function: or 10/10/2024 61

62. Optimum of the Consumer Count… The equilibrium condition requires partial derivatives of the Lagrange function with respect to the two goods and langrage multiplier, then equate to zero. by substituting and solving the above equations we get the equilibrium condition as: by rearranging we get 62 10/10/2024

63. Optimum of the Consumer Count… Example: A consumer consuming two commodities X and Y has the following utility function . If the price of the two commodities are 4 and 2 respectively and his/her budget is birr 60 then find the quantities of good X & Y which will maximize utility and at optimum. 10/10/2024 63

64. Optimum of the Consumer Count… Solution The Lagrange equation will be written as follows:     By solving the two lambda values and substituting on the third equation we get or 10/10/2024 64

65. 2.4.1 Changes In Income and Engel Curve We noted that an increase in the consumer’s income (all other things held constant) results in an upward parallel shift of the budget line. And the reverse is also true  If we connect all of the points representing equilibrium market baskets corresponding to all possible levels of money income , the resulting curve is called the 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. 10/10/2024 65

66. Engel Curve Count… The income –consumption and the Engle curves 10/10/2024 66 Commodity X Commodity Y X 1 X 2 X 3 I 3 I 1 I 2 Engle Curve ICC E 1 E 2 E 3 Commodity X Income

67. Engel Curve count… From the ICC we can derive the Engle Curve. The Engle curve is named after Ernest Engel, the German Statistician who established studies of family budgets and expenditure positions The Engle Curve is the relationship 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; (Ceteries paribus) per unit of time. 67 10/10/2024

68. Engel Curve count… In relation to the shape of the ICC and Engle curves, goods can be categorized as normal and inferior goods. Commodities are said to be normal, when ICC and its Engle curve are positively sloped ; meaning that more of the goods are purchased at higher levels of income. Commodities are said to be inferio r when the ICC and Engle curve is negatively sloped, i.e. their purchase decreases when income increases. 10/10/2024 68

69. 2.4.2 Changes in Price and Price Consumption Curve We have seen that an increase in the price of good X, for example, increases the absolute value of the slope of the budget line, but it does not affect the vertical (Y) intercept of the line. Thus, the change in the price of x will result in out ward rotate of the budget line that makes the consumer to buy more of good x. If we connect all the points representing equilibrium market baskets corresponding to each price of good X we get price-consumption curve (PCC) . 10/10/2024 69

70. Changes in Price and PCC Count… The price-consumption curve 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 and other factors are held constant. We can derive the demand curve of an individual for a commodity from the price consumption curve. Below is an illustration of deriving the demand curve when price of commodity X decreases from 10/10/2024 70

71. Changes in Price and PCC Count… The PCC and derivation of the demand curve 10/10/2024 71 Individual demand curve PCC Commodity X Commodity Y Commodity X X 1 Px 1 Px 1 Px 3 Px 2 X 2 X 3

72. 2.4.2 Decomposition of Income and Substitution Effects If price falls (rises), the good becomes cheaper (expensive) relative to other goods; and consumers substitute toward (away from) the good. This is the substitution effect. As price falls (rises), consumer’s purchasing power increases (decreases). Since the set of consumption opportunities increases (decreases) as price changes, the consumer changes the mix of his or her consumption bundle. This effect is called the income effect. 10/10/2024 72

73. Changes in Price and PCC Count… The total price effect (PE) can be decomposed into substitution effect (SE) and income effect (IE) Income effect : it shows the change in Qd of a good due to the change in real income or purchasing power of the consumer resulted from decrease in price of the good. the consumer has left over income to purchase more. Substitution effect : shows the change in Qd of a good due to the consumer inherent tenders to substitute the cheaper from the relatively expensive one. the consumer buys more of the cheaper and less of the expensive good 10/10/2024 73

74. A. Normal Good Suppose initially the income of the consumer is , price of good Y is , and Price of good X is , we have the budget line with y-intercept and X-intercept . The consumer’s equilibrium is point A that indicates the point of tangency between the budget line and indifference curve . As a result of a decrease in price of X from to the budget line shifts outward with Y-intercept & X-Intercept . The consumer’s new equilibrium will be on point B. The change in the quantity purchased of commodity X from point A to point B shows the Net effect or total effect of the price decline . The total effect of the price change can be conceptually decomposed into the substitution effect and income effect. 10/10/2024 74

75. Normal Good Income and Substitution effect for a normal good 10/10/2024 75 x 2 x 1 x 3 IC 2 I/py 1 I’/py 1 I/px 2 I’/px 1 IC 1 A C   B  SE IE NE Note that: = NE = Total (net) effect = SE =Substitution effect = IE =Income effect

76. Normal Good The Substitution Effect The decline in the price of X results in an increase in the consumer’s real income, as evidenced by the movement to a higher IC even though money income remains fixed. Now, imagine that we decrease the consumer’s income by an amount just sufficient to return to the same level of satisfaction enjoyed before the price decline. Graphically, this is accomplished by drawing an imaginary line of attainable combinations with a slope corresponding to new ratio of the product price so that it is just tangent to the original indifference curve . 10/10/2024 76

77. Normal Good The point of tangency is the imaginary point C (imaginary equilibrium). The movement from A to the imaginary intermediate equilibrium at point C , which shows increase in consumption of X from X 1 to X 2 is the substitution effect. In other words, the effect of a decrease in price encourages the consumer to increase consumption of X than Y. 10/10/2024 77

78. Normal Good The Income Effect It is defined as the change in the quantity demanded of a commodity exclusively associated with a change in real income. It is determined by observing the change in the quantity demanded of a commodity that is associated solely with the change in the consumer’s real income. 10/10/2024 78

79. Normal Good letting the consumer’s real income rise from its imaginary level (defined by the line of attainable combinations tangent to point C ) back to its true level (defined by the line of attainable combinations tangent to point B ) gives the income effect. The income effect is indicated by the movement from the imaginary equilibrium at point C to the actual new equilibrium at point B , the increase in the quantity of X purchased from X 2 to X 3 is the income effect. 10/10/2024 79

80. Normal Good The magnitude of the substitution effect is greater than that of the income effect. The reason is that : Most goods have suitable substitutes and when the price of good falls, the quantity of the good purchased is likely to increase very much as consumers substitute cheaper good for others. Spending only a small fraction of his /her income, i.e. with the consumers purchasing many goods and spending only a small fraction of their income on any one good, the income effect of a price change of any one good is likely to be small. 10/10/2024 80

81. Normal Good For normal goods, the income and substitution effects reinforce one another (operate in the same direction). The substitution effect is always negative. if the price of a good X decreases and real income is held constant, there will always be an increase in the consumption of good X. The income effect is always positive , one would expect that increases in real income would result in increases in consumption of a normal good. 10/10/2024 81

82. B. Case of Inferior Goods For an inferior good, a decrease in the price of the commodity causes the consumer to buy more of it (the substitution effect) At the same time the higher real income of the consumer tends to cause him to reduce consumption of the commodity (the income effect). We usually observe that the substitution effect still is the more powerful of the two; even though the income effect works counter to the substitution effect, it does not override it. Hence, the demand curve for inferior goods is negatively sloped. 10/10/2024 82

83. Inferior Goods Income, Substitution, and Net effect for inferior goods 10/10/2024 83 X E 1 Y X 2 E 2 E 3 X 1 X 3 IE SE NE KEY: X 1 X 3 = NE=Net effect X 1 X 2 = SE=Substitution effect X 2 X 3 = IE=Income effect

84. C. Case of Giffen Goods In very rare occasions (for giffen goods), a good may be so strongly inferior that the income effect actually overrides the substitute effect. Such an occurrence means that a decline in the price of a good would lead to a decline in the Qd and that a rise in price will induce an increase in Qd. The name given to such a unique situation is Giffen paradox; which oppose the Law of demand. Qd is directly related to the price, at least over some range of variation of price. 10/10/2024 84

85. Giffen Goods 10/10/2024 85 IC 1 IC 2 Y X E 3 E 1 E 2   X 2 X 3 X 1 SE IE NE KEY: X 1 X 3 = NE=Net effect X 1 X 2 = SE=Substitution effect X 2 X 3 = IE=Income effect   Income, Substitution and net effects for a Giffen good

86. The Consumer Surplus 10/10/2024 86 While consumers purchase goods and services, they often pay less than what they are willing to pay. Thus, the difference between what they are willing to pay and what they actually paid is considered as their surplus. Therefore, consumer surplus is the difference between what a consumer is willing to pay and what he actually pays. Graphically, it is measured by the area below the demand curve and above the price level.

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88. 10/10/2024 88 Numerical Example Suppose the demand function of a consumer is given by: Compute the consumer surplus when the price of the good is 2 Compute the consumer surplus when the price of the good is 4 Compute the change in consumer surplus when the price changes from 2 to 4. Solution When Price is zero the demand for quantity purchased will be 15 and when the demand for quantity is put to zero then the price level will be 15.And finally, when we insert the given price level 2 in the demand equation we get the level of quantity demanded that is 13.Hence,we can easily compute the area of the triangle that is found above the given price level that is 2.

89. In panel a, the area of the triangle above price that is the consumer surplus is and in panel b the consumer surplus is 60.5.Therfoere,due to a change in the price level the consumer surplus will be 10/10/2024 89 15   4 15   2 Panel (a) Panel b

90. 2.5 Elasticity of demand A. Price elasticity of demand (E) It is defined as the percentage change in quantity demanded divided by the percentage change in price. E = percentage change in quantity demanded Percentage change in price Rearranging E is generally negative , since demand curves invariably have a negative slope. But we consider the absolute value of the coefficients. 10/10/2024 90

91. Cont’d If a good has an elasticity of demand greater than 1 in absolute value we say that it has an elastic demand . If the elasticity is less than 1 in absolute value we say that it has an inelastic demand . If it has an elasticity of exactly 1, we say it has unitary elastic demand . With most demand curves, the elasticity coefficient varies along the curve. E.g. linear demand curve q = a – bp and its elasticity is When p = 0 , the elasticity of demand is zero. When q = 0 , the elasticity of demand is infinity. The elasticity of demand equals unity at p=a/2b. 10/10/2024 91

92. Cont’d . Coefficients Responsiveness of quantity demanded to changes in price Terminology e = 0 No change in Q d for whatever change of the price perfectly inelastic 0 < e < 1 quantity demanded changes by a smaller percentage than the percentage change in price inelastic e = 1 quantity demanded changes by a percentage equal to the percentage change in price unit elastic 1 < e <  quantity demanded changes by larger percentage than the percentage change in price elastic e =  quantity demanded goes to zero or to all that is available perfectly elastic 10/10/2024 92

93. Cont’d Constant elasticity demands A demand curve given by a vertical line shows that quantity demanded is totally unresponsive to changes in price. Consequently, the elasticity coefficient is zero. D Q d p 10/10/2024 93

94. Cont’d On the other hand, if demand curve is given by a horizontal line, which is also a limiting case, a very small decrease in price would cause an infinite quantity of the good to be demanded. We refer to such a curve as a perfectly elastic demand curve. P D Q d 10/10/2024 94

95. Cont’d Factors affect price elasticity of demand: The availability of substitutes the more the good has substitutes, the higher the chance for consumers to switch to/from the good and hence the elastic the demand for the good is. Time longer the period, the more elastic the demand will be. Nature of the goods the luxurious the goods are the more elastic the demand will be. The reverse holds for necessity goods. 10/10/2024 95

96. B. Cross elasticity of demand The responsiveness of demand for one commodity to the changes in the prices of other commodities is called cross elasticity of demand. If cross elasticity has positive sign it indicates that a rise in the price of one of the goods results in rise in the quantity demanded of the other good. As a result the two goods are substitutes . 10/10/2024 96

97. Cont’d If the elasticity coefficient has a negative sign, it reflects that a rise in the price of one of the goods results in decline in the demand for the other indicating that the goods are complements . If cross elasticity is Zero the two goods are unrelated Example: d ue to increase in the price of good Y from 5 to 10 birr, the quantity demanded for good X decreased from 30 to 20 units, then calculate the cross price elasticity of demand. εxy = %▲ Qx / %▲ Py = 0.33 / 1 = 0.33 > 0 This implies that the two goods are substitutes This implies when price of good Y increase by 1%, the demand for good X will increase by the amount of 0.33. 10/10/2024 97

98. C. Income elasticity of demand This measures the responsiveness of quantity demanded to changes in income assuming all other things, including price, constant. When income elasticity is positive , they are called normal goods . When there are negative income elasticities and are called inferior goods . Goods with high positive income elasticity are considered as luxury goods . Necessities in contrast have low income elasticity. 10/10/2024 98

99. Cont’d Example: The demand function for honey for Mr. John is given as follows QH = 5850 – 6 PH + 2 PJ + 0.15 Y. where Y = income of Arthur John = Birr 8000; PH = price of honey = Birr 125 per kilogram; PJ = price of jam = Birr 70 per kilogram. Then find P rice elasticity of demand for honey The cross price elasticity of demand for honey The income elasticity of demand for honey 10/10/2024 99

100. Cont’d Find elasticity first we have to find QH QH = 5850 – 6(125) + 2(70) + 0.15(8000) = 5850 – 750 + 140 +1200 = 6440 To find price elasticity of demand we have to find dQ / Dph =-6 Then e= dQx / dPH *pH/QH = -6 x 125/6440 = -0.12. Cross price elasticity e xy = dQx / dP J *P J /QH =2x70/6440=0.02 Income elasticity of demand is given by e y = dQ / dy *y/QH= 0.15 x 8000/6440 = 0.186 10/10/2024 100