ME

Analysis of Consumer Behaviour

 What will we cover in this Unit?
• How does the budget constraint represent the choices a
consumer can afford?
• How do indifference curves represent the consumer’s
preferences?
• What determines how a consumer divides his resources
between two goods?
• How does the theory of consumer choice explain
decisions such as how much a consumer saves,
or how much labour he supplies?

2
 Introduction
• Recall :
People face tradeoffs or opportunity costs.
– Buying more of one good leaves less income to buy
other goods
– Working more hours means more income and more
consumption, but less leisure time.
– Reducing saving allows more consumption today but
reduces future consumption.
• We will explore how consumers make choices like
these

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 The Budget Constraint:
What the Consumer Can Afford
• Example:
Rahul divides his income between two goods:
fish and mangoes.
• A “consumption bundle” is a particular combination of
the goods, e.g., 40 fish & 300 mangoes.
• Budget constraint: the limit on the consumption
bundles that a consumer can afford

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Activity
Budget Constraint
Rahul’s income: Rs.1200
Prices: PF = Rs.4 per fish, PM = Rs.1 per mango
A. If Rahul spends all his income on fish,
how many fish does he buy?
B. If Rahul spends all his income on mangoes,
how many mangoes does he buy?
C. If Rahul buys 100 fish, how many mangoes can he
buy?
D. Plot each of the bundles from parts A – C on a graph
that measures fish on the horizontal axis and
mangoes on the vertical, connect the dots.
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Activity
Answers
D. Rahul’s budget
Quantity of
Mangoes constraint shows the
B bundles he can
A. 1200/4 afford.
= 300 fish
B. 1200/1 C
= 1200
mangoes
C. 100 fish cost
400,
800 left
buys 800 A
mangoes Quantity
of Fish
 The Slope of the Budget Constraint
From C to D, Quantity of
Mangoes
–200 mangoes
= +50 fish
Slope = – 4
C
Rahul must
give up D
4 mangoes
to get one fish.

Quantity
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of Fish
 The Slope of the Budget Constraint
The slope of the budget constraint equals
– the rate at which Rahul can trade mangoes for fish
– the opportunity cost of fish in terms of mangoes

8
Activity
Budget constraint, continued.
Show what happens to Rahul’s budget constraint if:
A.His income falls to Rs.800.

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Activity
Answers, part A
Quantity of A fall in income
Now, Mangoes shifts the budget
Rahul constraint down.
can buy
800/4
= 200 fish
or
800/1
= 800 mangoes
or any
combination in
between.
Quantity
of Fish
 Preferences: What the Consumer Wants

Indifference curve: Quantity One of Rahul’s

shows different of Mangoes indifference curves
combinations of two
goods that give the
consumer the equal
utility or same level of B
satisfaction
A, B, and all other A
bundles on I1 make I1
Rahul equally happy – he
is indifferent between
Quantity
them. of Fish
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 Four Properties of Indifference Curves

Quantity One of Rahul’s

1. Indifference curves of Mangoes indifference curves
are
downward-sloping.

If the quantity of
fish is reduced, B

the quantity of
A
mangos must be
I1
increased to keep
Rahul equally happy.
Quantity
of Fish
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 Four Properties of Indifference Curves

Quantity A few of Rahul’s

2. Higher indifference of Mangoes indifference curves
curves are preferred
to lower ones.

Rahul prefers every

bundle on I2 (like C) C
D
to every bundle on I1
A I2
(like A).
I1
He prefers every bundle
on I1 (like A) I0
to every bundle on I0 Quantity
(like D). of Fish
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 Four Properties of Indifference Curves

Quantity Rahul’s indifference

3. Indifference curves of Mangoes curves
cannot cross.
Suppose they did.
Rahul should prefer
B to C, since B has B
more of both goods.
Yet, Rahul is indifferent C A
between B and C: I1 I4
He likes C as much as A
(both are on I4).
He likes A as much as B Quantity
(both are on I1). of Fish
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 Four Properties of Indifference Curves

Quantity
4. Indifference curves of Mangoes
are bowed inward.

A
Rahul is willing to give
up more mangos for a 6
fish if he has few fish (A)
1
than if he has many (B).
B
The shape of an 2
indifference curve is 1 I1
in-line with the theory of
marginal utility Quantity
of Fish
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 The Marginal Rate of Substitution

Marginal rate of Quantity MRS = slope of

substitution (MRS): of Mangoes indifference curve
the rate at which a consumer
is willing to trade one good for A
another.
MRS = 6
Rahul’s MRS is the
amount of mangoes he 1
would substitute for B
MRS = 2
another fish. 1 I1
MRS falls as you move down
along an indifference curve. Quantity
of Fish
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 Optimization: What the Consumer Chooses
A is the optimum: Quantity
The optimum
the point on the of Mangoes
is the bundle
budget constraint
Rahul most
that touches the
1200 prefers out of all
highest possible
the bundles he
indifference curve.
can afford.
Rahul prefers B to A, but B
he cannot afford B. 600
A

Rahul can afford C C

and D, D
but A is on a higher
indifference curve. 300
150 Quantity
of Fish
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 The Effects of an Increase in Income
Quantity
of Mangos
An increase in
income shifts the
budget constraint
outward.
B
If both goods are
A
“normal,” Rahul buys
more of each.

Quantity
of Fish
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Activity
Inferior vs. normal goods
• An increase in income increases the quantity
demanded of normal goods and reduces the
quantity demanded of inferior goods.
• Suppose fish is a normal good
but mangoes are an inferior good.
• Use a diagram to show the effects of
an increase in income on Rahul’s optimal
bundle of fish and mangoes.

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Activity
Answers Quantity
of Mangoes

If mangoes are
inferior, the new
optimum will contain
fewer mangoes.

A
B

Quantity
of Fish
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 The Effects of a Price Change
Initially, Quantity
of Mangoes
PF = 4
PM = 1 1200
initial
optimum

PF falls to 2 new
optimum
budget constraint 600
rotates outward, 500
Rahul buys
more fish and
fewer mangoes.
150 300 600 Quantity
350 of Fish

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 The Income and Substitution Effects
A fall in the price of fish has two effects on
Rahul’s optimal consumption of both goods.
– Income effect
A fall in PF boosts the purchasing power of Rahul’s
income, allows him to buy more mangoes and more fish.
– Substitution effect
A fall in PF makes mangoes more expensive relative to
fish, causes Rahul to buy fewer mangoes & more fish.
Notice: The net effect on mangoes is ambiguous.

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 CONCLUSION:
Do People Really Think This Way?
• People do not make spending decisions
by writing down their budget constraints and
indifference curves.
• Yet, they try to make the choices that maximize their
satisfaction given their limited resources.
• The theory in this chapter is only intended as a
metaphor for how consumers make decisions.
• It explains consumer behavior fairly well in many
situations and provides the basis for more advanced
economic analysis.

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CHAPTER SUMMARY
• A consumer’s budget constraint shows the possible
combinations of different goods she can buy given her income
and the prices of the goods. The slope of the budget
constraint equals the relative price of the goods
• An increase in income shifts the budget constraint outward.
A change in the price of one of the goods pivots the budget
constraint
• A consumer’s indifference curves represent her preferences.
An indifference curve shows all the bundles that give the
consumer a certain level of happiness. The consumer prefers
points on higher indifference curves to points on lower ones
• The slope of an indifference curve at any point is the marginal
rate of substitution – the rate at which the consumer is willing
to trade one good for the other

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CHAPTER SUMMARY
• The consumer optimizes by choosing the point on her
budget constraint that lies on the highest indifference
curve. At this point, the marginal rate of substitution equals
the relative price of the two goods.
• When the price of a good falls, the impact on the
consumer’s choices can be broken down into two effects, an
income effect and a substitution effect.
• The income effect is the change in consumption that
arises because a lower price makes the consumer better
off. It is represented by a movement from a lower
indifference curve to a higher one.
• The substitution effect is the change that arises because a
price change encourages greater consumption of the
good that has become relatively cheaper. It is
represented by a movement along an indifference curve.
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