AEA 101 INTRODUCTORY AGRICULTURAL ECONOMICS AND DEVELOPMENT

1. AEA 101: INTRODUCTION TOAEA 101: INTRODUCTION TO
AGRICULTURAL ECONOMICSAGRICULTURAL ECONOMICS
AND DEVELOPMENTAND DEVELOPMENT
Unit 3:Unit 3:
Consumer Equilibrium and MarketConsumer Equilibrium and Market
DemandDemand
Damian M. Gabagambi, PhDDamian M. Gabagambi, PhD
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2. Consumer EquilibriumConsumer Equilibrium
In the utility theory, we said, a consumer
purchases a good/service because of the
satisfaction he/she expects to receive from it.
They strive to0 achieve maximum satisfaction
from consumption of scarce resources =
consumer’s equilibriumconsumer’s equilibrium
The same applies for indifference curve
analysis, but this time we introduce the limitation
imposed by money/budget constraint
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3. Consumer Equilibrium…Consumer Equilibrium…
The consumer is said to be in
equilibrium when he/she obtains
the maximum possible
satisfaction from his purchases,
given the price in the market and
the amount of money he has for
making purchases.
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4. Consumer equilibriumConsumer equilibrium
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P
M
N
A
BR
H
O X
Y
IC3
IC1
IC2
IC4
Mangoes
Apples
•Consumer equilibrium will be reached at
point P, where a consumer will buy OR
units of apples and OH units of mangoes
•Note that the consumer is in equilibrium
where the slope of a budget line is equal to
the slope of an indifference curve = Point PPoint P
on IC2. This is the highest possible
satisfaction level in this case

5. Income Consumption LineIncome Consumption Line
 If income of any consumer increases, price
remaining the same budget line will shift upward
 Thus consumer equilibrium position will also
change
 When in the case of different budget lines,
different equilibrium points of the consumer are
obtained then the line which will join these points
is called income consumption lineincome consumption line or expenditureexpenditure
consumptionconsumption lineline.
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6. Income consumption lineIncome consumption line
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P2
M
DBO F
Y
IC3
IC1
IC2
IC4
Apples
P3
P1
P4
Income consumption line or Expenditure curve
A consumer will be equilibrium position at point P1, P2 ,P3 … at different incomes. When
these points join together, we get expenditure curve of the consumer. This curve shows
us the quantities of these two commodities that the consumer will purchase at different
levels income.
A
E
C
Mangoes

7. Price Consumption LinePrice Consumption Line
 When the price of any commodity changes, the budget line will
also change
 Equilibrium position of the consumer will also changes from one
point to another
 Due to changes in prices of one commodity, we can get different
equilibrium points of the consumer
 When all these points of the equilibrium are joined together, we get
the price consumption curveprice consumption curve of the consumer.
 Price consumption curve shows how the purchase plan of the
consumer should be revised if the price of one commodity
changes.
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8. Price consumption line
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P2
A
BRO C
Y
IC3
IC1
IC2
Apples
P3
P1
Price consumption line
•Original price line is
AB and the
consumer is in
equilibrium position
at P1.
•We assume that
price of apple falls
and equilibrium
position of the
consumer changes
from P1 to P2., etc
D
Mangoes

9. The Impact of a Price Change:The Impact of a Price Change:
Income and Substitution EffectIncome and Substitution Effect
Economists often separate the
impact of a price change into
two components:
–the substitution effect; and
–the income effect.

10. The Impact of a Price Change...
The substitution effect involves the
substitution of good x1 for good x2 or vice-
versa due to a change in relative prices of
the two goods
The income effect results from an increase
or decrease in the consumer’s real income
or purchasing power as a result of the price
change
The sum of these two effects is called the
price effect.

11. The Impact of a Price Change...
The decomposition of the price effect
into the income and substitution effect
can be done in several ways.
There are two main methods:
● The Hicksian method; and
● The Slutsky method

12. The Hicksian Method
Sir John R. Hicks lived 1904-
1989
Awarded the Nobel Laureate
in Economics in 1972 for work
on general equilibrium theory
and welfare economics.

13. The Hicksian MethodThe Hicksian Method
X2
X1
Ea
I1
xa
Optimal bundle is
Ea, on indifference
curve I1.

14. The Hicksian Method...The Hicksian Method...
X2
X1
I1
xa
Ea
A fall in the price of X1
The budget line pivots
out from PP*

15. The Hicksian Method...The Hicksian Method...
X2
X1
Eb
I1
I2
xa xb
Ea
The new optimum is
Eb on I2.
The Total Price
Effect is xa to xb

16. The Hicksian Method...The Hicksian Method...
To isolate the substitution effect we
ask….
“what would the consumer’s optimal
bundle be if s/he faced the new lower
price for X1 but experienced no change
in real income?”
This amounts to returning the consumer
to the original indifference curve (I1)

17. The Hicksian Method
X2
X1
I1
I2
xa xb
Ea
Eb
Draw a line parallel to
the new budget line and
tangent to the old
indifference curve

18. The Hicksian Method
X2
X1
Ec I1
I2
xa xc xb
Ea
Eb
The new optimum on I1 is
at Ec. The movement from
Ea to Ec (the increase in
quantity demanded from
Xa to Xc) is solely in
response to a change in
relative prices

19. The Hicksian Method
X2
X1
I1
I2
Substitution
Effect
Ea
Eb
Ec
This is the
substitution effect.
Xa Xc

20. The Hicksian Method
To isolate the income effect …
Look at the remainder of the total
price effect
This is due to a change in real
income.

21. The Hicksian Method
X2
X1
I1
I2
Income Effect
Ea
Eb
Ec
The remainder of the total
effect is due to a change
in real income. The
increase in real income is
evidenced by the
movement from I1 to I2
Xc
Xb

22. The Hicksian Method
X2
X1
I1
I2
xa xc xb
Sub
Effect
Income
Effect
Ea
Eb
Ec

23. The Slutsky Method
Eugene Slutsky (1880-1948)
Russian economist expelled from the
University of Kiev for participating in
student revolts.
In his 1915 paper, “On the theory of the
Budget of the Consumer” he introduced
“Slutsky Decomposition”.

24. The Slutsky Method
X2
X1
Ea
I1
xa
Optimal bundle is Ea, on
indifference curve I1.

25. The Slutsky Method
X2
X1
I1
xa
Ea
A fall in the price of X1
The budget line pivots
out from PP*

26. The Slutsky Method
X2
X1
Eb
I1
I2
xa xb
Ea
The new optimum is
Eb on I2.
The Total Price
Effect is xa to xb

27. The Slutsky Method
Slutsky claimed that if, at the new prices,
– less income is needed to buy the original
bundle then “real income” has increased
– more income is needed to buy the original
bundle then “real income” has decreased
Slutsky isolated the change in demand due
only to the change in relative prices by asking
“What is the change in demand when the
consumer’s income is adjusted so that, at the
new prices, s/he can just afford to buy the
original bundle?”

28. The Slutsky Method
To isolate the substitution effect we
adjust the consumer’s money income
so that s/he change can just afford the
original consumption bundle.
In other words we are holding
purchasing power constant.

29. The Slutsky Method
X2
X1
Eb
I1
I2
xa xb
Ea
The new optimum is
Eb on I2.
The Total Price
Effect is xa to xb

30. THE SLUTSKY METHOD
X2
X1
Eb
I1
I2
xa xb
Ea
Draw a line parallel
to the new budget
line which passes
through the point
Ea.

31. The Slutsky Method
X2
X1
Eb
I3
I2
xa xb
Ea
The new optimum
on I3 is at Ec. The
movement from Ea
to Ec is the
substitution effect
Ec
xc

32. The Slutsky Method
X2
X1
Eb
I3
I2
xa
Ea
The new optimum
on I3 is at Ec. The
movement from Ea
to Ec is the
substitution effect
Ec
xc
Substitution Effect

33. The Slutsky Method
X2
X1
Eb
I3
I2Ea
The remainder of
the total price effect
is the Income Effect.
The movement from
Ec to Eb.
Ec
xc
Income Effect
xb

34. It is possible to derive demand
function/curve from the income and
substitution effect concepts, and examine
the effect on price or income change on
demand
– Normal goods
– Inferior goods
– Ordinary goods
– Giffen goods
But such derivation is beyond the scope of
this introductory course

35. HICKSIAN ANALYSIS And DEMAND CURVES
22111 xpxpM +=
P1
P1*
22111 xpxpM += ∗
A
A
B
B
C
Hicksian Demand
Curve (A & C)
Marshallian Demand
Curve (A & B)
P
X1
X1
P
A fall in price
from p1 to p1
*
C