Chapter One

Theory of Consumer Behavior

and
Demand
1.1 Theory of Demand and Supply
 Demand
• Demand is more than desire.
• It states consumer’s willingness and ability to
purchase a commodity
• More specifically, demand refers to various
quantities of a commodity or service that a
consumer would purchase at a given time in a
market at various prices, given other things
unchanged (ceteris paribus).
• The quantity demanded of a commodity depends
on price of the commodity.
• Law of demand: price of a commodity and its
quantity demanded are inversely related (ceteris
 Demand...
• The r/ship b/n price and amount of a commodity
purchased can be represented by a demand schedule
(table) or a demand curve or an equation.
individual demand schedule

De individual demand curve

 Demand...
• Demand function is a mathematical r/ship b/n
price and quantity demanded (ceteris paribus)
• A typical demand function is given by: Qd=f(P)
where Qd is quantity demanded and P is price of commodity,
• Example: Let the demand function be Q = a+ bP
• B is slope of the demand curve and can be
denoted as b=∆Qd/∆P
• Taking any move from one point to the next, we
can find value of b or the slope (taking move from A to B)
• ; So, Qd= a-2P
 Demand...
• To find value of ‘a’ substitute P with respective Qd
at any point in the demand schedule or curve
• At point B, 7=a-2(4) and a is equal to 15.
• Hence, the demand function becomes Qd= 15-2P
• Market Demand: is derived by adding quantity
demanded for the product by all buyers at each
price.
Individual and market demand
 Individual and market demand...
• Numerical Example: Suppose individual demand
function of a product is given by: P=10 - Q /2 and
there are about 100 identical buyers in the
market.
• Then to find the market demand function first
write the demand function Qd as a function of P
• Qd=20-2P
• Then, multiply individual demand function by
total buyers
• Qm=100(20-2P)
• Then, the market demand (Qm) is Qm=2000-200P
 Individual vs. Market Demand…
• Example: - Suppose the demand of a typical
consumer is Qd= 20 -3P and that there are 200
identical consumers in the market for corn. What
is the market demand?
• Soln QM = 200 X Qd
= 200 (20-3P)
QM = 4,000 – 600P
• Q1. Suppose there are 100 identical consumers in
Kutcha butter market, and the inverse demand of a
typical consumer is given as P = 20 - 1/5.Qd. Find
the market demand function for Kutcha butter
market. [Ans. Q = 10,000-500P].
 Individual vs. Market Demand…
Exercise
• Suppose there are 500 consumers in Adama banana
market and they are grouped in three categories as
follows
– 150 consumers have identical demand function Q1
= 9-1/2P;
– 100 have identical demand equation of Q2 = 4 - 1/5P,
– 250 consumers have the same demand equation of the
form Q3 = 8 - P.
Find the aggregate demand for Adama Banana Market [Ans.
Qm= 3750 – 345P]
• [Hint: First find the demand equation of each group and then add
 Determinants of demand
• Factors affecting demand for a commodity include:
• The price of the commodity X (own price (Px)),
• The money income of the consumer (M),
- For normal good (+)
- For inferior good (-)
• The price of other goods,
- Price of substitute goods Ps (+)
- Price of complement goods Pc (-)
• Taste & preference of the consumer
• Number of buyers in the market,
• Future expectations of prices, income, and availability of
the commodity
 Movements Vs Shift of the Demand Curve

A . A change in Quantity demanded

 It designates the movement from one point to another

point – from one price quantity combination to another

 The cause of such movement is a change in the own price.

B. A Change in Demand

 The cause of such change is a change in non own price

determinants.

 graphically, shift in the location of the demand curve is called a

change in demand.
A. A Change Quantity Demand b. A Change in Demand
 2.2.5. Exceptional cases for the law of demand not to
work
a. Status goods: These goods show the social status of the individual in

the society. So, even if the price of those Luxury goods is increasing

the demand for those goods increases.

b. Giffen goods: named after the economist Sir Robert Giffen who has

• discovered them for the first time. Increase in prices of such goods is

considered as increase in qualities and people tend to consume more

of them at higher prices.

C. Uncertain future events: if consumers are expecting that there will

be increase in the price of the good in the near future, then they choose

to guard themselves against additional costs by buying now

d. Judging quality by price: people usually resort to the irrational

conclusion that price always follows the footsteps of quality.

 Determinants of demand...
• Now let us examine how each factor affect demand.
a) Taste or preference
• When the taste of a consumer changes in favour of a
good, her/his demand will increase and the opposite is
true.
b) Income of the consumer
• Goods are classified based on how a change in
income affects their demand
• Normal Goods are goods whose demand increases as
income increase,
• Inferior goods are those whose demand is inversely
related with income (buyers shift to better quality
 Determinants of demand...
C) Price of related goods
• Two goods are said to be related if a change in
the price of one good affects the demand for
another good.
• There are two types of related goods. These
are substitute and complimentary goods.
• Substitute goods: price of one and the
demand for the other are directly related. E.g
tea & coffee, pepsi & coca
• Complimentary goods : price of one and
demand for the other are inversely related. E.g ,
 Determinants of demand...
d) Consumer expectation of income and price
• Higher price expectation will increase demand
for goods and the opposite is true
e) Number of buyer in the market
• Since market demand is the horizontal sum of
individual demand, an increase in the number of
buyers will increase demand
• And decrease in the number of buyers in the
market will decrease demand.
 Elasticity of demand (1.6)
• Elasticity is a measure of responsiveness or
sensitivity of dependent variable to changes in an
independent variables (
• Elasticity of demand refers to degree of
responsiveness of quantity demanded of a good
to a change in its own price, income, price of
related goods.
• Accordingly, there are three kinds of demand
elasticity:
• price elasticity,
• income elasticity, and
•
 Price Elasticity of Demand
• Price elasticity indicates how consumers react to
changes in price
• Demand for commodities like clothes, fruit etc.
changes when there is even a small change in
their price, whereas demand for commodities
which are basic necessities of life, like salt, food
grains etc., may not change or shows smaller
change even if price changes
• Price elasticity of demand can be measured in
two ways:
• Point elasticity and
 Price Elasticity of Demand...
1. Point Price Elasticity of Demand
• It is calculated to find elasticity at a given point which are
assumed to be intimately close to each other.

• Point elasticity of demand on a straight line is different at

every point
2) Arc price elasticity of demand
• Arc Elasticity measurement is used when the change in price is
relatively large. It measures elasticity b/n to points. It is an
estimation of an average elasticity of an arc.
• The main drawback of point elasticity method is that it
requires information about slight changes in price and
quantity demanded of a commodity.
• We may possess demand schedules in which there are big
gaps in price as well as the quantity demanded.
• In such cases, there is an alternative method known as
arc method of elasticity measurement.
• It measures a portion or a segment of the demand curve
between two points.
• An arc is a portion or segment of demand curve
• Its formula is given as:

• Or

• Suppose that price of a commodity is Br. 5 and quantity

demanded at that price is 100 units. Assume price of the
commodity falls to Br. 4 and quantity demanded rises to 110
units.
• Value of the arc elasticity will be:

•Elasticity of demand is negative number b/s of the law of

demand.
•If the price elasticity of demand is positive the product is
inferior.
• Example: The price of sugar was 6 birr per kilo. Due

to unfavorable harvest in sugarcane the price has

raised to 8 birr per kilo. Because of this price change

the quantity purchased falls from 16 million quintals

to 14 million quintals of sugar. What is the arc price

elasticity of demand for sugar?

• Solution:

• If the price of sugar increases or decreases by 1%,

quantity demanded of sugar decreases or increases

 Elasticity Description, Implication and Demand curve

• > 1- Elastic- % ΔQ>%ΔP Flatter

• 1 -Unitary elastic- % ΔQ=%ΔP

• 0 < < 1 -Inelastic -% ΔQ<%ΔP Steeper

• = 0 -Perfectly inelastic -% ΔQ= 0 Vertical

• =∞- Perfectly elastic- % ΔQ= ∞ horizontal

 Determinants of price Elasticity of Demand
• The availability of substitutes: availability of more
substitutes results in greater elasticity
• Time: In the long- run, price elasticity of demand tends
to be elastic. Because:
• More substitute goods could be produced.
• People tend to adjust their consumption pattern.
• Proportion of income consumers spend for a product:-
the smaller the proportion of income spent for a good,
the less price elastic will be.
• Types /nature of commodity. The importance of the
commodity in the consumers’ budget : Luxury goods
tends to be more elastic, example: gold. Necessity
goods tends to be less elastic eg: Salt.
 Cross price Elasticity of Demand
• Measures responsiveness of demand for price
change of other product

Exy > 0 Exy <0 Exy = 0

substitutes complements unrelated

Note: Larger positive cross elasticity coefficient

shows greater substitutability, cetris paribus
The larger negative cross elasticity coefficient,
shows greater the complementarity, cetris paribus
 Cross price Elasticity of Demand...
• Eg: Consider the following data which shows the
changes QdX in response to changes in PY
Unit price of Y Quantity demanded of X
10 1500
15 1000

• Cross price elasticity of demand is:

Hence, the two goods are complement

 Income Elasticity of Demand
• It measures responsiveness of demand to
change in income

Ed < 0 (-ve) E d > 0 (+ ve)

Normal
Inferior 0< Ed < 1 Ed > 1
Necessity Luxury
 Theory of supply
• Supply indicates various quantities of a product that
sellers are willing and able to provide at different prices
in a given period of time, ceteris paribus
• Law of supply: ceteris paribus, as price of a product
increase, quantity supplied increases, and vice versa
• There is a positive r/ship b/n price and quantity
supplied.
• Supply schedule: shows different quantities of a
commodity offered at different prices in a table form
• Supply curve: conveys the same information but in a
curve
• Supply function: conveys the same information in
 Theory of supply...
• Market supply: is derived by horizontally adding
quantity supplied of the product by all sellers at
each price.
 Determinants of supply
– price of the product itself
– price of inputs ( cost of inputs)
– technology
– prices of related goods
– sellers‘ expectation of price of the product
– taxes & subsidies
– number of sellers in the market
– weather, etc.
 Determinants of supply
• Input price: An increase in the price of inputs
such as labour, raw materials, capital, etc causes
a decrease in the supply of the product which
is represented by a leftward shift of the
supply curve and the opposite is true.
• Technology: Technological advancement shifts
the supply curve outward
• weather: weather condition affect supply of
products, especially agricultural products.
 Elasticity of supply
• It is the degree of responsiveness of the
supply to change in price.
• We can measure the price elasticity of supply
using point and arc elasticity methods.
• However, a simple and most commonly used
method is point method.
• The formula for point price elasticity of supply
is:
 Elasticity of supply
• If Es >1, supply is elastic;
• if Es < 1, then supply is inelastic;
• If Es = 1, then supply is unitary elastic.
• If Es= 0, supply is perfectly inelastic;
• If Es = ∞, then supply is perfectly elastic.
 Market equilibrium
• Market equilibrium occurs when market demand
equals market supply.

 P is the market equilibrium (market clearing) price.

 M is the market equilibrium (market clearing) quantity.
 Market equilibrium...
• Numerical example: Given market demand: Qd = 100-2P, and market
supply: P =( Qs /2) + 10
a) Calculate the market equilibrium price and quantity
b) Determine, whether there is surplus or shortage at P= 25 and
P= 35.
Solution:
a) At equilibrium, Qd= Qs
• 100 – 2P = 2P – 20
• 4P =120
• 30 = P and 40 = Q
b) Qd (at P = 25) = 100-2(25)=50 and Q (at P = 25) = 2(25) -20 =30
• Therefore, there is a shortage of: 50 -30 =20 units

• Qd ( at =35) = 100-2(35) = 30 and Qs (at p = 35) = 2(35)-20 = 50, a

surplus of 20 units
Effects of shift in demand and supply on equilibrium
• Changes in Demand: - Keeping supply constant,
increases (decreases) in demand will lead to rise
(fall) in both equilibrium P and Qd
• Change in Supply:-Keeping demand constant,
increases (decreases) in supply leads to lower
(higher) P and higher (lower) Qd
 Effects of shift in demand and supply …
• Complex cases: - this is a case when both supply and
demand change. In this case, the effect is
combination/ net of the individual effects.
(i) Supply increase, Demand Decrease: - Both changed
decrease price, so the net result is a price drop greater
than that resulting from either change alone.
• The direction of the change in quantity depends on
the relative sizes of the changes in supply and
demand.
• If the increase in supply is larger than the decrease in
demand, the equilibrium quantity will increase.
• If the decrease in demand is larger than the increase in
supply, equilibrium quantity will decrease
 Effects of shift in demand and supply …
• (ii) Supply Decrease, Demand Increase: - A
decrease in supply and an increase in demand
both increase Price. So net effect is higher price
• But their effect on equilibrium quantity depends
on relative sizes of changes in supply and
demand.
• If the decrease in supply is larger than the increase
in demand, equilibrium quantity will decrease.
• In contrast, if the increase in demand is greater
than the decrease in supply, the equilibrium
quantity will in increase.
 Effects of shift in demand and supply …
iii) Supply Increase, Demand Increase: - A supply increase
drops equilibrium price, while demand increase boosts
it.
• Net effect is a raise in equilibrium quantity.
• The effect on equilibrium price depends on relative sizes
of changes in supply and demand.
• If the increase in supply is greater than the increase in
demand, the equilibrium price will fall. If the opposite
holds, equilibrium price will rise.
• The effect on equilibrium quantity is certain:
• Therefore, the equilibrium quantity will increase by an
amount greater than that caused by either change
alone.
 Effects of shift in demand and supply …
(IV) Supply Decrease, Demand Decrease: -
If the decrease in supply is greater than the
decrease in demand, equilibrium price will
rise if the reverse is true, equilibrium price
will fall.
Decreases in supply and demand each
reduces equilibrium quantity, so net effect is
fall in quantity
1.2 Theory of Consumer Behaviour
 Introduction
• As consumer, in our day to day life, we consume
goods and services and derive satisfaction form it
• Consumer theory is based on the premise that we can
infer what people like from the choices they make
• Consumer behaviour can be best understood in
three steps.
• 1st, by examining consumer‘s preference, : how
people prefer one good to another.
• 2nd, taking into account that consumers face budget
constraints or limited income
• 3rd, we will put consumer preference and budget
constraint together to determine consumer choice.
 Consumer preferences
• Given any two consumption bundles, a consumer
either decides that one of the consumption bundles
is strictly better than the other, or remain indifferent.
• If she always chooses X when Y is available, then it is
natural to say that this consumer prefers X to Y.
• So that X ≻ Y should be interpreted as saying
that the consumer strictly prefers X to Y,
• If the consumer is indifferent b/n two bundles of
goods, we use the symbol ∼ and write X~Y.
• If consumer prefers or is indifferent b/n the two
bundles we say that she weakly prefers X to Y and
write X ⪰ Y
 Consumer preferences...
• The relations are themselves related. For
example, if X ⪰ Y and Y ⪰ X, we can conclude
that X ~Y.
• 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 b/n the two bundles, then she thinks
that X is strictly better than Y
 The concept of utility
• Utility is described as satisfaction or pleasure
derived from consuming a good or service
• It is power of products to satisfy human wants
• In defining utility, it is important to bear in mind
the following points. (properties of utilities)
– Utility’ and Usefulness: are not synonymous
– Utility is subjective: utility of a product will vary from
person to person. For example, non-smokers do not
derive any utility from cigarettes.
– Utility can be different at different places and time
Eg. drinking coffee in the morning and at lunch time
 Approaches of measuring utility
• Two major approaches to measure utility:
– Cardinal approach and Ordinal approach
The cardinal utility theory
• Utility is measurable by arbitrary unit of measurement
called utils in the form of 1,2,3 etc
• Eg. we may say that consumption of an orange gives
Bilen 10 utils and a banana gives her 8 utils
Assumptions of cardinal utility theory
1. Rationality of consumers: objective of a consumer
is maximizing satisfaction
2. Utility is cardinally measurable: it is measurable in
 1.3 The ordinal utility theory
• Two major approaches to measure utility: Ordinal
approach and Cardinal approach
• According to the cardinal utility theory Utility is
measurable by arbitrary unit of measurement called utils in
the form of 1,2,3 etc
• According to ordinal utility approach the consumers can
rank commodities in an order of their preferences as 1st ,
2nd , 3rd and so on
Assumptions of ordinal utility theory
• Consumers are rational
• Utility is ordinal: utility is not absolutely (cardinally)
measurable. Consumers are required only to rank their
preference for various bundles of commodities
 The ordinal utility theory...
• Diminishing marginal rate of substitution: it is the
rate at which a consumer is willing to substitute
one commodity for another commodity so that
his total satisfaction remains the same.
• The total utility of a consumer is measured by
the amount (quantities) of all items he/she
consumes from his/her consumption basket.
• Consumer’s preferences are consistent. For eg. if
consumer prefers X to Y and Y to Z, then the
consumer is expected to prefer X to Z. This
property is known as axioms of transitivity.
 The ordinal utility theory...
• The ordinal utility approach is explained with the
help of indifference curves.
• Therefore, the ordinal utility theory is also known as
the indifference curve approach.
• 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.
• Indifference curve: When indifference set/ schedule
is expressed graphically, it is called an indifference
curve.
 The ordinal utility theory...
• A set of indifference curves is called
indifference map.
 The ordinal utility theory...
Properties of indifference curves
1. Indifference curves have negative slope: consumption
of one commodity can be increased only by cutting
consumption of the other commodity
2. Indifference curves are convex to the origin. It is
reflection of the DMRS. It implies commodities can
substitute one another at any point on an indifference
curve but are not perfect substitutes
3. Higher indifference curve is always preferred to a lower
one.
4. Indifference curves never cross each other: the
assumptions of consistency and transitivity will rule
out the intersection of indifference curves.
 The ordinal utility theory...
Marginal rate of substitution (MRS)
• MRS is a rate at which consumers are willing to
substitute one commodity for another to remain on
the same indifference curve
• MRS 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
• 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.
 The ordinal utility theory...
• It is possible to derive MRS using the concept of MU
• MRSY X is related to MUX and MUY as follows.
• Proof: Suppose utility function for two commodities X
and Y is defined as U= f(X,Y)
• Since utility is constant along an indifference curve,
total differential of utility function is zero.
The ordinal utility theory...
 1.4 The budget line or the price line
• IC only tell us about consumer preferences for any
two goods but cannot show which mix of goods
are affordable.
• In reality, the consumer is constrained by his/her
income and prices of the two commodities.
• This constraint is often presented with the help of
the budget line
• To draw budget line, we consider the ff assumptions
– There are only two goods say, X and Y.
– Each consumer is confronted with prices, PX and PY.
– The consumer has a known and fixed money income
(M)
 The budget line...
• Assuming that the consumer spends all his/her
income on the two goods (X and Y), we can
express the budget constraint as:
M = PxX+PyY
Graphically,
 The budget line...
Note that:
• The slope of the budget line is given is by -Px/Py
• Any combination of the two goods within the budget
line or along the budget line is attainable.
• Any combination of the two goods outside the
budget line is unattainable /unaffordable
• Example: A consumer has $100 to spend on
goods X and Y with prices $3 and $5 respectively.
• Derive equation of the budget line and sketch the
graph.
• Solution: The equation of the budget line can be
derived as follows.
 The budget line ...

• When the consumer spends all of her income

on good Y, we get the Y- intercept (0,20).
• 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.
 The budget line...
• Change in income: If the income of the consumer
changes (keeping the prices of the commodities
unchanged), the budget line also shifts (changes).
• Increase in income causes an upward/outward
shift in the budget line that allows the consumer
to buy more goods and services
• Decreases in income causes a downward/inward
shift in the budget line that leads the consumer to
buy less quantity of the two goods.
• The slope of the budget line (the ratio of the two
prices) does not change when income rises or falls.
 The budget line...
• Change in prices: An equal increase in the
prices of the two goods shifts the budget line
inward.
• An equal decrease in the prices of the two goods,
one the other hand, shifts the budget line out
ward.
 The budget line...
• Change in price of one commodity, keeping the
other good and income constant, changes the
slope of the budget line

Effect of decrease in the price of only good X on the budget line

 1.5 Optimum of the consumer
• A rational consumer tries to attain the highest
possible indifference curve, given the budget line.
• This occurs at the point where indifference curve is
tangent to the budget line
• Or where slope of indifference curve (MRSXY) is equal
to the slope of the budget line (Px/Py)
 Equilibrium of the consumer...
• Mathematically, consumer optimum (equilibrium) is attained
at the point where: Slope of indifference curve = Slope of the
budget line

• Example: A consumer consuming two commodities X and

Y has the utility function U ( X ,Y) = XY +2X
• Prices of the commodities are 4 br and 2 br respectively. The
consumer has a total income of 60 br
a) Find the utility maximizing quantities of good X and Y.
b) Find the MRSx,y at equilibrium.
Equilibrium of the consumer...