15B11HS211 Economics

THEORY OF CONSUMER
CHOICE

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15B11HS211 Economics

Topics to be covered:
➢ Indifference Curve
➢ Properties of Indifference Curve
➢ Utility
➢ Diminishing Marginal Utility
➢ Budget Constraint
➢ Consumer Equilibrium
➢ Utility maximisation
➢ Derivation of Individual demand curve from price consumption
curve

Resources that can be consulted:

•H. C. Petersen, W. C. Lewis and S. K. Jain, Managerial Economics, 4th ed.,
Pearson Education 2006.
•D. Salvatore, Managerial Economics in a Global Economy, 8th ed., Thomson
Asia, 2015.
•R. H. Frank, Microeconomics and Behavior, 7th ed., Mc-Graw Hill Irwin,
2008 2
15B11HS211 Economics

Y
c
25

20 f

e
15
a
d
10 b

0 15 25 30 X

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15B11HS211 Economics

Assumptions

• Individuals can rank their preferences

• Non-satiation - people prefer more to less

• Transitivity - rankings are consistent

• Individuals are willing to give up successfully

smaller amounts of one good in order to get
additional units of other goods

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15B11HS211 Economics

Bundles of Pizzas and Burgers a consumer

might consume
Y
Indifference Curve
c
• Individuals can rank their 25
preferences
20 f
• Non-satiation - people prefer
more to less e
15
a
• Transitivity - rankings are d I
10 b
consistent

• Individuals are willing to give

up successfully smaller
amounts of one good in
0 15 25 30 X
order to get additional units
of other goods
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15B11HS211 Economics

Indifference Curve: Preference Map

Y

c
25
Indifference curve f
20
on the right I 2
15 e
means greater
satisfaction d
I 1
10

I0

0 15 25 30 X

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15B11HS211 Economics

Impossible Indifference Curves

Y
Crossing

Violation of Transitivity

e
b

a I1
I0

X
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15B11HS211 Economics

Impossible Indifference Curves

Y Upward Sloping

X
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15B11HS211 Economics

Impossible Indifference Curves

Y
Thick

No two points can

have same b
satisfaction level
a

X
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15B11HS211 Economics

Properties of Indifference Curves

• Indifference curves (IC) are

• downward sloping
• Convex to the origin
• do not intersect

• Higher IC reflect greater level of satisfaction

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15B11HS211 Economics

Marginal Rate of Substitution

• Slope of IC is called Marginal

Rate of Substitution.
• It denotes rate at which an
individual is willing to trade
two goods/ services

U=f(x,y)
dU = (dU/ dx) * dx + (dU/ dy) *dy =0
(dU/ dx) * dx = - (dU/ dy) *dy

dy - dU/ dx = - MUx
MRS = =
dx (du/ dy) MUy
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15B11HS211 Economics

The Basis of Choice: Utility

• Utility – the satisfaction derived from a product or service in
consumption
• Marginal Utility – the extra utility, derived from an extra unit of the
good in consumption (MU)
• TU derived from n units of the good in consumption = MU1 + MU2 +
… + MUn

Units of the
good 1 2 3 4

Total Utility 6 15 18
11
TU

Marginal Utility 5 4 3
6
MU

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15B11HS211 Economics

The Law of Diminishing Marginal Utility

For any good or service, the marginal utility of
that good or service decreases as the quantity of
the good increases

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15B11HS211 Economics
Total and Marginal Utility
Bread Total Marginal
consumed Utility Utility Total Utility

per meal DTU 40

total utility
30
0 0 20
10
1 10 0
0 1 2 3 4 5 6 7 8
2 18 quantity

3 24
4 28
5 30
6 30
7 28
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15B11HS211 Economics
Total and Marginal Utility
Breads Total Marginal
consumed Utility Utility Total Utility

per meal DTU 40

total utility
30
0 0 20

1 10 10 10
0

2 18 8 0 1 2 3 4 5 6 7 8
quantity

3 24 Marginal Utility
4 28 marginal utilitiy
15

5 30 10
5

6 30 0
-5 0 1 2 3 4 5 6 7 8

7 28 quantity

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15B11HS211 Economics
Total and Marginal Utility
Breads Total Marginal Total Utility
consumed Utility Utility
per meal DTU 40

total utility
30

0 0 20
10
1 10 10 0

2 18 8 0 1 2 3 4
quantity
5 6 7 8

3 24 6
Marginal Utility
4 28 4
2
marginal utilitiy
15
5 30 10

6 30 0 5
0

7 28 -2 -5 0 1 2 3 4 5 6 7 8
quantity

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15B11HS211 Economics

Budget Constraint
Y

a
25 = M /py
b
20
L 1 (p x= $1, Py= $2, M= $50)

c
10
Opportunity set

d
0 10 30 50 = M /px

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15B11HS211 Economics

BUDGET LINE

• M PxQx + PyQy
• Qx = M/Px - Py/Px*Qy
• Qy = M/Py - Px/Py*Qx
• Slope = - Px/Py

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15B11HS211 Economics

Changes in the Budget Constraint

Price of X Doubles
25
25

L1 (p = $1)
x L1 (px = $1)

Loss
L2 (p = $2)
x
0 50 0 25 50

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15B11HS211 Economics

Changes in the Budget Constraint

Income Doubles
50
L3 (M= $100)

25
25
Gain
L1 (M= $50) L1 (M= $50)

0 50
0 50 100

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15B11HS211 Economics

Consumer Equilibrium

• Consumer Equilibrium is attained when

maximum satisfaction is obtained from
given choices-

– Utility Maximization

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15B11HS211 Economics

Utility Maximization

Budget line

g
25
c
20

B
10

d a
A
I1
0 10 30 50

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15B11HS211 Economics

Utility Maximization

Budget line

g
25
c f
20

B e
10
I3
d a I2
A
I1
0 10 30 50

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15B11HS211 Economics

A Deriving an
Individual’s Demand Curve
12.0

e3 Price-consumption curve
5.2

I3

L3 ( pb = $4)

0 58.9 B
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15B11HS211 Economics

A Deriving an Individual’s Demand Curve

12.0

As Price of B increases from

$4 to $6, consumer shifts to
lower IC

e Price-consumption curve
3
5.2
e
2
4.3
I3

I2

L2 ( p = $6) L 3 ( p = $4)
b b

0 44.5 58.9
B
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15B11HS211 Economics

A Deriving an Individual’s Demand Curve

12.0

e Price-consumption curve
3
5.2
e
2
4.3

e I 3
1
2.8
I2

L1 (p = $12) I 1
L2 ( p = $6) L 3 ( p = $4)
b b b

0 26.7 44.5 58.9

B
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15B11HS211 Economics
(a) Indifference Curves and Budget Constraints

A Deriving an
12.0 Individual’s Demand Curve

e3 Price-consumption curve
5.2
e2
4.3
e1 I3
2.8 I2

L 1 (pb = $12) I1 L2 (pb = $6) L 3 ( pb = $4)

0 26.7 44.5 58.9

B
(b) Demand Curve
p b, $ per unit

12.0 E1

6.0 E2

E3
4.0

0 26.7 44.5 58.9 B 27

15B11HS211 Economics
(a) Indifference Curves and Budget Constraints
A Deriving an
12.0
Individual’s Demand Curve

e3 Price-consumption curve
5.2
e2
4.3
e1 I3
2.8 I2

L1 (pb = $12) I1 L2 (pb = $6) L3 (pb = $4)

0 26.7 44.5 58.9
(b) Demand Curve
B
b p
, $ per unit

12.0 E1

6.0 E2
E3
4.0 D1
, Demand for B
0 26.7 44.5 58.9 B 28
15B11HS211 Economics

Reference
• H.C. Petersen, W.C. Lewis, Managerial Economics, 4th ed., Pearson Education
2001.
• D. Salvatore, Managerial Economics in a Global Economy, 8th ed., Thomson Asia,
2015.
• S. Damodaran, Managerial Economics, 2nd ed., Oxford University Press, 2010.
• P.A. Samuelson, W.D. Nordhaus, Economics, 19th ed., Tata Mc-Graw Hill, 2010.
• S.K. Misra & V. K. Puri, Indian Economy, 37th ed., Himalaya Publishing House, 2019.

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15B11HS211 Economics

Practice Questions
An indifference curve shows combinations of two goods that:
A. could provide the consumer with similar levels of satisfaction.
B. a consumer could buy with their given income.
C. would provide the consumer with the same level of satisfaction.
D. could be available to the consumer in a given time period.
Which of the following statements is NOT TRUE of indifference curves?
A. They are convex to the origin.
B. They could intersect.
C. They exhibit higher levels of utility as you move from the origin.
D. They are downward sloping.
A consumer with a given income will maximise their utility when:
A. the marginal utilities derived from each commodity consumed are proportional to their
prices.
B. the marginal utility derived from each commodity is equal.
C. the marginal utility derived from each product consumed is zero.
D. the total utility derived from each commodity consumed is equal.
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15B11HS211 Economics

Practice Questions
Which of the following defines marginal utility?
A. the change in total utility divided by the price of a product
B. the maximum amount of satisfaction from consuming a product
C. the total satisfaction received from consuming as much of the product that is available for consumption
D. the additional satisfaction received from consuming one more unit of a product
If a rational consumer is in equilibrium, then:
A. the marginal utility obtained from one product is equal to the marginal utility obtained from any other
product.
B. a reallocation of income would increase the consumer's total utility.
C. the marginal utility per last dollar spent is the same for all goods consumed.
D. total utility becomes zero.
Which situation is consistent with the law of diminishing marginal utility?
A. The more pizza Henry eats, the more he enjoys another slice.
B. The more pizza Henry eats, the less he enjoys another slice.
C. Henry's marginal utility from eating pizza becomes positive after eating three slices.
D. Henry's marginal utility from eating pizza reaches a maximum when total utility is zero.

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