Section 6

THE THEORY OF
CONSUMER CHOICE
The budget constraint:
what the consumer can afford
Marginal utility theory & Preferences

Optimization: what the consumer chooses

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 The budget constraint:
what the consumer can afford
▪ Budget constraint:
• The limit on the consumption bundles that a
consumer can afford
• The Budget Line
• Nam has $4 a day to spend on two goods: bottled
water (X) and gum (Y).
• The price of water is $1 a bottle.
• The price of gum is 50¢ a pack.

1
 The budget constraint
The line passing through the
Chewing gum (packs per day) points is Nam’s budget line.
Chewing
Water
gum
Possibility (bottles
(packs per
per day)
day)

Unaffordable A 0 8
B 1 6
C 2 4
D 3 2
E 4 0
Affordable
Budget line

2
Water (bottles per day)
 The budget constraint:
what the consumer can afford
▪ The consumer’s budget constraint shows the various
bundles of goods that the consumer can afford.
▪ The slope of the budget measures the rate at which
consumer can trade one good for another. It is the
relative prices of the two goods.
Y

8 •A

4 •C Budget Line

O •E
2 4
X
3
 The budget constraint
▪ A Change in the Budget
• When a consumer’s budget increases,
consumption possibilities expand.
• When a consumer’s budget decreases,
consumption possibilities shrink.

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 The budget constraint
Chewing gum (packs per day)

An increase in the
Budget $6
budget shifts the budget
line rightward.
Again, the slope of the
Budget $4
budget line doesn’t
change because prices
have not changed.

Budget $2 BL2
BL1
BL3

5
Water (bottle per day)
 The budget constraint
▪ Changes in Prices
• If the price of one good rises when the prices
of other goods and the budget remain the
same, consumption possibilities shrink.
• If the price of one good falls when the prices
of other goods and the budget remain the
same, consumption possibilities expand.

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 The budget constraint
When the price of water falls, the budget line rotates outward and becomes less steep.
Chewing gum (packs per day)
Water
Chewing
(bottles per day)
gum
Possibilit
$1 5€ a (packs
y
a bottle bottle per day)

A 0 0 8

B 1 2 6
Water 5€
C 2 4 4

Water $1 D 3 6 2

E 4 8 0

Water (bottles per day)

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 The budget constraint
Chewing gum (packs per day)
When the price of water
rises, the budget line rotates Water Chewing
(bottles per day) gum
inward and becomes steeper
Possibility $2 $1 (packs per
a bottle a bottle day)

A 0 0 8

1 6
Water $1
B 1 2 4

3 2
Water $2 BL1
BL4 C 2 4 0

Water (bottles per day) 8

 Marginal Utility Theory
▪ Utility
Utility is the benefit or satisfaction that a person gets from the
consumption of a good or service.
▪ Total Utility
Total utility is the total benefit that a person gets from the
consumption of a good or service.
▪ Marginal Utility
Marginal utility is the change in total utility that results from a one-
unit increase in the quantity of a good consumed.

∆𝑻𝑼𝒙 𝑑𝑇𝑈
𝑴𝑼𝒙 = =
∆𝑸𝒙 𝑑𝑄

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 Marginal Utility Theory
Q TU MU
0 0 -
𝑀𝑈𝑛 = 𝑇𝑈𝑛 − 𝑇𝑈𝑛−1
1 15 15
2 27 12
3 36 9
4 42 6
5 47 5
6 51 4
7 54 3
8 56 2
9 56 0
10 53 -3
TUX =2X2 + 4X
MUX = 4X + 4 10
 Marginal Utility Theory
We call the general tendency for marginal utility to
decrease as the quantity of a good consumed
increases the principle of diminishing marginal
utility.

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Marginal Utility Theory

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 Marginal Utility Theory
Marginal Utility

The downward
sloping blue line
is marginal
utility curve.

Water (bottles per day

Water
Total Utility
Marginal Utility
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 Preferences: what the consumer wants
Quantity of Y
Indifference curve:
shows consumption
bundles that give the
consumer the same
B
level of satisfaction
A
IC1

Quantity of X

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 Preferences: what the consumer wants
1. Higher indifference curves are preferred to lower ones

Quantity of Y

   IC3
IC2
IC1
O
Quantity of X

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 Preferences: what the consumer wants

2. Indifference curves are downward-sloping

The slope of an indifference curve at any point is the
marginal rate of substitution
Quantity of Y
•A

Y
•B
X

U (IC)
Quantity of X 16
Preferences: what the consumer wants
3. Indifference curves cannot cross
Quantity of Y

A
B

 IC1
C

IC2

O
Quantity of X
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 Preferences: what the consumer wants
4. Indifference curves are bowed inward
Marginal rate of substitution (MRS): the rate at which
a consumer is willing to trade one good for another
Quantity of Y
•A (1,6)

Y
X •B (2, 3)
Y
X •C (3,2)
Y
•D (6,1)
X IC
Quantity of X
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Optimization: what the consumer chooses
Nam has VND55k a day to spend on two goods: X and Y
• The price of X is 10k VND a unit.
• The price of Y is 5k VND a unit.

X,Y 1 2 3 4 5 6 7

TUX 60 110 150 180 200 206 211

TUY 20 38 53 64 70 75 79

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Optimization: what the consumer chooses

Step 1: Calculate the marginal utility from

consuming 1 unit of good X and 1 unit of
good Y.
Step 2: choose the good for which the
marginal utility per dollar spent is greater

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 Optimization: what the consumer chooses
X TUx MUx MUx/Px Y TUy MUy MUy/Py

0 0 0 0

1 60 60 6 1 20 20 4

2 110 50 5 2 38 18 3,6

3 150 40 4 3 53 15 3
4 180 30 3 4 64 11 2,2
5 200 20 2 5 70 6 1,2

6 206 6 0,6 6 75 5 1

7 211 5 0,5 7 79 4 0,8

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Optimization: what the consumer chooses

The best budget allocation occurs when a person

follows the utility-maximizing rule:
1. Allocate the entire available budget.
2. Make the marginal utility per dollar (MUX/PX;
MUY/PY) equal for all goods.

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Optimization: what the consumer chooses
▪ Assumption: the consumer maximizes his/her satisfaction, subject
to his/her budget constraint
▪ The consumer’s optimal choice:
• The consumer optimizes by choosing the point on her budget
constraint that lies on the highest indifference curve
Quantity of Y

•D
•A Optimal choice
IC3
•E
IC2
•C IC1
O BL
Quantity of X 23