HSC Upper Six
FORMAL DERIVATION OF DEMAND
CURVE
We all face a variety of potential goods and
services to consume. The choice of how much
and which goods/services to consume can be
thought of as consisting of two parts:
 our preferences (what we like and
dislike) and
 Our budget (constraints on our
preferences -- we can’t buy everything
we want).
Indifference curves represent an individual’s
preferences. For simplicity, assume that the
consumer has the choice of consuming just two
goods. An indifference curve shows all
combinations of the two goods that yield the
same level of utility. Utility is constant along
the indifference curve. All points along the
curve are equally satisfying. The consumer
does not prefer one combination of goods to
any other along the curve.
The indifference curve below represents a
consumer’s monthly preference for steak and
pizza. The indifference curve shows that 8
steaks and 3 pizzas per month yield the same
level of satisfaction as 2 steaks and 7 pizzas per
month.
Indifference Map
Note that an indifference curve shows various
combinations of goods that yield the same
utility, but different indifference curves show
different levels of utility. For instance, the
Lesson 2
green indifference curve on the graph below
indicates a higher level of utility than the red or
the blue indifference curves. Economists
assume that people want to attain the highest
level of utility possible (I3 is better than I2
which is better than I1)
There are an infinite number of indifference
curves in the indifference map, and each
person’s indifference map is unique to that
person.
Characteristics of Indifference Curves
 Downward sloping to the right: if a
consumer gives up a unit of one good,
he/she must have more of the other
good to maintain the same level of
utility
 Convex to the origin (bowed inward)
 Cannot intersect
As one moves along the indifference curve
(from left to right), each additional x-axis good
will replace fewer y-axis goods than the
previous one to maintain the same level of
utility. This is the diminishing marginal rate
of substitution (MRS). MRS is the rate at
which one good can be substituted for another
without changing the consumer’s total utility.
Goods substitute for one another at a
diminishing marginal rate because of
diminishing marginal utility for each.
To see the diminishing marginal rate of
substitution, start with consuming 8 units of
good Y and 3 units of good X. To increase
consumption of good X by one unit, this
HSC Upper Six
consumer is willing to trade-off (decrease)
consumption of good Y by 3 units (8 – 5) in
order to maintain a constant level of utility. But
notice what happens when more of good X is
consumed, say increasing consumption of good
X from 6 to 7. Now this consumer is only
willing to sacrifice one unit of good Y to get
one more unit of good X (remaining at the
same level of satisfaction). The rate at which
people are willing to trade-off good Y for X
diminishes as additional units of X is
consumed (The good Y is becoming more dear
as we consumer more and more of good X).
MRS is the slope of the indifference curve, and
can be measured as the ratio of marginal
utilities of the two goods.
MRSx,y = MUx / MUy
The Budget Constraint
Consumers have a limited amount of money
(income, I) to spend on the two goods (X and
Y). Each good has a price (Px and Py). The
budget line shows (if spending entire income
only on some combination of the two goods, X
and Y) all combinations of the goods that the
consumer could afford . The slope of the
budget line is the ratio of the prices.
Slope = (I / Py) / (I / Px) = (Px / Py)
Lesson 2
Example: Jane, a consumer has $100 to spend.
Good X costs $5 per unit. Good Y costs $10
per unit. If Jan spent all of her income on X,
she could purchase 20 units (100 / 5) of X. If
she spent all of her income on Y, she could
purchase 10 units (100 / 10) of Y. She could
also afford to buy different combinations of the
two goods. For example, she could buy 6 units
of X and 7 units of Y, or 10 units of X and 5
units of Y, or 14 units of X and 3 units of Y.
The budget line shows all combinations of the
goods that Jan can afford. The slope of Jan’s
budget line is 0.5 ( Px / Py = 5/10 ).
Jane’s budget line is shown below:
Consumer Choice
Equilibrium is determined by combining the
consumer’s preferences with the consumer’s
budget line.To maximize utility, the consumer
tries to achieve the highest indifference curve
(highest utility), given the budget constraint.
Therefore, the consumer should maximize
utility subject to the budget constraint, or
Max U s.t. BC
Utility maximization occurs where the
marginal rate of substitution (the slope of the
indifference curve) equals the price ratio (the
slope of the budget line).
MUx / MUy = Px / Py
At the point of utility maximization, the
marginal utility per dollar spent on each good
is equal.
HSC Upper Six Lesson 2

MUx / Px = MUy / Py

Utility maximization occurs where the budget

line is tangent to the indifference curve.
Suppose the graph below represented Jane’s
budget line and preferences. According to the
information shown on the graph, Jane would
consume 5 units of good Y and 10 units of
good X. Given her budget constraint (purple
line), the highest level of utility she can
achieve is the red indifference curve (she
cannot afford any combination of goods X and
Y represented on the green (a higher The demand curve for a good can be derived
indifference curve). by determining how consumer choices change
when the price of that good changes, all else
held constant. Returning to the Jan example,
we now have two points on Jan’s demand curve
for good X. The price of good X was originally
$5 and Jan consumed 10 units of X. When the
price increased to $10, Jan's consumption fell
to 6 units of X (see graph below).

Effect of Price Changes

Assume Jane’s income remains the same

($100), but the price of good X increases from
$5 to $10 per unit. Note how the budget line
changes. The increase in price of good X
reduces Jane’s purchasing power, so she can no
longer achieve a utility level associated with
the red indifference curve. The highest level of
utility Jane can now achieve is associated with
the blue indifference curve. With the higher
price of good X, Jane now consumes only 6
units of good X and 4 units of good Y.
HSC Upper Six Lesson 2

Income & Substitution effects of a price

change.
A fall in the price of commodity has two
effects:

INCOME EFFECT: The consumer enjoys an

increase in real purchasing power, because they
can buy the same amount of the good for less
money and thus have money left for additional
expenditures (purchases).

SUBSTITUTION EFFECT: They will

consume more of the good that has become
cheaper and less of the goods that are now
relatively more expensive.

These two effects occur simultaneously but the

The consumer is initially at A on the budget
distinction can be drawn between them for
line RS, thereby obtaining level of utility
analytical analysis.
associated with the curve of indifference U1.
When the price of food falls the budget line
a). Substitution effect.
rotates outwards to line RT. The consumer now
chooses to consume market basket B on the
This effect measures the change in the purchase
indifference curve U2.and the consumption
of a good that results from the change in its
increases (consumption of food) by F1F2 (i.e.
relative price alone. In this case the utility
from 0F1 to 0F2) While the consumption of
(satisfaction) remains constant but the price
clothing declines as represented by line
changes.
segment C1C2 (i.e. from 0C1 to 0C2).
b). Income effect
The substitution effect
It is a change in the consumption of a good
This can be measured by drawing a budget line
resulting from the change in the purchasing
parallel to the new budget line RT (reflecting
power of money that occurs as a result of a
the lower relative price of food) but that is just
price change. In this case the price remains
tangent to the original indifference curve. Thus
constant but utility changes.
holding the level of utility constant. Given the
budget line, the consumer chooses market
basket C and consumes 0E units of goods.
Therefore line segment F1E represents the
substitution effect (move from A to C)

The income effect.

EF2 (associated with the move from C to B)

keeps relative prices constant but increases real
income (satisfaction) Þ Food is a normal good
because the income effect EF2 is positive.
Income and substitution.
HSC Upper Six Lesson 2

Income and substitution effects.
Substitution and income effects for a normal
goods work in the same direction (positive)
For inferior goods the income and substitution
effects move in opposite direction
The income and substitution effects
for Inferior good.
budget line (DG) passing through shifts
outward to budget line RT. The consumer
chooses market basket B instead of market
basket Con indifference curve U2 [increase in
income] leading to a decline in food
consumption. (The move from OF2 to OE).
The income effect is represented by EF2 that is
move from B to C. In this case food is inferior
Þ income effect is negative because when
income rises consumption falls.

However the substitution is larger than income

effect.

So, a decrease in price on food initially leads to

an increase in Quantity of food demanded.

Consumer is initially at equilibrium at market

basket A on budget line RS and he is
consuming 0F1 units of food thereby obtaining
the utility level associated with indifference
curve U1.

A decrease in the price of food shifts the

budget line to line RT, where the consumer
chooses market basket B on indifference curve
U2

The substitution effect could be measured by

drawing a new line parallel to budget line RT,
that is tangent to indifference curve U1. Given
that budget line the consumer chooses market
basket C and now is consuming 0F2 units of
Food therefore the substitution effect is
represented by line segment F1F2 (the move
from A to C) on indifference curve U1.

The income effect occurs when the dotted