Kwame Nkrumah University of

Science & Technology, Kumasi,

Ghana

Lecture 4
Background
to Demand
 Kwame Nkrumah University of
Science & Technology, Kumasi,
Ghana

Water - Diamond Paradox

 Adam Smith in the 1760s gave the example of
water and diamonds.
 ‘How is it’, he asked, ‘that water which is so
essential to human life, and thus has such a
high -“value-in-use”, has such a low market
value (or “value-in- exchange”) ?
 And how is it that diamonds which are
relatively so trivial have such a high market
value?’
 Kwame Nkrumah University of
Science & Technology, Kumasi,
Ghana

Water - Diamond Paradox

 The marginal utility revolution of the 1870s.
William Stanley Jevons (1835–82) in England,
Carl Menger (1840–1921) in Austria, and Leon
Walras (1834–1910) in Switzerland all
independently claimed that the source of the
market value of a good was its marginal utility,
not its total utility.
 Kwame Nkrumah University of
Science & Technology, Kumasi,
Ghana

Rational consumer
 It means a person who attempts to get the best
value for money from his or her purchases. Given
that we have limited income, we do not want to
waste our money.
 Don’t confuse irrationality and ignorance.
 We are going to assume that consumers behave
rationally, but that does not mean that they have
perfect information.
 Kwame Nkrumah University of
Science & Technology, Kumasi,
Ghana

Rational consumer
 The term ‘rational’ does not imply any
moral approval. It is simply referring to
behaviour that is consistent with your own
particular goals, behaviour directed to
getting the most out of your limited income.
 Kwame Nkrumah University of
Science & Technology, Kumasi,
Ghana

Theory of Consumer Behaviour

 There are three theories that explain a consumer’s
behaviour; that is why a consumer buys more at a
lower price and vice versa.
These are:
 Marginal Utility Theory
 Indifference Theory
 Revealed Preference Theory
 Kwame Nkrumah University of
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Ghana

UTILITY
Utility is the sense of pleasure, or satisfaction,
that comes from consumption.

The utility that a person derives from

consuming a particular good depends on that
person’s tastes or preferences for different
goods and services.
 likes and dislikes,
 Thus Utility is subjective
 Kwame Nkrumah University of
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Ghana

UTILITY
We generally assume simply that tastes are
given and are relatively stable
 different people may have different tastes
but a given individual’s tastes are not
constantly in flux
 Kwame Nkrumah University of
Science & Technology, Kumasi,
Ghana

Total and marginal utility

 Total Utility (TU) is the total satisfaction a
person derives from all those units of a
commodity consumed within a given period
of time.
 In other words, Total utility is the total
utility a consumer derives from the
consumption of all of the units of a good or
a combination of goods over a given
consumption period, ceteris paribus.
 Thus if Christabel drinks 10 bottles of coke,
total satisfaction from the 10 bottles is the
total Utility.
 Kwame Nkrumah University of
Science & Technology, Kumasi,
Ghana

Total and marginal utility

 Marginal utility is the additional satisfaction
derived from consuming one extra unit of
the commodity within a given time period.
 Put differently, Marginal utility is the
change in total utility resulting from a one-
unit change in consumption of a good.
 Kwame Nkrumah University of
Science & Technology, Kumasi,
Ghana

Total and marginal utility

Units of Water Total Marginal
Consumed Utility Utility
(glasses)
0 0 -
1 40 40
2 60 20
3 70 10
4 75 5
5 73 -2
 Darren’s utility from consuming crisps (daily)
16

14

12

10 Packets TU
of crisps in utils
8
Utility (utils)

6 0 0
4 1 7
2
2 11
0
3 13
0 1 2 3 4 5 4 6 14
-2
5 14
6 13

Packets of crisps consumed (per day)

 Darren’s utility from consuming crisps (daily)
16

14
TU
12

10 Packets TU
of crisps in utils
8
Utility (utils)

0 0
6
1 7
4 2 11
3 13
2 4 14
5 14
0 6 13
0 1 2 3 4 5 6
-2

Packets of crisps consumed (per day)

 Darren’s utility from consuming crisps (daily)
16

14
TU
12

10 Packets TU MU
of crisps in utils in utils
8
Utility (utils)

0 0 -
6 1 7 7
2 11 4
4 3 13 2
4 14 1
2
5 14 0
0 6 13 -1
0 1 2 3 4 5 6
-2

Packets of crisps consumed (per day)

 Darren’s utility from consuming crisps (daily)
16

14
TU
12

10 Packets TU MU
of crisps in utils in utils
8
Utility (utils)

0 0 -
6 1 7 7
2 11 4
4 3 13 2
4 14 1
2
5 14 0
0 6 13 -1
0 1 2 3 4 5 6
-2

MU
Packets of crisps consumed (per day)
 Darren’s utility from consuming crisps (daily)
16

14
TU
12

10
DTU = 2

8 DQ = 1
Utility (utils)

4 MU = DTU / DQ
2

0
0 1 2 3 4 5 6
-2

MU
Packets of crisps consumed (per day)
 Darren’s utility from consuming crisps (daily)
16

14
TU
12

10
DTU = 2

8 DQ = 1
Utility (utils)

4 MU = DTU / DQ = 2/1 = 2
2

0
0 1 2 3 4 5 6
-2

MU
Packets of crisps consumed (per day)
 Kwame Nkrumah University of
Science & Technology, Kumasi,
Ghana

Total and Marginal Utility curves.

You Must notice the following about the TU and
MU Curves:
 The MU curve slopes downwards, this
illustrates the concept of diminishing marginal
utility.
 The TU curve stars from the origin, implying
that zero consumption yields zero utility.
 The Marginal utility is zero when TU reaches
its maximum.
 Kwame Nkrumah University of
Science & Technology, Kumasi,
Ghana
Law of Diminishing Marginal Utility
 The more of a good an individual consumes
per time period, other things constant, the
smaller the increase in total utility from
additional consumption.

 The law of diminishing marginal utility states

that as more and more units of a particular
good is consumed, the extra satisfaction
derived from extra units consumed declines.
 This applies to all consumption (Proverbs
25:17
 Kwame Nkrumah University of
Science & Technology, Kumasi,
Ghana

Question:
Christabel eats five slices of pizza one
evening but admits that each slice of pizza
doesn't taste as good as the previous one. This
suggests that for Christabel
A. The TU from pizzas is past its maximum point.
B. The MU of a slice of pizza is negative.
C. The MU is still rising but by smaller amounts.
D. The MU is positive but declining.
E. The TU is positive but declining.
 Kwame Nkrumah University of
Science & Technology, Kumasi,
Ghana
The optimum level of consumption: the one-
commodity version
 One solution to the problem is to measure
utility with money.
 utility becomes the value that people place on
their consumption. Marginal utility thus
becomes the amount of money a person would
be prepared to pay to obtain one more unit.
 If Philip is prepared to pay GH¢2 to obtain an
extra packet of plantain chips, then we can say
that packet yields him GH¢2 worth of utility:
MU = GH¢ 2.
 Kwame Nkrumah University of
Science & Technology, Kumasi,
Ghana
The optimum level of consumption: the one-
commodity version
 So how many packets should he consume if he
is to act rationally? To answer this we need to
introduce the concept of consumer surplus
 Kwame Nkrumah University of
Science & Technology, Kumasi,
Ghana
Consumer Surplus
 Consumer Surplus is the excess of what a
person would have been willing to pay for a
good (i.e. The utility) over what that person
actually pays.
 Marginal consumer surplus is the difference
between what a consumer would be willing to
pay for one more unit of a product and what
the person actually pays.
 Thus: MCS = MU - P
 Kwame Nkrumah University of
Science & Technology, Kumasi,
Ghana
Consumer Surplus
 If Novelta were willing to pay GH¢3 for
additional plate of indomie, which in fact only
cost her GH¢2.5, then she would be getting a
marginal consumer surplus of 50pesewas.

 If Philo is willing to pay GH¢5000 for Iphone

12 but the price is actually GH¢4850, then her
consumer surplus is GH¢150.
 Kwame Nkrumah University of
Science & Technology, Kumasi,
Ghana
Consumer Surplus
 Total consumer surplus is the sum of all the
marginal consumer surpluses obtained from
all the units of a good she consumes.

 It is the difference between the total utilities

from all the units a consumer consumes and
the total expenditures. THUS
 Kwame Nkrumah University of
Science & Technology, Kumasi,
Ghana
Consumer Surplus
 If Novelta consumes four packs of chocolate,
and if she would have been prepared to spend
GH¢16 on them and only had to spend GH
¢12, then her total consumer surplus GH¢4

 Suppose Christabel is willing to spend GH

¢240 on ten plates of pizza for her roommates.
If the price per box of pizza is GH¢9.50, what
is her total consumer surplus on the ten boxes
of pizza?
 Consumer surplus
MU, P

20
16
14
10

MU/D

O 1 2 3 4 Q
 Consumer surplus
MU, P

Total
consumer
surplus
P1

Total
consumer MU/D
expenditure

O Q1 Q
 Kwame Nkrumah University of
Science & Technology, Kumasi,
Ghana
Utility maximization Rule
 If we define rational consumer behaviour as
the attempt to maximize consumer surplus.

 How do people set about doing this?

 People will go on purchasing additional

units as long as they gain additional
consumer surplus: (MU>P).
 Kwame Nkrumah University of
Science & Technology, Kumasi,
Ghana
Utility maximization Rule
 But as more units are purchased, so they will
experience diminishing marginal utility.
 Their marginal utility will go on falling until
MU = P:
i.e. until no further consumer surplus can be
gained.

 Their optimum level of consumption has been

reached: consumer surplus has been
maximized.
 Kwame Nkrumah University of
Science & Technology, Kumasi,
Ghana
Utility maximization Rule
 A rational consumer attempts to maximize
consumer surplus.

 A rational consumer would buy an additional

unit of a good as long as the perceived dollar
value of the utility of one additional unit of
that good (say, its marginal dollar utility) is
greater than its market price.
 Kwame Nkrumah University of
Science & Technology, Kumasi,
Ghana
Utility maximization Rule
 The equilibrium occurs where:
MU = P

 If MU>P, the consumer must buy more since

the surplus is positive

 If MU < P, the consumer must buy less since

the consumer surplus is negative.
 Q Rational consumer behaviour is where a
person consumes the amount of a good that
A. maximises the total utility
from the good.
B. maximises the consumer
surplus from the good.
C. minimises the amount spent
on the good to achieve a
given level of utility.
D. maximises the marginal
utility from the good.
E. equates the marginal utility
with that from other goods.
 Q An individual’s consumer surplus
will tend to fall as:
A. the market approaches
equilibrium.
B. the market supply curve shifts
to the right.
C. marginal utility increases at
higher prices.
D. the individual’s demand curve
becomes more price elastic at
the optimum level of
consumption.
E. the individual’s demand curve
becomes less price elastic at the
optimum level of consumption.
Marginal utility and the demand curve
 maximising consumer surplus: P = MU
 Individual's demand curve for any good is the
same as their marginal utility curve for that
good, where utility is measured in monetary
terms.
 This is shown in the figure below:
 Deriving an individual person’s demand curve
MU, P

Consumption at Q1

P1
a where P1 = MU

MU = D

O Q1 Q
 Deriving an individual person’s demand curve
MU, P

Consumption at Q2

P1
a where P2 = MU

b
P2

MU = D

O Q1 Q2 Q
 Deriving an individual person’s demand curve
MU, P

Consumption at Q3

P1
a where P3 = MU

b
P2

P3
c

MU = D

O Q1 Q2 Q3 Q
 Kwame Nkrumah University of
Science & Technology, Kumasi,
Ghana
Multiple commodity rule:
Limitations of the one-commodity version
 marginal utility affected by consumption of other
goods
 marginal utility of money not constant
Optimum combination of goods
the equi-marginal principle
MUA/MUB = PA/PB
 Kwame Nkrumah University of
Science & Technology, Kumasi,
Ghana
Multiple commodity rule:
 If the price of good a falls such that
MUA/MUB > PA/PB
The consumer would buy more of good A and
less of other goods
 If the price of good a rises such that
MUA/MUB < PA/PB
The consumer would buy less of good A and
more of other goods
 Kwame Nkrumah University of
Science & Technology, Kumasi,
Ghana

Indifference analysis
 Kwame Nkrumah University of
Science & Technology, Kumasi,
Ghana
the indifference analysis
 In the indifference analysis, we do not measure
utility, we merely measure satisfaction by
ranking various combinations of goods in order
of preference.
 In other words, it assumes that consumers can
decide whether they prefer one combination s
of goods to another.
 Kwame Nkrumah University of
Science & Technology, Kumasi,
Ghana
Assumptions of Consumer Behaviour
 Baskets or bundles is a collection of goods or services that an individual
might consume.

1. Complete:

 Preferences are complete if the consumer can rank any two baskets of goods.
Thus, the consumer can always do one of these:

 A preferred to B
 B preferred to A
 Kwame Nkrumah University of
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Ghana
Assumptions of Consumer Behaviour
2. Transitive:
Preferences are transitive if a consumer who
prefers basket A to basket B, and basket B to
basket C also prefers basket A to basket C.

3. More is better less.

basket with more of at least one good and no
less of any good is preferred to the original
basket. Thus, there is non-satiation.
 Kwame Nkrumah University of
Science & Technology, Kumasi,
Ghana
Assumptions of Consumer Behaviour
 An Indifference curve shows all the various
combinations of two goods that give an
equal amount of satisfaction or utility to a
consumer.
 A Typical Indifference curve

•
A
Y1

B
Y2
• IC

0 X
X1 X2

46
Constructing an indifference curve

Pears Oranges Point

30 6 a
24 7 b
20 8 c
14 10 d
10 13 e
8 15 f
6 20 g

Combinations of pears and

oranges that Clive likes
the same amount as
10 pears and 13 oranges
 Constructing an indifference curve
30
28
26
Pears Oranges Point
24
22 30 6 a
20 24 7 b
18 20 8 c
14 10 d
16
10 13 e
14
Pears

8 15 f
12
6 20 g
10
8
6
4
2
0
0 2 4 6 8 10 12 14 16 18 20 22

Oranges
 Constructing an indifference curve
30 a
28
26 Pears Oranges Point
24
30 6 a
22
24 7 b
20
20 8 c
18
14 10 d
16
10 13 e
Pears

14
8 15 f
12 g
6 20
10
8
6
4
2
0
0 2 4 6 8 10 12 14 16 18 20 22

Oranges
 Constructing an indifference curve
a
30
28
Pears Oranges Point
26
b 30 6 a
24
22 24 7 b
20 8 c
20
14 10 d
18
10 13 e
16
Pears

8 15 f
14
6 20 g
12
10
8
6
4
2
0
0 2 4 6 8 10 12 14 16 18 20 22

Oranges
 Constructing an indifference curve
a

Pears Oranges Point

b 30 6 a
30
24 7 b
28
20 8 c
26 c d
14 10
24 e
10 13
Pears

22 f
8 15
20 g
d 6 20
18
16
14 e
12 f
10
8 g
6
4
2
0
0 2 4 6 8 10 12 14 16 18 20 22

Oranges
 Kwame Nkrumah University of
Science & Technology, Kumasi,
Ghana
The Slope of Indifference curve
 The indifference curves are negatively
sloped and thus have negative slopes.

 The negative slope of the indifference curve

is called the Marginal Rate of Commodity
Substitution.
 Kwame Nkrumah University of
Science & Technology, Kumasi,
Ghana
The Slope of Indifference curve
 The MRS shows the amount of one
commodity that a consumer is prepared to
give up in order to consume one more unit
of another commodity and still maintain the
same level of satisfaction.

 The MRS declines as one moves down on

an IC. This concept is called Diminishing
MRS
 Deriving the marginal rate of substitution (MRS)
30
a
DY = 4 MRS = 4
26 b

20 DX = 1 MRS = Y/X
Units of good Y

10

0
0 10 20

67
Units of good X
 Deriving the marginal rate of substitution (MRS)
30
a
DY = 4 MRS = 4
26 b

20 DX = 1 MRS = Y/X
Units of good Y

Diminishing marginal
10 rate of substitution

MRS = 1
c
DY = 1 d
9
0 DX = 1
0 10 20

67 13 14
Units of good X
 Q The marginal rate of substitution is:

A. the total amount of utility

received by a consumer from
consuming one product
relative to another.
B. the amount by which demand
falls as price rises.
C. the ratio of the extra amount
of one product needed to
compensate for the loss of a
unit of another.
D. marginal utility divided by
the price of the product.
E. the degree of convexity of a
given indifference curve.
 Kwame Nkrumah University of
Science & Technology, Kumasi,
Ghana
Indifference Map
 An indifference map is the collection of
Indifference curves corresponding to
different levels of satisfaction
 Indifference Map
Y

IC5
IC4
IC3
IC2
IC1
0 X

58
 An indifference map
30

The further out the curve, the

20
higher the level of utility
Units of good Y

An indifference curve shows all

10
combinations of X and Y that
give a particular level of utility.

0 I5
0 10 20
I4
I3
I2
I1

Units of good X
 Kwame Nkrumah University of
Science & Technology, Kumasi,
Ghana
Properties of Indifference Curves
 Property 1: Higher indifference curves are
preferred to lower ones.
 Property 2: Indifference curves are
downward sloping. This reflects the law of
diminishing MRS.
 Property 3: Indifference curves do not
cross
 The impossibility of two indifference curves crossing
30

A consumer cannot be
indifferent between a
20
and both b and c
Units of good Y

10
a
c
0
I2
0 10
b 20

I1

Units of good X
 Q Indifference curves cannot intersect
because this would imply that:

A. the consumer has 20% 20% 20% 20% 20%

imperfect information.
B. the ratio of the marginal
utilities had risen.
C. both prices and income
have fallen.
D. the consumer is not a
rational agent.
E. the marginal rate of A. B. C. D. E.

substitution had become

negative.
 Kwame Nkrumah University of
Science & Technology, Kumasi,
Ghana
The budget constraint
 The budget constraint shows all
combinations of goods that just exhaust the
consumer’s resources.
 That is, the set of baskets that the consumer
may purchase given the limits of the
available income.

PxX + PyY = I
 Kwame Nkrumah University of
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Ghana
The budget constraint
 Two goods available: X and Y
 I= GHȻ10
 Px = GHȻ5
 Py = GHȻ2
 Budget Line :

5X + 2Y = 10
 The budget Line
Y

I/PY
•
Budget line

•C
Slope -PX/PY

•
I/P X
X
 A budget line
30 a

Units of Units of Point on

good X good Y budget line
20
0 30 a
Units of good Y

5 20
10 10
15 0
10

Assumptions

PX = £2
0
0 5 10 15 20 PY = £1
Budget = £30

Units of good X
 A budget line
30 a

Units of Units of Point on

good X good Y budget line
20
0 30 a
b
Units of good Y

5 20 b
10 10
15 0
10

Assumptions

PX = £2
0
0 5 10 15 20 PY = £1
Budget = £30

Units of good X
 A budget line
30 a

Units of Units of Point on

good X good Y budget line
20
0 30 a
b
Units of good Y

5 20 b
10 10 c
15 0
10

c Assumptions

PX = £2
0
0 5 10 15 20 PY = £1
Budget = £30

Units of good X
 A budget line
30 a

Units of Units of Point on

good X good Y budget line
20
0 30 a
b
Units of good Y

5 20 b
10 10 c
15 0 d
10

c Assumptions

PX = £2
0
0 5 10 15 20 PY = £1
Budget = £30

Units of good X
 Effect of an increase in income on the budget line
40

30
Units of good Y

20

10

Assumptions

PX = £2
0
0 5 10 15 20 PY = £1
Budget = £30

Units of good X
 Effect of an increase in income on the budget line
40

Assumptions
30 PX = £2
PY = £1
Budget = £40
Units of good Y

20

10
16
m

0
Budget
0 5 10 15 20 = £40
Budget
= £30

7
Units of good X
Effect on the budget line of a fall in the price of good X
30

Assumptions

PX = £2
20 PY = £1
Budget = £30
Units of good Y

10

0
0 5 10 15 20 25 30

Units of good X
Effect on the budget line of a fall in the price of good X
30

Assumptions

PX = £2
20 PY = £1
Budget = £30
Units of good Y

10

0
0 5 10 15 20 25 30

Units of good X
Effect on the budget line of a fall in the price of good X
30

Assumptions

PX = £1
20 PY = £1
Budget = £30
Units of good Y

10

0
0 5 10 15 20 25 30

Units of good X
Shift in the Budget Line from A fall in Price of
Y
X

M/PY
•
Initial Budget line
New Budget line

Slope –PX/PY

Slope –P*X/PY

M/PX
•
M/P* X
X
 Shift in the Budget Line from A Rise in Price
Y
of X

M/PY
•
New Budget line

Initial Budget line

Slope –P*X/PY
Slope –PX/PY

M/P*X
•
M/P X
X
Shift in the Budget Line from A Fall in Consumer
Income
Y

M/PY
•
New Budget line

M*/PY Initial Budget line

Slope –PX/PY
Slope –PX/PY

M*/PX
•
M/P X
X
Shift in the Budget Line from A Fall in Consumer
Income
Y

M*/PY
•
Initial Budget line

M/PY New Budget line

Slope –PX/PY
Slope –PX/PY

M/PX
•M*/P X
X
 Q If the price of both goods doubles and
also income doubles, the budget line will:
A. not change. 20% 20% 20% 20% 20%

B. shift outward parallel to

the previous budget line.
C. shift inward parallel to
the previous budget line.
D. become steeper, crossing
the mid-pint of the
previous budget line.
E. become less steep, A. B. C. D. E.
crossing the mid-pint of
the previous budget line.
 Kwame Nkrumah University of
Science & Technology, Kumasi,
Ghana
Consumer Equilibrium
 A consumer is in equilibrium when, given
personal income and price constraints, the
consumer maximizes the total utility or
satisfaction from her expenditures.
 In other words, a consumer is in
equilibrium when, given her budget line,
the person reaches the highest possible
indifference curve. This occur at the point
where the consumer’s budget line is tangent
to the highest indifference curve.
 Consumer Optimum
Y

D
•A
• Optimal Choice

E
•
C
• IC
•
B
BL
0 X
81
 Kwame Nkrumah University of
Science & Technology, Kumasi,
Ghana

Consumer Equilibrium
 At the point of equilibrium, the slope of the
IC (MRS) must be equal to the ration of the
two Prices(Px/Py)

 That is MRS = Px/Py

 “The rate at which the consumer would be

willing to exchange X for Y is the same as
the rate at which they are exchanged in the
marketplace.”
 Finding the optimum consumption
Points r, s, u and v
give a lower level of
r utility than point t.
s
Units of good Y

Point t gives
the maximum
level of utility
Y1 t

u I5
I4
v I3
I2
I1
O X1
Units of good X
 Income Consumption Curve
Income consumption curve is the locus
of point of consumer equilibrium
resulting when only the consumer’s
income is varied.
The Engel curve shows the amount of a
commodity that the consumer would
purchase per unit of time at various
levels of income. The Engel curve is
derived from Income consumption
curve
 Effect on consumption of a change in income
Units of good Y

B1 I1
O
Units of good X
 Effect on consumption of a change in income
Units of good Y

I2
B1 B2 I1
O
Units of good X
 Effect on consumption of a change in income
Units of good Y

I4
I3
I2
B1 B2 B3 B4 I1
O
Units of good X
 Effect on consumption of a change in income
Units of good Y

Income-consumption curve

I4
I3
I2
B1 B2 B3 B4 I1
O
Units of good X
 Effect of a fall in the price of good X
30

Assumptions

PX = £2
20 PY = £1
Budget = £30
Units of good Y

10

0
0 5 10 15 20 25 30

Units of good X
 Effect of a fall in the price of good X
30

Assumptions

PX = £2
20 PY = £1
Budget = £30
Units of good Y

10
j

0
0 5 10 15 20 25 30

B1 I1

Units of good X
 Effect of a fall in the price of good X
30

Assumptions

PX = £1
20 PY = £1
Budget = £30
Units of good Y

10
j

0
0 5 10 15 20 25 30

B1 I1

Units of good X
 Effect of a fall in the price of good X
30
a
Assumptions

PX = £1
20 PY = £1
Budget = £30
Units of good Y

10
j

I2
0
0 5 10 15 20 25 30

B1 I1 B2

Units of good X
 Effect of a fall in the price of good X
30
a The price–consumption curve shows how
consumption is affected by a change in the
price of one of the two goods

20
Price-consumption curve
Units of good Y

10
j

I2
0
0 5 10 15 20 25 30

B1 I1 B2

Units of good X
 Q If good X is a normal good and its price
falls, the price–consumption curve must be:
A. upward sloping (and 20% 20% 20% 20% 20%

positive).
B. downward sloping.
C. upward sloping (and positive)
or downward sloping.
D. upward sloping and either
positive or negative
(backward bending), but not
downward sloping.
A. B. C. D. E.
E. upward sloping and negative
(backward bending).
 Indifference analysis

 The effect of changes in price

 the price–consumption curve
 deriving the individual's demand curve
Deriving a demand curve from a price-consumption curve

As the price
of X falls, so

Expenditure on
all other goods
a the budget
line swings
outwards.

I1
B1

Units of good X
Deriving a demand curve from a price-consumption curve

Fall in the

Expenditure on
all other goods
price of X
a b

I2
I1
B1 B2

Units of good X
Deriving a demand curve from a price-consumption curve

Further falls in

Expenditure on
all other goods
the price of X
a b

I2
I1
B1 B2

Units of good X
Deriving a demand curve from a price-consumption curve

Further falls in

Expenditure on
all other goods
the price of X
a b
c d

I4
I3
I
I1 2
B1 B2 B3 B4

Units of good X
Deriving a demand curve from a price-consumption curve

Expenditure on
all other goods
a b Price-consumption
c d
curve

I4
I3
I
I1 2
B1 B2 B3 B4

Units of good X
Deriving a demand curve from a price-consumption curve

Expenditure on
all other goods
a b Price-consumption
c d
curve

I4
I3
I
I1 2
B1 B2 B3 B4

Units of good X

P1 a
Price of good X

Q1 Units of good X
Deriving a demand curve from a price-consumption curve

Expenditure on
all other goods
a b Price-consumption
c d
curve

I4
I3
I
I1 2
B1 B2 B3 B4

Units of good X

P1 a
Price of good X

P2 b
P3 c
P4 d
Demand

Q1 Q2 Q3 Q4 Units of good X
 Indifference analysis

 The effect of changes in price

 the price–consumption curve
 deriving the individual's demand curve

 Income and substitution effects of a price change

 a normal good
Units of good Y Income and substitution effects: normal good

f
I1
I2
I3
I4
I5
B1 I6
QX 1
Units of Good X
 Income and substitution effects: normal good

Rise in the price

of good X
Units of good Y

f
I1
I2
I3
I4
I5
B2 B1 I6
QX 3 QX 1
Units of Good X
 Income and substitution effects: normal good

Substitution effect
of the price rise
Units of good Y

g
h

f
I1
I2
I3
I4
I5
B2 B1a B1 I6
QX 3 QX 2 QX 1
Substitution Units of Good X
effect
 Income and substitution effects: normal good

Income effect of
the price rise
Units of good Y

g
h

f
I1
I2
I3
I4
I5
B2 B1a B1 I6
QX 3 QX 2 QX 1
Incom Substitution Units of Good X
e effect
 Q The substitution effect will be bigger:
A. the more similar the two goods are
to each other and hence the more
convex the indifference curves are. 25% 25% 25% 25%
B. the less similar the two goods are
to each other and hence the more
convex the indifference curves are.
C. the more similar the two goods are
to each other and hence the
straighter the indifference curves
are.
D. the less similar the two goods are A. B. C. D.
to each other and hence the
straighter the indifference curves
are.
 Indifference analysis

 The effect of changes in price

 the price–consumption curve
 deriving the individual's demand curve
 Income and substitution effects of a price change
 a normal good
 an inferior good
 Income and substitution effects: Inferior (non-Giffen) good
Units of good Y

I1

I2 B1

QX 1
Units of Good X
 Income and substitution effects: Inferior (non-Giffen) good

Rise in the price

of good X
Units of good Y

f
h

I1

B2 I2 B1

QX 3 QX 1
Units of Good X
 Income and substitution effects: Inferior (non-Giffen) good

Substitution effect
of the price rise
g
Units of good Y

f
h

I1

B2 B1a I2 B1

QX 2 QX 1
Substitution effect Units of Good X
 Income and substitution effects: Inferior (non-Giffen) good

Income effect of
the price rise
g
Units of good Y

A positive income
effect: a rise in price
f partially offsetting the
fall in consumption.
h

I1

B2 B1a I2 B1

QX 2 QX 3 QX 1
Substitution effect Units of Good X
Income effect
 Indifference analysis

 The effect of changes in price

 the price–consumption curve
 deriving the individual's demand curve
 Income and substitution effects of a price change
 a normal good
 an inferior good
 a Giffen good (a special type of inferior good)
Units of good Y Income and substitution effects: Giffen good

I1

I2 B1
QX 1
Units of Good X
 Income and substitution effects: Giffen good

Rise in the price

of good X
Units of good Y

I1
h

B2 I2 B1
QX1QX3
Units of Good X
 Income and substitution effects: Giffen good

Substitution effect
g of the price rise
Units of good Y

I1
h

B1a
B2 I2 B1
QX2 QX1QX3
Substitution effect Units of Good X
 Income and substitution effects: Giffen good

Income effect of
g the price rise
Units of good Y

A positive income
I1 effect that is bigger
than the negative
h substitution effect. A
rise in price causes a
rise in consumption.

B1a
B2 I2 B1
QX2 QX1QX3
Substitution effect Units of Good X
Income effect
 Q If the income and substitution effects of
a price change work in the same direction,
the good whose price has changed is:
20% 20% 20% 20% 20%
A. a normal good.

B. an inferior good.

C. a Giffen good.

D. a normal or inferior good,

but not a Giffen good.

E. an inferior or Giffen good, A. B. C. D. E.

but not a normal good.