Micro

1. Microeconomics I (Econ 2021)
Addis Ababa University
College of Business and Economics
Department of Economics
Instructor: Negash Mulatu
Email: negash.mulatu@aau.edu.et
Physical Address: Near Parking Lot, Old Economics
Building,
Ground Floor, # 222, Or
Office of the Student Career Development Centre (SCDC)

2. Chapter One
Theory of Consumer Behavior
and Demand

3. Chapter One
Theory of Consumer Behavior
 Consumer behavior can be best
understood in three steps.
◦ Examining consumer‘s preference, to
describe how people prefer one good to
another
◦ Looking at consumers budget
constraints – they have limited incomes
that restrict the quantities of goods they
can buy.
◦ Putting consumer preference and
budget constraint together to determine
consumer choice.

4. Consumer Preferences and Choices
Axioms of consumer preferences
 Strict preference: Given any two consumption
bundles(X1, X2) and (Y1, Y2), if (X1,X2)>(Y1,Y2)
 Weak preference: 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: 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 and Consistency:
 More is better than less: Consumers always
prefer more of any good to less and they are never
satisfied or satiated.

5. UTILITY
 Utility is the level of satisfaction that is
obtained by consuming a commodity or
undertaking an activity.
 Utility is characterized by the following
◦ ‘Utility’ and ‘Usefulness” are not
synonymous.
◦ Utility is subjective. The utility of a product
will vary from person to person.
◦ The utility of a product can be different at
different places and time.

6. Approaches of measuring utility
There are TWO Approaches
I. The cardinal utility theory
II. The ordinal utility theory
1. The cardinal utility theory
 According to the cardinal utility theory,
utility is measurable by arbitrary unit of
measurement called utils in the form of
1, 2, 3 etc.

7. 1.1. Assumptions of cardinal
utility theory
1. Rationality of consumers
2. Utility is cardinally measurable: Utility
is measured in objective terms/units
called utils.
3. Constant marginal utility of money: A
given unit of money deserves the same
value at any time or place it is to be
spent.
4. Diminishing marginal utility (DMU):
This refers to the marginal utility of
successive units of consumption
5. The total utility of a basket of goods
depends on the quantities of the
individual commodities. TU = f (X1 , X2

8. 1.2. Total and marginal utility
 Total Utility (TU) is the total
satisfaction a consumer gets from
consuming some specific quantities of
a commodity at a particular time.
 Marginal Utility (MU) is the extra
satisfaction a consumer realizes from
an additional unit of the product.
◦ It is the change in total utility that results
from the consumption of one more unit of a
product.
◦ Graphically, MU is the slope of total utility.

9.  Mathematically, marginal utility is:
where, ∆TU is the change in total
utility, and ∆Q is the change in the
amount of product consumed.
Table : Total and marginal utility

10. Graphically, the above data can be depicted as
follows.

11.  As it can be seen from the above figure,
◦ When TU is increasing, MU is positive.
◦ When TU is maximized, MU is zero.
◦ When TU is decreasing, MU is negative.
1.3. Law of Diminishing Marginal
Utility (LDMU)
 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 extra satisfaction that a consumer
derives declines as he/she consumes
more and more of the product in a given
period of time.

12.  The law of diminishing marginal
utility is based on the following
assumptions.
◦ The consumer is rational
◦ The consumer consumes identical or
homogenous product. The commodity
to be consumed should have similar
quality, color, design, etc.
◦ There is no time gap in consumption
of the good
◦ The consumer taste/preferences
remain unchanged

13. 1.4. Equilibrium of a consumer
 The objective of a rational consumer is to
maximize total utility.
 As long as the additional unit consumed
brings a positive marginal utility, the
consumer wants to consumer more of the
product because total utility increases.
 Given the limited income and the price
level of goods and services, what
combination of goods and services should
the consumer consume so as to get the
maximum utility?
 Two cases of equilibrium
I. One commodity case, &
II. Two or more commodity case

14. I. The case of one commodity
 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.

15.  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.

16. II. Case of two or more commodities
 The consumer‘s equilibrium is
achieved when the marginal utility per
money spent is equal for each good
purchased and his money income
available for the purchase of the goods
is exhausted.
where, M is the income of the consumer.

17. Example: Suppose Mr. X has 20 Birr to be spent on two
goods: banana and bread. The unit price of banana is 3
Birr and the unit price of a loaf of bread is 4 Birr. The
marginal utility he obtains from consumption of each
good is given below.Banana Bread
Quantity MU MU/P MU MU/P
1 18 6 12 3
2 15 5 8 2
3 9 3 6 1.5
4 6 2 3 0.75
5 0 0 2 0.5
6 -6 -2 1 0.25
Combinations satisfying the ratio are:
• 3 units of banana and 1 loaf of bread = requires 13 birr = (3*3) +
(1*4)
• 4 units of banana and 2 loaves of bread = requires 20 birr = (4*3) +
(2*4)

18.  Recall that 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 market price.
◦ From the table above, there are different
combinations of the two goods where MU of the
last birr spent on each commodity is equal.
◦ But, only one of the two combinations is
consistent with the prices of the goods and his
income.
◦ Mr. x will be at equilibrium when he consumes 4
units of banana and 2 loaves of bread.
◦ The total utility that Mr. x derives from this
combination 68 ( = 48 + 20 )

19. 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.

21. Limitation of the Cardinalist approach
1. The assumption of cardinal utility is
doubtful because utility may not be
quantified.
2. Utility can not be measured absolutely
(objectively). The satisfaction obtained
from different commodities can not be
measured objectively.
3. The assumption of constant MU of money
is unrealistic because as income increases,
the marginal utility of money changes.

22. 2. The ordinal utility theory
 The ordinal utility theory is also known as
the indifference curve approach.
 It is not possible for consumers to
express the utility of various commodities
they consume in absolute terms, like 1
util, 2 utils, or 3 utils
◦ but it is possible to express the utility in
relative terms (in ordinal terms).
◦ consumers can rank commodities in the order
of their preferences as 1st, 2nd, 3rd and so on.
◦ Therefore, the consumer need not know in
specific units the utility of various commodities
to make his choice.

23. 2.1. Assumptions of ordinal utility
theory
i. Consumers are rational
ii. Utility is ordinal - utility is not absolutely
(cardinally) measurable.
iii. Diminishing marginal rate of substitution
(MRS): MRS is the rate of substitution is the
rate at which a consumer is willing to
substitute one commodity for another
commodity so that his total satisfaction
remains the same.
iv. The total utility of a consumer is measured
by the quantities of all items he/she
consumes from his/her consumption
basket.
v. Consumer’s preferences are consistent

24. 2.2. Indifference set, curve and map
 Indifference set or schedule is a
combination of goods for which the
consumer is indifferent.
◦ It shows the various combinations of goods
from which the consumer derives the same
level of satisfaction.

25.  When the indifference set/schedule is
expressed graphically, it is called an
indifference curve.
 Indifference curve: An indifference
curve shows different combinations of
two goods which yield the same utility
(level of satisfaction) to the consumer.
 A group of indifference curves is called
indifference map.

27. Properties of indifference curves (ICs)
1. Indifference curves have negative slope
◦ Implies the consumption one good can be
increased only by reducing the consumption of
the other.
◦ To keep the utility constant, as the quantity of
one good is increased the other must be
decreased.
◦ Shows trade-off and substitution between
goods
2. ICs are convex to the origin.
 implies that slope of an IC decreases as we move
along the curve from the left to the right.
 Also, implies that MRS diminishes.
 Commodities can substitute one another at any

28. 3. A higher indifference curve is always
preferred to a lower one.
 The further away from the origin an
indifferent curve lies, the higher the level
of utility it denotes.
 A higher indifference curve contains more
of the two commodities than the lower
ones.
4. Indifference curves never cross each
other (cannot intersect).
 Intersection of ICs rules out the
assumptions of consistency and
transitivity
 The figure below shows the violations of
the assumptions of preferences due to
the intersection of indifference curves.

29. Figure : Intersection of indifference curves
• The figure implies that the consumer prefers bundle B to
bundle C.
• On IC1, the consumer is indifferent between bundle A
and C, and along IC2 the he is indifferent between
bundle A and B.
• By transitivity, this implies that the consumer is
indifferent between bundle B and C which is
contradictory or inconsistent with the initial statement
where the consumer prefers bundle B to C.
• Therefore, indifference curves never cross each other.

30. Marginal Rate of Substitution (MRS)
 Marginal rate of substitution is a rate at
which consumers are willing to substitute
one commodity for another in such a way
that the consumer remains on the same
indifference curve.
 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
X so that the consumer maintains the
same level of satisfaction.
 Since one of the goods is scarified to
obtain more of the other good, the MRS is
negative.

31. It is also possible to derive MRS using the concept of
marginal utility.

32.  Proof: Suppose the utility function for two
commodities X and Y is defined as:
U = f (X,Y)
 Since utility is constant along an
indifference curve, the total differential of
the utility function will be zero.
 From the total differential, we can get
 Example: Suppose a consumer‘s utility
function is given by
MRSX,Y = 2Y/X

33. Special Indifference Curves
 Convexity or down ward sloping is among
the characteristics of indifference curve and
this shape of indifference curve is for most
goods.
 In this situation, we assume that 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.

34. I. Perfect substitutes
 If two commodities are perfect substitutes (if
they are essentially the same), the
indifference curve becomes a straight line
with a negative slope.
 MRS is constant.
 Represented by

35. II. Perfect complements
 If two commodities are perfect complements,
the indifference curve shaped as right angle.

36. • MRS can be either zero or infinite.
• Marginal rate of substitution is zero
whenever there are more right shoes than left
shoes. This is because the consumer would
not give up any left shoes to get additional
right shoes.
• Marginal rate of substitution is infinite
whenever there are more left shoes than
right, since the consumer will give up all but
one of the excess left shoes she has in order
to obtain an additional right shoe.
• Represented by

37. 2.3. The Budget Constraint
 It is represented by a line called the
budget line
 The budget line is a set of the
commodity bundles that can be
purchased if the entire income is spent.
 It is a graph which shows the various
combinations of two goods that a
consumer can purchase given his/her
limited income and the prices of the
two goods.

38.  Assume that there are two goods
(good X and good Y) with their prices
Price of good X (Px) and Price of good
Y (Py) and limited income of the
consumer (M).
 By rearranging the above equation, we
can derive the following general
equation of a budget line.
 The slope of the budget line is given is
by -Px/Py

39. Figure : The budget line
• Example: A consumer has $1000 to
spend on two goods X and Y with prices
$100 and $25 respectively. Derive the
equation of the budget line and sketch the
graph.

40. Effects of Change in Income and
Prices on the Budget Line
A. Change in income:
 If the income of the consumer changes
(keeping the prices of the commodities
unchanged), the budget line shifts
(changes).
◦ Increase in income causes an
upward/outward shift in the budget line that
allows the consumer to buy more goods and
services
◦ Decrease in income causes a
downward/inward shift in 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)

41. Figure: Effects of increase (right) and decrease
(left) in income on the budget line

42. B. Change in prices:
 A simultaneous increase in the prices
of the two goods shifts the budget line
inward.
 A simultaneous decrease in the prices
of the two goods, one the other hand,
shifts the budget line out ward.
Figure: Effect
of
proportionate
increase
(inward) and
decrease (out
ward) in the
prices
of both goods

43.  An increase or decrease in the price of
one of the two goods, keeping price of
the other good & income constant,
changes the slope of the budget line by
affecting only the intercept of the
commodity that records the change in
the price.
Figure : Effect
of decrease in
the price of
only good X
on the budget
line

44. 2.4. Optimum of the consumer
 A rational consumer tries to attain the
highest possible indifference curve,
given the budget line.
 This occurs at the point where the
indifference curve is tangent to the
budget line so that the slope of the
indifference curve is equal to the
slope of the budget line.

45.  In figure below, the equilibrium of the
consumer is at point E where the
budget line is tangent to the highest
attainable indifference curve (IC2).
Fig : Consumer
equilibrium
under
indifference
curve approach

46.  Mathematically, consumer optimum
(equilibrium) is attained at the point
where:
Slope of indifference curve = Slope of the
budget line

47. Example: If she spends all of her income on
trouser and shoe during Easter shopping,
Amen can afford 2 trousers and 4 pairs of
shoes. She could also use her entire budget to
buy 6 trousers and 2 pairs of shoes. If the price
of a trouser is 600 Birr, then
A) How much is Amen’s income allocated for
Easter shopping?
B) What is the budget line equation of Amen?
C) If Amen’s utility function is U=T0.6S0.4,
where T is Trousers and S is Pair of
Shoes. What is the optimal combination of
Trousers and Pair of Shoes for Amen?

48. Effects of Changes in Income and Prices on
Consumer’s optimum
A. Changes In Income
 This will be analyzed using the Income
Consumption Curve and the Engel Curve.
 If we connect all of the points representing
equilibrium market baskets corresponding to all
levels of income, the resulting curve is called the
Income Consumption Curve (ICC) or Income
Expansion Curve (IEC).
 ICC is a curve joining the points of consumer
optimum (equilibrium) as income changes (ceteris
paribus).
◦ It is the locus of consumer equilibrium points resulting when
only the consumer’s income varies.

50.  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;
(celeries paribus) per unit of time.
 Normal and Inferior Goods
 Normal goods: ICC and Engle curve are
positively sloped; meaning that more of the goods
are purchased at higher levels of income.
 Inferior goods: when the income consumption
curve and Engle curve are negatively sloped, i.e.
purchase decreases when income increases.

51. B. Changes in Price
 This will analyzed using the Price
Consumption Curve (PCC) and Individual
Demand Curve
 The PCC is the locus of the utility-
maximizing combinations of products that
result from variations in the price of one
commodity when other product prices, the
money income and other factors are held
constant.
Example: Change in price of good x
 Increase in price of good x rotates the
budget line to the inward direction
 Decrease in price of good x rotates the

52. • If we connect all the points representing
equilibrium market baskets corresponding to
each price of good x, we get a curve called
price-consumption curve (PCC).

53. Mathematical derivation of equilibrium
(reading assignment)
The maximization problem will be formulated
as follows:
 It can be derived using the Lagrangian
method of optimization. Finally, you will get
And,

54. 2.5. Income and Substitution Effects
 Why demand curves slope downward?
 There are two effects of a price change.
 Substitution Effect: If price falls (rises), the
good becomes cheaper (more expensive)
relative to other goods; and consumers
substitute toward (away from) the good.
 Income Effect: As price falls (rises), the
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.

55. The case of a price-decline for good x
 Here, we assume that good x is Normal
Good
 Decrease in price increases the consumer’s
real income (purchasing power), thus
enhancing the ability to buy more goods and
services to some extent. This is called the
Income Effect (IE)
 Decrease in the price of a commodity
induces some consumers (the consumer) to
substitute it for others, which are now
relatively expensive (higher price)
commodities. This is called Substitution
Effect (SE).

56.  In order to graphically decompose the net
effect in to substitution and income effect:
Note the following points
 The Substitution Effect: The 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; thereby restricting the consumer’s
reaction to the price change to a movement along
the original indifference curve.
 The Income Effect: The income effect may be
defined as the change in the quantity demanded
of a commodity exclusively associated with a
change in real income. The income effect is
determined by observing the change in the
quantity demanded of a commodity that is

57. In short in the case of normal goods, the income
effect and the substitution effect operate in the
same direction – they reinforce each other.

58. What happens to the SE and IE if the good
is Inferior Good?
 Not all goods are normal.
 For inferior goods, the income effect is the
opposite (of that of a normal good).
 IE and SE operate in opposite direction.
 A decrease in the price of the commodity
causes the consumer to buy more of it (the
substitution effect), but
 At the same time the higher real income of
the consumer tends to cause him to reduce
consumption of the commodity (the income
effect).

59.  For Inferior Goods, the
substitution effect still is the more
powerful than the income effect,
 Even though the income effect
works counter to the substitution
effect, it does not override it.
 Hence, the demand curve for
inferior goods is still negatively
sloped.

61.  In very rare occasions, a good may be so
strongly inferior that the income effect
actually overrides the substitute effect. In this
case the good is called Giffen Good.
 For Giffen goods the income effect (which
decreases the quantity demanded) is so
strong that it offsets the substitution effect
(which increases the quantity demanded),
with the result that the quantity demanded is
directly related to the price, at least over
some range of variation of price.

62. Figure 1.20: Income, Substitution and Net Effects for a
Giffen Good, when there is a decline in price of good x.

63. The Slutsky Equation
 The Slutsky Equation says that the total
change in demand is the sum of the
substitution effect and the income effect.
Example: Suppose the consumer has a
demand function for good X is given by
 Initially, his income is $ 200 per month and the price
of the good is 5 per kilogram. Therefore, his demand
for good X will be 28 units.
 Suppose that the price of the good falls to 4 per
kilogram. Therefore, the new demand at the new
price will be 32.5 units.
 Thus, the total change in demand is 32.5 – 28 = 4.5
units.

64.  When the price falls the purchasing power of
the consumer changes. Hence, in order to
make the original consumption of good X, the
consumer adjusts his income. This can be
calculated as follows:
 Subtracting the second equation from the
first gives
 Therefore, the new income to make the
original consumption affordable when price
falls to 4 is:

65.  Hence, the level of income necessary
to keep purchasing power constant is
 The consumers new demand at the
new price and income will be :
 Therefore, the substitution effect will
be:
 The income effect will be:

66. 2.6. The Consumer Surplus
 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.

67. Example: Suppose the demand function of a consumer is
given by: Q= 15 - P
a. Compute the consumer surplus if price of the good is 2.
b. Compute the consumer surplus if price of the good is 4
c. Compute the change in consumer surplus when the
price changes from 2 to 4.

68. 2.7. Elasticity of Demand (Reading
Assignment)
 There are three types of elasticities of demand:
i. Price Elasticity of Demand
ii. Income Elasticity of Demand
iii. Cross Elasticity of Demand
 You are expected to revise on the following points
and work on few mathematical exercises for
yourself.
◦ Types of Price Elasticities of Demand (Inelastic
Demand, Elastic Demand, Unitary Elastic Demand,
Perfectly Elastic Demand, and Perfectly inelastic
Demand) and their interpretation.
◦ Income Elasticity for Normal Goods and Income
Elasticity for Inferior Goods.
◦ Cross-Price Elasticity of Demand for Substitutes and

69. End of
Chapter One