CONSUMER THEORY

All of us would like to spend more time relaxing or doing the things that we like. We
would like to get a better phone or have a longer vacation. But then, what is stopping us? I
would like to go away to the hills for a month but I have to be here and work because I can
spend my time either working or vacationing. I would like to get a better phone but my
landlord will kick me out if I don’t pay the rent so I can spend my money either on the
phone or on the rent. These are all constraints. There is a constraint on the time that I have.
There is a constraint on the money that I have. Time and money are resources and
resources are scarce. I have only 24 hours a day and 12 months a year and I have only a
fixed monthly income. Such resource constraints lead to the need to make trade-offs;
trade-off between work and vacation and trade-off between a new phone and paying my
rent.

BUDGET CONSTRAINT

Income constraint is the first thing were are going to focus on. We have a consumer who
buys only two goods: Pizza and Pepsi. His income is $1000 per month and he spends his
entire income on Pizza and Pepsi i.e. he does not save any of his money. (All these
assumptions are not necessary but keeping things simple will help us get started.) Further,
the price of Pizza is $10 and the price of a pint of Pepsi is $2.
Let’s now get graphs involved. Plot the number of pizzas on the horizontal axis and the
number of pints of Pepsi on the vertical axis.
Given his income level, if he buys no pizza, then how many pints of Pepsi can he buy? $2
can buy him one pint so $1000 can buy him how many pints? 500 pints, right? So you have
one point on the graph: (0,500) which represents zero pizza and 500 pints of pepsi.
Given his income level, if he buys zero pints of Pepsi, then how many Pizzas can he buy?
$10 can buy him 1 pizza so how many pizzas can $1000 buy him? 100 pizzas, right? You
have another point: (100, 0) which represents 100 pizzas and 0 pints of pepsi.
Given his income level, what if he decides to spend half his income on pizza and half his
income on pepsi i.e. $500 on each? $500 will buy him 250 pints of pepsi and the other $500
can buy him 50 pizzas. You have another point: (50,250)

What do these three points tell us? Given his income level, this person could go for the
combination no pizza & 500 pints of pepsi or he could go for 100 pizzas and no pepsi or he
could go for 50 pizzas and 250 pints of pepsi. But these are not the only possible
combinations. He can divide his income between pizza and pepsi in a number of ways and
these are only three of the many ways possible. Basically, he divides his income into
expenditure on pepsi and expenditure on pizza. Let number of pints of pepsi be y and let
number of pizzas be x. What is the expenditure of this person on pizza if he consumes ‘x’
number of pizzas? It is price times quantity i.e. 10x. Similarly, if he consumes ‘y’ number of
pints of pepsi, his expenditure on pepsi is 2y. The maximum expenditure he can make is
the amount of money he earns i.e. his income=$1000. Therefore, 10x+2y=1000 represents
his BUDGET CONSTRAINT. You can check that the three bundles (100,0), (0,500) and
(50,250) are located on the line 10x+2y=1000. There would be many more such
combinations. Basically, any bundle that lies on or below the budget constraint is
affordable by this person and any bundle above the budget constraint is not affordable by
this person.
The budget constraint represents all the combinations (or consumption bundles) of Pizza
and Pepsi that this person can afford, given his income level and the prices i.e. it
represents the trade-off between pizza and pepsi faced by the consumer in the sense that
the more he spends on pizza, the less he will have left to spend on pepsi, and vice versa.
Therefore, the slope of the budget constraint measures the rate at which the consumer can
trade one good for the other. What is the slope in our example? It is -5. What does it mean?
To gain one more pizza, the person will have to let go of 5 pints of pepsi. (This is nothing
but the relative price. y-intercept=income/price of pepsi and x-intercept=income/price of
pizza therefore slope=(income/price of pepsi)/(income/price of pizza)= price of pizza/
price of pepsi= $10/$2=5.)

PREFERENCES

Now the question is that among all these possible consumption bundles (i.e. combinations
of Pizza and Pepsi) which bundle will this person choose? The answer will depend on his
tastes i.e. his preferences. If a certain bundle, say (40,300) suits his tastes better than bundle
(10,450) then we say that he prefers bundle (40,300) to (10,450) i.e. he likes the combination
of 40 pizzas & 300 pints of pepsi more than the combination of 10 pizzas & 450 pints of
pepsi. If he likes these bundles equally, i.e the two bundles suit his tastes equally well, then
he is said to be indifferent between them.
Using graphs again. If bundles (40,300) and (10,450) make him equally happy i.e. he is
indifferent between the two bundles, then these two lie on the same curve on the graph
called the indifference curve. Indifference curve is a curve that shows consumption
bundles that give the consumer the same level of satisfaction. (Level of satisfaction
achieved from the consumption of a good or service is formally called the utility of that
good or service. More on utility later.)
What is the significance of the slope of indifference curve? If the slope of indifference
curve in our example is -5, it means for every 1 pizza that the person gains, he is willing to
give up 5 pints of pizza. This is the marginal rate of substitution (MRS). Equivalently, -5
means for every loss of 1 pizza the person needs to be compensated by 5 pints of pepsi to
make sure his level of satisfaction remains the same. (Recall how is the slope of the budget
constraint interpreted? If slope of the budget constraint is -5, it represents the willingness
of the market to trade 1 pizza for 5 pints of pepsi i.e. the consumer has to give up 5 pints of
pepsi to gain one pizza. In contrast, a slope of indifference curve equal to -5 represents the
willingness of the consumer to trade 1 pizza for 5 pints of pepsi.)
Notice that an indifference curve is not a straight line i.e. its slope is not constant.
Therefore, MRS is not the same at all points on the indifference curve. The rate at which a
consumer is willing to trade one good for another depends on the amounts of the goods he
is already consuming. In our example, compare point A and point C. At which point is the
slope (or the MRS) smaller? The slope is smaller at point C (the indifference curve is
becoming flatter as we move from point C to point A). As the person moves from A to C,
his satisfaction level does not change (because he is moving along the same indifference
curve) but he gets thirstier (because the number of pints of pepsi in his consumption
bundle is falling) and he gets less hungry (because the number of pizzas in his
consumption bundle is rising) therefore the number of pints of pepsi he is ready to give up
for pizza will fall i.e. he values pepsi more since he is getting more thirsty and less hungry.
Another way to look at the same the same thing is that the number of pints of pepsi
needed to compensate him for the loss of every pizza increases as he moves from C to A as
he gets less thirst but hungrier.
Now think about bundle (40,300) and (80,600). He is likely to prefer the second bundle,
right? More is good. He will prefer more consumption to less. Higher satisfaction is
represented by a higher indifference curve. Higher indifference curves are preferred to
lower ones. Having a bunch of indifference curves helps us rank the consumer’s
preferences. As we move from a lower indifference curve to higher and higher indifference
curves, the consumer’s preferences are ranked higher and higher. Using this information,
we can rank any two consumption bundles. Out of two consumption bundles, the
consumption bundle that is located on a higher indifference curve is preferred by the
consumer.

Some of the elementary properties of a standard indifference curve are summarised below.
(Preferences with the following properties are known as well-behaved preferences. There
would be deviations from these properties. These are discussed later.)

Properties of indifference curves

1. Higher indifference curves are preferred to lower ones. (More is good.)
2. Indifference curves are downward sloping. (He likes both goods. When he loses one,
he has to be compensated with the other to make sure his satisfaction level remains the
same.)
3. Indifference curves do not cross. (look at figure 3)
4. Indifference curves are bowed inward. (falling MRS)

Focus on the last property. Indifference curves are bowed i.e. MRS falls as we move down
along the indifference curve. The more bowed the curve is, the MRS will fall at a higher
rate i.e. the steepness will diminish quickly. Agree? The less bowed the curve is, the MRS
will fall a lower rate i.e. the steepness will diminish slowly.
Take two extreme examples. First, when the indifference curve does not bow at all i.e. MRS
does not fall as we move along the curve i.e. steepness does not diminish. Simply put,
MRS i.e. slope is constant. Indifference curve is a down-ward sloping straight line. This is
the case of perfect substitutes. Let’s say we have coins of nickels and dimes. (1 dime= 2
nickels). You will only care about the total money you have in your pocket. It does not
matter to you whether your money is made up or nickels or dimes. For how many nickels,
will you exchange a dime with me? Will this exchange rate matter on the number of dimes
or the number of nickels currently in your pocket? You will always be willing to give up 2
nickels to gain 1 dime or equivalently, 2 nickels are needed to compensate you for the loss
of 1 dime, irrespective of the number of nickels or dimes in your pocket i.e. the marginal
rate of substitution is fixed at -2. This just means that the slope of indifference curves is
fixed at -2. There is no bowing. It is a downward-sloping straight line.

The other extreme is extreme bowing. There is a bunch of left shoes and and a bunch of
right shoes in front of you. What do you care about? The number of pairs of shoes you can
take home, right? Out of a bundle of 5 left shoes and 7 right shoes, how many pairs can
you take home? 5 pairs. Out of a bundle of 7 left shoes and 5 right shoes, how many pairs
can you take home? 5 pairs again, yeah? A bundle of 13 left shoes and 5 right shoes? A
bundle of 5 left shoes and 9 right shoes? Each of these bundles can give us only 5 pairs i.e.
the satisfaction level from any of these bundles is the same.
What about the MRS? First, look at the bundle of 7 left shoes and 5 right shoes. Now
assume that I am also a consumer of right and left shoes and ask you to have an exchange
with me. For how many left shoes will you give up one right shoe? Losing one right shoe
will mean the loss of one pair and gaining any number of left shoes will just add to your
trash of useless left shoes. So, you wouldn't give up a right shoe for any number of left
shoes at all. Or we can say it will take an infinite number of left shoes to make you give up
one right shoe. Next question: how many left shoes will you give me if I give you one
right shoe. Gaining a right shoe would mean you can make one more pair of shoes. The
two extra left shoes that you have are useless to you and you would happily give both of
them away for one right shoe. If you had an infinite number of extra left shoes, you would
have given them as well in return for one right shoe. Hence, the MRS at this point is
infinity. (Note that the MRS is determined while moving along the same indifference curve
so while you’re trying to answer these two questions that I just asked you, remember that
the number of pair of shoes in you hand has to be fixed at 5 i.e. your satisfaction level be
fixed.) Now look at the bundle of 5 left shoes and 7 right shoes. I ask you for how many
left shoes will you give up one right shoe? You have two extra right shoes which you
anyway would be trashing so you won’t even demand anything in return i.e. you'll give
me a right shoe in return for zero left shoes. If I ask you how many left shoes will you give
me if I give you one right shoe? Losing a left shoe would mean the loss of a pair of shoes
and gaining one right shoe would just add to your trash i.e. you will give zero left shoes
for any right shoe that I give you. Hence, at this point the MRS is zero.

OPTIMIZATION

So we have the two ingredients (consumer budget and consumer preferences) to know
what choice will the consumer will make. The consumer wants to reach the highest
possible indifference curve but he also must end up on or below his budget constraint.
The highest indifference curve that he can reach (given his income level) is the curve that
just barely touches his budget constraint. The point at which this indifference curve and
the budget constraint touch is called the optimum. The consumer would prefer a bundle
on a higher indifference curve but he cannot afford anything that is above his budget
constraint. There are bundles below his budget constrain that he can afford but he
wouldn’t go for them because moving to a lower indifference curve would decrease his
satisfaction level.
Notice that at the optimum the slope of the indifference curve equals the slope of the
budget constraint i.e. the marginal rate of substitution equals the relative price.
MRS is the rate at which a consumer is willing to trade the goods. Relative price is the rate
at which the market is wiling to trade the goods. So at the optimum, consumer valuation
equals market valuation. Therefore, market prices reflect the value that consumers place
on those goods.

CHANGE IN BUDGET CONSTRAINT WHEN INCOME CHANGES

Now, suppose that the income of this person increases from $1000 to $2000. Previously,
had he spent all his income on pizza, he could have afforded 100 pizzas. Now, if he spends
all his income on pizza, he can afford 200 pizzas. Similarly, had he spent all his income on
pepsi, he could have afforded 500 pints of pepsi. Now, he can afford 1000 pepsis. What is
his budget constraint now? It would be 10x+2y=2000. Compare this with the old budget
constraint 10x+2y=1000. With higher income, the consumer can afford more of both goods.
The increase in income, therefore, shifts the budget constraint outward. What about the
slope? Has it changed? No, it hasn’t. The relative price is the same. The slope is still -5.
There is only a parallel shift in the budget constraint.

CHANGE IN BUDGET CONSTRAINT WHEN PRICE CHANGES

Now suppose that the price of Pepsi falls from $2 to $1. Now, if the consumer spends all
his income of $1000 on Pepsi, he can afford 1000 pints of pepsi (compared to 500 pints,
when the price of pepsi was $2). If he spends all his income on pizza, he can still afford the
same number i.e. 100 Pizzas. What is the budget constraint now? It is 10x+y=1000.
Compare it to the old budget constraint 10x+2y=1000. The slope has changed from -5 to
-10. The consumer can now trade a pizza for 10 rather than 5 pints of pepsi. Therefore,
because of change in price, there is not a parallel shift in the budget constraint but a
movement.

Utility

Let’s go back to our discussion of preferences and make it a bit more formal. We said that
an indifference curve represents a certain level of happiness/satisfaction and that as we
move up higher indifference curves, the consumer’s satisfaction level increases. A more
formal term for satisfaction level is utility. Utility is an abstract measure of the satisfaction
or happiness that a consumer receives from a bundle of goods.

Relating utility with preferences

We had defined preferences as: a consumer prefers one good to another, if the former suits
his tastes better i..e gives him a higher level of satisfaction. Equivalently, a consumer
prefers one bundle of goods to another if one provides more utility than the other.

Relating utility with indifference curves

Regarding indifference curves, we said that on the same indifference curve, a consumer is
equally satisfied on any point. Secondly, a consumer prefers higher indifference curves to
lower ones because higher indifference curves provide him higher satisfaction level.
Equivalently, the bundles of goods on the same indifference curve provide the same utility
and bundles on higher indifference curves provide higher utility.

Marginal Utility

The marginal utility of any good is the increase in utility that the consumer gets from an
additional unit of that good.

Relating marginal utility with MRS

If the marginal utility of good X is twice the marginal utility of good Y , then what do you
think is the MRS of good X wrt good Y? Recall what is MRS. Marginal rate of substitution
of X wrt Y is the number of units of good Y the consumer is willing to give up to gain one
unit of good Y. What does marginal utility of good X being twice of that of good Y mean?
The consumer values good X twice as much as he values good Y. Hence, the consumer
would be willing to give up two units of good Y to gain one unit of good X.
Does this answer the question: what is MRS? It is 2.
In essence, the relationship is that MRSxy=MUx/MUy

Relating utility with optimisation

One economist might say that the goal of the consumer is to maximize utility. Another
economist might say that the goal of the consumer is to end up on the highest possible
indifference curve. They mean the same thing.
At the optimum,
MUx/MUy=Px/Py
or, MUx/Px=MUy/Py
At the optimum, the marginal utility per dollar spent on good X equals the marginal
utility per dollar spent on good Y. (Why? If this equality did not hold, the consumer could
increase utility by spending less on the good that provided lower marginal utility per
dollar and more on the good that provided higher marginal utility per dollar.)

Deviations from well-behaved preferences

Let’s take three different kinds of goods: good A, good B and good C.

Consuming more of good A makes me happier. (Think about your favourite chocolate.)
Consuming more of good B makes me sadder. (Think about the mess food.)
Consuming more of good C induces no reaction in me. (Think about the free minutes that
come with a wifi connection.)

A is a ‘good’ good.
B is a ‘bad’ good.
C is a ‘neutral’ good.

What do you think the graphs look like? Let there be two goods, X and Y. Let quantity of
good X be on x-axis and quantity of good Y be on y-axis.

So far, the indifference curves have been for both good X and good Y being ‘good’. Higher
consumption of pepsi made the person happier and so did a higher consumption of pizza.
The utility increases in the direction ‘up and right’ because going right means higher
consumption of pizza (so I am happier) and going up means higher consumption of pepsi
(so I am happier). In order to make sure I stay on the same indifference curve i.e. my utility
is constant, when I gain some good X, I will have to give up some good Y. Hence, MRS is
negative. When I am gaining more and more of good X, I will be willing to give up less
and less of good Y because the value of good X for me is falling. Hence, MRS is falling as
consumption of good X increases. The curve starts out steep and goes on to become flatter.

‘Good’ on x-axis, ‘good’ on y-axis ‘Bad’ on x-axis, ‘good’ on y-axis

How about good X is ‘bad’ while good Y is ‘good’? Example: Takeaway pizza on y-axis
and mess food on x-axis. What would the indifference curve look like? The utility will
increase in the direction ‘up and left’ because going left means lesser mess food (so I am
happier) and going up means more pizza (so I am happier). In order to keep me on the
same indifference curve, when I am forced to have more mess food, I will have to be
compensated by more pizza. Hence, MRS is positive. When I consume more and more of
mess food, I will have to be compensated by more and more pizza (since the annoyance
would increase from every additional meal in the mess). Hence, MRS is rising as my
consumption of pizza increases. The curve starts out flat and goes on to become steeper.

How about both good X and good Y are ‘bad’? Example: mess food on x-axis and

‘Bad’ on x-axis, ‘Bad’ on y-axis ‘Neutral’ on x-axis, ‘good’ on y-axis

economic classes on y-axis. The utility will increase in the direction ‘down and left’
because going down means lesser number of economic classes (so I am happier) and going
left means lesser mess food (so I am happier). MRS is negative and rising. If I am forced to
have more mess food, I will want to avoid siting for an economics class. (It’s like having
two annoyances in my life. If one rises, I would be too annoyed and want a relief from the
other.) Hence, MRS is negative. When I consume more and more of mess food, I would
want to avoid more and more of economics classes (since the annoyance from mess food
increases with every additional meal there). Hence, MRS is rising as my consumption of
mess food increases. The curve starts out flat and becomes steeper.

How about good Y is ‘good’ while good X is ‘neutral’? Example: internet data on y-axis
and free minutes on x-axis. The utility will increase in the direction ‘up’ since going up
means more of good Y (so I am happier). Going right (that is, more of good X) or going left
(that is, less of good X) makes no difference on happiness since I am neutral toward it.
MRS is zero. If I am promised more free minutes, I will neither ask for nor give up on
internet data.
You could say you gain utility (positive utility) from a ‘good’ good, you gain disutility
(negative utility) from a ‘bad’ good and you gain no utility (zero utility) from a ‘neutral’
good.

More on marginal utility

- I am thirsty. Water is a ‘good’ commodity for me. Compare the fulfilment I get from the
first glass of water to the fulfilment I get from the fourth glass of water. The former will
be higher. The use of water to quench my thirst (utility from water) will keep on
decreasing as the number of glasses I drink increases since I am becoming less thirsty.
Marginal utility of water decreases as its consumption increases.
- You hate economics lectures. Economics is a ‘bad’ commodity for you. Compare the
annoyance you get from the first hour of sitting for this lecture to the annoyance you get
from the third hour of sitting for this lecture. The latter will be higher. Your disdain
toward the lecture i.e. the (negative) utility from the lecture will increase with every
additional hour that you sit for it. (Negative) Marginal utility increases as the
consumption of these lectures increases.
- My friend does not care about the number of free minutes he gets with a broadband
connection. ‘Free minutes’ is a ‘neutral commodity’ for my friend. Compare his
satisfaction level on getting a plan with 1000 free minutes with his satisfaction level on
getting a plan with 2000 free minutes. Both are equal. Marginal utility for my friend
from free minutes neither falls nor rises with a change in the number of free minutes in
his plan.