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CONSUMER SURPLUS:

 Consumer surplus is the difference between the amount consumers are prepared to
pay to obtain a particular good and the amount they actually pay in the market.
 It is a measure of the surplus utility or welfare consumers receive over and above
what they pay for.

Consumer surplus = Total utility – Total amount spent.

 The market price (the price actually paid by the consumer) is 0P and market quantity
is 0Q. But at this quantity 0Q, total amount that the consumer is prepared to pay (total
utility) is 0ABQ, but actual total amount spent is 0PBQ.
 Thus, consumer surplus is given by the area of the triangle PAB.
 Consumer surplus may change due to changes in demand and supply conditions. For
instance, an increase in supply causes price to fall. As a result, consumer surplus rises.
This can be illustrated as follows:

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 At the initial equilibrium price is 0P, consumer surplus is represented by the area
PKA. A rise in supply to S1S1 causes equilibrium price to fall to 0P1 and quantity to
rise to 0Q1, thereby, causing a rise in consumer surplus to KP1B.
 In fact, consumer surplus increases by PABP1.
 It increases because of the fall in price. On the other hand, a fall in supply causes
equilibrium price to rise, and hence, a fall in consumer surplus.

 Similarly, a change in demand conditions may also change consumer surplus. But, the
change depends upon the price elasticity of supply.
 If demand increases and supply is elastic, consumer surplus may increase because the
price will not rise much when demand rises.

 When demand rises to D1, consumer surplus changes from PAC to P1A1E. Since the
increase in price is less than the increase in demand due to elastic supply, consumer
surplus increases.
 On the other hand, when supply is inelastic, consumer surplus may even fall because
the price will rise significantly with a rise in demand. Besides, the change in
consumer surplus depends upon the price elasticity of demand. Consider the following
diagrams when demand is inelastic.

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 When demand for a good is inelastic, consumer surplus is high. Thus, when demand
is perfectly inelastic, consumer surplus is maximum.
 On the other hand, when demand for a good is elastic, consumer surplus is low.
Hence, when demand is perfectly elastic, there is no consumer surplus. This can be
illustrated as follows:

PRODUCER SURPLUS

 Is the difference between the price a producer is willing to accept and what is actually
paid
 Producers are very keen to supply consumers who are willing to pay a price above
that which they would normally be prepared to accept.
 Producer surplus is shown by the shaded area above the supply curve but below the
price line at P2. Anything the firm sells below price P2 is because it is willing to sell
to consumers at that price.

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TAX INCIDENCE

 When a tax is levied on a good, this has the effect of shifting the supply curve
upwards by the amount of the tax.
 In order to persuade producers to produce the same quantity as before the imposition
of the tax they must now receive a price which allows them fully to recoup the tax
they have to pay (i.e. P1 + tax)

The effect of a tax on price and quantity

 The effect of the tax is to raise price and reduce quantity.

 Price will not rise by the full amount of the tax, however, because the demand curve is
downward sloping. Price rises only to P2.
 Thus the burden or incidence of such taxes is distributed between consumers and
producers.
 Consumers pay to the extent that price rises.

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 Producers pay to the extent that this rise in price is not sufficient to cover the tax.

Elasticity and the incidence of taxation

 If the PED and PES is relatively more inelastic, the quantity will fall less, and hence
tax revenue for the government will be greater, (cases (1) and (3)).
 Price will rise more, and hence the consumers’ share of the tax will be larger, if the
PED is inelastic and PES is elastic (cases (1) and (4)).
 Price will rise less, and hence the producers’ share will be larger, if the PED is more
elastic and the PES is inelastic (cases (2) and (3)).

PRUCE CEILING AND PRICE FLOOR

1. Price Ceiling

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 Maximum price controls or price ceilings are only valid in markets where the
maximum price imposed is below the normal equilibrium price as determined in a free
market.
 It is a price that is fixed below market price.
 Governments use legislation to enforce maximum prices for:

 staple foodstuffs, such as bread, rice and cooking oil

 rents in certain types of housing
 services provided by utilities, such as water, gas and electricity
 transport fares especially where a subsidy is being paid.

 If the government sets a maximum price below the equilibrium (a price ceiling), there
will be a shortage: Qd − Qs.
 Price will not be allowed to rise to eliminate this shortage.
 There danger of black market selling price at Pe

2. Price Floors

 A minimum price or price floor is a legal price set above the equilibrium market price.
One can buy at or above the minimum price but cannot buy at a price below it. It is set

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to protect incomes of producers when the equilibrium market price for a product is
found to be unfairly low.
 Minimum prices are normally set for agricultural products to protect the incomes of
farmers and labour (the minimum wage). When a minimum price is set for a good it
reduces quantity demanded while quantity supplied increase thereby resulting in
persistent excess supply or surplus of the good.
 The government sets minimum prices to prevent them from falling below a certain
level. It may do this for various reasons:
 To protect producers’ incomes- If the industry is subject to supply fluctuations
(e.g. fluctuations in weather affecting crops), prices are likely to fluctuate
severely. Minimum prices will prevent the fall in producers incomes that
would accompany periods of low prices.
 To create a surplus (e.g. of grains) – particularly in periods of glut – which
can be stored in preparation for possible future shortages.
 In the case of wages (the price of labour)- minimum wage legislation can be
used to prevent workers’ wage rates from falling below a certain level

 The introduction of a minimum wage reduces the number of workers employed from
equil to Qd and increase the supply from equil to Qs
 There will be disequilibrium in the market.

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CONSUMER BEHAVIOUR

UTILITY THEORY

 The theory was put forward by Alfred Marshall and other economist who shared the
same sentiments with him and they called themselves Cardinalists.
 By definition, utility is the satisfaction derived from the consumption of a good or a
service. To say a good has utility means it has the ability to satisfy the customer’s
needs.

MARGINAL UTILITY

 Refers to the satisfaction derived from consuming an additional unit or one more or
less unit of a good. So as one consumes a good, we able to tell the satisfaction that
one derives from the consumption of that good.
 The theory was based on certain assumptions and these are explained below.

ASSUMPTIONS OF THE THEORY

i. Rationality- A rational consumer is one who aims to maximize satisfaction. Alternatively,

the one prefers more to less.
ii. Diminishing marginal utility- A basic assumption of utility theory, which is sometimes
called the law of diminishing marginal utility.

 The marginal utility generated by additional units of any product diminishes as an

individual consumes more of it, holding constant the consumption of all other
products.

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 The way in which most of us use water provides a good example of diminishing
marginal utility.
 We consume it in many forms; water, soft drinks, bottled water, or water flavored
with such things as tea leaves and coffee.
 Therefore total utility of that much water is extremely high, as is the marginal utility
of the first few units drunk, but the marginal utility of successive amounts of water
drunk.

iii. Utility is Cardinal- The cardinalists assumed that it was possible for utility to be measured
in cardinal numbers as opposed to ordinal numbers. Hence these economists are called
cardinalists.

 A cardinal measure of utility implies that we can quantify how much more utility one
unit of a good gives a person than the next. The same way we measure mass that’s
how we can quantify utility also.
 For example we might say a consumer derives 10 utils of utility from consuming the
first unit of commodity, 8 utils from the second, and so on.

AN INDIVIDUAL UTILITY SCHEDULE

The following table shows glasses of a soft drink drunk by a certain individual during a
particular evening

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 The figures clearly display an element of utility theory: the law of diminishing
marginal utility.
 The law states that the satisfaction derived from the consumption of an additional unit
of a good will decrease as more of a good is consumed, assuming that the
consumption of all other goods is held constant.
 From the table above, if the individual was forced to drink the 7th glass, his total
utility would actually be reduced. This is sometimes called disutility.

 The diagrams above illustrate the relationship between total utility and marginal
utility.
 Thus total utility is increasing with a decreasing rate and this rate is the marginal
utility.
 If you were given the choice of giving up totally your consumption of either water or
petrol, you would choose to give up petrol.
 The implication is that water provides you with more total utility than petrol.

CONSUMER EQUILIBRIUM

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 A man dying of thirsty in a desert is faced with different conditions and therefore
different marginal utilities. He would definitely place more value on extra gallon of
water.
 If we assume that consumers are utility maximizers, i.e. they wish to obtain as much
as they can, a rational consumer will be in equilibrium when marginal utility is equal
to the price.
MUX = PRICEX
 Thus the consumer will be willing to pay more for higher marginal utility than at a
lower marginal utility.
 If MUx > Px the consumer should buy more of X to derive additional satisfaction.
Thus MU falls as more units of a good is consumed.
 If MUx < Px, the consumer should reduce the consumption of X to increase
satisfaction. Thus MU will increase as less units of a good is consumed.
 The figures of marginal utility decline as each successive unit are consumed. If a
consumer goes on consuming more and more units, eventually we see that the sixth
unit yields no satisfaction at all, and, should a seventh unit be consumed, total utility
actually decreases so that marginal utility becomes negative.

EQUI MARGINAL UTILITY

 It states that having a fixed income and facing given market prices of goods will
achieve maximum satisfaction or utility when the marginal utility of the last dollar
spent on each good is exactly the same as the marginal utility of the last dollar spent
on any other good.
 The above equilibrium condition shows how a consumer will be in equilibrium when
he consumes one good.
 However, in reality consumers have more than one good to spend their incomes on
and this led to the concept of equi-marginal utility principle which shows consumer’s
equilibrium when a consumer is consuming more than on good.

 This is referred to as the equi-marginal principle.

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 A change in the price of any of the goods will cause a change in a person’s spending
patterns.
 From the above principle, the value of the expression MUX/ PX will now fall as the
price of x is increased so the MUx per $ spent will now be less than any other good.
 The consumer will therefore increase TU by spending less on good x and more on all
other goods. In other words, the consumer only maximizes TU by buying less of good
x. The conclusion is that the demand curve is downward sloping.

Limitations of the MU theory

 Theories based on utility place a great emphasis upon rationality and the search for
utility maximization. This is often hard to accord with observed behavior. How many
of your friends are completely rational? How many of your decisions to buy goods
lack calm rational calculation?
 Secondly, the theory was criticized on the ground that utility cannot be measured
objectively in cardinal numbers as assumed by the theory.
 Students to research on this.

Exercise

An individual derives the utility in the table below from consuming different quantities of
three products Oranges, Bananas, and Apples.

An individual derives the utility in Table above from consuming different quantities of three
products: oranges, bananas and Apples.

(Hint: It is necessary to calculate values for the second column in each case in order to work
out consumer equilibrium.)

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i. What will the individual’s consumption be if:

(a) The price in dollars per kilo is Oranges $2; Bananas $3; Apples $5; and income is
$35?

(b) All the conditions in (a) apply except the price of Apples rises to $6 per kilo? Which
is a better substitute for Apples, Oranges or Bananas?

INDIFFERENCE CURVE ANALYSIS

 The marginal utility approach is subject to major criticism that we have never found a
satisfactory way of quantifying utility.
 In the 1930’s a group of economists, including Sir John Hicks and Sir Roy Allen,
came to believe that cardinal measurement of utility was not necessary. They argued
that consumer behavior could be explained with ordinal numbers (i.e. 1st, 2nd, 3rd
and so on.
 An indifference curve is a curve that describes a combination of two goods that yield
the same level of satisfaction or utility to the consumer.
 The indifference curve shows the various sets of goods that make a consumer
indifferent to the satisfaction derived from consuming them.
 Based on the same utility derived from various baskets of goods, it becomes uneasy
for a consumer to choose a particular basket of goods because utilities derived from a
series of combinations to another are indifferent.

ASSUMPTIONS OF THE THEORY

1. Rationality – Other things being equal, the consumer always prefers more of any one
product to less of that same product and they aim to maximize satisfaction.

2. Diminishing marginal rate of substitution – The less of one product that is presently
being used by a consumer, the smaller the amount of it that the consumer will be willing to
forgo in order to increase consumption of a second product.

 The rate of substitution tells us how much more of one product we need to
compensate for successive lost units of the other.

3. Preferences are transitive – It means, that if a consumer prefers basket A to B and prefers
B to C, should also prefers A to C.

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4. Ordinal utility – Consumers are able to rank their bundles according to preferences. That
is 1st, 2nd, and 3rd and so on.

An illustration below shows combination of two goods that derive the same utility.

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 From the diagram, the consumer is indifferent to combinations a (30 pears and 6
oranges), b(24 pears and 7 oranges) and c ( 20 pears and 8 oranges) etc.
 Thus is because the satisfaction a consumer will derive for consuming either of the
two combinations is the same.
 Therefore, the consumer can consume any of the combinations on the curve because
any of the combinations makes the consumer just happy as the other, be it a or b or c
or d or e or f or g.
 One will discover that by moving downward along the curve or graph, the consumer
prefers more of oranges in exchange for fewer pears, and moving upward along the
same curve, the consumer prefers more of pears in exchange of oranges.

PROPERTIES/ CHARACTERISTICS OF INDIFFERENCE CURVES

a) Indifference curves slopes downwards from left to right – Since we assume that
consumers are rational then we must conclude that if consumer give up some of X they

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will want more of Y. This will therefore imply a negative, or an inverse slope of the
indifference curve.

b) Indifference curves are convex to the origin – IC bends inwards towards the origin. This
is because, as consumers gives up more of X, they want relatively more and more of Y to
compensate them.

c) Indifference curves never cross each other – If they do cross each other they will violate
the transitivity assumption. It would be logically absurd for ICs to cross each other since
this would imply that a consumer was equally happy with for example the same
combination of X and Y, both of which have the same quantity of X but different
Quantities of Y.

d) Diminishing marginal rate of substitution – As noted above consumers require more of

X in return for Y ( or vice versa) as the consumer moves along the IC. In other words the
rate of exchange of X and Y changes along the whole length of the curve.

e) An indifference map – If we are to construct another IC to the right of the original one
this must show a situation where a consumer derives greater total utility, since for each
point a consumer will derive more of both goods. The furthest IC from the origin has the
greatest satisfaction.

 It should be noted that bundles or basket of goods found on the same indifference
curve produce the same level of satisfaction.

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 From the diagram I3 > I2 and I2 > I1.

 Given that consumers are rational most purchases of goods and services will like to
consume along the highest indifference curve i.e. I3.

BUDGET LINE/ BUDGET CONSTRAINT

 A budget line shows combinations of two products which can be purchased with a
given level of income.
 The budget line slope shows the relative prices of the two goods i.e. Px/ Py
 A consumer’s ability to purchase goods and services is limited by his level of Y and
the prices of goods and services.

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 A budget constraint/budget line or consumption possibilities curve measures the
relative scarcity between two goods.
 The line shows the combination of goods a consumer can purchase given his/her
income at market prices.
 It also classifies attainable and unattainable regions.
 The budget constraint in the case of two goods x and y is formulated as follows:

I = PxQx + PyQy

 Where: I is the consumer’s income

Px is the price of the good x

Qx is the quantity of the good x

Py is the price of the good y

Qy is the quantity of the good y

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A BUDGET LINE

 A budget line of $100 and price of Y of $2 per unit and for X of $5 per unit gives a
budget line AB.
 The consumer can attain any position on the budget line.

Effect of an Increase I income

 An increase in the level of the consumer’s income. When the level of income
increases the household’s purchasing ability increases therefore more quantities of the
two goods can be afforded. The budget line will shift outwards.
 When income levels decreases, the purchasing ability of households decreases hence
less goods will be purchased thus the budget line will shift inwards

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 An increase in Income from £30 to £40 will result in a shift in the budget line from M
to N. the consumer will consume more bundles of good Y and X. a decrease in
income will lead to an inward shift of the budget line thus purchasing less of the two
goods.

Pivoting of the Budget Line.

 This occurs when the price of one good changes while the price of the other remain
constant. Changes in the price of the good increases the purchasing power of the
household.
 The budget line will pivot outwards when there is a price decrease, however when the
price of the good increases the Budget line will pivot inwards.

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 The Effect of a fall in the price of good X

Consumer Equilibrium under Indifference Curve Analysis

 Given the consumer income and the prices of goods or supplies in the market, the
consumer maximizes satisfaction at the point of equilibrium.
 Graphically it is the point where the budget line is tangential to the highest possible
indifference curve

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 Point t is the equilibrium point. The equilibrium quantities are x1 and y1.
 The slope of the budget line = Px/ Py and the slope of the indifference curve = MUx/
MUY are equal at their point of tangency
 The marginal rate of substitution of x and y MRSxy = MUx/ MUY = Px/ Py
 MRSxy = MUx/ MUy = Px/ Py mutipliying both sides with Py and Px would result in
MUxPy = MUyPx which is simplified
 MUx/ Px = MUy/ Py this is achieved at the point of tangent at t
 At equilibrium situation, the ratio of marginal utilities of the 2 goods must be equal to
the ratio of their prices – by cross multiplying we obtain the following:- MUx/ Px =
MUy/ Py
 This means that at equilibrium, the consumer derives the same marginal utility from
the last $ spent on one commodity in the same way he/she derives marginal utility
from spending the last $ on the other good.

Applications of Indifference Curves Analysis/Changes in Consumer Equilibrium

1) Effects of Changes in Income

 A rise in the level of the consumer’s income shifts from r to s to t then to u as more of
both x and y are consumed. The line C, C1, C2 is income consumption line/ curve it
is also called the Engel curve.

Effects on consumption of a change in income

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 An income consumption curve is the line that traces the different equilibrium points
of the consumer arising from changes in his income.
 If the increase in income leads to an increase in the quantity demanded of a good then
this is a normal good. If the increment in income results in a reduction in quantity
purchased, the good is inferior.

2) Effects of changes in prices

 Changes in price of X , while that of good Y remains fixed. As the price of good x
falls, the budget line shifts/pivots outwards and the consumer equilibrium shifts from
C to C1 to C2. CC1C2 is the price consumption curve/line (ppc) .

 A price consumption curve (ppc) is a line that traces or joins the new equilibrium
points as a result of continuous falling or increasing of the price of a commodity.

THE SUBSTITUTION AND INCOME EFFECT

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a. NORMAL GOOD

Substitution effect

 The additional amount of a product purchased as a result of its price being cheaper
relative to other substitutes in consumption.
 It will always be the case that the consumer will substitute towards the product which
has become relatively cheaper.

Income effect

 The additional purchasing power resulting from a fall in price of one or more products
in the consumption bundle.
 As the price of product x falls it means that the consumer has more money to
spend on other products.
 It can be said that the consumer’s real income has increased since it costs less to buy a
given quantity of goods.

 If the price of product x falls this will lead to a pivot in the budget line to AC,
allowing the consumer to reach a higher indifference curve (IC2) and a new
equilibrium of point c.
 The result of this is that the quantity of product x bought has risen from X1 to X3.
 The movement from a to b is the substitution effect and there is an expansion in the
quantity consumed from X1 to X2.

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 Since there is a fall in the price of X, consumers will now have more real income,
resulting in a parallel shift of the budget line( from hypothetic BL A1C1 to BL AC)
 The movement from point b to point c represents the income effect, allowing the
consumer to reach a higher indifference curve IC2 and consume more of product x,
i.e. a move from X2 to X3.
 Income effect X2 to X3 is positive.
 Substitution effect X1 to X2 is positive
 Total effect if also positive (X1 to X3)

Price change Income effect Substitution effect Total effect

Price decrease +ve +ve +ve
Price increase -ve -ve -ve

b. INFERIOR GOOD

 Cheap but poor quality substitutes for other goods. As real incomes rise above a
certain ‘threshold’, consumers tend to substitute more expensive but better quality
alternatives for certain products.
 A fall in the price of X substitution effect towards the product, i.e. a movement from a
to b, with more being consumed (X1 to X2).
 However, the income effect is negative, unlike the previous example, and this means a
movement from b to c with less being consumed, X2 to X3.
 Although the income effect is negative, in this case it is not sufficient to outweigh the
substitution effect, which means that overall there is still more of the product
demanded as the consumer has moved from X 1 to X3.

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Price change Income effect Substitution effect Total effect

Price decrease -ve +ve -ve

c.GIFFEN GOOD

 Named after the nineteenth-century economist Sir Robert Giffen, who claimed to
identify an upward-sloping demand curve for certain inferior goods. To be a Giffen
good it is necessary, but not sufficient, that the good be inferior.

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Price change Income effect Substitution effect Total effect
Price decrease -ve +ve -ve

Derivation Of The Demand Curve

 We can now use indifference curves to show how an individual’s demand curve is
derived. The upper portion of the diagrams below shows the effect of a price change
 In this case we can see that the price–consumption line shows how demand for X
grows as its price falls relative to Y. The lower portion of the diagrams plots the price
of X against the demand for it.
 If we correlate quantities of X demanded along the price– consumption line with the
various prices on the demand curve we can see that we derive a normal downward-
sloping demand curve.
 As the price of product x falls, represented by the budget line pivoting from AB to AC
to AD, the quantity of product x demanded rises from X1 to X2 to X3, thus giving a
downward sloping demand curve.

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