Basics of Economics

Introduction
Have you ever heard anything about Economics? Yes!!! It is obvious you heard about
economics and even you talked a lot about economics in your day to day activities. And you
may have questions such as: What are resources? What does efficient allocation mean? What are
human needs? What does demand mean? What is economics? This course will answer those
questions and introduce you to the nature of economics, demand and supply theories, theories of
consumer, production, cost, market structure and fundamental concepts of macroeconomics at
large.

In this chapter you will be introduced to the subject matter of economics and the rationale that
motivates us to study economics.

Definition of economics
Economics is one of the most exciting disciplines in social sciences. The word economy comes
from the Greek phrase ―one who manages a household‖. The science of economics in its
current form is about two hundred years old. Adam Smith – generally known as the father of
economics – brought out his famous book, ―An Inquiry into the Nature and Causes of Wealth
of Nations‖, in the year 1776. Though many other writers expressed important economic ideas
before Adam Smith, economics as a distinct subject started with his book.

There is no universally accepted definition of economics (its definition is controversial). This is

because different economists defined economics from different perspectives:
a. Wealth definition,
b. Welfare definition,
c. Scarcity definition, and
d. Growth definition

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Hence, its definition varies as the nature and scope of the subject grow over time. But, the
formal and commonly accepted definition is as follow.

Economics is a social science which studies about efficient allocation of scarce resources so asto
attain the maximum fulfillment of unlimited human needs. As economics is a science of choice,
it studies how people choose to use scarce or limited productive resources (land, labour,
equipment, technical knowledge and the like) to produce various commodities.

The following statements are derived from the above definition.

 Economics studies about scarce resources;
 It studies about allocation of resources;
 Allocation should be efficient;
 Human needs are unlimited
 The aim (objective) of economics is to study how to satisfy the unlimited human needs
up to the maximum possible degree by allocating the resources efficiently.

The rationales of economics

There are two fundamental facts that provide the foundation for the field of economics.
1) Human (society‘s) material wants are unlimited.
2) Economic resources are limited (scarce).

The basic economic problem is about scarcity and choice since there are only limited amount
of resources available to produce the unlimited amount of goods and services we desire. Thus,
economics is the study of how human beings make choices to use scarce resources as they seek
to satisfy their unlimited wants. Therefore, choice is at the heart of all decision-making. As an
individual, family, and nation, we confront difficult choices about how to use limited resourcesto
meet our needs and wants. Economists study how these choices are made in various settings;
evaluate the outcomes in terms of criteria such as efficiency, equity, and stability; and search for
alternative forms of economic organization that might produce higher living standards or a more
desirable distribution of material well-being.

Scope and method of analysis in economics

Scope of economics
The field and scope of economics is expanding rapidly and has come to include a vast range of
topics and issues. In the recent past, many new branches of the subject have developed,
including development economics, industrial economics, transport economics, welfare
economics, environmental economics, and so on. However, the core of modern economics is

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 formed by its two major branches: microeconomics and macroeconomics. That means
economics can be analyzed at micro and macro level.

A. Microeconomics is concerned with the economic behavior of individual decision making

units such as households, firms, markets and industries. In other words, it deals with how
households and firms make decisions and how they interact in specific markets.
B. Macroeconomics is a branch of economics that deals with the effects and consequences of
the aggregate behaviour of all decision making units in a certain economy. In other words,it
is an aggregative economics that examines the interrelations among various aggregates, their
determination and the causes of fluctuations in them. It looks at the economy as a whole and
discusses about the economy-wide phenomena.

Microeconomics Macroeconomics
 Studies individual economic units of an  Studies an economy as a whole and its
economy. aggregates.
 Deals with individual income, individual  Deals with national income and output
prices, individual outputs, etc. and general price level
 Its central problem is price determination  Its central problem is determination of
and allocation of resources. level of income and employment.
 Its main tools are the demand and supply of  Its main tools are aggregate demand and
particular commodities and factors. aggregate supply of an economy as a
 It helps to solve the central problem of whole.
‗what, how and for whom to produce‘ in an  Helps to solve the central problem of
economy so as to maximize profits ‗full employment of resources in the
 Discusses how the equilibrium of a economy.‘
consumer, a producer or an industry is  Concerned with the determination of
attained. equilibrium levels of income and
Examples: Individual income, individual employment at aggregate level.
savings, individual prices, an individual firm‘s Examples: national income, national
output, individual consumption, etc. savings, general price level, national output,
aggregate consumption, etc.

Note: Both microeconomics and macroeconomics are complementary to each other. That is,
macroeconomics cannot be studied in isolation from microeconomics.

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 Positive and normative analysis

Is economics a positive science or normative science, or both? What is your justification?

Economics can be analyzed from two perspectives: positive economics and normative
economics.

Positive economics: it is concerned with analysis of facts and attempts to describe the world asit
is. It tries to answer the questions what was; what is; or what will be? It does not judge a system
as good or bad, better or worse.

Example:
 The current inflation rate in Ethiopia is 12 percent.
 Poverty and unemployment are the biggest problems in Ethiopia.
 The life expectancy at birth in Ethiopia is rising.

All the above statements are known as positive statements. These statements are all concerned
with real facts and information. Any disagreement on positive statements can be checked by
looking in to facts.

Normative economics: It deals with the questions like, what ought to be? Or what the economy
should be? It evaluates the desirability of alternative outcomes based on one‘s value judgments
about what is good or what is bad. In this situation since normative economics is loaded with
judgments, what is good for one may not be the case for the other. Normative analysis is a
matter of opinion (subjective in nature) which cannot be proved or rejected with reference to
facts.

Example:
 The poor should pay no taxes.
 There is a need for intervention of government in the economy.
 Females ought to be given job opportunities.
Any disagreement on a normative statement can be solved by voting.

Inductive and deductive reasoning in economics

The fundamental objective of economics, like any science, is the establishment of valid
generalizations about certain aspects of human behaviour. Those generalizations are known as
theories. A theory is a simplified picture of reality. Economic theory provides the basis for
economic analysis which uses logical reasoning. There are two methods of logical reasoning:
inductive and deductive.

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a) Inductive reasoning is a logical method of reaching at a correct general statement or
theory based on several independent and specific correct statements. In short, it is the
process of deriving a principle or theory by moving from facts to theories and from
particular to general economic analysis.

Inductive method involves the following steps.

1. Selecting problem for analysis
2. Collection, classification, and analysis of data
3. Establishing cause and effect relationship between economic phenomena.

b) Deductive reasoning is a logical way of arriving at a particular or specific correct statement

starting from a correct general statement. In short, it deals with conclusions abouteconomic
phenomenon from certain fundamental assumptions or truths or axioms through a process of
logical arguments. The theory may agree or disagree with the real world and we should
check the validity of the theory to facts by moving from general to particular. Major steps in
the deductive approach include:
1. Problem identification
2. Specification of the assumptions
3. Formulating hypotheses
4. Testing the validity of the hypotheses

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Theory of Demand

Having learnt about the concept and meaning of economics as a subject and its nature, scope,
different systems and various other fundamentals in the previous chapter, we now resort to a
very important issue in economics. This is the issue of how free markets operate. In this
chapter we will forward our exploration and understanding of the vast field of economics by
focusing on two very powerful tools, namely, theory of demand and theory of supply.

The purpose of this chapter is to explain what demand and supply are and show how they
determine equilibrium price and quantity. We will also show how the concepts of demand and
supply reveal consumers‘ and producers‘ sensitivity to price change.

Chapter objectives
After covering this chapter, you will be able to:
 understand the concept of demand and the factors affecting it;
 explain the supply side of a market and the determinants of supply;
 understand how the market reaches equilibrium condition, and the possible factors that
could cause a change in equilibrium and
 explain the elasticity of demand and supply

Theory of demand

1. Are demand and want similar? Why?

2. Why can’t we purchase all that we need or we desire to have?
3. Can we say that, with a decrease in the price of a commodity, a consumer
normally buys more of it? Why?
4. Explain why demand curves always slope downwards from left to right. Are
there any exceptions to this?

Demand is one of the forces determining prices. The theory of demand is related to the
economic activities of consumers-consumption. Hence, the purpose of the theory of demand is
to determine the various factors that affect demand.

In our day-to-day life we use the word ‗demand‘ in a loose sense to mean a desire of a person to
purchase a commodity or service. But in economics it has a specific meaning, which is different
from what we use it in our day to day activities.

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 Demand implies more than a mere desire to purchase a commodity. It states that the consumer
must be willing and able to purchase the commodity, which he/she desires. His/her desire should
be backed by his/her purchasing power. A poor person is willing to buy a car; it has no
significance, since he/she has no ability to pay for it. On the other hand, if his/her desire to buy
the car is backed by the purchasing power then this constitutes demand. Demand, thus, means
the desire of the consumer for a commodity backed by purchasing power. These two factors
are essential. If a consumer is willing to buy but is not able to pay, his/her desire will not become
demand. Similarly, if the consumer has the ability to pay but is not willing to pay, his/her desire
will not be called demand.

More specifically, demand refers to various quantities of a commodity or service that a

consumer would purchase at a given time in a market at various prices, given other things
unchanged (ceteris paribus). The quantity demanded of a particular commodity depends on the
price of that commodity.

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

Demand schedule (table), demand curve and demand function

The relationship that exists between price and the amount of a commodity purchased can be
represented by a table (schedule) or a curve or an equation.

Demand schedule can be constructed for any commodity if the list of prices and quantities
purchased at those prices are known. An individual demand schedule is a list of the various
quantities of a commodity, which an individual consumer purchases at various levels of prices in
the market. A demand schedule states the relationship between price and quantity demanded in a
table form.

Table 2.1 Individual household demand for orange per week

Combinations A B C D E

Price per kg 5 4 3 2 1

Quantity demand/week 5 7 9 11 13

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Demand curve is a graphical representation of the relationship between different quantities ofa
commodity demanded by an individual at different prices per time period.

Price
5 A
4 B

3 C

2 D

1 E

0 X Quantity demanded
55 7 9 11 13

Figure 2.1: Individual demand curve

In the above diagram prices of oranges are given on ‗OY‘ axis and quantity demanded on ‗OX‘
axis. For example, when the price per kilogram is birr 1 the quantity demanded is 13 kilograms.
From the above figure you may notice that as the price declines quantity demanded increases
and vice-versa.

Demand function is a mathematical relationship between price and quantity demanded, all
other things remaining the same. A typical demand function is given by:

Qd=f(P)

where Qd is quantity demanded and P is price of the commodity, in our case price of orange.

Example: Let the demand function be Q = a+ bP

Q
b= (e.g. moving from point A to B on figure 2.1 above)
P

75
b=  2 , where b is the slope of the demand curve
45

Q = a-2P, to find a, substitute price either at point A or B.

7= a-2(4), a = 15

Therefore, Q=15-2P is the demand function for orange in the above numerical example.

Market Demand: The market demand schedule, curve or function is derived by horizontallyadding
the quantity demanded for the product by all buyers at each price.

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 Table 2.2: Individual and market demand for a commodity

Price Individual demand Market

Consumer-1 Consumer-2 Consumer-3 demand
8 0 0 0 0
5 3 5 1 9
3 5 7 2 14
0 7 9 4 20

The following graph depicts market demand curve at price equal to 3

Price Price Price Price

3 + 3 + 3 = 3

5 Q 7 Q 2 Q 14 Q
Consumer-1 Consumer - 2 Consumer - 3 Market Demand

Figure 2.2: Individual and Market demand curve

Numerical Example: Suppose the individual demand function of a product is given by:
P=10 - Q /2 and there are about 100 identical buyers in the market. Then the market demand
function is given by:

P= 10 - Q /2 ↔ Q /2 =10-P ↔ Q= 20 - 2P and Qm = (20 – 2P) 100 = 2000-200P

Determinants of demand

The demand for a product is influenced by many factors. Some of these factors are:
I. Price of the product
II. Taste or preference of consumers
III. Income of the consumers
IV. Price of related goods
V. Consumers expectation of income and price
VI. Number of buyers in the market

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When we state the law of demand, we kept all the factors to remain constant except the price of
the good. A change in any of the above listed factors except the price of the good will change the
demand, while a change in the price, other factors remain constant will bring change in quantity
demanded. A change in demand will shift the demand curve from its original location. For this
reason those factors listed above other than price are called demand shifters. A change in own
price is only a movement along the same demand curve.

Changes in demand: a change in any determinant of demand—except for the good‘s price-
causes the demand curve to shift. We call this a change in demand. If buyers choose to purchase
more at any price, the demand curve shifts rightward—an increase in demand. If buyers choose
to purchase less at any price, the demand curve shifts leftward—a decrease in demand.

When demand increases, demand

Price
curve shifts upward (D1) while a
1 decrease in demand shifts demand
curve downwards (D2).
2 D1

D0
D2
Quantity

Figure 2.3: Shift in demand curve

Now let us examine how each factor affect demand.

I. Taste or preference

When the taste of a consumer changes in favour of a good, her/his demand will increase and
the opposite is true.

II. Income of the consumer

Goods are classified into two categories depending on how a change in income affects their
demand. These are normal goods and inferior goods. Normal Goods are goods whose demand
increases as income increase, while inferior goods are those whose demand is inversely related
with income. In general, inferior goods are poor quality goods with relatively lower price and
buyers of such goods are expected to shift to better quality goods as their income increases.
However, the classification of goods into normal and inferior is subjective and it is usually
dependent on the socio-economic development of the nation.

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 III. Price of related goods

Two goods are said to be related if a change in the price of one good affects the demand for
another good.

There are two types of related goods. These are substitute and complimentary goods. Substitute
goods are goods which satisfy the same desire of the consumer. For example, tea and coffee or
Pepsi and Coca-Cola are substitute goods. If two goods are substitutes, then price of one and the
demand for the other are directly related. Complimentary goods, on the other hand, are those
goods which are jointly consumed. For example, car and fuel or tea and sugar are considered as
compliments. If two goods are complements, then price of one and the demand for the other are
inversely related.

IV. Consumer expectation of income and price

Higher price expectation will increase demand while a lower future price expectation will
decrease the demand for the good.

V. Number of buyer in the market

Since market demand is the horizontal sum of individual demand, an increase in the number of
buyers will increase demand while a decrease in the number of buyers will decrease demand.

Elasticity of demand

1. List some goods/commodities you think that increase in their prices will not
significantly decrease their quantity demanded.
2. Can you list some products for which increase in their prices will significantly
decrease/increase their quantity demanded?

In economics, the concept of elasticity is very crucial and is used to analyze the quantitative
relationship between price and quantity purchased or sold. Elasticity is a measure of
responsiveness of a dependent variable to changes in an independent variable. Accordingly, we
have the concepts of elasticity of demand and elasticity of supply.

Elasticity of demand refers to the degree of responsiveness of quantity demanded of a good to a

change in its price, or change in income, or change in prices of related goods. Commonly, there
are three kinds of demand elasticity: price elasticity, income elasticity, and cross elasticity.

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 i. Price Elasticity of Demand

Price elasticity of demand means degree of responsiveness of demand to change in price. It

indicates how consumers react to changes in price. The greater the reaction the greater will be
the elasticity, and the lesser the reaction, the smaller will be the elasticity. Price elasticity of
demand is a measure of how much the quantity demanded of a good responds to a change in the
price of that good, computed as the percentage change in quantity demanded divided by the
percentage change in price.

Demand for commodities like clothes, fruit etc. changes when there is even a small change in
their price, whereas demand for commodities which are basic necessities of life, like salt, food
grains etc., may not change even if price changes, or it may change, but not in proportion to the
change in price.

Determinants of price Elasticity of Demand

The following factors make price elasticity of demand elastic or inelastic other than changes in
the price of the product.
i) The availability of substitutes: the more substitutes available for a product, the more
elastic will be the price elasticity of demand.
ii) Time: In the long- run, price elasticity of demand tends to be elastic. Because:
 More substitute goods could be produced.
 People tend to adjust their consumption pattern.
iii) The proportion of income consumers spend for a product:-the smaller the
proportion of income spent for a good, the less price elastic will be.
iv) The importance of the commodity in the consumers’ budget :
 Luxury goods  tend to be more elastic, example: gold.
 Necessity goods  tend to be less elastic example: Salt.

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 ii. Income Elasticity of Demand

It is a measure of responsiveness of demand to change in income.

%Qd Q I
 dI   .
%I I Q

Point income elasticity of demand:

i) If  I d  1, the good is luxury good.

ii) If  I d  1( and positive), the good is necessity good,

iii) If  I d  0, (negative), the good is inferior good.

iii. Cross price Elasticity of Demand

Measures how much the demand for a product is affected by a change in price of another good.

%Qx Qx  Qx Py
 xy  = 1 o
.Q 0

%Py Py  Py
1 0 x0

i) The cross – price elasticity of demand for substitute goods is positive.

ii) The cross – price elasticity of demand for complementary goods is negative.

iii) The cross – price elasticity of demand for unrelated goods is zero.

Example: Consider the following data which shows the changes in quantity demanded of good
X in response to changes in the price of good Y.

Unit price of Y Quantity demanded of X

10 1500
15 1000

Calculate the cross –price elasticity of demand between the two goods. What can you say about
the two goods?

Qx Pyo 1000 1500  10  500 10  0.67

  *  .*  .
xy
Py Qxo   5 1500
15 10 1500

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 Theory of Consumer Behaviour

In our day –to- day life, we buy different goods and services for consumption. As consumer, we
act to derive satisfaction by using goods and services. But, have ever thought of how your
mother or any other person whom you know decides to buy those consumption goods and
services? Consumer theory is based on what people like, so it begins with something that we
can‘t directly measure, but must infer. That is, consumer theory is based on the premise that we
can infer what people like from the choices they make.

Consumer behaviour can be best understood in three steps. First, by examining consumer‘s
preference, we need a practical way to describe how people prefer one good to another. Second,
we must take into account that consumers face budget constraints – they have limited incomes
that restrict the quantities of goods they can buy. Third, we will put consumer preference and
budget constraint together to determine consumer choice.

Chapter objectives

After successful completion of this chapter, you will be able to:

 explain consumer preferences and utility

 differentiate between cardinal and ordinal utility approach

 define indifference curve and discuss its properties

 derive and explain the budget line

 describe the equilibrium condition of a consumer

Consumer preferences

A consumer makes choices by comparing bundle of goods. Given any two consumption bundles,
the consumer either decides that one of the consumption bundles is strictly better than the other,
or decides that she is indifferent between the two bundles.

In order to tell whether one bundle is preferred to another, we see how the consumer behaves
in choice situations involving two bundles. If she always chooses X when Y is available, thenit
is natural to say that this consumer prefers X to Y. We use the symbol ≻ to mean that one bundle
is strictly preferred to another, so that X ≻Y should be interpreted as saying that the consumer
strictly prefers X to Y, in the sense that she definitely wants the X-bundle rather than the Y-

bundle. If the consumer is indifferent between two bundles of goods, we use the symbol

Therefore, the two goods are complements.

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∼ and write X~Y. Indifference means that the consumer would be just as satisfied, according to
her own preferences, consuming the bundle X as she would be consuming bundle Y. If the
consumer prefers or is indifferent between the two bundles we say that she weakly prefers X toY
and write X ⪰ Y.

The relations of strict preference, weak preference, and indifference are not independent
concepts; the relations are themselves related. For example, if X ⪰ Y and Y ⪰ X, we can
conclude that X ~Y. That is, if the consumer thinks that X is at least as good as Y and that Y is
at least as good as X, then she must be indifferent between the two bundles of goods. Similarly,if
X ⪰ Y but we know that it is not the case that X~ Y, we can conclude that X≻Y. This just says
that if the consumer thinks that X is at least as good as Y, and she is not indifferent between the
two bundles, then she thinks that X is strictly better than Y.

The concept of utility

Economists use the term utility to describe the satisfaction or pleasure derived from the
consumption of a good or service. In other words, utility is the power of the product to satisfy
human wants. Given any two consumption bundles X and Y, the consumer definitely wants the
X-bundle than the Y-bundle if and only if the utility of X is better than the utility of Y.

Do you think that utility and usefulness are synonymous? Do two individuals always derive
equal satisfaction from consuming the same level of a product?

In defining utility, it is important to bear in mind the following points.

 ‗Utility’ and ‘Usefulness’ are not synonymous. For example, paintings by Picasso may be
useless functionally but offer great utility to art lovers. Hence, usefulness is product centric
whereas utility is consumer centric.

 Utility is subjective. The utility of a product will vary from person to person. That means,
the utility that two individuals derive from consuming the same level of a product may
not be the same. For example, non-smokers do not derive any utility from cigarettes.

 Utility can be different at different places and time. For example, the utility that we get
from drinking coffee early in the morning may be different from the utility we get during
lunch time.

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 Approaches of measuring utility

How do you measure or compare the level of satisfaction (utility) that you obtain from goods and
services?

There are two major approaches to measure or compare consumer‘s utility: cardinal and ordinal
approaches. The cardinalist school postulated that utility can be measured objectively.
According to the ordinalist school, utility is not measurable in cardinal numbers rather the
consumer can rank or order the utility he derives from different goods and services.

The cardinal utility theory

According to the cardinal utility theory, utility is measurable by arbitrary unit of measurement
called utils in the form of 1, 2, 3 etc. For example, we may say that consumption of an orange
gives Bilen 10 utils and a banana gives her 8 utils, and so on. From this, we can assert that Bilen
gets more satisfaction from orange than from banana.

Assumptions of cardinal utility theory

The cardinal approach is based on the following major assumptions.
1. Rationality of consumers. The main objective of the consumer is to maximize his/her
satisfaction given his/her limited budget or income. Thus, in order to maximize his/her
satisfaction, the consumer has to be rational.

2. Utility is cardinally measurable. According to the cardinal approach, the utility or

satisfaction of each commodity is measurable. Utility is measured in subjective units called
utils.

3. Constant marginal utility of money. A given unit of money deserves the same value at
any time or place it is to be spent. A person at the start of the month where he has received
monthly salary gives equal value to 1 birr with what he may give it after three weeks or so.

4. Diminishing marginal utility (DMU). The utility derived from each successive units of a
commodity diminishes. In other words, the marginal utility of a commodity diminishes as
the consumer acquires larger quantities of it.

5. The total utility of a basket of goods depends on the quantities of the individual
commodities. If there are n commodities in the bundle with quantities X 1 , X 2 ,...X n , the

total utility is given by TU = f ( X 1 , X 2 X n ).

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Total and marginal utility

Total Utility (TU) is the total satisfaction a consumer gets from consuming some specific
quantities of a commodity at a particular time. As the consumer consumes more of a good per
time period, his/her total utility increases. However, there is a saturation point for that
commodity beyond which the consumer will not be capable of enjoying any greater satisfaction
from it.

Marginal Utility (MU) is the extra satisfaction a consumer realizes from an additional unit of
the product. In other words, marginal utility is the change in total utility that results from the
consumption of one more unit of a product. Graphically, it is the slope of total utility.

Mathematically, marginal utility is:

TU
MU 
Q
where, TU is the change in total utility, and Q is the change in the amount of product
consumed.

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

Table 3.1: Total and marginal utility

Quantity Total utility (TU) Marginal utility (MU)

0 0 -
1 10 10
2 18 8
3 24 6
4 28 4
5 30 2
6 30 0
7 28 -2

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

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 Graphically, the above data can be depicted as follows.

TU

30

TU

18

0 2 6 Quantity Consumed

MU

Quantity Consumed
0 2 6

Figure 3.1: Total and marginal utility curves

As it can be observed from the above figure,

 When TU is increasing, MU is positive.
 When TU is maximized, MU is zero.
 When TU is decreasing, MU is negative.

Law of diminishing marginal utility (LDMU)

Is the utility you get from consumption of the first orange the same as the second or the third
orange?

The law of diminishing marginal utility states that as the quantity consumed of a commodity
increases per unit of time, the utility derived from each successive unit decreases, consumption
of all other commodities remaining constant. In other words, the extra satisfaction that a
consumer derives declines as he/she consumes more and more of the product in a given period
of time. This gives sense in that the first banana a person consumes gives him more marginal
utility than the second and the second banana also gives him higher marginal utility than the
third and so on (see figure 3.1).

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 The law of diminishing marginal utility is based on the following assumptions.
 The consumer is rational
 The consumer consumes identical or homogenous product. The commodity to be
consumed should have similar quality, color, design, etc.
 There is no time gap in consumption of the good
 The consumer taste/preferences remain unchanged

Equilibrium of a consumer

The objective of a rational consumer is to maximize total utility. As long as the additional unit
consumed brings a positive marginal utility, the consumer wants to consumer more of the
product because total utility increases. However, given his limited income and the price level of
goods and services, what combination of goods and services should he consume so as to get the
maximum total utility?

a) the case of one commodity

The equilibrium condition of a consumer that consumes a single good X occurs when the
marginal utility of X is equal to its market price.
MU X  PX

Proof
Given the utility function
U  f (X )

If the consumer buys commodity X, then his expenditure will be 𝑄K𝑃K. The consumer
maximizes the difference between his utility and expenditure.
Max(U  QX PX )

The necessary condition for maximization is equating the derivative of a function to zero.
Thus,
dU d (QX PX )
 0
dQX dQX
dU
 PX  0  MU X  PX
dQX

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 MUX
A


PX C


 B

MUX
QX

Figure 3.2: Equilibrium condition of consumer with only one commodity

At any point above point C (like point A) where MUX > PX, it pays the consumer to consume
more. When MUX < PX (like point B), the consumer should consume less of X. At point C where
MUX = PX the consumer is at equilibrium.

b) the case of two or more commodities

For the case of two or more goods, the consumer‘s equilibrium is achieved when the marginal
utility per money spent is equal for each good purchased and his money income available for the
purchase of the goods is exhausted. That is,

𝑀𝑈X
=
𝑀𝑈Y
=⋯=
𝑀𝑈𝑁 and 𝑃K 𝑄K +𝑃F 𝑄F + ⋯ + 𝑃𝑁 𝑄𝑁 = M
𝑃X 𝑃Y 𝑃𝑁

where, M is the income of the consumer.

Example: Suppose Saron has 7 Birr to be spent on two goods: banana and bread. The unit price
of banana is 1 Birr and the unit price of a loaf of bread is 4 Birr. The total utility she obtains
from consumption of each good is given below.

Table 3.2: Utility schedule for two commodities

Income = 7 Birr, Price of banana = 1 Birr, Price of bread = 4 Birr

Banana Bread
Quantity TU MU MU/P Quantity TU MU MU/P
0 0 - - 0 0 - -
1 6 6 6 1 12 12 3
2 11 5 5 2 20 8 2
3 14 3 3 3 26 6 1.5
4 16 2 2 4 29 3 0.75
5 16 0 0 5 31 2 0.5
6 14 -2 -2 6 32 1 0.25

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 Recall that utility is maximized when the condition of marginal utility of one commodity
divided by its market price is equal to the marginal utility of the other commodity divided by
its market price.
MU1 MU 2

P1 P2
In table 3.2, there are two different combinations of the two goods where the MU of the last
birr spent on each commodity is equal. However, only one of the two combinations is
consistent with the prices of the goods and her income. Saron will be at equilibrium when she
consumes 3 units of banana and 1 loaf of bread. At this equilibrium,

i) MU1/P1 = MU2/P2
MUbanana MUbread 3 12
   3
Pbanana Pbread 1 4

ii) P1.Q1+ P2.Q2= M

(1*3) + (4*1) = 7

The total utility that Saron derives from this combination can be given by:
TU= TU1 + TU2
TU= 14 + 12
TU= 26

Given her fixed income and the price level of the two goods, no combination of the two goods
will give her higher TU than this level of utility.

Limitation of the cardinal approach

1. The assumption of cardinal utility is doubtful because utility may not be quantified. Utility
cannot be measured absolutely (objectively).
2. The assumption of constant MU of money is unrealistic because as income increases, the
marginal utility of money changes.

The ordinal utility theory

In the ordinal utility approach, it is not possible for consumers to express the utility of various
commodities they consume in absolute terms, like 1 util, 2 utils, or 3 utils but it is possible to
express the utility in relative terms. The consumers can rank commodities in the order of their
preferences as 1st, 2nd, 3rd and so on. Therefore, the consumer need not know in specific units the
utility of various commodities to make his choice. It suffices for him to be able to rank the
various baskets of goods according to the satisfaction that each bundle gives him.

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Assumptions of ordinal utility theory
The ordinal approach is based on the following assumptions.
 Consumers are rational - they maximize their satisfaction or utility given their income
and market prices.
]

 Utility is ordinal - utility is not absolutely (cardinally) measurable. Consumers are

required only to order or rank their preference for various bundles of commodities.
 Diminishing marginal rate of substitution: The marginal rate of substitution is the rate at
which a consumer is willing to substitute one commodity for another commodity sothat
his total satisfaction remains the same. The rate at which one good can be substituted for
another in consumer‘s basket of goods diminishes as the consumer consumes more and
more of the good.
 The total utility of a consumer is measured by the amount (quantities) of all items he/she
consumes from his/her consumption basket.
 Consumer’s preferences are consistent. For example, if there are three goods in a given
consumer‘s basket, say, X, Y, Z and if he prefers X to Y and Y to Z, then the consumer is
expected to prefer X to Z. This property is known as axioms of transitivity.

The ordinal utility approach is explained with the help of indifference curves. Therefore, the
ordinal utility theory is also known as the indifference curve approach.

Indifference set, curve and map

Indifference set/ schedule is a combination of goods for which the consumer is indifferent. It
shows the various combinations of goods from which the consumer derives the same level of
satisfaction.

Consider a consumer who consumes two goods X and Y (table 3.3).

Table 3.3: Indifference schedule

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

In table 3.3 above, each combination of good X and Y gives the consumer equal level of total
utility. Thus, the individual is indifferent whether he consumes combination A, B, C or D.

Indifference curve: When the indifference set/schedule is expressed graphically, it is called an

indifference curve. An indifference curve shows different combinations of two goods which
yield the same utility (level of satisfaction) to the consumer. A set of indifference curves is
called indifference map.

22
 10 A

Banana
Banana
6 B

C
3 IC3
D IC2
1
IC1
Orange
1 2 4 7 Orange

i) Indifference curve ii) Indifference map

Figure 3.3: Indifference curve and indifference map

Properties of indifference curves

1. Indifference curves have negative slope (downward sloping to the right). Indifference
curves are negatively sloped because the consumption level of one commodity can be
increased only by reducing the consumption level of the other commodity. In other words, in
order to keep the utility of the consumer constant, as the quantity of one commodity is
increased the quantity of the other must be decreased.

2. Indifference curves are convex to the origin. This implies that the slope of an indifference
curve decreases (in absolute terms) as we move along the curve from the left downwards to the
right. The convexity of indifference curves is the reflection of the diminishing marginal rate of
substitution. This assumption implies that the commodities can substitute one another at any
point on an indifference curve but are not perfect substitutes.

3. A higher indifference curve is always preferred to a lower one. The further away from the
origin an indifferent curve lies, the higher the level of utility it denotes. Baskets of goods on a
higher indifference curve are preferred by the rational consumer because they contain more
of the two commodities than the lower ones.

4. Indifference curves never cross each other (cannot intersect). The assumptions of
consistency and transitivity will rule out the intersection of indifference curves. Figure 3.4
shows the violations of the assumptions of preferences due to the intersection of indifference
curves.

23
 Good Y
A
B
IC2
C
IC1

Good X
Figure 3.4: Intersection of indifference curves

In the above figure, the consumer prefers bundle B to bundle C. On the other hand, following
indifference curve 1 (IC1), the consumer is indifferent between bundle A and C, and along
indifference curve 2 (IC2) the consumer is indifferent between bundle A and B. According to the
principle of transitivity, this implies that the consumer is indifferent between bundle B and C
which is contradictory or inconsistent with the initial statement where the consumer prefers
bundle B to C. Therefore, indifference curves never cross each other.
22

Marginal rate of substitution (MRS)

Marginal rate of substitution is a rate at which consumers are willing to substitute one
commodity for another in such a way that the consumer remains on the same indifference curve.
It shows a consumer‘s willingness to substitute one good for another while he/she is indifferent
between the bundles.

Marginal rate of substitution of X for Y is defined as the number of units of commodity Y that
must be given up in exchange for an extra unit of commodity X so that the consumer maintains
the same level of satisfaction. Since one of the goods is scarified to obtain more of the other
good, the MRS is negative. Hence, usually we take the absolute value of the slope.

MRS Number of units of Y given up Y

X ,Y
 
Number of units of X gained X
To understand the concept, consider the following indifference curve.
Good Y

30 A

20 B

12 C
8 D
IC

5 10 15 20 Good X

Figure 3.5: Indifference curve for two products X and Y

24
 From the above graph, MRSX,Y associated with the movement from point A to B, point B to C
and point C to D is 2.0,1.6, and 0.8 respectively. That is, for the same increase in the
consumption of good X, the amount of good Y the consumer is willing to scarify diminishes.
This principle of marginal rate of substitution is reflected by the convex shape of the
indifference curve and is called diminishing marginal rate of substitution.

It is also possible to derive MRS using the concept of marginal utility. MRSX ,Y is related to

MUX and MUY as follows.

MU X
MRS 
X ,Y
MUY
Proof: Suppose the utility function for two commodities X and Y is defined as:
U  f ( X ,Y )

Since utility is constant along an indifference curve, the total differential of the utilityfunction
will be zero.
U U
dU  dX  dY  0
X Y

MU X dX  MUY dY  0

MU X dY MUY dX
  MRS X ,Y Similarly,   MRS Y , X
MUY dX MU X dY

Example: Suppose a consumer‘s utility function is given by U ( X ,Y )  X 4Y 2 . Find MRSX,Y

MU X
Solution: MRS 
X ,Y
MUY
U U MU 4X 3Y 2 2Y
 
3 2 4
MU X   4X Y and MUY   2X Y Hence, MRS X ,Y  X
X Y MUY 2X 4Y X

The budget line or the price line

Do you think that the indifference curve discussed in the previous section tells us whether a
given combination of goods is affordable to the consumer? If no, what are the major
constraints to the consumer in maximizing his/her total utility?

Indifference curves only tell us about consumer preferences for any two goods but they cannot
show which combinations of the two goods will be bought. In reality, the consumer is
constrained by his/her income and prices of the two commodities. This constraint is often
presented with the help of the budget line.

25
The budget line is a set of the commodity bundles that can be purchased if the entire income is
spent. It is a graph which shows the various combinations of two goods that a consumer can
purchase given his/her limited income and the prices of the two goods.

In order to draw a budget line facing a consumer, we consider the following assumptions.
 There are only two goods bought in quantities, say, X and Y.
 Each consumer is confronted with market determined prices, PX and PY.
 The consumer has a known and fixed money income (M).

Assuming that the consumer spends all his/her income on the two goods (X and Y), we can
express the budget constraint as:
M  PX X  PY Y
By rearranging the above equation, we can derive the following general equation of a budget
line.
M PX
Y  X
PY PY

Graphically,

Good Y

M/PY

B

A


Good X
M/PX
Figure 3.6: The budget line
Note that:
PX
 The slope of the budget line is given is by  (the ratio of the prices of the two goods).
PY
 Any combination of the two goods within the budget line (such as point A) or along the
budget line is attainable.
 Any combination of the two goods outside the budget line (such as point B) is
unattainable (unaffordable).

26
Example: A consumer has $100 to spend on two goods X and Y with prices $3 and $5
respectively. Derive the equation of the budget line and sketch the graph.

Solution: The equation of the budget line can be derived as follows.

PX X  PY Y  M Y
3X  5Y  100
5Y  100  3X 20

100 3
Y   X
5 5
3
Y  20  X
X
5
33.3

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

Recall that a budget is drawn for given prices and fixed consumer‘s income. Hence, the changes
in prices or income will affect the budget line.

Change in income: If the income of the consumer changes (keeping the prices of the
commodities unchanged), the budget line also shifts (changes). Increase in income causes an
upward/outward shift in the budget line that allows the consumer to buy more goods and
services and decreases in income causes a downward/inward shift in the budget line that leads
the consumer to buy less quantity of the two goods. It is important to note that the slope of the
budget line (the ratio of the two prices) does not change when income rises or falls.

Good Y

M/Py

Good X
M/Px

Figure 3.7: Effects of increase (right) and decrease (left) in income on the budget line

27
Change in prices: An equal increase in the prices of the two goods shifts the budget line
inward. Since the two goods become expensive, the consumer can purchase the lesser amount of
the two goods. An equal decrease in the prices of the two goods, one the other hand, shifts the
budget line out ward. Since the two goods become cheaper, the consumer can purchase the more
amounts of the two goods.

Good Y

M/Py

Good X
M/Px
Figure 3.8: Effect of proportionate increase (inward) and decrease (out ward) in the prices of
both goods

An increase or decrease in the price of one of the two goods, keeping the price of the other good
and income constant, changes the slope of the budget line by affecting only the intercept of the
commodity that records the change in the price. For instance, if the price of good X decreases
while both the price of good Y and consumer‘s income remain unchanged, the horizontal
intercept moves outward and makes the budget line flatter. The reverse is true if the price of
good X increases. On the other hand, if the price of good Y decreases while both the price of
good X and consumer‘s income remain unchanged, the vertical intercept moves upward and
makes the budget line steeper. The reverse is true for an increase in the price of good Y.

Good Y

Good X
Figure 3.9: Effect of decrease in the price of only good X on the budget line

28
 Equilibrium of the consumer

The preferences of a consumer (what he/she wishes to purchase) are indicated by the
indifference curve. The budget line specifies different combinations of two goods (say X and
Y) the consumer can purchase with the limited income. Therefore, a rational consumer tries to
attain the highest possible indifference curve, given the budget line. This occurs at the point
where the indifference curve is tangent to the budget line so that the slope of the indifference
curve ( MRS XY ) is equal to the slope of the budget line (PX / PY ). In figure 3.10, the equilibrium of
the consumer is at point ‗E‘ where the budget line is tangent to the highest attainable
indifference curve (IC2).

Y* E
IC3
IC2
IC1

X
X*

Figure 3.10: Consumer equilibrium under indifference curve approach

Mathematically, consumer optimum (equilibrium) is attained at the point where:

Slope of indifference curve = Slope of the budget line
PX
MRS XY 
PY
MU X PX
 
MUY PY

Example: A consumer consuming two commodities X and Y has the utility function U
(X ,Y )  XY  2X . The prices of the two commodities are 4 birr and 2 birr respectively. The
consumer has a total income of 60 birr to be spent on the two goods.

a) Find the utility maximizing quantities of good X and Y.

b) Find the MRSX ,Y at equilibrium.

29
 Solution
a) The budget constraint of the consumer is given by:
PX.X+ PY.Y = M
4X+2Y= 60 ......................................(i)

Moreover, at equilibrium
MU X PX

MUY PY
Y 2 4

X 2
Y 2
2
X
Y  2X  2 ............................... (ii)

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

b) MRS MU X Y  2 14  2
X ,Y
   2
MUY X 8

30
(At the equilibrium, MRS can also be calculated as the ratio of the prices of the two goods)

31