UNIT 2.

THEORY OF DEMAND AND SUPPLY

Contents
2.0 Aims and Objectives
2.1 Introduction
2.2 Demand Analysis
2.2.1 Definition of Demand
2.2.2 Factors Affecting Demand
2.2.3 Change in Quantity Demanded and Change in Demand
2.2.4 Individual and Market Demand Curve
2.3 Supply Analysis
2.3.1 Definition of Demand
2.3.2 Factors Affecting Supply of a Commodity
2.3.3 Change in Quantity Supplied and Change in Supply
2.3.4 Individual and Market Supply Curves
2.4 Market Equilibrium
2.4.1 Definition of Market Equilibrium
2.4.2 Effects of Change in Demand or Supply on the Market Equilibrium
2.5 Elasticities
2.5.1 Elasticity of Demand
2.5.1.1 Price Elasticity of Demand
2.5.1.2 Income Elasticity of Demand
2.5.1.3 Cross-Price Elasticity of Demand
2.5.2 Elasticity of Supply
2.5.2.1 Price Elasticity of Supply
2.5.3 Application of Elasticity
2.6 Key Terms
2.7 Answers to Check Your Progress Exercise
2.8 Model Examination Questions
2.9 References

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2.0 AIMS AND OBJECTIVES

After completing this unit you will be able to:

 state the law of demand and supply.
 clearly distinguish between a change in quantity demanded ( supplied)
and a change in demand (supply).
 understand why demand curves slope downward and supply curves
slope upward.
 explain how equilibrium price and quantity are determined in a market.
 describe how the market tends to remedy surpluses and shortages.

2.1 INTRODUCTION
We began the study of economics by stressing the importance of scarcity in determining
society's choice. Economics is concerned with problem of scarcity. When there is free
exchange (no government control and other barriers), prices will allocate scarce goods and
services. Therefore, one of the major objectives of economics is to analyze the factors that
determine the prices and quantities of commodities sold. The determinants of price and
quantity sold (purchased) for analytical purpose, are usually separated into two categories:

Factors affecting demand for a good

Factors affecting supply of a good

The purpose of this chapter is to explain what demand and supply are and show how they
determine price and quantity sold in markets. Moreover, concepts such as market equilibrium,
elasticity, etc. are introduced. These concepts frequently appear almost in every economic
analysis.

2.2 DEMAND ANALYSIS

2.2.1 Definition of Demand

In the theory of demand, it is common to come across such words as "desire", "wants"
"wants" and
demand.

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Desire: is a wish to attain some object from which pleasure and satisfaction are derived.
Desire is basic human attributes, which induces him (her) to work or make an effort to fulfill
it.

Want:
Want: is desire for anything as a necessity to life or happiness but which is not satisfied due
to lack of resources (e.g. Income). Man desires house but if he has no money to constuct or
buy it, his desire remains unsatisfied. Here house is a necessity but remains as want due to
lack of money.

Demand is a willingness and ability of a consumer to purchase goods and services at specific
price within a set of possible prices at a given period of time.

Law of demand:
demand: This is the principle of demand, which states that, other things being
constant, price of a commodity and it quantity demanded are inversely related i.e., as price of
a commodity increases (decreases) quantity demanded for that commodity decreases
(increases), ceteris paribus.

Quantity demanded of a commodity is the amounts of the commodity purchased at a given

price level. The inverse relationship between the quantity demand and price of a commodity
can be shown by a demand schedule and a demand curve.

Demand Schedule is a table which shows how much of a good individuals are willing and
able to buy at different price levels during a given period of time
(week, month etc)

Table 2.1 Hypothetical Demand Schedule for Teff.

Teff.
Price of teff (in Birr) Quantity Demanded for teff
(in quintals)
100 40
150 35
200 25
250 15
300 10

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At each price level consumers buy definite quantity of teff. As price of teff increases from
100 Birr to 300 Birr, quantity demanded for the teff decreases from 40 quintals to 10 quintals.
This demand schedule can also be depicted graphically as a demand curve for teff as follows.

Price of teff
300
250
200
150
100

0 10 15 25 35 40
Quantity of teff
Fig. 2.1. Demand curve for teff

Demand curve of a commodity is a curve, which shows the relationship between the quantity
demanded of the commodity at different price levels. In drawing the demand curve we
singled out price of a commodity as the most important factor affecting the quantity
demanded of the commodity and ignored the influences of other factors. However in addition
to own price, quantity demanded of a commodity depends on a number of other factors. A
fundamental analytical method used in economics is to hold all other influences constant &
focus on one important variable.

Economists do not say price is the only variable which influence purchases but they say that
price generally has very important effect on quantity purchased. It is to identify the influence
of price of a commodity on its quantity demanded that economists hold other variables
constant and concentrate on the relation between quantity demanded and price, that is, the
relation shown by the demand curve. In this way attention can be focused on the effect of
price. However, in using the demand curve students should be aware of the other factors,
which actually can influence quantity demanded, but which were held constant in deriving the
demand curve.

2.2.2 Factors Affecting Demand

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The demand curve shows how a change in commodity's own price will affect the quantity
demanded, but what determine the shape and the position of the curve itself?

The shape and position of the demand curve depends on the following major determinants.
That is to say, the following variables are also important determinants of quantity demanded
of a commodity. However, we treat them separately from own price of a commodity because
unlike change in own price level, change in these variables has quite different effect on the
position of the demand curve itself. All the following variables cause demand curve to change
its position and we call them shift variables of demand curve. As one of the following
determinants changes assuming other things being constant demand curve shifts either to the
right or to the left. A right ward (left ward) shift of the demand curve indicates an increase (a
decrease) in demand.

A. Tastes and Preferences of the Consumers

Individuals' preferences and tastes for particular commodity differ according to the
satisfaction they get from the commodity.

When people change their mind about taste and preference for a commodity demand for the
commodity also changes. For example if consumers have favorable (unfavorable) taste and
preference for a commodity the demand for commodity increases (decreases), other things
being constant.

Tastes and preferences of the individuals to wards the consumption of egg increases if it is
announced that consumption of egg is helpful in curing lung Cancer. For example,
advertisement on different goods and services changes tastes and preferences of consumers
and accordingly the demand for these goods and services changes.

For example, other things being constant, during rainy season demand for raincoat
increases.
The following demand curve depicts the effect of a favorable tastes and
preferences of a consumer on raincoat during rainy season.

46
 An increase in Demand
A decrease in demand (a left ward shift)

Price of
Raincoat A decrease in demand ( a left ward shift)

Quantity of raincoat
Fig. 2.2. An individual demand for raincoat

B. The Income of Consumers

Other things being constant, as income of the consumers' increases (decreases) demand for
normal goods increases (decreases), but demand for inferior goods decreases (increases).

C. Prices of Related Goods

If two goods are related, then the change in price of one good affects demand for the other. .
If two goods are related they can be either" substitute or "complementary" each other in
consumption. When price of its substitute good (Injera) increases (decreases) demand for the
commodity (Bread) increases (decreases), ceteris paribus. As price of its complementary good
(Fuel) increases (decreases) demand for that commodity (Car) decreases (increases), ceteris
paribus.

Price of Price of
Substitute Complementary
good (injera) (fuel)

0 0
Quantity of Commodity (bread) Quantity of Commodity (car)

Fig. 2.3. Effects of change in other prices on demand of a commodity

D. Number of Consumers

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An increase in a number of consumers causes an increase in demand for commodities given
that consumers have ability to pay for. For example,
example, Addis Ababa with the total population of
3 million people buys commodities 3 times than the population of Nazareth with 1 million
people.

E. Expectation of Consumers
Just as current income and price affect demand for a commodity so can expected price and
income. If consumers expect their income to increase in the future, they may buy more since
they would be able to pay for this later on. If consumers expect higher (lower) prices in the
future, they may buy more (less) of the goods today. In discussing the effect of each of the
above variables on quantity demanded of a commodity we assumed other things remain
constant.

Check Your Progress Exercise - 1

1. What are normal goods?
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………

2. What are inferior goods?

………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………

3. What are substitutes goods?

………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………

4. What are complementary goods?

goods?

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………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………

5. What is an effect of a decrease in income of the consumer on demand for inferior good
ceteris paribus? Show your answer graphically.

2.2.3 Change in Quantity Demanded and Change in Demand

The law of demand states that other things being constant, price and quantity demanded of a
commodity are inversely related.

The demand curve is derived under the assumption of Ceteris Paribus (other things remain
constant) i.e., other determinants of demand except own price are held constant. Thus, the
demand curve shows how quantity demanded of a commodity varies when the price of the
commodity changes. In this case we observe change in quantity demanded simply because of
change in the price of a commodity, and the dd curve remained unchanged (not shifted).

Thus, if we vary only price of a commodity and hold other determinants of demand (income,
taste and preference, prices of related goods, expectation, no of consumers) constant, the
demand curve does not shift In this case as price varies we are moving along the same dd
curve and we call this movement change in quantity demanded. The following graph shows
change in quantity demanded from Q1 to Q2 or from Q2 to Q1 due to change in price of the
commodity from p1 to p2 or from p2 to p1 respectively, ceteris paribus.

Price A
P1
Fig. 2.4: Change in quantity demanded
B
(movement along the same demand)
P2

P3 C
0
Q1 Q2 Q3
Quantity

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If the price of a commodity (own price) remains constant and one or more of those other
factors affecting demand (e.g., income, taste and preference, prices of other goods,
expectation and number of consumers) change, then the demand curve shifts from its position
either to the right or to the left.

Thus, when the demand curve changes its position we call it change in demand (shift in
demand)
Price D1 D0 D2

P0

D1 D0 D2
0 Quantity

When demand Fig.

curve2.5. Change
shifts from in
D0demand
D0 to D2(shift
D2 we insay
demand curve)
increase in demand, i.e., shift of the
demand curve to the right

When demand curve shifts from D0 D0 to D1 D1 (shift of demand curve to the left) we say
decrease in demand.

Increase in demand (shift from D0 D0 to D2 D2) is caused due to: increase in consumers'
income for normal goods, favorable taste and preference for a commodity, expectation of
higher price in the future, increase in the price of substitute goods, decrease in price of
complementary goods and others, ceteris paribus the reverse is also true.

Therefore, when we say increase (decrease) in demand we mean shift of the demand curve to
the right (left). When we say increase (decrease) in quantity demanded we mean downward
(upward) movement along the same demand curve.

NB. An increase (decrease) in demand also implies purchasing of more (less) of goods at
each price level. Thus, change in demand necessarily implies change in quantity
demanded, but change in quantity demanded does not necessarily imply change in

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 demand. Change in own price causes movement along the same demand curve without
causing shift of the demand curve while change in other factors affecting demand cause
shift in the demand curve.

Check Your Progress Exercise 2

1. Why people act according to the law of demand or in other words why price of a
commodity and its quantity demanded are inversely related or why demand curve is
downward sloping?
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………

2. When teff prices rise other things being constant, an individual purchases more wheat but
fewer teff. How you explain substitution and income effects of the price change on these two
goods?
………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………

2.2.4 Individual and Market Demand Curve

Individual demand curve is defined as amount of goods that a single consumer is willing and
able to buy at different price levels over certain time period.

Market Demand Curve is the total amount of goods that all consumers are willing and able to
buy at each price level over certain time period.

Table 2.2. Demand for wheat by three individual consumers over the last five months
Price per Abebe's demand Bekele's demand Almaz's demand Total (market)
quintal for wheat for wheat for wheat demand for wheat
of wheat
(1) (2) (3) (4) 5 = 2+3+4

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 300 0 3 5 8
260 2 6 10 18
220 4 9 15 28
180 6 12 20 38
140 8 15 25 48
100 10 18 30 58
60 12 21 35 68

From this table we can see that market demand is the horizontal summation of the demand
of those three consumers, which can be shown as individuals and market demand curve as
follows.

300
260 + + =
220
180
140
100
60 0 2 4 6 8 10 12 3 6 9 12 15 18 21 8 18 28 38 48 58 68
5 10 15 20 25 30 35

Quantity of wheat
Fig. 2.6. Individual and Market Demand Curves.

Check Your Progress Exercise 3

1. Why economists assume other things being constant (ceteris paribus)?

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………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………

2.3 SUPPLY ANALYSIS

2.3.1 Definition of Supply

Supply refers to the willingness and ability of producers to produce goods and services and
make available for sale in the market at a given price level within a set of possible prices over
certain period of time (e.g., week, month, year, etc).

Law of Supply states that other things being equal the quantity supplied of a commodity
varies directly with the price of that commodity i.e. quantity supplied increases (decreases) as
price of the commodity increases (decreases), ceteris paribus.

Supply Schedule is a table which shows how much of a good individuals are willing and able
to produce and make available for sale in the market at different price levels during a given
period of time (week, month etc)

Quantity Supplied is the amount of commodity that producer supplies to the market at a
given price level. The direct (positive) relationship between price of a commodity and
quantity supplied can be shown using either the supply schedule or the supply curve.

Table 2.3 An individual supply schedule of coffee

Price of coffee Quantity supplied
(Birr) for coffee ( k. g)
70 700
60 600
50 500
40 400
30 300
20 200
10 100

Supply curve of a commodity is a curve, which shows the relationship between the quantity
supplied of the commodity at different price levels. In drawing the supply curve we singled
out price of a commodity as the most important factor affecting the quantity supplied of the
commodity and ignored the influences of other factors. However in addition to own price,

53
quantity supplied of a commodity depends on a number of other factors. A fundamental
analytical method used in economics is to hold all other influences constant & focus on one
important variable.

Economists do not say price is the only variable which influence sales but they say that price
generally has very important effect on quantity sold. It is to identify the influence of price of
a commodity on its quantity supplied that economists hold other variables constant and
concentrate on the relation between quantity supplied and price, that is, the relation shown by
the supply curve. In this way attention can be focused on the effect of price. However, in
using the supply curve students should be aware of the other factors, which actually can
influence quantity supplied, but which were held constant in deriving the supply curve.

S
70
60
50
40
Price 30
20
10
0 100 200 300 400 500 600 700 Quantity
Fig. 2.7 The Supply Curve

As price of a commodity increases from 10 Birr to 70 Birr then quantity supplied increases
from 100 to 700. Supply curve is derived under the assumption that other factors that can
affect quantity supplied are hold constant and only price of a commodity is allowed to vary.

Quantity supplied of a commodity and its price is positively related i.e. as price increases
quantity supply also increases.
Check Your Progress Exercise - 4
1. Now the question is why producers act according to the law of supply or in other words
why supply curve is upward sloping?

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………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………

2.3.2 Factors Affecting Supply of a Commodity

Firms are interested in supplying of commodities in order to get profit. Thus, they supply
more goods when price is high relative to cost of production and supply less when production
cost is high relative to price. Price of a commodity is not the only determinant of quantity
supplied of the commodity. There are a number of other factors. These are:

A. Prices of Production Substitutes

Production substitutes are goods, which a producer tends to substitute for one another when
their price changes. If price of a good increases other things remain, constant, producers
decrease the production of its substitute because production of the good is more profitable
than production of its substitute. For example, if price of wheat increases in the market in
relation to price of teff a farmer allocates large part of its land to wheat production instead of
teff production.

B. Prices of factor inputs

Other things being constant, an increase (decrease) in the price of factors of production causes
an increase (decrease) in cost of production. As cost of production increases (decreases) profit
- margin decreases (increases) and therefore amount supplied to the market decreases
(increases). Thus, increase (decrease) in price of factor inputs causes quantity supplied to fall
(rise) of course under the assumption of other things being constant.

S2
S0
S1

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 Price of Commodity
A decrease in
supply
An increase in
supply

Quantity of a commodity
Fig, 2.8 Shift of supply curve

C. Technological State of production

The development of the new method of production or the invention of efficient machines may
make possible a big expansion of output at a lower cost and so causes supply to increase. i.e.
improvement in technology causes supply to increase and absolute technology causes supply
to decrease.

D. Taxes and Subsidies

Taxes are a compulsory payment imposed on producers or consumers. Subsidies are some
amount of money given to producers or consumers to supplement their expenditure. An
increase (decrease) in tax, other thing being constant, causes supply to decrease (increase),
because producers feel as if their cost of production were increased (decreased). If subsidy to
producers increases (decreases), then supply will increase (decrease) because producers feel
as if their cost of production were decreased (increased) thereby causing profit to increase
(decrease).

E. Number of Producers
As number of firms producing a good increases more and more goods will be supplied.

F. Expectation of Change in Price

Expectation of higher price in the future may cause decrease in current supply as producers
store their outputs to sell them later at a higher price assuming other things being constant.

56
Quantity of goods kept in store is not considered as a supply. Goods are considered as a
supply only when they are brought to the market.

G. Market Organization
If a market for certain commodity is monopolized (i.e., there is only a single producer) then a
producer charges higher price by producing few outputs, because, the producer faces no
competition. If a market for certain commodity is characterized by a perfect competition
(many producers and sellers), then producers produce more outputs, because, there is no
possibility of increasing price to increase revenue

H. Weather
For some products, especially agricultural products weather affects the quantity to be
supplied. Favorable (unfavorable) weather increases (decreases) supply of agricultural
outputs.

2.3.3 Change in Quantity Supplied and Change in Supply

Change in quantity supplied refers to the movement along the some supply curve and it is
caused by a change in commodity's price. In this case only price of a commodity is allowed
to vary and other determinants of supply (e.g. Price of production substitute, prices of factor
inputs, technological state, taxes and subsidies, no of producer, expectation of producers and
weather etc,) are held constant.

Price P3 S
Fig. 2.9 Change in quantity supplied
P2 B (movement along the same supply
P1 A
curve)

Quantity
0 Q1 Q 2 Q3
As price increases from P1 to P2, quantity supplied also increases from Q1 to Q2, i.e., we call
this increase in quantity supplied and as price decreases from p 3 to p2 quantity supplied also
decreases from Q3 to Q2.

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Change in supply refers to the shift of the supply curve. If we fix price of a commodity (own
price) constant and vary any of those other factors affecting supply (e.g. Prices of production
substitute and inputs, technological state, tax and subsidy, no of producers, producers'
expectation and weather) then the supply curve changes its position, i.e., the supply curve
shifts.

S1 S0 S2
Price decrease in supply
Increase in supply
Po

0
Q 1 Q0 Q2
Quantity
Fig. 2.10 Change in Supply (Shift in the supply curve)

If the supply curve shifts from S oSo to S2S2 (shift of the curve to the right), we call it increase
in supply. If the supply curve shifts from S oSo to S1S1 (shift of the curve to the left), we call it
a decrease in supply.

Increase in supply, i.e., shift of the supply curve to the right is caused by the following
factors: decrease in price of production substitute, decrease in prices of inputs, improvement
in technology, increase in subsidy, decrease in tax, increase in number of producers,
expectation of lower price in the future, good weather and others, ceteris paribus.

The supply curve shifts to the left (decrease in supply) when the above factors change in
opposite direction.

NB. As supply curve shifts, quantity supplied also changes therefore change in supply
necessarily implies change in quantity supplied. However, change in quantity supplied
does not necessarily imply change in supply, because change in quantity supplied can be
observed by moving along the same supply curve (without shift in supply curve).

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2.3.4 Individual and Market Supply Curve

Individual Supply Curve shows us the quantity that a single producer is willing and able to
supply at each price level over certain period of time.

Table 2.4. A hypothetical supply schedule for the production of wheat by three individual
producers over the last seven months
Price of wheat Kebede's supply of Balcha's supply of Birke's supply of Market supply
(Birr) wheat (k.g) wheat (k.g) wheat (k.g) of wheat (k.g)
(1) (2) (3) (4) [5 = 2 + 3 + 4]
300 7 26 35 68
260 6 22 30 58
220 5 18 25 48
180 4 14 20 38
140 3 10 15 28
100 2 6 10 18
60 1 2 5 8

These supply schedules can be transferred into the supply curves as follows:
A supply curve of individuals (Kebede, Balcha and Birke)

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 300
260
220
Price 180 + +
140
100
60

1 2 3 4 5 6 7 2 10 14 18 22 26 5 10 15 20 25 30 35
Quantity
Fig 2.11 Individuals Supply Curves

S
300
260
Price 220
180
140
100
60
y
0 8 18 28 38 48 58 68
Quantity
Fig. 2.12. Market Supply Curve
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When price of wheat is300 per quintal, quantity supplied of individual kebede, Balcha and
Birke is 7, 26 and 35 quintals respectively.

Market Supply Curve shows the total amount of particular commodity supplied by all
producers at each price level, i.e., market supply curve is the horizontal summation of
individuals. Supplies at each price level. For example, the market supply curve for the three
individual producers of wheat cited above is shown by the following graph.

2.4 MARKET EQUILIBRIUM

2.4.1 Definition of Market Equilibrium

Market can be considered as a mechanism or structure that facilitates exchange of goods and
services among different economic units (e.g., firm, government, etc). Market does not
necessarily refer to certain geographical area. It can exist wherever there is a contact between
buyers and sellers without any spatial dimension attached to it.

In this section we will discuss market equilibrium in a perfectly competitive market. A

perfectly competitive market is a market, which fulfills the following criteria, i.e., the
followings are assumptions of perfectly competitive market:

1. Large number of buyers and sellers (so that the influence of individuals seller or buyer is
insignificant.

2. Firms produce a homogeneous product (so that an attempt to increase price by the producer
brings loss of market share)

3. Perfect information (knowledge) of the market (so that each market participant can act
according to the market operation)

4. Absence of government control of economic activities (no government price control, no

taxation, no subsidy, etc)

5.Free entry and exist of firm (no business license, no patent right, etc)

6.Free mobility of resources

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Under these assumptions (conditions) no individual buyer or seller has control over the price
of a commodity. Both consumers and producers are price takers not makers, i.e., price is
determined by the market (by forces of supply and demand)

At that equilibrium, price and quantity remain unchanged as long as we have the assumption
of other things being equal, i.e., until something operates to change supply or demand. If
some changes occur to shift either the supply curve or the demand curve, then the market
equilibrium point also changes.

In order to understand the market equilibrium let us consider our market demand schedule
and supply schedule of wheat we showed in the table 2.2 and table 2.4 respectively.

Table 2.5. Market Equilibrium

Price Per Quintal Total Total Excess Supply State of Pressure on

(in Birr) (Market) (market) (+) Excess Market Price
Supply Demand Demand (-)
(1) (2) (3) 4 = [2 - 3] (5) (6)
300 68 8 +60 Surplus Downward
260 58 18 +40 Surplus Downward
220 48 28 +20 Surplus Downward
180 38 38 0 Equilibrium Neutral
140 28 48 -20 Shortage Upward
100 18 58 -40 Shortage Upward
60 8 68 -60 Shortage Upward

From our demand and supply analyses, we know that consumers tend to buy more of the
goods as price falls while producers tend to sell more as price increases. Thus, consumers
need price to fall while producers need price to (rise).

Now the question is, what determines the price level on which both consumers and
producers agree on, i.e., the equilibrium?

The operation of the forces of supply and demand provides answer to this question. At any
price level above the equilibrium price (like point G and others in figure 2.12) quantity
supplied is greater than quantity demanded. At that price level producers plan to supply more
and more of the goods in order to get more profit. However, consumers plan to buy less and
less as goods are too costly to them. Therefore, there will be an excess supply (surplus). In

62
order to get rid of this excess supply there will be completion among producers to decrease
price. This decrease in price encourages consumers to demand more and more of the goods.
Thus, producers continue to decrease their prices and consumers continue to buy more until
the excess supply is eliminated or until the equilibrium point is reached at point E. At any
price below the equilibrium price level (such as point F and others in figure 2.12) quantity
demanded is greater than quantity supplied. At that price level producers plan to supply less
and less of the goods. However, consumers plan to buy more and more as they feel goods are
relatively cheap. Thus, there is an excess demand (shortage of goods) and this creates
competition among consumers to get these scarce goods by increasing price. This increase in
price encourages producers to supply more and more. Thus, consumers continue to bid up
price and producers continue to supply more and more until the excess demand is eliminated
or the equilibrium price is reached again at point E. Graphically the market equilibrium (i.e.,
equilibrium price which is 180 birr and equilibrium quantity which is 38 quintals) can b
shown as follows:

Excess supply or
shortage of demand
Price
G Fig. 2.13 Market equilibrium
180 E

Excess demand
F or
shortage of supply
D
Quantity
38
At point E supply and demand curve intersect each other and therefore quantity supplied is
equal to quantity demanded hence market equilibrium is attained at point E.
2.4.2 Effects of Change in Demand or Supply on the Market Equilibrium

Strictly speaking market equilibrium is achieved under the assumption of perfectly

competitive market, in which all factors affecting supply and demand except the price of a
commodity are assumed to be constant. When one of the factors varies and others held
constant, then the market equilibrium point also changes. This situation can be shown by the
following graph.

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 D0 D1 S
Price

P1 e1

P0 e

S
D0 D1
Quantity
Q1 Q0
Fig. 2.14 Effects of an increase in Demand when Supply Remains Unchanged

An increase in demand (shift of the demand curve from D0 D0 to D1D1) supply being
unchanged causes equilibrium point to change from e to e1. In this case the new equilibrium
point (point e1) is attained both at a higher price and quantity than the initial equilibrium
(point e).

A decrease in demand (shift of the demand curve from D1D1 to D0D0) and supply remains
constant causes attainment of the equilibrium at a lower point. i.e., equilibrium point decrease
from point e1 to e and therefore equilibrium quantity decreases from Q 1 to !0 and equilibrium
price decreases from P1 to P0.

D0 S0 S1
Price
P0 e

P1 e1
S0
S1 D0
0 Q0 Q1 Quantity
Fig. 2.15 Effects of an increase in supply when demand remains unchanged

64
An increase in supply (shift of supply curve from S 0S0 to S1 S1) assuming demand not to
change causes equilibrium point to change from point e to e 1. As a result equilibrium price
decreases from P0 to P1 and equilibrium quantity sold or bought increases from Q 0 to Q1, i.e.,
the new equilibrium is attained at a lower price but higher quantity than before.

Decrease in supply (shift of the curve from S1 S1 to S0S0) assuming demand being unchanged
causes equilibrium point to change from e1 to e. That is to say the new equilibrium point e is
attained at higher price but lower quantity level than before.
D0 S0 S1
Price
P0 e
P1 e1
S0
S1 D0
Q0 Q1 Quantity
Fig. 2.16 Effects of a decrease in supply when demand remains unchanged

Effect of simultaneous change in demand and supply on equilibrium price and quantity. If
both demand and supply increase simultaneously, then the equilibrium quantity increases but
equilibrium price may increase, decrease or remain unchanged depending on the relative
magnitude of the percentage change in demand and supply. There are three cases.

(1) If demand increases by more proportion than the supply, the new equilibrium (e 1) is
attained at both higher equilibrium price and quantity than before. Thus, the new
equilibrium quantity (Q1) is greater than the previous equilibrium quantity (Q 0) and the
new equilibrium price (P1) is also greater than the previous equilibrium price (P0).

65
 D1 S 0 S1
D0
Price P1 e1

P0 eo D1
S0
S1 Do
Q0 Q1 Quantity
Fig. 2.17 Effects of increase in demand by more proportion than supply increase.

(2) If supply increases by more proportion than demand, then the new equilibrium (e 1) is
attained at a higher equilibrium quantity (Q 1) than previous quantity (Q0) but at a lower
equilibrium price (P1) than the previous price (P0).

S0
D 0 D1
S1
Price P0 e0

P1 S0 e1
S1 D0 D1 Quantity
Q0 Q1

Fig. 2.18 Effects of increase in supply by more proportion than demand increase.

3) If both demand and supply increases by an equal proportion the new equilibrium quantity
is attained at a higher level then the initial equilibrium quantity. But equilibrium price
remains unchanged.

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 Price D0 D1 S0 S1

P0 e0 E1

S0
S1 D0 D1
Q0 Q1 Quantity

Fig. 2.19 Effects of increase in supply and demand by equal proportion.

So far we discussed the relationship between price and quantity demanded in terms of
demand schedule and demand curve. As well, we have seen the relationship between price of
a commodity and quantity supplied in terms of supply schedule and supply curve. Our
demand and supply curves helped us in explaining basic concepts in demand and supply
analysis such as market equilibrium, change in demand, change in quantity demand, change
in supply, change in quantity supply, etc.

The supply schedule (curve) or demand schedule (curve) can also be represented by supply
equation or demand equation respectively and can be used to explain those basic demand and
supply concepts we mentioned above.

E.g. if the demand and supply curve equation of a commodity are given by:
Qd = 250 - 50P
and
Qs = 25 + 25P, respectively, where Qd, Qs and P are quantity
demanded, quantity supplied and price respectively. The equilibrium price and quantity will
be: Qd = Qs at market equilibrium, so
250 - 50P = 25 + 25P
250 - 25 = 25P + 50P
225 = 75P
P=3
Qd = 250 - 50(3) = 100 = Qs
Thus, equilibrium price and quantity is 3 and 100 units respectively.

67
Check Your Progress Exercise - 5

1.What is Market Equilibrium?

………………………………………………………………………………………………………
………………………………………………………………………………………………………
………………………………………………………………………………………………………

2. Given:
If the Demand and supply equations of a commodity are:
Qd = 30 - 5P (demand equation)
and
Qs = 25P (supply equation), respectively, where Qd, Qs and P arequantity demanded,
quantity supplied and price respectively.

Based on the above demand and supply equations, what will be:
a) equilibrium price ?
b) equilibrium quantity ?

2.5 ELASTICITIES

Business -people who use economics in decision making is interested in knowing the
responsiveness of the dependent variable (say quantity demanded) to the change in any one of
the independent variable (say price).

2.5.1 Elasticity of Demand

Elasticity of demand is defined as a measure of the degree of responsiveness of quantity
demanded (consumers) to the change of determinants of demand including price of a product.

In economics, the following elasticities are quite important for the decision making of both
consumers and producers.

Elasticity of demand
Elasticity of supply

There are three major types of elasticity of demand:

68
  Price elasticity of demand
 Income elasticity of demand
 Cross-price elasticity of demand

2.5.2 Price Elasticity of Demand

Price elasticity of demand is also "called elasticity of demand". It is a concept that measures
by how much percent will quantity demanded changes when its price changes by certain
percent, i.e.,

Ep = percentage change in quantity demanded = (Q/Q) x 100

Percentage change in price (P/P) x 100
(
Where Ep = Price elasticity of demand
Q = Quantity demanded of a commodity
P = Price of a commodity
P = Change in price
Q = Change in quantity demanded
but Q = Q2 - Q1 and
 P = P2 - P 1
Where Q2 and Q1 are quantity demanded of a commodity at price level P 2 and P1 respectively.
Therefore,

Ep = [(Q2 - Q1)/Q1] x 100

[(P2 - P1)/P1] x 100

Ep = (Q2 - Q1) x P1 = (Q2 - Q1) x P1

Q1 P2-P1 (P2- P1) Q1
This type of elasticity is called point price elasticity of demand. Even though calculation of
price - elasticity of demand yields negative value because of the inverse relationship between
quantity demanded and price, for convenience we consider a positive value in terms of its
"absolute value".

Table2.4 demand schedule for barley

69
 Point Price Quantity
Demanded
A 15 20
B 10 30
C 5 40

From this example we can calculate 'point" price elasticity of demand in two ways:

1. Considering movement from point A to B, i.e.,

Ep = Q2 - Q1 x P1 = (30 - 20) x 15 = / -1.5 / = 1.5

P2 - P1 Q1 (10 - 15) 20

2. Considering the same points but movement in opposite direction, i.e., from B to A we get:
Ep = Q2 - Q1 x P1 = 20 - 30 x 10 = / -0.67/ = 0.67
P2 - P1 Q1 15-10 30

In the first case we used point A as the base for computation of e p whereas in the second case
we used point B as the base of computation of e p. In both cases the price elasticity of demand
we calculated is point price elasticity. Thus, one of the problems of using point price
elasticity is that it yields two different values of elasticity depending on the direction of our
movement (point which we select as a base of our computation). In order to avoid this
discrepancy in value of elasticity it is better to use "arc" or" average" elasticity which takes
the average price and average quantity as a base for computation.

Let's see mathematical derivation of arc elasticity of demand as follows:

follows:

Ep = 2 (Q2 - Q1) x (P1 + P2)

(Q2 + Q1) 2(P2- P1)

Ep = (Q2 - Q1) x ( P1 + P2 ) This formula is an arc elasticity formula and it is widely

used.
(P2 - P1) (Q1 + Q2 )

70
The Five Categories of Price Elasticity of Demand
Depending on its magnitude, elasticity of demand can be categorized as follows:

1. Perfectly inelastic demand;

demand; in this case coefficient price elasticity of demand (Ep) is zero,
i.e., if demand for the commodity is perfectly elastic, change in price of the commodity does
not affect quantity demanded and the demand curve is vertical.
D
P
P1 ep = 0
P2
Q
Q0
Fig.
Fig.2.20 Perfectly inelastic demand curve

Although price decreased from P1 to P2 quantity demanded remained unchanged.

2. Inelastic Demand:
Demand: in this case percentage change in quantity demanded is less than
percentage change in price. eg . a change of price by 10%, which caused quantity,
demanded to change only by 5%. Here the value of demand elasticity lies between 0 and
1, i.e. 0 < ep < 1. Graphically it can be shown as follows.

D
P P1 0 < ep < 1

P2

D Q
Q1 Q2
Fig. 2.21 Inelastic Demand curve

3. Elastic Demand:
Demand: When percentage change in quantity demand is greater than
percentage change in price, it is said to be elastic demand. eg change in quantity demand
by 10% which was caused by 5% change in price.

71
 P D
P1 ep > 1

P2
D
Q
Q1 Q2
Fig. 2.22 Elastic Demand

4. Unitary Price Elasticity:

Elasticity: here percentage change in price is equal to percentage in
quantity demanded. e.g. As demand changes by 10% price also changes by 10%.

P D
P1 ep = 1

P2
D
Q
Q1 Q
Fig. 2.23 Unit Price Elastic demand curve

5. Perfectly Elastic demand:

demand: The percentage change in price is zero but percentage change in
quantity demanded is high. Here elasticity of demand is infinite, ep = 

P
P0 D ep = 

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 Q1 Q2 Quantity
Fig. 2.24 Perfectly Elastic demand:
demand:

Linear demand curve and price elasticity of demand

Graphically, elasticity of demand for a straight-line demand curve can be shown as follows:

Price 4 D
ep > 1
3 B

2 M ep = 1

1 E ep < 1
1
D
o 1 2 3 4 Quantity
Fig.2.25 Elasticity of demand and price elasticity of demand

Point m is the mid point of straight-line demand curve DD 1 (i.e. DM = MD1). Above the mid
point M to the left of M demand is elastic (i.e., ep > 1). At the mid point demand is unitary
elastic with ep = 1. Below the mid point to the left of M demand is in elastic with e p<1.

Factors Affecting Price Elasticity of Demand

Elasticity of demand depends on a number of things. Some of them are:
a) Availability and number of substitute: - if a commodity has many substitutes, a change in
price of one substitute will affect quantity demanded of the other substitute highly.
The larger the number of good substitute products available, the grater the elasticity of
demand i.e., a commodity with many substitutes has larger price elasticity (purposes)

b) Number of alternative uses of a commodity: If a commodity has many alternative uses it

has high price elasticity of demand, i.e., the higher is the number of alternative uses of a
commodity, the higher is its price elasticity.

73
c) The nature of a commodity (i.e. whether it is luxury or necessity)
If a commodity is a necessity-good, then its, ep is low (inelastic demand) because
whatever price level is, consumers buy almost fixed quantity of this good. If a commodity
is non-essential or luxury then it has high price elasticity, because for this commodity a
consumer has an alternative to postpone consumption if price increases, as it is not so
essential for daily activity.

Other factors such as size of percentage share of commodity's expenditure in total

expenditure of a consumer, time horizon of consumption, durability of a good, etc can also
affect price elasticity of demand.

2.5.1.2 Income Elasticity of Demand

Income elasticity of demand measures percentage change in quantity demanded due to certain
percentage change in income of the consumer.

ey = (Qd/Qd) x 100
(y/y)x 100
Where ey is income elasticity of demand
Qd is changed in quantity demand
Y is change in income of consumers.
i.e. ey = [(Q2 - Q1)/Q1)] x 100
[(Y2 - Y1)/Y1] x 100

ey =

where Q1 is quantity demanded at income level Y1 and Q2 is quantity demanded at income

level ½.

If income elasticity of demand for certain good is positive, then the good is said to be normal
good.

If income elasticity of a commodity is negative, then the good is said to be inferior good.

2.5.1.3 Cross Price Elasticity of Demand

Cross price elasticity is used to measure the percentage change in quantity demanded of a
commodity, (say X) due to percentage change in price of the other commodity, (say Y)

74
 exy = (Qdx) / Qdx = Qdx , Py
 py/py py Qx
Where Qdx is changed in quantity demand of x.
py is changed in price of commodity y
Qxd is quantity demanded of x at particular price

exy = x this is point cross price elasticity

If goods are related in consumption they are either a substitute or a complementary to each
other. Cross price elasticity can be positive, negative or zero. For a substitute goods cross
price elasticity is positive. For complementary goods cross price elasticity is negative. If
goods have no relation their cross price elasticity of demand is zero.

Table 3.2 Demand schedule for good X and Y

points Px Py Qx Qy
A 2 3 18 13
B 4 5 12 9
C 5 6 10 4

Cross - elasticity of demand for commodity X i.e. exy as we move from A to B is given by

exy = -

x = x = -½ for the movement from A to B

For the movement from B to A, exy = x

exy = 6/-2 x 5/12 = -5/4

Arc cross - price elasticity (exy) = .

2.5.2 Elasticity of Supply

2.5.2.1 Price Elasticity of Supply

75
Price elasticity of supply measures percentage change in quantity supplied due to certain
percentage change in the price of a commodity.

es = - = x - Point elasticity it

supply

Where es = price elasticity of supply

Qs = Change in quantity supply
P1 = price of a commodity
Qs = quantity supplied at a particular price.
Price elasticity of supply is positive. It may vary from 0 to 
Arc cross - price elasticity (exy) = (Qx2d - Qdx1) . (Py2+Py1)
(Py2 - Py1) (Qdx2 + Qx1d)
If es = 0 it is called perfectly inelastic supply. Graphically it is:
S
P1
Price P2 es = 0

Q Quantity
Fig 2.26 perfectly inelastic supply curve

If es =  i.e p = 0 then it is called a perfectly elastic supply

P es = 
P0 S

Q1 Q2 Q
Fig2.27 perfectly elastic supply curve

If 0 < es < 1, it is called inelastic supply

76
 P S

0 < es < 1
S
Q
Fig 2.28 inelastic supply curve

If es = 1 it is called unitary elastic

S
P es = 1

0 Q
Fig 2.29 unitary elastic supply curve

If es > 1, it is called elastic supply

P
S
es > 1
S
Q
Fig 2.30 elastic supply curve

2.5.3 Application of Elasticity

The concept of demand elasticity is useful for businesspeople. If a producer wants to sell
more of his commodity by reducing price then the demand curve for his product must have
elastic demand.

If demand for the product is elastic, an increase in price results decrease in revenue as small
percentage change in price causes large decrease in quantity sold.
If a producer faces an inelastic demand curve for his product he can increase his revenue by
increasing price because under this case large percentage increase in price causes little

77
percentage decrease in quantity demanded. If a producer faces inelastic demand curve, then it
cannot increase its revenue by decreasing price.
If demand is unitary, change in price does not affect total revenue. In this case there is no
need of decreasing or increasing price, as it does not affect total revenue of the producer.

Check Your Progress Exercise - 6

1. Using the following table, compute arc price elasticity of demand of increase in price from
10 to 15?
Table 2.8 Demand Schedule
Point Price Quantity Demanded
A 15 20
B 10 30
C 5 40

2.6 KEY TERMS

Define and explain the following concepts

Other things being constant or "Ceteris paribus" Law of demand
The demand schedule The demand curve
Substitution effect Income effect
Change in quantity demanded Change in demand
Variables, which cause change in demand Law of supply
Supply schedule and supply curve Individual and market demand curve
Individual and market supply curve Variables which cause change in supply
Change in quantity supplied Market equilibrium
Excess supply Excess demand
Change of market equilibrium point Elasticity (general)
Price elasticity of demand Income elasticity of demand
Cross - price elasticity Arc - elasticity
Point elasticity Elastic demand
Inelastic demand Perfectly elastic demand
Perfectly inelastic demand

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 2.7 ANSWERS TO CHECK YOUR PROGRESS EXERCISES

Check Your Progress Exercise - 1

1.A normal good is one that is consumed voluntarily, and for which demand rises as income
of the consumer increases and falls as income of the consumer falls, other things being
constant.
2.Inferior good is one that is consumed due to economic circumstances, and for which falls
as income of the consumer increases and rises as income of the consumer falls, ceteris
paribus.

3. Substitutes --Two
--Two or goods are considered substitutes if they satisfy the same needs or
desires separately like, Pepsi cola and coca cola, Pork and Beef and coffee and tea etc.

4. Complements -- Two or more goods are complements, if they are used or consumed jointly
to satisfy the needs of the consumer like, Sugar and tea, car and petrol, etc.

Check Your Progress Exercise - 2

This inverse relationship is explained by the following reasons.

1.a. As price of a commodity increases consumers cut down consumption of that good and
substitute other commodity whose price was not rose this is substitution effect.
b. As price of a commodity increases real income of consumer decreases and so quantity to
be purchased decreases. This is income effect.
c. Law of diminishing marginal utility also theoretically explains this inverse relationship,
i.e. as a consumer consumes more of the same good, the additional satisfaction
(marginal utility) keeps on decreasing and consumer is eager to pay less and less for each
successive unit he consumes.

Check Your Progress Exercise - 3

1. The net effect of all the factors that affect dependent variable can't be predicted when all
independent variable change simultaneously. In order to find the effect of each of the factors

79
on dependent variable, we must keep other factors unchanged and vary just one factor at a
time.

Check Your Progress Exercise - 4

This question is possibly explained by the following two major reasons:
reasons:
a. The law of diminishing marginal returns to the variable input. This law states that for
a certain range of production, as more and more of one variable input (say labor) is
added on the other fixed input (say machinery) then less and less of additional output
is gained. Therefore, higher price is needed to compensate for the successive fall in
the additional output, i.e., each of the additional output should be priced at a higher
price to make the production profitable. This is simply a theoretical explanation. In
practice, all quantities of the same good have the same price whether it is produced
first or last.

b. Profit motives. In real world firms are willing to supply more as price increases
because, other things being constant, increase in price of output implies increase in
profit of the firm, which induces it to, supply more and more of output.

Check Your Progress Exercise - 5

Market equilibrium denotes a situation in which all buyers and sellers are satisfied with the
current combination of prices and quantities bought or sold, and so they are not changing
their present actions. A market is said to be in equilibrium when demand for a commodity is
equal to its supply, i.e., where all quantities supplied to the market are sold.

Check Your Progress Exercise - 6

Ep = (Q2 - Q1) (P1 + P2)
(P2 - P1) (Q2 + Q1)
Ep = (20 - 30) x (15 +10)
(15 -10) (20 + 30)

Ep = x = = =

Thus arc price elasticity of demand is equal to 3/5, which is interpreted as follows.

80
 As price increases (decreases) by 5 percent, then quantity demanded decreases (increases) by
3 percent.

2.8 MODEL EXMAINATION QUESTIONS

I. Choose the correct answer.

1. When two goods are substitutes on production, then __________________.
a) the price of one good and the supply for other good move in opposite direction
b) the price of one good and the supply for the other good are independent
c) the price of one good and the supply for the other good are directly related
d) a and c
e) none of the above

2. When percentage change in quantity demanded is greater than percentage change in price
then, _______________________.
a) consumers are relatively sensitive to price changes
b) demand is inelastic
c) coefficient of price elasticity is less than one
d) all of the above
e) none of the above

3. Given the following demand and supply equations: what will be the equilibrium price and
quantity?
-1/2Qd + 10 = 3/ 2p
1/2Qs-15/2 = 1/ 2p

a) 4/5 equilibrium price and 16 equilibrium quantity

b) 5/4 equilibrium price and 16.25 equilibrium quantity
c) 16.25 equilibrium price and 4/5 equilibrium quantity
d) 4/5 equilibrium price and 16.25 equilibrium quantity
e) None of the above

4. A downward movement along the fixed demand curve implies

a) increase in supply

81
 b) increase in quantity supplied
c) decrease in quantity supplied
d) increase in quantity demanded
e) increase in demand

5. One of the following does not affect demand for wheat.

a) Number of population.
b) Expectation of consumers.
c) Price of substitute goods in production.
d) Income of consumers.
e) None of the above

6. The market equilibrium for a commodity is determined by _________________.

a) the market demand for the commodity
b) the market supply of the commodity
c) the interaction between demand for and supply of a commodity
d) all of the above
e) none of the above

7. Reason for differences in price elasticity of demand is _______________________.

a) the nature of the good
b) availability of substitutes
c) adjustment time
d) number of alternative uses

8. If demand is perfectly elastic, then ___________________

a) % change in Qd = 0 and % change in price equals positive infinitive
b) % change in Qd is high and % change in price is a positive number
c) % change in Qd is positive infinitive and % change in price is = 0
d) all of the above
e) none of the above

9. As price of commodity Y increases, demand curve for commodity X shifts to the left,
then X and Y are

82
 a) substitute goods
b) unrelated goods
c) complementary goods
d) either substitute or complementary goods
e) neither complementary nor substitute goods

10. The elasticity of demand for a good is 0.8 with respect to price. Therefore, one expects
that a 1% increase in price would _________
a) increase quantity demanded by 0.8%
b) increase quantity demanded by 0.16%
c) decrease quantity demanded by 0.8%
d) decrease quantity demanded by 0.16%
e) none of the above

II. Write "True" if the statement is true, and "False" if the statement is false.
____________ 1. The coefficient of price elasticity of supply of a commodity is always
negative.
____________ 2. A decrease in input prices causes a left ward shift in the supply curve.
____________ 3. The income-effect on demand for an inferior good is negative (inverse).
____________ 4. If a consumer expects price to increase in the future, other things being
constant, he or she purchases more units of normal goods currently
_____________5. Every straight supply line passing through the origin has unitary elasticity.
_____________6. Substitute goods are those that are competing for the same demand.
_____________7. The coefficient of cross- price elasticity of demand for unrelated goods
is negative.
_____________8. As price of a commodity increases its demand Curve shifts to the left,
ceteris paribus.
____________ 9. Equilibrium price and quantity increase if both demand and supply
increase.
____________10.
____________10. Expectation of the producer in price changes affects demand for a
commodity, ceteris paribus.

83
III. Give brief definition or explanation for the following concepts in the space
provided

1. Change in quantity demanded

2. Change in demand
3. Normal goods
4.Inferior goods
5. Income effect
6. Market equilibrium
7. Substitution effect

IV. Attempt the following problems.

problems.

1) State and explain why the demand curve is negatively sloped?

2) State factors that affect quantity demanded and quantity supplied and explain how
they affect the position of the demand curve or supply curve.

3) Why the supply curve is up - ward sloped (ie why price of a commodity and its
quantity supplied are positively related)?
4) What is market equilibrium? How it is arrived at? Under a perfect competitive market
assuming other things being constant, explain why any deviation from the equilibrium is a
self - adjusting, i.e., it finally returns to the initial equilibrium level?

5) Define price elasticity of demand. How it is computed, what are its determinant and
what is its use in business world?

6) Based on the following table answer questions a and b.

Table 2.9 Demand Schedule for two commodities

Points Price of Price of Quantity Quantity
Teff Wheat demanded of teff demanded of
In Birr In Birr In quintals Wheat
In quintals
A 100 160 18 15

84
 12
B 150 120 6 19
C 200 80 23

a) Calculate cross - price elasticity of teff?

b) Calculate cross - price elasticity of wheat. Are the two goods substitutes or
complementary? Why?
7) What are the factors held constant while deriving the demand and supply curve? State
their significance.

8) Use supply and demand curve to show the effect of increase in consumer income on
market equilibrium? Compare the resulted equilibrium quantity and price with the
original quantity and price.

9) Suppose the demand and supply functions for Coca are given by
Qd = 200 - 30p and
Qs = 20p, respectively.
a. Find the equilibrium quantity of coca demanded?
b. Find equilibrium price of Coca
c. Do you have excess demand or excess supply when price of Coca is 20 Birr?
When price of Coca is 50 Birr?
10) Suppose unseasonable flood attacked wheat production of maize in the upper Awash
Valley, assuming other things being constant. What effect will this have on:
a. the market supply curve for maize?
b. The market demand curve for maize?
c. The market equilibrium of maize?

11) Assuming other things being constant an increase (decrease) in supply will lower (raise)
price, why? How?

12) Draw a hypothetical demand and supply curve, which shows market equilibrium. Then
illustrate how the following variables affect your initial equilibrium point.

a. increase in consumer income

85
 b. improvement in technology
c. decrease in the price of a substitute goods
d. increase in price of complementary goods.

2.9 REFERENCES
1. Samuelson, P. and W.D. Nordhaus (1989) 13th ed. Economics,
Economics,
New York; Mcgraw - Hill Company.

2. Mavrice, Chories and Philps, R. (1992), 5 th ed. Economic

Analysis: Theory and Application,
Application, new Delhi: Universal Book Stoll.

3. Barthwol, R. (1992), Micro economic Analysis,

Analysis, New Delhi:
Wiley Eastern Limited.
Dwivedi, D. (1997), 3rd. ed. Micro economic Theory,
Theory, new Delhi: Vikas Publishing Howe
Pvt. Ltd.

UNIT 3 THE THEORY OF CONSUMER BEHAVIOR

Contents
3.0 Aims and Objectives
3.1 Introduction
3.2 Consumer Choice and the Concept of Utility
3.2.1 Cardinal Utility
3.2.1.1 Total and Marginal Utility
3.2.1.2 Consumer’s Equilibrium

86
 3.2.2 The Budget Line
3.2.2.1 Shift and Rotation of the Budget Line
3.2.3 Ordinal Utility
3.2.3.1 The Indifference Curve
3.2.3.2 Marginal Rate of Substitution
3.2.3.3 Consumer’s Equilibrium Using Ordinal Approach
3.3 Key Terms
3.4 Answers to Check Your Progress Exercises
3.5 Model Examination Questions
3.6 References

3.0 AIMS AND OBJECTIVES

After completing this unit students should be able to:

- explain the difference between cardinal and ordinal utility analysis
- distinguish between total and marginal utility
- explain indifference curve and its properties
- understand consumer's equilibrium in consumption
- understand budget constraints
- distinguish between rotation and shift of budget line
- derive budget equation
- derive income and price consumption curves

3.1 INTRODUCTION

In this chapter we develop a framework to analyze question such as: what is the relationship
between the price we pay for a good and the overall benefit, worth of the good to us? Do low-
priced goods cost less because they are not worth much to us?

This analysis of individual consumer decisions provides the underpinnings for our earlier
general analysis of demand in chapter 2, because when we put all the individual purchase
decisions of consumers together, we get the market demand curve for a good. This chapter

87
discusses utility, the budget constraints, and impacts on consumer behavior of income and
price changes.

3.2 CONSUMER CHOICE AND THE CONCEPT OF UTILITY

The law of demand may be treated as a common sense notion. A high price usually does
discourage consumers from buying; a low price typically does encourage them to buy. The
purpose of the theory of consumer behavior is to determine the various factors that affect
demand.

The theory of consumer behavior examines and verifies the postulate of preference and
consistency of choice. Consuming certain goods and services, a consumer derives some
benefits or satisfaction from the activity. Economists have called this benefit or satisfaction
utility, and have assumed that, in choosing among goods, the consumer will attempt to gain
the greatest possible utility, subject to his/her budget constraints. Utility is thus the
satisfaction obtained from consuming good or service. In short, utility is a want satisfying
power of a product to satisfy human needs. The two approaches to consumer's behavior
analysis:

3.2.1 Cardinal Utility

Some 19th century economists thought that utility might be measurable as if it were a physical
commodity. These economists have become known as cardinalists, because they believed that
cardinal numbers (i.e. 1, 2, 3 …) could be used to express the utility derived from the
consumption of a commodity. Some economists suggested that utility could be measured in
monetary units while others (in the same school) suggested the measurement of utility in
subjective units, called units.

Example: a consumer may obtain 10 utils, of utility from a consumption of good A, but only
5 utils from the consumption of good B. The cardinalists would conclude from this that the
consumer obtains twice as much utility from A as from B, and the absolute difference
between the utility derived from A and that obtained from B is 10 utils.

However, utility is an abstract, subjective concept and there are two major problems involved
in trying to measure it: It is difficult to find an appropriate unit of measurement. If we call the

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unit a util, what is a util? Are 5 utils enjoyed by one individual equivalent to 5 utils enjoyed
by another? Stated differently, can we make interpersonal comparison of utility?

3.2.1.1 Total and Marginal Utility

The satisfaction that someone receives from consuming commodities and services is called
utility.
utility. The total obtained from consuming some commodity can be distinguished from the
marginal utility of consuming one unit more or one unit less of it

The total utility is the total satisfaction obtained from the consumption of a good or bundle of
goods in a given time period.
The total utility (U) of the consumer depends on the quantities of the commodities consumed:

TU = f (q1, q2, ... qn)

The marginal (or incremental) utility is the satisfaction added by the consumption of the last
unit or in other words, it is the change in total utility caused by changing consumption of a
good by on unit, holding consumption of all other goods fixed. Geometrically, the marginal
utility of X is the slope of the total utility curve.

Mathematically this can be written as:

Mux = ΔTu/Δx

The following table shows the relationship between total and marginal utility of a particular
commodity.

Table 3.1 Total and marginal utility hypothetical data.

Units of a commodity X Total utility of commodity X Marginal utility of commodity X

(TUx) (MUx)
0 0 _
1 40 40
2 75 35
3 105 30
4 130 25
5 150 20

89
 6 165 15
7 175 10
8 180 5
9 180 0
10 175 -5

Saturation point
Tu

Tu

90
 0 1 2 3 4 5 6 7 8 9 10

Quantity of a commodity

Mu

0 1 2 3 4 5 6 7 8 9 10 Quantity

Fig 3.1. Graphical representation of total and marginal utility of the commodity

The total utility increases, but at decreasing rate, up to quantity 9, reaches its maximum and
then starts to decline there after. Accordingly the marginal utility of X declines continuously
and becomes zero when total utility reaches maximum or saturation point and then negative
beyond quantity 9.

As indicated in fig3.2 below, If the marginal utility is measured in monetary units, the
demand curve for X is identical to the positive segment of the marginal utility curve. At
quantity X1 the marginal utility is MU1, and this is equal to P1, by definition. Hence at P1 the
consumer demands X1 quantity of commodity X. Similarly at X2 the marginal utility is MU2,
which is equal to P2. Hence at P2 the consumers will buy X2 units of X, and so on. The

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negative section of the MU curve does not form part of the demand curve, since negative
quantities do not make sense in economics.

The fact that marginal utility will decline as the consumer acquires additional units of a
specific product is known as the law of diminishing marginal utility.

MU1 ------- ------------------------------------------------------P1---------

demand curve
MU2 -------------------------------------------------------------- P2 ---------------

MU3 ---------------------------------------------------------------------------------------------------- P3 ----------------------------

MU4 ------------------------------------------------------------------------------------------P4- --------------------------------------------

0 1 2 3 4
D 0 1 2 3
Quantity MU
Quantity
Fig. 3.2 Derivation of demand curve from marginal utility curve
3.2.1.2 Consumer's Equilibrium

A consumer is said to have reached his/her equilibrium position when he/she has maximized
the level of his/her satisfaction, given budget constraints and other conditions. At equilibrium,
the consumer is supposed to have spent his/her entire income on the goods and services
he/she consumes. If we assume that the consumer consumes only two products, say, X and Y,
then the following condition should fulfill in equilibrium:

= or =

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The utility derived from spending an additional unit of money must be the same for all
commodities. If the consumer derives greater utility from any one commodity, he can
increase his welfare by spending more on that commodity and less on the others, until the
above equilibrium condition is fulfilled.

We will illustrate this using a three - commodity model.

Table 3.2 Marginal utility and units of a good

Unit Marginal Utility

Good A Good B Good C
1 60 36 16

2 50 30 14

3 40 18 10

4 30 12 8

Given:
1) The price of commodity A(PA) = birr 5, commodity B(PB) = birr 3, and commodity
C(PC) = birr 1.

2) The total income of the consumer is birr 19, Now, would the consumer purchase the first
unit of A, B or C? The answer is the consumer would purchase the first unit of commodity
C. Why? Because, the highest level of marginal utility per birr is obtained from the first
unit of C That is:
Commodity A will have 60/5 = birr 12
Commodity B will have 36/3 = birr 12
Commodity C will have 16/ 1= birr 16

Now that consumer is left with birr 18. Which unit of commodity will he buy next? Again by
the same logic, he will purchase the 2nd unit of C. This time is having 17 birr.

The consumer's next choice will be either the first unit of A or B since both have the same
level of utility per birr, which is greater than that from the 3 rd unit of C. Assuming that his 3 rd
purchase is commodity x, the first unit of commodity B will then be his 4 th purchase (choice).
Now he is left with 9 birr, after he purchases 2 units of commodity C and one unit each from

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A and B. Next, the consumer can purchase either the 2 nd unit of A or the 2 nd unit of B or the
3rd unit of C. Let us say the consumers fifth, sixth and seventh choices are the 2 nd unit of
commodity A, the 3rd unit of B and the 3rd unit of C, respectively. At this level of purchase
(i.e. 2 units of A, 2 units of B and 3 units of C), the consumer has exhausted all his income
and is in a position to purchase nothing.

Note here that the last units of expenditure spent on each commodity consumed bring about
the same level of utility. When this condition is satisfied no shifting of expenditure between
goods can serve to increase total utility, and hence consumer equilibrium is said to exist. As
we can clearly see from and example, the last birr spent on A, B and C yields the same
amount of utility, that is:

MUA /PA = 50/5 = 10 Birr

MUB/PB= 30/3 = 10 Birr
MUC/PC= 10/1 = 10 Birr

If the condition is not satisfied, then with the same fixed income, total utility can be increased
by altering the pattern of expenditure. In short, we may conclude that, as long as the objective
of the consumer is to maximize total utility, expenditure switching between goods will take
place until the marginal utility of a Birr's worth of each good consumed is equal to the
marginal utility of Birr's worth of any other goods consumed.

Check Your Progress Exercise - 1

Assume that a consumer consumes only two types of goods, X and Y. The units of X and Y
consumed and total utility of X (TU x) and Y (TUy) are given in the following table. Price of
X and price of Y are 4 and 7 birr, respectively; and the consumer's budget income is 26 Birr.

Table 3.3 Total utility of a commodity

Units of goods Total utility of good X (TUX) Total utility of good Y (TUY)

1 16 35

2 30 56

3 42 76

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 4 48 91

5 52 101

1. Based on the above information:

a) Find the combination of X and Y, which maximizes total utility.
…………………………………………………………………………………………………
…………………………………………………………………………………………………
………………………………………………………………………………………………….

b) Find total utility in equilibrium position of the consumer.

…………………………………………………………………………………………………
…………………………………………………………………………………………………
………………………………………………………………………………………………….

3.2.2 The Budget Line

The budget line is, the locus of combinations or bundle of goods that can be purchased if the
entire money income is spent. It shows all combinations of commodities that are available to
the household given its money income and the prices of the goods that it purchases, if it
spends all of its income on them.

In order to draw the budget line facing the consumer, let us assume that there are only two
goods, X and Y, bought in quantities X and Y. Each consumer is confronted with market
determined prices, Px and Py, of X and Y respectively. Finally, the consumer in question has a
known and fixed money income (M). M is the maximum amount the consumer can spend,
and we assume that it is all spent on X and Y. The amount spent on X (i.e. X.P x) plus the
amount spent on Y (i.e. Y.Py) is equal to the stipulated money income Algebraically.
M = XPx + YPy
The equation can be expressed as the equation for a straight line. Solving for the quantity Y
(since Y is generally plotted on the vertical axis), we have:

Y= - X

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Assigning successive values to X (given the income M and the commodity prices, P x and Py)
we may find the corresponding values of Y. Thus, if x = 0 (i.e., if the consumer spends all

his/her money (income) on Y) the consumer can buy units of Y. Similarly if Y = 0 (i.e., if

the consumer spends all his/her income on X) the consumer can buy units of X. If we join

there two points with a line, we obtain the budget line.

Y
A

Budget set (Market opportunity set)

Y= - X

0 B X

Fig. 3.3 The Budget Line

(-) , Mathematically speaking, is the Y - intercept.

(-) In the above equation, - (the negative of the price - ratio), is the slope of the budget

line. That is,

Slope = = =

The negative sign in the price ratio indicates that the budget line slopes downward

from left to the right.

3.2.2.1 Shift and Rotation of the Budget Line

What will happen to the budget line when income (M) and price change? Consider first the
effect of a change in M, prices of X and Y remaining constant. If a consumer has an increase
in money income at the original set of commodity prices, the amount of the commodities (in

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our case, X and Y), which the consumer can purchase, must increase. And since the increase
in money income allows the consumer to buy more goods (of X and Y) the budget line is
pushed out ward (shifts outward). Since prices are not changed, the slope of the budget line
does not change. Therefore, an increase in money income (prices of commodities remaining
constant) caused an outward parallel shift in the budget line, as indicated below.

Where >M

X
Similarly, a decrease in money income, the price ratio held constant, causes a parallel inward
Fig.3.4 Rightward Shift of the budget line
shift in the budget line.

C Where <M

0 DB
X

Fig. 3.5 Leftward shift of the budget line

What happens to the budget line when price ratio changes with money income held constant?
Hold money income (M) and the price of Y(Py) constant, then let the price of X(Px) increases.

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Since Px increases, increases also. The budget line becomes stepper, in this case the line

AB!

A
Here Px > Px, hence M/Px >

0 B' B
M/ Px X
Fig. 3.6 Rotation of budget line
Since the Y-intercept (M/Py) is constant, the consumer can purchase the same amount of Y by
spending the entire money income on Y regardless of the price of X. We can see from above
figure that an increase in the price of X rotates the budget line back ward, the Y - intercept
remaining fixed. Similarly, in decrease in the price of X, money income and price of Y held
constant, pivots the budget line out-ward in the above fig. from AB' to AB.

Check Your Progress Exercise 2

1. In the figure below if price of commodity Y is 6 Birr and the budget line of the consumer is
given by AB, then

Y
Y A
(0, 36)

B
0 X
(54.
0)

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Fig. 3.7 Budget line

a) What is the consumer's budget (income)?

…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………

b) What is the price of commodity X?

…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………

2. Assume a consumer consumes only two products (X, Y); show graphically effect of
decrease in price of commodity Y on budget line, ceteris paribus. Use vertical axis for
commodity Y and horizontal axis for commodity X.
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………

3.2.3 Ordinal Utility

By the 1930's many economists were coming to the view that utility could not be measured
cardinally and that cardinally measurement was not essential for a theory of consumer
behavior. These economists have become known as ordinalists. This is because they claimed
that an individual can only rank bundles of goods in order of his/her preference. And the
consumer can say that he/she obtains more utility from one bundle than from another, or the
consumer derives equal utility from two or more bundles. It is impossible, though to measure
by how much one bundle is preferred to another. Only ordinal numbers (first, second, … so
on) can be used to "measure" utility, and these say nothing about the absolute difference of
any other relationship between utilities.

3.2.3.1 The Indifference Curve (iso-utility curve)

Before we get out to discuss indifference curve and consumer equilibrium, let us first of all
state the basic assumptions of indifference curves:

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 1) The consumer is assumed to be rational: the consumer aims at the maximization of his
utility, given his/her income and market prices.

2) The consumer can rank his/her preferences according to the satisfaction of each basket
of goods. He/She need know precisely the amount of satisfaction derived from the
consumption of the commodities. The ranking of goods according to his/her
preference is all that is needed.

3) Diminishing marginal rate of substitution: the slope of the indifference curve, which
depicts the rate at which the consumer is willing to substitute one good for another,
declines. The indifference curve analysis is, thus, based on the axiom of diminishing
marginal rate of substitution.

4) The total utility (U) of the consumer depends on the quantities of the commodities
consumed: U = f (q1, q2, ... qn)

5) 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: If A > B then B < A

6) Similarly, it is assumed that consumer's choice are characterized by transitivity: if

bundle A is preferred to B, and B is preferred to C, then bundle A is preferred to C.
Symbolically, If A > B, and B > C, then A > C

7) The non- satiety assumption. This assumption implies that the consumer always
prefers the bundle with at least one more commodity in it.

Example:
Example: The first bundle consists of 8 units of X and 6 units of Y while the second
bundle consists 10 units of X and 6 of Y. According to the above assumption, the
consumer prefers the second bundle to the first one.

8) The consumer is assumed to have all relevant information.

Indifference Curve (Iso-curve)

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An indifference curve shows all combinations of two products, which will yield the same
level of total utility to the consumer. The consumer is therefore indifferent (equally happy)
among the bundles (combinations) represented by the points on the curve.

In order to draw the indifference curves, which depict the consumer's preferences, let us
assume there are only two goods, say X and Y, available for consumption. We assume this
assumption to simplify the analysis. The vertical axis in fig below measures the quantity of
good Y and the horizontal axis measures the quantity of goods X. Thus, every point on the
graph represents some combination of X and Y.

25 A
17 B
11 C
7 D
5 E
IC
0 2 4 6 8 10 X
Fig. 3.8 Indifference curve

In the above diagram, the consumer is said to be indifferent between combinations A, B, C,

D, and E, since all combinations are on the same indifference curve. In other words, all
combinations yield the same utility to the consumer.

Basic properties of the indifference curve:

2) An indifference curve has a negative slope downward from left to right.
This means that if the quantity of one commodity, say Y decreases, and the quantity of the

101
 other (x) must increase, if the consumer is to stay on the same level of satisfaction. In
moving from A to B, in above fig.as 8 units of Y are given up, to two more units of X are
obtained and the utility derived is unchanged. For this to be true, the indifference curve
must slope downwards from left to right.

3) The further away from the origin an indifference curve lies, the higher the
level of utility it denotes. Bundle of goods on a higher indifference curve are preferred by
the rational consumer. This property holds true, only assuming non-satiety assumption.

4) Indifference curves do not intersect each other. If they did, the point of
intersection would imply consumer would obtain two different levels of satisfaction
consuming one combination of the two goods at the same time, which is impossible. To
show this, consider below fig., which shows two intersecting indifference curves.

Y
I2
Y2 I1

Y1

0 X1 X
Fig. 3.9 Indifference curves

Since both combinations A and C are on the same indifference curve, the consumer must be
indifferent between them. Combinations B and C, however, are also on the same indifference
curve, so the consumer must be indifferent between them as well. If the consumer is
indifferent between A and C, and between B and C, he/she must (by the rule of transitivity)
be indifferent between A and B. This however, is absurd because A contains more Y and the
same amount of X and B and so must be preferred to it. We conclude, therefore, that
indifference curves can never intersect each other.

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4) 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 left
down - wards to the right. The curve is convex to the origin due to imperfect substitution
of the goods in question. In other words, as more and more units of one good, say Y, are
given up, successively bigger quantities of X must be obtained to compensate the
consumer for the loss and leave him/her at the same level of utility.

An indifference map consists of a set of indifference curves. A set of indifference curves is

called an indifference map.

The further away any indifference curve is from the origin, the higher is the level of
satisfaction given by any of the combinations of goods indicated by points on the curve.

I4
I3
I2
I1
0 X
Fig. 3.2 Indifference map

For example, I4 > I3 > I2 > I1 In their level of satisfaction (Utility)

Check Your Progress Exercise - 3

1.What is an indifference curve?
…………………………………………………………………………………………………
………………………………………………………………………………………………..

2.What are the four properties of indifference curve? Explain them briefly.

103
…………………………………………………………………………………………………
………………………………………………………………………………………………..
…………………………………………………………………………………………………
………………………………………………………………………………………………..
…………………………………………………………………………………………………
………………………………………………………………………………………………..

3.2.3.2 Marginal Rate of Substitution

On essential feature of indifference curve analysis is that different combination of
commodities can give rise to the same level of satisfaction. Therefore, one commodity can be
substituted for another in the right amount so that the consumer remains just as well off as
before, or remain on the same indifference curve. An important concept in the indifference
curve approach is the rate at which a consumer is willing to substitute one commodity for
another in consumption.

Consider the below fig. An indifference curve is represented by I where the consumer is
indifferent between bundle R, containing 2 units of X and 14 units of Y, and bundle P,
containing 7 of units of X and 4 of Y.
Y
R
14
N
4 S P
I
0 2 7 X
Fig 3.3 Marginal rate of substitution

At point P, the consumer is willing to give up 5 units of X for 10 more units of Y. At point R,
the consumer is willing to give up 10 units of Y for 5 more units of X. The rate at which the
consumer is willing, on average, to substitute X and Y is therefore:

MRS = = = = =2

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The ratio measures the average number of units of Y the consumer is willing to forego
(sacrifice) in order to obtain one additional unit of X (over the range of consumption pairs
under consideration, i.e. over the range of RP). The consumer is willing to give up 2 units of
Y in order to gain one more unit of X, stated alternatively, the ratio measures the amount of Y
that must be given up (2 units) per unit of X gained to remain at precisely the same level of
satisfaction. We define this rate of substitution as: -

3.2.3.3 Consumer's Equilibrium using ordinal approach

The principal assumption on which the theory of consumer behavior is built is that the
consumer aims at the maximization of utility, given his/her income and market prices of the
commodities available for consumption. Therefore in order to be able to determine the
equilibrium (optimum) of the consumer, we have to bring together the indifference map and
the budget line facing the consumer on the same diagram stated differently, we need to
consider both what the consumer is willing (wishes) to do and what he/she can do. Fig. below
depicts the indifference curves and the budget line facing the individual consumer under
consideration.

Y' I3
I2
I1

0 X' X

Fig 3.4 Consumer's equilibrium

The indifference map describes the preference of the consumer (what he/she wishes) while
the budget line specifies the different combinations of x and y the consumer can purchase
with the limited income (M).

The consumer cannot purchase any bundle lying above and to the right of the budget line and,
therefore, cannot consume any combination lying on indifference curves is. However, some

105
points on indifference curves I1, I2 and I3 are attainable. The question then arises as to which
combinations of X and Y the rational consumer will purchase.

If a consumer were situated at a point such as C, experimentation would lead him to substitute
Y for X, there by moving the consumer in the direction of E. The consumer would not stop
short of E, because each successive substitution of Y for X brings him/her to a higher
indifference curve. Therefore, the position of maximum satisfaction or the point of consumer
optimization is attained at E, where an indifference curve is just tangent to the budget line.

It will be recalled that the slope of the budget line is the negative of the price ratio, the ratio
of the price of X to the price of Y. It is also stated earlier that the slope of an indifference
curve at any point is called MRS of X for Y. Therefore, the point of consumer equilibrium is
defined by the condition that the marginal rate of substitution of X for Y must equal the price
ratio.

The MRS shows the rate at which the consumer is willing to substitute X for Y. The price
ratio shows the rate at which market prices permit substitution of X for Y. Unless these rates
are equal, it is possible to change the combination of X and Y purchased to attain a higher
level of satisfaction.

Example: Suppose the MRS is two - meaning the consumer is willing to give up two units of
Y in order to obtain one unit of X. Let the price ratio be unity, meaning that one unit of Y can
be exchanged for one unit of X. Clearly, the consumer will benefit by trading Y for X. This is
because, he or she is willing to give up two Y for one X but only has to give up one Y for one
X in the market. In general, unless the MRS and the price ratio are equal, some exchange can
be made to move the consumer to a higher level of satisfaction. Therefore,

MRSx for y =

MRSx for y =

Check Your Progress Exercise 4

1. What is marginal rate of substitution?

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 ………………………………………………………………………………………………
………………………………………………………………………………………………
2. What is consumer's equilibrium?
………………………………………………………………………………………………
………………………………………………………………………………………………

3.3 KEY TERMS

Define and explain the following concepts

Utility
Marginal utility
Law of diminishing marginal utility
Utility - maximizing rule
Budget line
Indifference curve
Marginal rate of substitution
Indifference map
Equilibrium position of the consumer
Cardinal utility
Ordinal utility.

3.4 ANSWERS TO CHECK YOUR PROGRESS EXERCISES

Check Your Progress Exercise - 2

1.a) Budget formula: M= XPx +YPY
At Y intercept, M = 0 X P x +36 X 6 = 216 .Birr
Income of the consumer is 216 Birr.

b) At X intercept, 216 = 54 X Px + 0 X 6
216 =54P x; Px= 216/54 = 4
Price of commodity X is 4 Birr.
2. Draw the graph yourself and come pore. It with the text

Check Your Progress Exercise - 3

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1. Indifference curve is a curve that shows different combinations of the two goods that give
the same utility to the consumer. It is also called iso utility curve. That is, so means equal,
utility means satisfaction, then equal satisfaction curve.

Check Your Progress Exercise - 4

1. Marginal rate of substitution is the rate at which consumer substitutes one commodity
for another commodity so as to obtain the same utility.

3.5 MODEL EXAMINATION QUESTIONS

I. Choose the correct answer

1. Total utility reaches its maximum point when,

a) marginal utility is negative
b) total utility reaches its peak point
c) marginal utility is zero
d) b and c
e) none of the above

2. As we move downward along the same indifference curve (where X is on the horizontal
axis and Y is on the vertical axis), ______.
a) total utility decreases
b) marginal utility of commodity Y decreases
c) marginal utility of commodity X increases
d) consumers gradually want to consume more of commodity X because its marginal
utility increases.
e) none of the above

3. On the same indifference curve,

a) marginal utility is constant

108
 b) total utility is constant
c) quantity consumed of X varies
d) marginal rate of substitution varies
e) all except a

4. The budget line shows,

a) different combinations of two goods purchased at given price but different income
level
b) a given quantity of a commodity that can be purchased at constant income
c) different numbers of two goods that can be purchased at constant prices and income
d) the same level of utility obtained from different consumption levels.
e) c and d

5. An equation of budget line is given by Y = -½ X + 10.

Where Y and X are commodities. Then,
a) the slope of the budget line is -½
b) maximum amount of X purchased is 20 units
c) price of commodity X is 20 Birr if that of y is 10 Birr.
d) a and b
e) all of the above

6. In the above equation of question No. 5 if the Y - intercept of the budget line equation
increased to 15 at constant income it,
a) is due to increase in price of X
b) is due to decrease in price of Y
c) implies rotation of budget line to the left
d) implies shift of budget line to the left
e) all except d
7. The objective of a rational consumer is to _________.
a) maximize marginal utility
b) maximize total cost of purchasing
c) maximize total utility

109
 d) consume infinite quantity of any commodity with a given income
e) c and d
8. As price of commodity Y decreases, other things being constant, budget line_____.
a) shifts outward (to the right) parallel to the origin
b) rotates to the right along X axis
c) rotates inward (to the origin) along Y axis
d) rotates upward (to the right) along Y axis
e) all of the above
II. Write "true" if the statement is true and "false" if the statement is false.

__________1. As the amount of commodity X consumed on a given indifference curve

increases, the marginal utility of commodity increases.
__________2. If the price of shirt is 200 Birr and the price of shoe is 100 Birr, then the
condition for a consumer to maximize his or her total utility from purchasing
shirt and shoe is when MRS shirt for shoe is 2.
__________3. The shape of indifference curve is convex and its slope is positive
III. Attempt the following problems.
problems.

1) Explain the law of demand in terms of diminishing marginal utility.

2) What information is contained in an indifference curve?
3) Why are indifference curves downward sloping?
4) Why does total utility increases as a consumer moves to indifference curves further from
the origin?
5) Explain why the point of tangency of the budget line with an indifference curve is the
consumer's equilibrium position.

3.6 REFERENCES

1) Bradley R. Schiller: The micro economy today, 4th ed. (New York: Mc Graw Hill publishing
company, 1989).

2) Geoffry Whitehead: Economics Made simple, (London: W. H. allen and Co.ltd, 1970).

110
3) Henderson and Poole: principles of microeconomics, (U.S.A. D.C.Health and Company,
1991).

4) Mauric / Philips: Economic analysis Theory and application, 5th ed. (Richard D. Irwin, Inc,
1986).

5) McConnell, Campbell R.: Economics, principles, problems, and policies, 11 th ed. (New York:
McGraw-Hill Publishing Company, 1990).

6) Economics, 13thed. McGraw - Hill book

Paul A. Samuelson and William, D. Nurdhous, Economics,
Company, 1989.

7) Stanley Fischer, Rudiger Dornbushch, Richard Sctimalensee: Economics, 2nd ed. (New York:
McGraw-Hill book company) 1988.

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