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2.  Why to study?
 Facilitates estimation of Market demand for
product
(market demand is summation of individual demand)
 Theory: Given money income and price of
commodities, consumer plans spending
income so as to attain the highest possible
satisfaction or utility.

3. Consumer
Factor Market
(Decide about supply of resources
at different prices)
Product Market
(Decide about the quantity of output to be
purchased at different prices)

4.  Demand for the Product is determined by Consumer
Behaviour
 Consumer:
 Unlimited wants but limited income
 Necessity for allocation of resources among various wants to get
maximum possible satisfaction.
Consumer is having a PREFERENCE SET (list of wants) and OPPORTUNITY
SET (constraints including limited income, operation in the same market)
Adoption of OptimizationTechnique to chose a commodity basket that
can provide maximum satisfaction

5.  What is Utility?
 Satisfaction a consumer derives from consumption of commodities
 Can we measureUtility?
 Two different approaches
A. Cardinal School: Utility is measurable just as price and quantity
 Some argues it can be measured in monetary units (by the amount of money
the consumer is willing to sacrifice for another unit of a commodity)
 Others argue one can assign a number of ‘utils’ to consumption of each
commodity
 Few cardinalists argue utility is measurable and additive (Marshall, Walras)
Others argue it is cardinal but cannot be added (not additive utility)-
Edgeworth, Fisher

6.  William Stanley Jevons (1835-1882) build relationship between Utility &
Price.
 Coined Marginal Utility and linked Marginal Utility to Price instead of
Total Utility.
 The change in total utility per unit change in the quantity of a
commodity consumed-Marginal Utility.
 With increase in consumption of commoditiesTotal Utility increases
but Marginal Utility Declines.
Once Consumption reaches maximum, MarginalUtility will become Zero
(saturation point).
Further increase in consumption of commodity will lead to fall inTotal
utility and negative Marginal Utility.

7.  Ordinal School:Wilfred Pareto et.al.
 Utility cannot be measured.
 ‘The consumer need not know in specific units the utility of various
commodities to make his choice’-A Koutsoyiannis
 Rank Commodities in order of Preferences based on satisfaction that
each bundle can provide.

Adopted INDIFFERENCE CURVES Approach & Revealed Preference
Hypothesis.

8.  Rationality:Consumer is assumed to be rational.
 Utility is measurable and can be measured most conveniently by
MONEY
 Constant Marginal Utility of Money
Diminishing Marginal Utility: Utility gained from consumption of
successive units declines.
 *Total utility of a basket of goods depends on the quantities of the
individual commodities.
U=f(x1,x2,…xn)
Total utility
U=U1(x1)+U2(x2)+..+Un(xn)

9. Assumption of Cardinal utility: Satisfaction can not
be measured objectively.
Marginal utility (MU) of money can not be constant.
As income goes up, MU goes down.
 Money can not be used as a measuring rod since its
own utility undergoes change.
 Diminishing MU is derived from introspection.

10. Quantity Total Marginal
Consumed Utility Utility
0 0 -
1 10 10
2 18 8
3 24 6
4 28 4
5 30 2
6 30 0
7 28 -2
Source: D Salvatore (2005):Microeconomic Theory, P.63

12.  An indifference curve is a graph showing
different bundles of goods, each measured as
to quantity, between which a consumer is
indifferent.That is, at each point on the curve,
the consumer has no preference for one
bundle over another. In other words, they are
all equally preferred. One can equivalently
refer to each point on the indifference curve
as rendering the same level of utility
(satisfaction) for the consumer.

13. Clothing
Units per
week
Food (units
per week)
40
20
10
30
50
0 X
Y
A
E
C

14.  An indifference curve
depicts bundles of
goods/commodities
that leave the
consumer equally well-
off.
 Every point on an
Indifference Curve (IC)
reflects combinations of
goods that give the
consumer a constant
level of utility, i.e., all
bundles are equally
preferred in an IC).
Food (units per week)
Clothing
(Units
per
week)
A
B

15.  Assume Indifference Curve is upward Slopping?
Implications:
Violations of Assumption that more of any commodity is
Preferred to less.
How can a consumer become indifferent between two commodity bundles
having different amount of goods? One is having more of both Food &
Clothing as compared to other.
 Can Indifference Curve become HORIZONTAL Straight Line?
 Can Indifference Curve become Downward Slopping Straight Line?
 Can IC be concave to the Origin?

16.  Indifference Curves are CONVEX or Bowed Inward.
WHY?
 (A) Diminishing MRS
 Slope of Indifference Curve increases (less negative) as one
move down along the IC.
 Previous Exp. -6 to -4 for movement from A to B and B to D.
(B) Generally Consumers prefer Balanced Bundle
(Containing both goods) to a basket constituting only
ONE GOOD.

17.  Marginal rate of substitution of X forY: Reflects
the number of units of commodityY that must be given
up for an extra unit of X so that the consumer maintains
the same level of satisfaction.
How much ofY one can give up in order to gain one
additional unit of X and still remain on the same
IndifferenceCurve?
 Decreasing Marginal Rate of Substitution expresses
that number of units of ‘X’ consumer is willing to sacrifice
in order to obtain an additional unit of ‘Y’ increases as the
quantity ofY decreases. WHY?

18.  Shape of IC reflect how a
consumer is willing to substitute
one good for another.
 For Movement from
Commodity Bundle A to B
consumer can give up 6 units of
clothing for 1 extra unit of Food.
 For Movement from B to D she
can give up 4 units of Clothing
for 1 extra unit of Food.
 When she has more clothing
and less of food, it will be
feasible to give up more
clothing to obtain more food.
-6
1
-4
1
A
B
D
Food
Clothing

19. Marginal Rate of Substitution = Slope of Indifference Curve.
(slope of IC is –dy/dx = MRSxy).
 Slope is Negative as change inY and Change in X are in opposite direction
(one is +ve and other is –Ve).
 Diminishing MRS: Slope of IC DECREASES (in absolute
terms) as one move along the curve from left downwards to
right.
Implication: Commodities can substitute for one
another, but not perfect substitutes.
Perfect substitute: Indifference Curve can be a negative sloped straight line
Complements: ICs are ‘L’ Shaped Curve (takes the shape of right angle)

20.  A Budget constraint represents the
combinations of goods and services that a
consumer can purchase given current prices
and his income.

21.  Budget Constraint:
Constraints that consumers
face as a result of limited
income- Pindyck et.al.
 Budget Line (constraint): All
combinations of goods for
which the total amount of
money spent is equal to
Income.
Any point on the constraint line
equals Rs5,000, the income
available to spend on the two
products.
Pepsi
(Rs 5)
Pizza
(Rs 50)
B
100
A
1000
O

22.  Shows what combination of goods the consumer can afford given his income
and the prices of the two goods.
 The slope of the budget constraint measures the rate at which the
consumer can trade one good for the other.
 The slope equals the relative price of the two goods, i.e. the price of one
good compared to the price of the other.
 Refer previous figure. Slope=OA/OB=
(Y/Py)/ (Y/Px)=Px/Py
WhereY:Total income, Px and Py are price of x (Pepsi) and y (Pizza) respectively.
Y/Py: Given incomeY if she buys only y then how much she could buy.
Y/Px: given incomeY and Price of x as Px how much X she could buy.
Interpretation: Slope of Budget line is the ratio of Price of X to Price ofY.

23.  Given budget constraint, choose the bundle (goods) that can
maximize satisfaction
 Consumers would like to obtain the combination of goods on
the highest possible indifference curve.
 But budget constraint may restrict or limit the consumer to a
lower indifference curve.

24.  Combination of indifference curve and budget constraint
determines the optimum choice.
 For Maximization of satisfaction
Feasible basket should be located on the budget line
(Rules out any bundle below or above the budget line)
Commodity basket must offer the consumer the most
preferred combination of commodities.

25.  Consumer’s
indifference curves,
based on personal
preferences

26. Pizza
Pepsi
I1
I2
I3

27. Given the indifference map of the consumer and his budget line, the
equilibrium is defined by the point ofTANGENCY of the budget line
with his/her possible IC.
 At the point of tangency slopes of budget line Px/Py and slope of IC are
equal.
 But Slope of IC= MRSx,y=MUx/MUy
Or MUx/MUy= Px/Py
Or MUx/Px=MUy/Py

28. Equilibrium Condition:
(a) Necessary Condition:
Marginal Rate of Substitution should be equal to
ratio of commodity prices
MRSx,y = MUx/MUy= Px/Py
Or MUx/Px= MUy/Px
Marginal utility of rupee spent on x and y should be equal to
price of x and price of y.
Marginal utility derived from last rupee spent on X must be
equal to marginal utility derived from last rupee spent onY.

29.  Satisfaction is maximized when Marginal rate of substitution of X forY is equal to
the price ratios of two commodities.WHY?
 Another Interpretation:
 Satisfaction is maximized when Marginal Benefit is equal to Marginal Cost.
 Marginal Benefit: Benefit associated with the consumption of one
additional unit of the good (say food)
 Measured by MRSxy (the amount of Cloth willing to give up for an
additional unit of Food)
 MarginalCost: Cost of additional unit of a good (say Food)
 Measured by magnitude of slope of Budget line (price ratio of x & y).
 Let MRS= slope=1/2
 Implies consumer is willing to give up ½ units of Cloth to obtain one unit of food.
Let Slope of Budget Line=1/2= PF/PC Where PF: Price of Food and PC: Price of Cloth
 cost of getting 1 unit of Food is feasible by giving up ½ unit of Cloth- Price Ratio).

30. (b) Sufficient Condition:
Indifference curve to be convex to the origin.
or Slope of the Indifference curve decreases (in
absolute terms) as we move along the curve from
left to right downwards

31. Perfect Substitutes:
Two goods can be substituted for one another at a
constant rate (not necessarily 1)
Indifference Curve: Downward Slopping straight
Line
 The indifference curves have a CONSTANT Marginal Rate of
Substitution
 Marginal Rate of Substitution is 1 to 1
(Slope of IC: -1)
 Equilibrium of a consumer may be a corner solution
(consumer spends all her income on one commodity)

32. I1 I2 I3
31
2
6
Mango Juice
Pineapple
Juice

33. Two goods are consumed in a FIXED proportion
Indifference curves have lines that are at right-angles to each
other.
ICs analysis is violated as there is no scope to substitute one
good for other
Ex: Consumption ofThree Biscuits with one Cup ofTea
 (slope: Ratio of two goods consumed: 3)
 Ex: Left Shoe and Right Shoe

34. I1
I2
Tea
Biscuit
2
6

35.  Consumer maximize utility
by consuming only ONE
commodity.
 Consumer Prefer C to D as
former is on a higher
Indifference Curve.
I1
A
I2
B
C
D

36.  Initial equilibrium: e1.
 Assume price ofY and Income remain constant.
 Now Price of X (a normal good) declined.
 The budget line shifts to AB’ on account of rise in real purchasing power of the consumer.
The consumer can buy more of X ( andY).
 New Equilibrium: e2 (x2, y2) as AB’ is tangent to a higher IC (IC2).
 New Equilibrium occurs to the right of the original equilibrium implying increase in
demand on account of fall in price of normal good.
 Assume the price to fall continuously and join the tangency point of different budget line
and IC.
 By joining the points one can get PRICE CONSUMPTION LINE (PCL).
 From PCL we can derive Demand Curve for Commodity X. At e1 consumer buys X1 at
priceY1 and at e2 consumer buys X2 at priceY2.
 Plot it in a graph paper to get the demand curve.

37.  ‘Description of how consumers allocate incomes among
different goods and services to maximize their well-being’-
Pindyck et.al.
Necessitates Preference Ordering of Commodities.
 What is a Preference Ordering?
 ‘A Preference ordering is a scheme that enables the
consumer to RANK different bundles of goods in terms of
their DESIREA BILITY or order of preference’-Anidya Sen
(1998).

38. A. Completeness: Preferences to be complete.
 Consumers can compare and rank their preferences among
alternative available bundles of goods and services.
Based on Ranking Consumer can be able to make a CHOICE
between any two given bundles.
Either Prefer commodity bundle A (3 Apples, 3 Oranges) to B (2
Apples, 4 Orange), B to A or remain indifferent.
(A is weakly preferred to B or B is Weakly preferred to A).
 Note :Weakly Prefers: Consumer either prefers one of the two bundles or
remain indifferent between the two

39.  B. Consistency andTransitivity of Choice:
 Preferences need to be consistent
 If she chooses A over B in one period then she cannot
chose B over A in another period.
 Transitivity:
▪ If A (4 Apples, 3 Oranges) is weakly preferred to B (5A,1O) and B is
weakly preferred to C (2A, 5O) thenA is weakly preferred to C.
(if consumer thinksA is at least as good as B and B is at least as
good as C, then A is at least as good as C)
Transitivity property facilitates making the ‘best choice’

40.  C. More of any good is better than Less of it
(Nonsatiation)
 One bundle is preferred to other as it contains more quantity of items.
(Exception: Pollution and Garbage-Bad items.Two much consumption of
sweet……!)
D. Law of Diminishing Marginal Rate of Substitution (MRS)
Preferences are ranked in terms of indifference curves which
are assumed to be convex to the origin.

41. The increase in income shifts the budget
constraint outward. This results in two
affects:
 A parallel shift in the budget constraint.
 Allows the consumer to choose a better
combination of goods on a higher indifference
curve.

42. Apple
Orange
QO
QA
An Increase in income
shifts the budget
constraint.
I3
I1
I2
Income Consumption Curve

43. If a consumer wants more of a good when his
income rises, the good is called a normal
good.
If a consumer buys less of a good when his
income rises, the good is called an inferior
good.

44.  Income Consumption: Locus of consumer
optimum points resulting when only
consumers income varies.
 Engel Curve propounded by Ernst Engel
 Based on Family budget and expenditure
patterns.
 Shows the amount of a good that a consumer
would purchase per unit of time at various income
levels

45. Money
Income
per unit of
Time
Apple Consumed
per unit ofTime
Engel
Curve
 If Engel Curve rises gently for
some goods-Luxury Goods
 Implication:Given increase in
income leads to proportionately
larger increase in quantity
purchased.
 Rapid increase in Engel Curve
implies, given rise in income
leads to proportionately smaller
increase in quantity purchased.
 Exp: Necessary Goods
 (food stuff)

49.  With the fall in price of X, the Q.D went up from X1 to X2.
The new Equilibrium Point is e2 in IC (II).
 Total PRICE EFFECT can be decomposed into SUBSTITUTION EFFECT and
INCOME EFFECT.
 Let the real income be the same as before.To achieve this draw a budget line
parallel (dotted line) to the new budget line
(AB’).
 Movement from e1 to e1’ : Substitution effect
 Movement from e1’ to e2: Income Effect
 Movement from e1 to e2: Price Effect.

50.  Substitution effect:
Increase in the quantity bought as price of the commodity falls, after
adjusting income so as keep the real purchasing power of the
consumer the same as before.
(Hicksian COMPENSATINGVARIATION Method)
 INCOME EFFECT
Decline in Price leads to improvement in consumer’s purchasing power.
Assuming the commodity is normal, She will spend more real
income on X
(Movement from X1’ to X2)- INCOME EFFECT OF
PRICE CHANGE.