Economics

Reading 12 b
Demand and Supply Analysis:
Consumer Demand
 LOS
a) Describe consumer choice theory and utility theory
b) Describe the use of indifference curves, opportunity sets, and
budget constraints in decision making,
c) Calculate and interpret a budget constraint
d) Determine a consumer’s equilibrium bundle of goods based
on utility analysis
e) Compare substitution and income effects
f) Distinguish between normal goods and inferior goods, and
explain Giffen goods and inferior goods, and Veblen goods in this
context
 Introduction

The reading addresses the foundation of

demand and supply analysis.

It seeks to understand the sources of consumer

demand through the theory of the consumer
(Consumer choice theory)
 a) Describe consumer choice theory and utility
theory
Consumer choice theory can be defined as the
branch of microeconomics that relates
consumer demand curves to consumer
preferences.

A combination of preference theory with the

budget constraint gives us the demand curve
 a) Describe consumer choice theory and utility
theory
Modeling Preferences and Tastes
Consumption bundle or basket is a specific combination of the
goods and services that the consumer would like to consume.

Axioms of the theory of consumer choice

Complete preferences: The consumer is able to make a
comparison between any two possible bundles.
Transitive preferences: If Bundle A is preferred to B and B is
preferred to C then A should be preferred to C.
Non Satiation: “more is better” Consumer could never have so
much that they would refuse any more , even for free
a) Describe consumer choice theory and utility
theory
a) Describe consumer choice theory and utility
theory
Utility Function
Utility is a measure of happiness or well-being
Utility function is a ranking of basket of goods
 a) Describe consumer choice theory and utility
theory
Indifference curves: It represents all the combinations of two goods
such that the consumer is entirely indifferent among them

• The MRS is the rate at which the consumer is

willing to give up one good to obtain a small
increment of another, holding utility constant
(i.e., movement along an indifference curve.

• The willingness to give up diminishes as

captured by the convex nature of the curve
a) Describe consumer choice theory and utility
theory
Example
a) Describe consumer choice theory and utility
theory
Indifference map is a family of indifference curves
a) Describe consumer choice theory and utility
theory
a) Describe consumer choice theory and utility
theory
Opportunity set: Consumption, production and
investment choice

• Budget Constraint
• PbQb + PwQw=I
Opportunity set: Consumption, production and
investment choice
Opportunity set: Consumption, production and
investment choice
The budget constraint in the form of an intercept and slope

The slope shows the amount of wine (Qw) to be given up for

the purchase of one slice of bread (QB)
Opportunity set: Consumption, production and
investment choice
Budget constraint
Budget constraint
 Production Opportunity Set

• Producers do face a constraints as to the

quantities they can produce.
• Constrained by limited capacity
• The company’s production opportunity
frontier shows the maximum number of units
of one good it can produce, for any given
number of the other good that it chooses to
manufacture.
Production Opportunity Set
Investment Opportunity Set
 Consumer equilibrium

• The consumer’s constrained optimisation

problem consist of maximising utility, subject to
the budget constraint.
• At equilibrium MRS=price ratio(slope of the
constraint)
• At point b MRS>price ratio meaning the
consumer is willing to give up wine at a rate
greater rate than they must
• At point c MRS<price ratio meaning the price for
additional unit is above her willingness to pay
Consumer equilibrium
Consumer equilibrium
Consumer equilibrium
 Consumer equilibrium
• Consumer response to changes in income
• Normal good
 Consumer equilibrium
• Consumer response to changes in income
• Inferior good
 Consumer equilibrium
• Consumer response to changes in price
 Consumer equilibrium
• Consumer demand curve from preferences and budget constraints
 Consumer equilibrium
• Substitution & income effect on normal goods
 Consumer equilibrium
• Substitution & income effect on normal goods
 Consumer equilibrium
• Substitution & income effect on normal goods
 Consumer equilibrium
• Substitution & income effect on inferior goods
 Consumer equilibrium
• Substitution & income effect on giffen goods
 Consumer equilibrium
• Example
 End

Dan Chirchir, CPA, CFA

2022