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• Utility is the level of satisfaction that is obtained

by consuming a commodity or undertaking an 
activity.

Utility is characterized 
• Utility is subjective 
• The utility of a product can be different at

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• Neo classical economists argued that utility is measurable

like weight, height, temperature and they suggested a unit of 
measurement of satisfaction called utils.

• A utility is a cardinal number like 1, 2, 3 etc simply attached

• Hence, utility can be quantitatively measured.  
Assumption 
• Rationality of Consumers.  
• Utility is Cardinally Measurable 
• Constant Marginal Utility of Money.  
• Limited Money Income 
• Diminishing Marginal Utility (DMU).

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• Total Utility (TU) refers to the total amount of

satisfaction a consumer gets from consuming or 
possessing 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, total utility can not be increased indefinitely.

• Marginal Utility (MU) refers to the additional utility

obtained from consuming an additional unit of a 
commodity.

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TU 
                                              TU

Quantity consumed 
                                           MU 
• When TU is increasing, MU is positive. 
• When TU is maximized, MU is zero. 
• When TU is decreasing, MU is negative.

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• LDMU 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.

Equilibrium of a consumer 
equilibrium condition of a consumer that consumes a single 
good X occurs when the marginal utility of X is equal to its 
market price and the whole income has been consumed (Total 
Expenditure =Total Income) 
A consumer that maximizes utility reaches his/her equilibrium 
position when allocation of his/her expenditure is such that the 
last birr spent on each commodity yields the same utility.

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• The assumption of cardinal utility is doubtful

• Utility can not be measured absolutely

• The assumption of constant MU of money is

unrealistic because as income increases, the 
marginal utility of money changes.

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• In the ordinal utility approach, utility cannot be measured in

• The consumer is expected to rank different consumption

bundles according to his/her preferences.

• It is practically possible for the consumers to rank

commodities in the order of their preference as  and so on.

Assumption  
Consumers are rational 
Utility is ordinal 
Diminishing Marginal Rate of Substitution  
total utility of the consumer depends on the quantities of the

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• It is the rate at which a consumer is willing

to substitute one commodity for another 
commodity so that his total satisfaction 
remains the same.

substituted for another in consumer‘s basket 
of goods diminishes as the consumer 
consumes more and more of the good.

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DEFINITION  
 Demand the various amounts of a product that consumers are

willing and able to purchase at various prices during some 
specific period.

 The behavior of potential buyers in a market is called demand  
 the amount of a commodity that buyers are willing and able to

purchase at a certain price in a given period of time is called 
quantity demanded

LAW OF DEMAND 
The law of demand states that there is a negative, or inverse, 
relationship between price and the quantity of a good demanded and 
its price. Other things equal, when the price of the good rises 
quantity demanded of a good falls

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that shows the relationship 
between the price of a good 
and the quantity demanded.

relationship between price 
and quantity demanded all 
other 
factors 
remain

P 
 
 
 
 
                                               Q

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Market Demand as the Sum of Individual Demands

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• The price of own commodity (PA) (-) 
• The price of substitutes (PS) (+) 
• The Price of Complements (PC) (-) 
• Change in household income and Wealth (I) (+) 
• Consumer's tastes and Preferences (T) eg fashion

• Consumer’s expectation about future price change

(E) expectation of future price rise increases 
current demand for a commodity and expectation 
of future price fall reduces current demand for it.

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10    20    30    40    50    60    70    80

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Number of buyers 
• An 
increase 
in 
the

causes an increase in 
quantity demanded at 
each price, which shifts 
the demand curve to the 
right.

P 
 
 
 
 
 
                                D         D’ 
                                          Q

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Demand for a normal good is positively related to income

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Demand for an inferior good is negatively related to

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• Two goods are substitutes if an increase in the price of

one causes an increase in demand for the other. Example: 
coffee and tea. An increase in the price of coffee  increases 
demand for tea, shifting tea demand curve to the right.

• Two goods are complements if  an increase in the price of

one causes a fall in demand for the other. Example: 
computers and software. If price of computers rises, people 
buy fewer computers, and therefore less software.   
Software demand curve shifts left.

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• Tastes: Anything that causes a shift in tastes

toward a good will increase demand for that 
good  and shift its D curve to the right.

• Expectations: If people expect their incomes

to rise,  their demand for meals at expensive 
restaurants may increase now.

• If the economy turns bad and people worry

about their future job security, demand for new 
autos may fall now.

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– Inverse relationship between price and quantity.

– Utility is the extra satisfaction that one receives

– Marginal means extra. 
– Diminishing means decreasing.

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• law of demand holds true in most cases. The

price keeps fluctuating until an equilibrium is 
created. However, there are some exceptions to 
the law of demand. These include the

1. Giffen goods,  
2. Veblen goods, 
3. Possible price changes, and  
4. Essential goods.

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• These goods are goods that are inferior in

• However, the unique characteristic of Giffen goods

is that as its price increases, the demand also 
increases.

• And this feature is what makes it an exception to

• Eg During the potato famine, when the price of

potatoes increased, people spent less on luxury 
foods such as meat and bought more potatoes to 
stick to their diet.

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• According to Veblen, there are certain goods that

become more valuable as their price increases. If 
a product is expensive, then its value and utility 
are perceived to be more, and hence the demand 
for that product increases

• this happens mostly with precious metals and

stones such as gold and diamonds and luxury 
cars

• As the price of these goods increases, their

demand also increases because these products 
then become a status symbol

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• another exception to the law of demand is the expectation of

• There are times when the price of a product increases and

market conditions are such that the product may get more 
expensive. In such cases, consumers may buy more of these 
products before the price increases any further.

• For instance, in recent times, the price of coffee had

increased to quite an extent. Consumers started buying and 
storing more coffee fearing further price rise, which resulted 
in increased demand.

• There are also times when consumers may buy and store

commodities due to a fear of shortage. Therefore, even if the 
price of a product increases, its associated demand may also 
increase as the product

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• Another exception to the law of demand is

necessary or basic goods. People will continue 
to buy necessities such as medicines or basic 
staples such as sugar or salt even if the price 
increases. The prices of these products do not 
affect their associated demand.

Chapter 2. Theory of Consumption

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