Introduction to economics Academic Year:-2021

Chapter Three: Theory of Consumer Behavior

3.1. Introduction
 In explaining consumer behavior, economics relies on the fundamental premise that people
choose those goods and services they value most highly.
 When analyzing consumer behavior, we’re talking about people trying to get
satisfaction—that is, about subjective feelings.
 Consumer theory is based on what people like, so it begins with something that we
can‘t directly measure, but must infer. That is, consumer theory is based on the premise
that we can infer what people like from the choices they make.
 The theory of consumer behavior is explanation of how consumers allocate their
resources (income) to the purchase of different goods and services to maximize their
wellbeing.
 All desires of a consumer are not of equal urgency or importance. Since his
resources are limited and he cannot fulfill all his desires, he must pick and
choose more important and more urgent desires for satisfaction.
 Thus, some desires take precedence of others. This is how a consumer ranks his
desires and builds up a scale of preferences. Scarcity forces him to choose.
 Ability to arrange preferences in order of importance or urgency is inherent in
human nature.
 The consumer makes choices by comparing bundle of goods.
 To describe the way consumers choose among different consumption possibilities, economists
a century ago developed the notion of utility.
 When analyzing consumer behavior, we’re talking about people trying to get satisfaction—
that is, about subjective feelings.
 What do we mean by “utility”? In a word, utility denotes satisfaction.
 Utility’ and ‘Usefulness’ are not synonymous.
- Utility is not essentially useful: A commodity having utility need not be useful.
- E.g. Liquor and cigarette are not useful, but if these things satisfy the want of addict
then they have utility for him.
 Utility is subjective: the utility of a product will vary from person to person.
- That means, the utility that two individuals derive from consuming the same level of a
product may not be the same.
- For example, non-smokers do not derive any utility from cigarettes.
 Utility can be different at different places and time
- For example, the utility that we get from drinking coffee early in the morning may be
different from the utility we get during lunch time.
 More precisely, it refers to how consumers rank different goods and services.
 If basket A has higher utility than basket B for Smith, this ranking indicates that Smith
prefers A over B.
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 Often, it is convenient to think of utility as the subjective pleasure or usefulness that a

person derives from consuming a good or service.
 Utility is a scientific construct that economists use to understand how rational
consumers make decisions.
 We derive consumer demand functions from the assumption that people make decisions
that give them the greatest satisfaction or utility.
 In the theory of demand, we assume that people maximize their utility, which means
that they choose the bundle of consumption goods that they most prefer.

3.2. Preferences and Utility

 Preference Relations
- Consumer preferences are characterized axiomatically.
- These axioms of consumer choice are intended to give formal mathematical expression to
fundamental aspects of consumer behavior and attitudes towards the objects of choice.
- Together, they formalize the view that the consumer can choose and that choices are consistent
in a particular way.
- A consumer makes choices by comparing bundle of goods.
- Given any two consumption bundles, the consumer either decides that one of the consumption
bundles is strictly better than the other, or decides that he or she is indifferent between the
two bundles.
 The basic preference relation
- In order to tell whether one bundle is preferred to another, we see how the
consumer behaves in choice situations involving two bundles.
 Strict Preference Relation
- If he or she always chooses X when Y is available, then it is natural to say that
this consumer prefers X to Y.
- We use the symbol ≻ to mean that one bundle is strictly preferred to another,
so that X ≻Y should be interpreted as saying that the consumer strictly prefers
X to Y, in the sense that she definitely wants the X-bundle rather than the Y-
bundle.
- X ≻Y if and only if X ⪰ Y and Y ⋡X
 Indifference Relation
- If the consumer is indifferent between two bundles of goods, we use the symbol
∼ and write X~Y. Indifference means that the consumer would be just as
satisfied, according to his or her own preferences, consuming the bundle X as
he or she would be consuming bundle Y.
- If the consumer prefers or is indifferent between the two bundles we say that he
or she weakly prefers X to Y and write X ⪰ Y or Y ⪰ X.
 The relations of strict preference, weak preference, and indifference are not independent
concepts; the relations are themselves related.

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- For example, if X ⪰ Y and Y ⪰ X, we can conclude that X ~Y. That is, if the
consumer thinks that X is at least as good as Y and that Y is at least as good as
X, then she must be indifferent between the two bundles of goods.
- Similarly, if X ⪰ Y but we know that it is not the case that X~ Y, we can
conclude that X≻Y. This just says that if the consumer thinks that X is at least
as good as Y, and she is not indifferent between the two bundles, then she thinks
that X is strictly better than Y.
3.3. Utility and Consumption
- An individual’s utility depends on everything that individual consumes.
- The set of all the goods and services an individual consumes is known as the individual’s
consumption bundle.
- The relationship between an individual’s consumption bundle and the total amount of utility
it generates for that individual is known as the utility function.
 Let each commodity be measured in some infinitely divisible units.
 Let 𝑥𝑖 ∈ R represent the number of units of good i.
 We assume that only non-negative units of each good are meaningful and that it is
always possible to conceive of having no units of any particular commodity.
 Further, we assume there is a finite, fixed, but arbitrary number n of different goods.
 We let x = (𝑥1 ,..., 𝑥𝑛 ) be a vector containing different quantities of each of the n
commodities and call x a consumption bundle or a consumption plan.
 What is feasible set?
- We let B represent all those alternative consumption plans that are both
conceivable and, more important, realistically obtainable given the consumer’s
circumstances.
- What we intend to capture here are precisely those alternatives that are
achievable given the economic realities the consumer faces.
- The feasible set B then is that subset of the consumption set X that remains
after we have accounted for any constraints on the consumer’s access to
commodities due to the practical, institutional, or economic realities of the
world.
- Therefore, is feasible set is a set which shows subset of consumption X is
conceivable and obtainable given the consumer’s circumstances.
3.4. Theories of Utility
 The consumer is assumed to be rational.
- Given his/her income and the market prices of the various commodities, he/she plans
the spending of his income so as to attain the highest possible satisfaction or utility.
- This is the axiom of utility maximization.
- In the traditional theory it is assumed that the consumer has full knowledge of all the
information relevant to his/her decision that is he has complete knowledge of all the
available commodities, their prices, and his/her income.

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- In order to attain this objective the consumer must be able to compare the utility
(satisfaction) of the various 'baskets of goods' which he can buy with his income.
 There are two approaches to measure or compare consumer’s utility derived from consumption
of goods and services.
- Cardinal and ordinal utility theories.
 The cardinalist school postulated that utility can be measured. Various suggestions have been
made for the measurement of utility.
- Under certainty (complete knowledge of market conditions and income levels over the
planning period) some economists have suggested that utility can be measured in
monetary units, by the amount of money the consumer is willing to sacrifice for
another unit of a commodity. Others suggested the measurement of utility in subjective
units, called utils.
 The ordinalist school postulated that utility is not measurable, but is an ordinal magnitude.
- The consumer need not know in specific units the utility of various commodities to
make his/her choice.
- It suffices for him/her to be able to rank the various 'baskets of goods' according to the
satisfaction that each bundle gives him.
- He/she must be able to determine his order of preference among the different bundles
of goods.
- The main ordinal theories are the indifference-curves approach and the revealed
preference hypothesis.

3.4.1. Cardinal utility theories

 According to the cardinal utility theory, utility is measurable by arbitrary unit of measurement
called utils in the form of 1, 2, 3 etc.
 We can measure utility in hypothetical units called utils.
- A util is a unit of utility.
- For example, we may say that consumption of an orange gives Bilen 10 utils and a
banana gives her 8 utils, and so on.
- From this, we can assert that Bilen gets more satisfaction from orange than from
banana.
 Assumptions
 Rationality.
- The consumer is rational.
- He/she aims at the maximisation of his utility subject to the constraint imposed by
his given income.
- In other words, given income and the market prices of the various commodities,
consumer plans the spending of his/her income so as to attain the highest possible
satisfaction or utility.
 Cardinal utility.

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- The utility of each commodity is measurable.

- Utility is a cardinal concept.
- The most convenient measure is money: the utility is measured by the monetary
units that the consumer is prepared to pay for another unit of the commodity.
 Constant marginal utility of money.
- This assumption is necessary if the monetary unit is used as the measure of
utility.
- A given unit of money deserves the same value at any time or place it is to be
spent.
- The essential feature of a standard unit of measurement is that it be constant.
- If the marginal utility of money changes as income increases (or decreases) the
measuring-rod for utility becomes like an elastic ruler, inappropriate for
measurement.
 Diminishing marginal utility.
- The utility gained from successive units of a commodity diminishes.
- In other words, the marginal utility of a commodity diminishes as the consumer acquires
larger quantities of it. This is the axiom of diminishing marginal utility.
 The total utility of a 'basket of goods' depends on the quantities of the individual
commodities.
- If there are n commodities in the bundle with quantities 𝑥1 , 𝑥2 , ..., 𝑥𝑛 , the total
utility is
U = f (𝑥1 , 𝑥2 , ..., 𝑥𝑛 )

3.4.2. Total and marginal utility

 Total Utility (TU): it refers to the sum total of satisfaction which a consumer receives by
consuming the various units of the commodity.
- The more units of a commodity she/he consumes, the greater will be her/his total
utility or satisfaction from it, up to a certain point.
- As he/she keeps on increasing the consumption of the commodity, he/she
eventually reaches the point of saturation represented by maximum total utility.
- If further units of the commodity are consumed, her/his total utility starts declining.
 Marginal Utility (MU): it is the extra satisfaction a consumer realizes from an additional
unit of the product.
- In other words, marginal utility is the change in total utility that results from the consumption
of one more unit of a product.
- Graphically, it is the slope of total utility.
- Mathematically, marginal utility is:
TU
MU  dTU
Q MU  or MUnth = TUn – TUn-1
dQ
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- Where, TU is the change in total utility, and Q is the change in the amount of product
consumed.
 Marginal utility can be:
- Positive Marginal Utility: If by consuming additional units of commodity, total
 Utility goes on increasing, then marginal utility of these units will be
positive.
- Zero Marginal Utility: If the consumption of additional unit of commodity
 Causes no change in the total utility, it means the marginal utility of
additional unit is zero.
- Negative Marginal Utility: If the consumption of an additional unit of a
 Commodity causes fall in total utility; it means the marginal utility is
negative
 Relationship between Total Utility and Marginal Utility

To explain the relationship between TU and MU, let us consider the following hypothetical
example.

Table 3.1: Total and marginal utility

Quantity Total utility (TU) Marginal utility (MU)
0 0 -
1 10 10
2 18 8
3 24 6
4 28 4
5 30 2
6 30 0
7 28 -2

- The total utility first increases, reaches the maximum (when the consumer consumes 6 units)
and then declines as the quantity consumed increases. On the other hand, the marginal utility
continuously declines (even becomes zero or negative) as quantity consumed increases.

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Graphically, the above data can be depicted as follows.

TU

30

TU

18 6 Quantity Consumed

0 2

0 2 6
Quantity Consumed
Figure 3.1: Total and marginal utility curves
 As it can be observed 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.



3.4.3. The law of diminishing marginal Utility
- According to the law of diminishing marginal utility, “for any individual consumer the
value that she/ he attaches to successive units of a particular commodity will diminish
steadily as her/his total consumption of that commodity increases, the consumption of all
other goods being held constant.
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- The law can also be stated in a simple language as follows: As the amount of a commodity
increases, the utility derived by the consumer from the additional units, that is, marginal
utility, goes on decreasing.
- Assumptions of the Law of Diminishing Marginal Utility:
 Various units of the good are homogeneous.
 There is no time gap between consumption of the different units.
 Consumer is rational (that is, she/he has complete knowledge and maximises utility).
 Tastes, preferences, and fashions remain unchanged.

3.4.4. Equilibrium of the consumer

 One commodity case
- We begin with the simple model of a single commodity x. The consumer can either buy x or
retain his money income Y.
- Under these conditions the consumer is in equilibrium when the marginal utility of x is equated
to its market price (𝑃𝑥 )·
- Symbolically: 𝑀𝑈𝑥 = 𝑃𝑥
 If the marginal utility of x is greater than its price, the consumer can increase his welfare
by purchasing more units of x.
 Similarly if the marginal utility of x is less than its price the consumer can increase his
total satisfaction by cutting down the quantity of x and keeping more of his income
unspent.
 Therefore, he attains the maximization of his utility when 𝑀𝑈𝑥 = 𝑃𝑥 .
 Mathematical derivation of the equilibrium of the consumer
The utility function is
U = f(𝑞𝑥 ) ……………………………………………………………………………. (1)
where utility is measured in monetary units.
If the consumer buys 𝒒𝒙 ; his expenditure is 𝑷𝒙 × 𝒒𝒙 Presumably the consumer seeks
to maximize the difference between his utility and his expenditure
U-(𝑃𝑥 × 𝑞𝑥 ) ………………………………………………………………………… (2)
The necessary condition for a maximum is that the partial derivative of the function with respect
to be 𝑞𝑥 equal to zero.
𝜕𝑈 𝜕(𝑃𝑥 ×𝑞𝑥 ) 𝜕𝑈
− = 0 => − 𝑃𝑥 = 0
𝜕𝑞𝑥 𝜕𝑞𝑥 𝜕𝑞𝑥

𝜕𝑈
= 𝑃𝑥 =>𝑀𝑈𝑥 = 𝑃𝑥 …………………………………………………………………………… (3)
𝜕𝑞𝑥

 More than one commodity case

- If there are more commodities, the condition for the equilibrium of the consumer is the
equality of the ratios of the marginal utilities of the individual commodities to their prices.

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MUx MUy 𝑀𝑈𝑛

=> = =⋯=
Px Py 𝑃𝑛

Example: Given a utility function of the form:

U(x,y) = 4x2 + 3xy +6y2: maximize utility subject to the budget constraint:
x + y = 56
Solution: The equilibrium condition is given by:
MU X MU Y
=
PX PY
Thus, 𝑀𝑈𝑥 = 8x + 3y, and px = 1
𝑀𝑈𝑦 = 12y + 3x, and py = 1

Applying the equilibrium condition , we have:

X = 36, and Y = 20 . Therefore, the consumer purchases 20 units of good Y and 36 units of
good X.

 Critique (Limitation) of the cardinal approach

- The assumption of cardinal utility is extremely doubtful. The satisfaction derived from
various commodities cannot be measured objectively.
- The assumption of constant utility of money is also unrealistic. As income increases the
marginal utility of money changes. Thus money cannot be used as a measuring-rod since its
own utility changes.

3.4.5. The ordinal utility theory ( 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.
- Ordinal utility theory says that the consumer can rank or order the utility he/she derives
from consuming different goods & services.
 The consumers can rank commodities in the order of their preferences as 1st, 2nd, 3rd and so
on.
 Assumptions
 Rationality.
- The consumer is assumed to be rational- he aims at the maximization of his utility,
given his income and market prices.
- It is assumed he has full knowledge (certainty) of all relevant information.
 Utility is ordinal.

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- It is taken as axiomatically true that the consumer can rank his preferences
(order the various 'baskets of goods') according to the satisfaction of each
basket.
- He need not know precisely the amount of satisfaction.
- It suffices that he expresses his preference for the various bundles of
commodities.
- It is not necessary to assume that utility is cardinally measurable. Only ordinal
measurement is required.
 Diminishing marginal rate of substitution.
- Preferences are ranked in terms of indifference curves, which are assumed to
be convex to the origin.
- This implies that the slope of the indifference curves increases.
- The slope of the indifference curve is called the marginal rate of substitution of
the commodities.
- The indifference-curve theory is based, thus, on the axiom of diminishing
marginal rate of substitution.
 The total utility of the consumer depends on the quantities of the commodities
consumed
U = f (𝑞1 , 𝑞2 , 𝑞𝑥 , 𝑞𝑦 , ..., 𝑞𝑛 )
 Consistency and transitivity of choice.
- It is assumed that the consumer is consistent in his choice, that is, if in one
period he chooses bundle A over B, he will not choose B over A in another
period if both bundles are available to him.
- The consistency assumption may be symbolically written as follows:
If A > B, then B ≯A
- Similarly, it is assumed that consumer's choices are characterised by
transitivity: if bundle A is preferred to B, and B is preferred to C, then bundle
A, is preferred to C. Symbolically we may write the transitivity assumption as
follows: If A > B, and B > C, then A > C

3.4.6. Indifference set, curve and map

 Indifference set/ 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.
Consider a consumer who consumes two goods X and Y (Table 3.1).

Bundle (Combination) A B C D
Orange 1 2 4 7
Banana 10 6 3 1

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- In table 3.1 above, 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 curve: When the indifference set/schedule is expressed graphically, it is

called an indifference curve.
- It is the locus of points each represents a different combination of two substitute
goods which yield the same utility or level of satisfaction to the consumer.
- It shows combinations of goods among which an individual is indifferent.
- Indifference curve is also called iso-utility curve and equal utility curve
- The slope of the indifference curve is the ratio of marginal utilities of the two
goods.

 A set of indifference curves is called indifference map.

- Each indifference curve in the map shows the market baskets among which the
person is indifferent.
- An indifference map shows all the indifference curves which rank the preferences
of the consumer.
- Combinations of goods situated on an indifference curve yield the same utility.
- Combinations of goods lying on a higher indifference curve yield higher level of
satisfaction and are preferred (𝑰𝑪𝟑 in figure 3.2).
- Combinations of goods on a lower indifference curve yield a lower utility (𝑰𝑪𝟏 in
figure 3.2)

Figure 3.2: Indifference curve and indifference map

3.4.7. Properties of indifference curves
 An indifference curve has a negative slope
- Which denotes that if the quantity of one commodity (y) decreases, the
quantity of the other (x) must increase, if the consumer is to stay on the
same level of satisfaction.
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 The further away from the origin an indifference curve lies, the higher the level of
utility
- It denotes: bundles of goods on a higher indifference curve are preferred
by the rational consumer.
 Indifference curves do not intersect (never cross each other).
- If they did, the point of their intersection would imply two different levels
of satisfaction, which is impossible.
 The 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:
the marginal rate of substitution of the commodities is diminishing.
- This axiom is derived from introspection, like the 'law of diminishing
marginal utility' of the cardinalist school. The axiom of decreasing
marginal rate of substitution expresses the observed behavioural rule that
the number of units of x the consumer is willing to sacrifice in order to
obtain an additional unit of y increases as the quantity of y decreases. It
becomes increasingly difficult to substitute x for y as we move along the
indifference curve.
- This assumption implies that the commodities can substitute one another at
any point on an indifference curve but are not perfect substitutes.
- If the commodities are perfect substitutes the indifference curve becomes
a straight line with negative slope.
- If the commodities are complements the indifference curve takes the shape
of a right angle.

3.4.8. 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.

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 It shows a consumer‘s willingness to substitute one good for another while he/she
is indifferent between the bundles.
 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. Hence, usually we take the absolute value of the slope.

Number of units of Y given up Y

MRS X ,Y  
Number of units of X gained X

- To understand the concept, consider the following indifference curve.

- From the above graph, 𝑀𝑅𝑆𝑥𝑦 associated with the movement from point A
to B, point B to C and point C to D is 2.0, 1.6, and 0.8 respectively. That is,
for the same increase in the consumption of good X, the amount of good Y
the consumer is willing to scarify diminishes.
- This principle of marginal rate of substitution is reflected by the convex
shape of the indifference curve and is called diminishing marginal rate of
substitution.
 It is also possible to derive 𝑀𝑅𝑆𝑥𝑦 using the concept of marginal utility.
 𝑀𝑅𝑆𝑥𝑦 is related to 𝑀𝑈𝑥 and 𝑀𝑈𝑦 as follows.
𝑀𝑈
𝑀𝑅𝑆𝑥𝑦 = 𝑀𝑈𝑥
𝑦
 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.
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 Example: Suppose a consumer‘s utility function is given by U(X,Y) = 𝑋 4 𝑌 2

Required: 𝑴𝑹𝑺𝒙𝒚

3.4.9. The budget line or the price line

 Indifference curves only tell us about consumer preferences for any two goods but they cannot
show which combinations of the two goods will be bought.
- In reality, the consumer is constrained by his/her income and prices of the two
commodities.
- Preferences do not explain all of consumer behavior.
- Budget constraints also limit an individual’s ability to consume in light of the must pay
for various goods and services.
- This constraint is often presented with the help of 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.
- In order to draw a budget line facing a consumer, we consider the following
assumptions.
 There are only two goods bought in quantities, say, X and Y.
 Each consumer is confronted with market determined prices, PX and PY.
 The consumer has a known and fixed money income (M).
- Assuming that the consumer spends all his/her income on the two goods (X and Y), we
can express the budget constraint as:
M  PX X  PYY

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Note:
Px
- The slope of the budget line is given is by= − (the ratio of the prices of the two
Py
goods).
- Any combination of the two goods within the budget line (such as point A) or along the
budget line is attainable.
- Any combination of the two goods outside the budget line (such as point B) is
unattainable (unaffordable).
 Example: A consumer has $100 to spend on two goods X and Y with prices $3 and $5
respectively. Derive the equation of the budget line and sketch the graph.

 When the consumer spends all of her income on good Y, we get the Y- intercept
(0, 20). Similarly, when the consumer spends all of her income on good X, we
obtain the X- intercept (33.3, 0). Using these two points we can sketch the graph
of the budget line.

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 Factors affecting Budget Line

 Effects of Changes in Income
 An increase in income causes the budget line to shift outward, parallel to the original
line (holding prices constant).
 A decrease in income causes the budget line to shift inward, parallel to the original
line (holding prices constant).
 An equal increase in the prices of the two goods shifts the budget line inward.
- Since the two goods become expensive, the consumer can purchase the lesser
amount of the two goods.
 An equal decrease in the prices of the two goods, one the other hand, shifts the
budget line out ward.
- Since the two goods become cheaper, the consumer can purchase the more
amounts of the two goods.

Qy

Qx
 Income effect on inferior goods; inferior commodity’s consumption declines with
increase in income, it has a negative income effect.
 Income effect on Normal goods; normal commodity’s consumption increases with
increase in income, it has a positive income effect.

 Effects of price change

1. Price Changes: When price changes the slope of the budget line changes and the consumer
equilibrium also changes. Total price effect is the change in consumption basket resulting
from changes in prices.
 If the two goods increase in price, but the ratio of the two prices is unchanged,
the slope will not change.
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By Asimamaw B. (Msc.)
Introduction to economics Academic Year:-2021

 However, the budget line will shift inward to a point parallel to the original
budget line.
 If the two goods decrease in price, but the ratio of the two prices is unchanged,
the slope will not change.
 However, the budget line will shift outward to a point parallel to the original
budget line.

 The total price effect can be divided in to two factors; the income effect and the
substitution effect.
 What would happen if price of x falls, while the price of good Y and money income
remaining constant?
𝑀
Py

Effect of a decrease in price of x on the

budget line

𝑀 𝑀
X1 X2

 What would happen if price of x rises, while the price of good Y and money income
remaining constant?
𝑀
Py

𝑀 𝑀
X2 X1

3.4.10. Equilibrium of the consumer

 The consumer is in equilibrium when he maximizes his utility, given his income and the market
prices.

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By Asimamaw B. (Msc.)
Introduction to economics Academic Year:-2021

 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
𝐏𝐱
the slope of the indifference curve (𝑴𝑹𝑺𝒙𝒚 ) is equal to the slope of the budget line ( 𝐏𝐲 ).
- Marginal rate of substitution be equal to the ratio of commodity prices

 Graphical presentation of the equilibrium of the consumer

- At the equilibrium, the budget line is tangent to the indifference curve.

Figure 3.7: Consumer equilibrium under indifference curve approach

 Example: A consumer consuming two commodities X and Y has the utility
function U(X, Y)  XY  2X. The prices of the two commodities are 4 birr and
2 birr respectively. The consumer has a total income of 60 birr to be spent on
the two goods.
a. Find the utility maximizing quantities of good X and Y.
b. Find the MRSxy at equilibrium
o Solution
a. The budget constraint of the consumer is given by: PX.X+ PY.Y = M
4X+2Y= 60 …………..…………. (i)
Moreover, at equilibrium

18 | P a g e
By Asimamaw B. (Msc.)
Introduction to economics Academic Year:-2021

Substituting equation (ii) into (i), we obtain Y 14 and X  8.

b. At the equilibrium, MRS can also be calculated as the ratio of the prices of the two goods

“End of Chapter Three”

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By Asimamaw B. (Msc.)