Chapter One

2. The theory of consumer behavior

Defn: The theory of consumer behavior deals with the way in which scarcities encroach upon the
individual consumer & hence the way such individual makes a choice. The theory states the way
consumers take decision on such goods and services. Consumers buy goods /services to obtain
satisfaction from possession of goods /services.
2.1. Consumer preference, utility and consumer choice
Given vast number of goods and services that the economy provides and given wide diversity of
personal tastes, the consumer make preference among the market basket—collection of one or more
commodities. The economic theory f consumer is understood in terms of concepts like;
Budget constraint,
Consumer preference &
Consumer choice
Budget constraint
Budget is the level of income an individual consumer has acting as a constraint to the quantities of
goods the consumer can buy.
E.g. suppose a consumer with the money income “M” buys only two goods, say good X and good
X, then the budget constraint is written as follow;
PX.X+PY.Y < M where
PX-Price of good X Y- Quantity of good Y
PY- Price of good Y M- Money income of the consume
X- Quantity of good X
It can also be illustrated using Budget line which shows a combination of the two goods (X & Y)
for which total expenditure equals income, i.e. PX.X+PY.Y =M
Good Y

Budget line – tell us what choices are available

• D to the consumer
.C Budget line

0 M Good X
PX
Note: Point “D” shows the non-feasibility area (unattainable) i.e. the consumer is unable to buy
the corresponding quantities because his /her income is fixed. Point “C” shows the feasibility area
(attainable) i.e. the consumer is able to buy the corresponding quantities / or the consumer doesn’t
spend his/ her income totally on the consumption of these two goods.
Consumer preference
In addition to budget line, the information we need about consumer to analyze his/her choice is
his/her ranking of the alternative combination of goods /services available. But all combination of

1
“It is not due to the benevolent of the waiter that we get our dinner, rather from their interest of
maximizing their utility” A. Smith
goods /services has no equal importance for an individual consumer. That is why a consumer ranks
his/her desire and builds up a scale of preference.
E.g. See the following graph
Coffee
Mr. A. prefers coffee to tea
Mr. B. prefers coffee & tea equally
Mr. C. prefers tea to coffee
6 A
4 B

2 C

0 2 4 6 Tea
Preference ordering: - is the scheme that enables the consumer to rank different bundles of
goods in terms of their desirability or order of preference. It depends on the following assumptions:
a. Completeness: - i.e. a consumer able to compare and rank all possible combination or has a
complete information about the good he /she can buy.
b. Consistency and Transitivity:- Consistency in a sense if at one time regards combination X
is better than of Y he/she will not consider combination Y is better than of X at another time.
Where as when we say transitivity, if consumer prefers combination X to combination Y
and combination Y to Z, then he /she prefers combination X to Z.
c. No satiation: - i.e. a consumer is never satisfied and always prefers more of a good to less.
Utility
Utility is the level of satisfaction that a person gets from consuming a good or undertaking an
activity. For example if you purchase, say an apple, and consume this apple, then the
satisfaction that you obtained by doing so, is said to be utility. . It varies from person to person
and from time to time. Whether good is useful or not, it has utility for the consumer consuming
it. E.g. -Drug
-Alcoholism, etc, though they are socially immoral, they give a satisfaction for the
consumer consuming these items.
2.2. Approaches to Analyze consumer behavior/Measurement of
utility
In order to analyze consumer behavior economists agreed on the axiom that consumers ate utility
maximizing entity. But they are not agreed on the measurability of utility. There are two approaches
which can be used to measure utility. These are the cardinal utility approach and the ordinal utility
approach. The first says that utility is measurable (quantifiable) using total utility and marginal
utility, the classical and Neo-classical economists. The second approach, on the other hand says that,
utility can be ranked using indifference curve, rather than being measured, the modern economists.
A. Cardinal Utility Analysis
Assumptions
The cardinal utility approach builds on certain assumptions:
1. Utility is additive: 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
2
“It is not due to the benevolent of the waiter that we get our dinner, rather from their interest of
maximizing their utility” A. Smith
 U= f (X1, X2 ,… Xn).
2. Rationality: the consumer is rational. He/she aims at the maximization of his/her utility
subject to the constraint imposed by his /her given income.
3. Utility is cardinal: the utility derived from each commodity is measurable.
4. Constant marginal utility of money: this assumption is necessary if monetary units are to be
used as the measure of utility.
5. Diminishing marginal utility: the extra satisfaction gained from successive units of a
commodity diminishes.
2.2.1. Relation between Total and marginal utility
n
Def : - Total utility is the total amount of utility that consumers receive from consumption of
commodities. Utility being measurable, it is given as the sum of the utilities obtained from
consumption of each unit of the commodity consumed. If for example a consumer consumes 5 units
of a commodity the total utility he derives would be:
TU = U1+U2+U3+U4+U5
Where TU is total utility, U1, U2, U3, U4 and U5 are utils from the successive units consumed.
-Marginal utility is the amount of satisfaction added by an additional unit of consumption.
Marginal utility is calculated as
MU = = where Un is the total utility from consumption
of n units of a good, while Un-1 units of a good. Un-Un-1, therefore, measures the extra satisfaction
from consuming the nth unit.
2.2.2. Principle of diminishing marginal utility
The principle of diminishing marginal utility holds that for a given time period, the greater the level
of consumption of a particular commodity, the lower the marginal utility.

Total
Utility

Total Utility

Quantity
Marginal
Utility

X* MU Quantity of X

Fig.2.12 Total and marginal utility

The total utility increases at decreasing rate up to quantity X*, and starts declining. Graphically,
MU is the slope of the Total utility curve. The slope of the total utility curve decreases until TU
reaches its maximum at X*. At the maximum point of the TU curve slope is zero, and hence MU
will be zero. Beyond X*, however, since TU curve is falling MU is negative.
Mathematically, MU is given as

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“It is not due to the benevolent of the waiter that we get our dinner, rather from their interest of
maximizing their utility” A. Smith
 = , where dU is change in TU and dQ is change in quantity of the commodity.
2.2.3. Equilibrium of the consumer: Cardinal utility approach
A consumer is said to be at equilibrium when he/she maximizes his/her utility from the
consumption of commodities for a given price and income. In the simplest case, where the
consumer buys just a single commodity X, he/she is faced with the choice of either spending his
income on the purchase of good X or retaining his/her income. The decision of the consumer
depends on the satisfaction he/she derives from consuming additional units of the commodity and
the satisfaction he/she derives from keeping his/her income. If consumption gives him /her more
satisfaction than saving, he/she would buy the commodity. If consumption yields relatively lower
satisfaction to the consumer compared to the satisfaction from saving, then the consumer would
keep his/her income. The equilibrium quantity of the commodity is, then, defined at the equality of
the additional utility (Marginal Utility) of the commodity and the marginal utility of money (which
is assumed to be constant).
Mathematically, the equilibrium condition of the consumer that consumes a single good X occurs
when the marginal utility of X (MUX) is equal to its market price (PX).
MUX= PX
Proof
The utility function is given as U=f(X)
If utility is measured in monetary terms and the consumer buys Qx units of the commodity, his
expenditure is PX.QX. The consumer wishes to maximize his utility for any birr spent. Therefore, the
consumer wishes to maximize the difference between his utility and his expenditure:
Max (U - QX.PX)
The necessary condition for maximization is that the partial derivative with respect to QX be zero.
This is because, at the maximum point, the slope of the total utility function (MU) is equal to zero.
$!% &% '
− =0
!" !"
Rearranging we obtain
= &% * = &%
)

If MUx is greater than Px, the consumer can increase his welfare by purchasing more units of X. If,
on the other hand, MUx is less than Px, the consumer can increase its welfare by reducing the
quantity of X he purchases. Utility is maximized when the condition MUx=Px is satisfied.
The consumption decision involving n commodities, the consumer’s equilibrium is defined by the
equality of the ratios of marginal utilities of individual commodities to their prices.
" +
= =⋯=
&" &+ &

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“It is not due to the benevolent of the waiter that we get our dinner, rather from their interest of
maximizing their utility” A. Smith
Derivation of the Demand Curve of the Consumer
The derivation of demand curve is based on the axiom of diminishing marginal utility. The MU of
the commodity X may be depicted by a line with a negative slope. Geometrically, MU is the slope
of the TU function U=f (QX). MUX declines continuously, and become negative beyond quantity X*.
If MU is measured in monetary units, the demand curve for X is identical to the positive segment of
the marginal utility curve.
MUX PX

P1
MU1 Demand curve
P2
MU2
P3
MU3
QX QX
X1 X2 X3 X* X1 X2 X3 X*
MUx
At X1 the marginal utility is MU1, which at equilibrium is equal to P1 and at X2 marginal utility is
MU2, which in turn is equal to P2 at equilibrium. The negative section of the MU curve does not
form part of the demand curve, since negative quantities and price do not make sense in economics.
Weaknesses of cardinal utility approach:
The assumption of cardinal (measurable) utility is doubtful. The satisfaction derived from
the consumption of various commodities cannot be objectively measured.
The assumption of constant marginal utility of money is also unrealistic. The utility derived
from a unit of money varies with the level of income of the consumer. MU of a unit of
money for a poor person is by far higher than the MU of a rich person. Thus, money cannot
be used as a measuring rod since its own utility changes.
B. Ordinal Utility Approach
Ordinal theorists say utility is not measurable cardinally (quantitatively) but can be ranked
as 1st ,2nd,3rd,….
Assumptions
Consumer have limited income that maximize his/ her satisfaction
Consumer can rank bundles of good as their desirability.
Having these assumptions in mind, consumer’s preference which is discussed in the above
section can be shown graphically in terms of Indifference curve.
2.3.1. Indifference curve analysis
Indifference curve (IC) – is a curve or a locus of points which represent various combinations of
two goods which give the same level of satisfaction so the consumer is indifferent between any two
bundles on the curve.

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“It is not due to the benevolent of the waiter that we get our dinner, rather from their interest of
maximizing their utility” A. Smith
Indifference schedule
Y
Bundle com com utility
X Y 30 E
A 25 5 U
B 15 7 U
C 10 12 U
D 6 20 U 5 A U
E 4 30 U
4 25 x
Indifference Map
A consumer similarly make many other combination of goods X &Y with less one or both the
good or many other combination with more of one or both of the goods yielding equal level of
satisfaction but less than & greater than the curve drawn above respectively. These ICs create a family
of ICs corresponding to different levels of satisfaction called Indifference map.

I3

I2

I1

X
N.B: movement from one IC to the other to Northeast wards leads to higher level of satisfaction.
Higher ICs correspond to higher level of utility
2.3.1.1. Characteristics of indifference curves
i) ICs slope downward from left to right
If both X&Y are goods and if the consumer is rational, then we must conclude that if consumers give up
some of X, they will want more of Y to remain at the same level of utility.
Y
P

YO A

Y1 B

XO X1 X X
Figure a figure b

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“It is not due to the benevolent of the waiter that we get our dinner, rather from their interest of
maximizing their utility” A. Smith
Consider figure a moving from A to B , as units of Y are given up ,more units of X are
obtained and the utility derived is unchanged .for this to be true , ICs must slope downward from
left to right .
ii) ICs are convex to the origin
As more and more units of one good, say Y, are given up, it is reasonable to suppose that
successively bigger quantities of X must be obtained to compensate the consumer for his loss and leave
him the same level of utility. In the above figure b this proposition is considered. Since the slope of an
IC is called the Marginal Rate of Substitution (MRS), the proposition is sometimes summed as the
Diminishing MRS. The slope of IC measures MRS between two goods.
dMRS
⇒ <0 Y
dQ
B A
iii) ICs can never intersect each other
Consider the graph below C I2
I1

X
From the above graph, A ≻ B ^ A ~C, thus by the axiom of transitivity B ≻ C, however since
both bundles lie on the same indifference curve I1 , they should be indifferent. That is, why ICs can
never intersect each other.
2.3.1.2. The Marginal Rate of Substitution (MRS)
It is a rate at which one commodity can be substituted for another, keeping the level of
satisfaction constant. Thus, it measures the slope of an IC.
i) Conceptual derivation of MRS
Given U= f(x, y)
Let’s suppose x is substituted for y. when the consumption of y decreases, the stock of y declines by
∆y
I.e. level of marginal sacrifice will be -MUy. ∆y
When the consumption of x increases, the stock of x will increase by ∆x
I.e. level of marginal gain will be MUx. ∆x
thus, for the total utility to remain constant, the level of marginal gain should be equal with
the level of marginal sacrifice .
⇒ MUx. ∆x =-MUy. ∆y
MUx − ∆y
= =MRSxy
MUy ∆x
ii) Mathematical derivation of MRS
Given U=f(x, y)
Total differential of the utility function will give us
∂U ∂U
dU = . dX + . dY =0 ⇒ MUx . dx + MUy. dy = 0
∂X ∂Y
MUx. dx= - MUy. dy

MUx − dy
⇒ = = MRSxy
MUy dx
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“It is not due to the benevolent of the waiter that we get our dinner, rather from their interest of
maximizing their utility” A. Smith
The law of Diminishing MRS
ICs are usually convex or bowed inward .the term convex means the slope of the IC increases
(becomes less negative ) as we move down along the curve. In other words, an IC is convex if
MRS diminishes along the curve.
2.3.2. The Budget Line Analysis
Budget line- is the set of bundles that cost exactly consumer income
I.e. PxX + PyY=Y where PA-Price of good A, PB- Price of good B, QA- Quantity of good A,
QB- Quantity of good B and Y- Money income of the consumer.
Com Y

Budget line
BS
0 Com X
Budget set (BS) - a set of bundles that are affordable by the consumer at a given price and Income.
Economic interpretation of budget line: it measures the rate at which the market is willing to substitute
one good for another good, or the opportunity cost of consuming one good.
Effects of change in price
Change in price of commodity changes the budget line either inward or out ward based on the direction
of price changes.
E.g. if the price of two goods (X,Y) doubled, then the horizontal and vertical intercepts shift in ward by
factor of one half and the budget line shifts in ward by one half as well. But, the slope remains as before.
Proof: Y=PxX +PyY
Solution Y=PxX +PyY, since prices of the two commodities doubled
Y=2PxX +2PyY = 2(PxX +PyY)
Y/2= PxX +PyY
Examples of utility functions
i) perfect substitutes
U(X1, X2) = aX1+bX2 , where a and b are the values of goods 1 & 2 respectively to the consumer.
E.g. utility function for blue and black pencils.
ii) perfect complements
U(X1, X2) =min (aX1, bX2), where a and b are the proportions in which the goods are consumed.
E.g. utility function for left and right shoes.
iii) Quasilinear preferences: they are partly linear or vertically shifted version of IC.
U(X1, X2) =V(X1) +X2
iii) Cobb-Douglas preferences
U(x, y) = xcyd , c>0, d>0.
2.3.3
2.3. 3 . Consumer equilibrium: O rdinal utility approach
A consumer attains his equilibrium position when he maximizes his total utility given is income and
price of the commodities.

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“It is not due to the benevolent of the waiter that we get our dinner, rather from their interest of
maximizing their utility” A. Smith
 Technically, the conditions that make the consumer in equilibrium are:
i) First order condition (Necessary condition)
MRSxy should be equal with price ratio. i.e. MRSxy=-./-0
ii) Second order condition ( Sufficient condition)
MRSxy= -./-0 at higher IC
Graphically,
Com y

I3
E. ← equilibriu m po int
I2
I1
← budgetline
Com x
At point of equilibrium E,
Slope of the budget line = slope of I2
Px
⇒ = MRSxy
Py
Mathematical derivation of equilibrium point
To determine the consumer’s optimum point, we will maximize
U=f (Qx, Qy) subject to the budget constraint Qx.Px +Qy.Py=Y
To do so, we will follow the following steps:
i) Rewrite the budget equation as Qx.Px+Qy.Py-Y=0
ii) then multiply left hand side of the above equation by the lagrangian multiplier ( λ ),
in doing so, we get λ (Qx.Px + Qy.Py − Y ) = 0
iii) subtract the above rewritten constraint from the utility function and construct the
composite function as
φ = U − λ (Qx.Px + Qy.Py − Y )
iv) Then maximize the composite function and find the optimal values of Qx, Qy and λ
∂φ ∂U ∂λ (Qx .Px + Qy .Py − Y )
⇒ = − = 0 .......... .......... .......... .......... .......... .......... ...(1)
∂Qx ∂Qx ∂Qx
∂φ ∂U ∂λ (Qx.Px + Qy.Py − Y )
⇒ = − = 0.......... .......... .................... .................... ...( 2)
∂Qy ∂Qy ∂Qy
∂φ ∂U ∂λ (Qx.Px + Qy.Py − Y )
⇒ = − = 0.......... .......... .......... .......... .......... .......... .......( 3) Then,
∂λ ∂λ ∂λ
∂φ ∂U
= − λPx = 0............................ from(1)
∂Qx ∂Qx
∂U MUx
⇒ = λPx = MUx ⇒ λ =
∂Qx Px
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“It is not due to the benevolent of the waiter that we get our dinner, rather from their interest of
maximizing their utility” A. Smith
 ∂φ ∂U
= − λPy = 0............................ from(2)
∂Qy ∂Qy
∂U MUy
⇒ = λPy = MUy ⇒ λ =
∂Qy Py
∂φ
= −(Qx.Px + Qy.Py − Y ) = 0.......... .......... ........ from (3)
∂λ
⇒ Qx.Px + Qy.Py − Y = 0
Solving the above simultaneous equations we will get
λ =λ
MUx MUY
⇒ =
Px Py
Rearranging the above expression ,we will arrive at the consumer’s equilibrium point
MUx Px
= = MRSxy
MUy Py
Interpretation of λ : λ is interpreted as the marginal utility of income (MU I ), because
∂U ∂U ∂X ∂U ∂Y ∂X ∂Y
MUI = = . + . ⇒ MUx. + MUy.
∂I ∂X ∂I ∂Y ∂I ∂I ∂I
∂X ∂Y
= λPx. + λPy.
∂I ∂I
λ ( Px.∂X + Py∂Y )
= , here Px.∂X + Py.∂Y = ∂I
∂I
λ (∂I )
= ∴ MUI = λ Thus, MUI is interpreted as the extra satisfaction derived from having one
∂I
more birr and it is amounted to λ .
Illustration
Consider Cobb-Douglas utility function of the consumer having a given income of 120 birr and
consuming only two commodities X&Y is given as
3 5
$*, 2' = * 2 ,assuming further that prices of X&Y are 3 birr and 5 birr respectively,
4 4
determine:
a) the consumer’s optimal bundles
b) his marginal utility of income and its interpretation
c) the portion of income that he spends on the consumption of the optimal bundles X&Y
respectively.
Solution
i) Technique 1 (using lagrangian)
The budget equation: 3x+5y=120
3 5
∅ = * 4 7 4 − 8$3* + 57 − 120'
>? 1 A C D
= * B 7 B − 38 = 0 … … … … … … … … … … . . $1'
>* 4
>? 3 D
A C
= * B7 B − 58 = 0 … … … … . … … … … … … . $2'
>7 4

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“It is not due to the benevolent of the waiter that we get our dinner, rather from their interest of
maximizing their utility” A. Smith
 GH
GI
= −$3* + 57 − 120' … … … … … . . … … … … . … . . $3'
1 D D
⟹ * B 7 B = 38 … … … … … … … . KLMN $1'
4
3
⟹ * B 7 B = 58 … … … … … . . KLMN $2'
4
D D
* B 7B 3* B 7 B
⟹ =8= … … … … … … … … … … . . KLMN $1'&$2'
4∗3 4∗5
D D
* B 7B 3* B 7 B
⟹ D = D
12* B 7 B 20* B 7 B
D D
7 $B B' 3* $B B'
⟹ 12 ∗ = ∗ 12
12 20
18
7= *
10
Now, let’s substitute this proportion in to equation (3)
18
⟹ 3* + 5 R *S = 120 ⟹ 3* + 9* = 120 ⟹ 12* = 120
10
⟹ * = 10UVWXY
Z
⟹ 7 = [*10⟹ 7 = 18UVWXY
∴ Xℎ^ _MVYUN^L ` Y aXWNbc dUV c^Y eWcc d^ 10 UVWXY MK *
bV 18 UVWXY MK 7.
5 3
f5 5
Z 4 hZDg 4
C = i √5.832k
4
b)MUI=8 = A10 C A18 C = A
4 = 4 C A ≈ 0.129 UVWXY
D∗B g [ g [[[ g
and it is interpreted as the extra satisfaction that the consumer derives from consuming one
more birr is approximately 0.129 units.
c) the portion of income that the consumer spends on the consumption of X
3
n o
= = 3
4
5 = MKXℎ^ 120 dWLL = 30 dWLL
m nA CmA Co B
4 4
The portion of income that the consumer spends on the consumption of Y
5
n o D
= = 3
4
5 = MK Xℎ^ 120 dWLL = 90 dWLL
m nA CmA Co B
4 4
ii) Technique 2: the short cut (marginal analysis)
> 1 A C D
*= = * B 7B
>* 4
> 3 D
A C
7= = * B7 B
>* 4
* 7
= … … … … Xℎ^ _MVYUN^L ` Y ^pUcWdLWUN aMWVX
&* &7

1 D D 3 1 D D 3
q R* B S R7 B Sr q R* B S R7 B Sr q R* B S R7 B Sr q R* B S R7 B Sr
4 4 4 4
⟹ = ⟹ =
3 5 D D
q3 R* B S R7 B Sr q5 R* B S R7 B Sr

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“It is not due to the benevolent of the waiter that we get our dinner, rather from their interest of
maximizing their utility” A. Smith
 f5 f5 5 f3 3 f5 f3 f3
A C A C D
⟹ R* 4 4 S R7 4 4 S= A* 4 4 C A7 4 4 C
B∗D B∗h
1 3 18
⟹ 7= *⟹7= *
12 20 10

Then substitute this proportion to equation (3)

18
3* + 5 R S * = 120 ⟹ 12* = 120 ⟹ MaXWNbc * = 10 UVWXY
10
18
⟹7= ∗ 10 ⟹ MaXWNbc 7 = 18 UVWXY
10
∴ the consumer’s optimal bundles are 10 units of X and 18 units of Y.
Then after, similar procedures to the 1st technique will be employed to determine the rest
requirements.
2.4 Effects of change in Income and price on consumer optimum
point
2.4.1 E ffects of change in I ncome on C onsumption
a) Income effect on Normal good (eI>0)

Good y
ICC- Income Consumption Curve (Income Offer Curve)
Or Income Expansion Path

I4
I3
I2

I1
Good X
ICC- is a curve which is a locus of various consumer equilibrium points resulting from changes in
income, citrus paribus.
b) Income effect on Inferior good (eI<0)
i) Let commodity x be inferior good
Com y ICC

I3

I2

I1
Com x
ii) Let commodity y be inferior good
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“It is not due to the benevolent of the waiter that we get our dinner, rather from their interest of
maximizing their utility” A. Smith
 Com y

I2 I3
I1

ICC

Com x
Engle curve
It is a curve depicting the relationship between equilibrium quantity purchased of a
commodity and the level of income

Graphical derivation of an Engle curve for a Normal good X

Com y

ICC

M3

M2
M1
Com x
Money

M3 Engle curve

M2

M1

X1 X2 X3 Com x
Exercise: Derive and explain Engle and ICC curve for inferior goods
Distinction
ICC - traces the utility-maximizing combinations of two goods as a consumer’s income changes. Engle
curve - depicts the relationship between consumer’s income & equilibrium quantity consumed of a
commodity.
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“It is not due to the benevolent of the waiter that we get our dinner, rather from their interest of
maximizing their utility” A. Smith
 2.4.2 Effects of change in price on C onsumption
a) On Normal good
Com y

PPC – Price Consumption Curve (Price offer curve)

C Or price expansion path
A B
I3
I1 I2
Price Com x

P3 A
P2 B

P C Demand curve

X1 X2 X3 com x
PPC - is a locus of equilibrium points on Indifference curves resulting from changes in the price of a
commodity.
b) On Giffen good: Giffen good is a type of good whose demand decrease as its price decreases.
Giffen good is an inferior good but not all inferior goods are giffen
Com y price

ICC Demand curve

Com x quantity

Elasticity
It is a measure of responsiveness of the dependent variable with a unit change in the independent
variable. OR, it measures the percentage in the dependent variable when the independent variable
changes by one percent.
1) Price elasticity of demand (Ed)
Ed measures the percentage change in quantity demanded of a commodity when its
price changes by one percent. It is always negative.
%∆
Ed=
%u
Decision: 1. |Ed|>1, elastic , 2. |Ed|<1. Inelastic 3. |Ed|=1, unitary
i) Point price elasticity of demand
Measures elasticity of the demand function at a point
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“It is not due to the benevolent of the waiter that we get our dinner, rather from their interest of
maximizing their utility” A. Smith
 ∆vw
%∆ ∗ [[% ∆ u G ux
Ed= = vx
∆y = ∗ = ∗
%u ∗ [[% ∆u Gu% x
yz
ii) Arc price elasticity of demand
measures the average elasticity between two points on a demand function
∆vw
v3|vx ∗ [[%
%∆ ∆ u mu[ G u mu[
{ = = = ∗ = ∗
vx
∆y
%u ∆u m [ Gu m [
y3|yx ∗ [[%
yx
2) Income elasticity of demand ( EI)
Measures the percentage change in quantity demanded of a commodity when income
changes by one percent. Usually applied to analyze Engel curves.
%∆
EI=
%∆u
Decision:
1. EI>0 , Normal good 3. 0<EI<1, necessity good
2. EI<0 , Inferior good 4. EI>1, Luxury good
i) Point income elasticity of demand
∆ }x G }x
EI= ∗ = ∗
∆} x G} x
ii) Arc income elasticity of demand
∆ $}3 'm$}x ' G $}3 'm$}x '
EI = ∗$ = ∗$
∆} 3 'm$ x ' G} 3 'm$ x '
3) Cross price elasticity of demand (Exy)
Measures the percentage change in the quantity demanded of one good when the price
of the other good changes by one percent.
%∆ ∆ u% G u%
Exy = = ∗ = ∗
%∆u% ∆u% ~ Gu%
Decision: 1. Exy>0, substitutes 2. Exy<0, complements 3. Exy=0, unrelated
4) Price elasticity of supply (Es)
Measures the percentage change in quantity supplied of a commodity when its price
changes by one percent. It is always positive.
%∆
Es =
%u
Decision: 1. Es>1, elastic 2. Es<1. Inelastic 3. Es=1, unitary
iii) Point price elasticity of supply
Measures elasticity of the supply function at a point
∆v•
%∆ ∗ [[% ∆ u G ux
Es= = vx
∆y = ∗ = ∗
%u ∗ [[% ∆u Gu x
yz
iv) Arc price elasticity of supply
measures the average elasticity between two points on a supply function
∆v•
v3|vx ∗ [[%
%∆ ∆ u mu[ G u mu[
{ = = = ∗ = ∗
vx
∆y
%u ∆u m [ Gu m [
y3|yx ∗ [[%
yx
====================The End====================
15
“It is not due to the benevolent of the waiter that we get our dinner, rather from their interest of
maximizing their utility” A. Smith