Session 4 - Chp4 Consumer Theory

21
4
Background to Demand:
Consumer Choices
PowerPoint Slides prepared by:

Andreea CHIRITESCU
Eastern Illinois University
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Preference and Utility
• How do consumer’s make consumption decisions?
• In this chapter, we will look at a fundamental
economic model that studies consumer purchasing
behavior.
• In this model, we need two pieces of “puzzles” to
find a consumer’s choice of consumption:
1. What the consumer likes
2. What can the consumer afford
• The theory of consumer choice builds the
background to demand that we studied in the last
hours.
• Preference (piece #1: what the consumer likes)
– Tells us what the consumer prefers
– Axiom of Comparison:
• A consumer can always compare and rank any two
bundles (a combination of goods with quantities
specified)
• Two bundles, A and B: either A ≿ 𝐵 or 𝐴 ≻ 𝐵 or 𝐴 ∼ 𝐵
– Axiom of transitivity:
• If A ≿ 𝐵 and B ≿ 𝐶, then A ≿ 𝐶
• Relation between preference and utility:
– If consumer prefers bundle A to bundle B, then
consumer gets a higher utility from consuming bundle A
than from bundle B
– If consumer equally likes A and B, consuming A and
consuming B give the same utility
• Utility:
– Numerical way to specify preference
– Utility numbers can tell us the satisfaction the
consumer receives from consuming all kinds of
bundles
Cups of tea Utility
0 0
1 20
2 38
3 52
4 60
5 64
• Utility:
– Numerical way to specify preference
– Utility numbers can tell us the satisfaction the
consumer receives from consuming all kinds of
bundles
Bundle Quantity of Quantity of Utility *All these
Pizza Pepsi numbers are
simply my
A 0 0 0 construction,
B 1 1 1 for illustration
purposes only
C 2 2 4
D 3 3 9
X 3 4 12
Y 4 3 12
E 4 4 16 6
Marginal Utility
• Marginal Utility:
– the additional utility gained as a result of
consuming one extra unit of a good
Marginal Utility
• Common to have: “diminishing marginal utility”

– the tendency for the additional satisfaction from consuming extra
units of a good to fall
• However, we also assume: “More is always better
than less”! 8
Indifference Curve
• Indifference curve
– Shows consumption bundles that give the
consumer the same level of satisfaction (utility)
– All points on the same indifference curve give
the same utility, hence “indifference”
Quantity
Higher Utility
of Pepsi
Indifference curve
0 Quantity of Pizza
Figure 2
The Consumer’s Preferences
Quantity
of Pepsi A, B, and C are equally enjoyed
D is preferred to A, B, and C
C
D
Indifference curve, I2
A
0 Quantity of Pizza
The consumer’s preferences are represented with indifference curves, which show the
combinations of pizza and Pepsi that make the consumer equally satisfied. Because the
consumer prefers more of a good, points on a higher indifference curve (I2 here) are
preferred to points on a lower indifference curve (I1).
Indifference Curve
• Slope of indifference curve
– is called: Marginal Rate of Substitution (MRS)
Figure 2
MRS Approximation
Quantity
of Pepsi
B
X A I2
1
0 Quantity of Pizza
The marginal rate of substitution (MRS) shows the rate at which the consumer is willing
to trade Pepsi for pizza. It measures the quantity of Pepsi the consumer must be given in
exchange for 1 pizza.
Indifference Curve
– is called: Marginal Rate of Substitution (MRS)
– At any point on an IC, the slope tell us:

• Rate at which a consumer is willing to trade
one good for another without changing the
utility level
Figure 2
MRS Approximation
Quantity
of Pepsi
B
MRS A I2
1
0 Quantity of Pizza
The marginal rate of substitution (MRS) shows the rate at which the consumer is willing
to trade Pepsi for pizza. It measures the quantity of Pepsi the consumer must be given in
exchange for 1 pizza.
Indifference Curve
Calculating MRS
– Formally, MRS equals the marginal utility of
good 1 divided by marginal utility of good 2
MU1
slope of IC = MRS =
MU 2
– Informally, approximate MRS using “rise/run”
– MRS is not the same along an IC. Why?
Figure 4
MRS Approximation
Indifference curves are usually
Quantity of Pepsi
bowed inward. This shape
implies that the marginal rate
of substitution (MRS) depends
on the quantity of the two
goods the consumer is
14 consuming. At point A, the
consumer has little pizza and
MRS=6 much Pepsi, so she requires a
lot of extra Pepsi to induce her
A to give up one of the pizzas:
8 The marginal rate of
1 substitution is 6 liters of Pepsi
per pizza. At point B, the
consumer has much pizza and
4 B Indifference
MRS=1 little Pepsi, so she requires
3 curve
1 only a little extra Pepsi to
induce her to give up one of
the pizzas: The marginal rate
0 2 3 6 7 Quantity of Pizza of substitution is 1 liter of
Pepsi per pizza.
Indifference Curve
• Next: Special preferences
Indifference Curve
• Extreme examples of indifference curves
• Perfect substitutes
– Two goods with straight-line indifference
curves
– Marginal rate of substitution – constant
– Not bowed inward
• Perfect complements
– Two goods with right-angle indifference
curves
Figure 5
Perfect Substitutes and Perfect Complements
(a) Perfect Substitutes (b) Perfect Complements
Nickels
Left
shoes
4 7 I2
5 I1
2
I1 I2 I3
0 1 2 3 Dimes 0 Right 5 7
shoes
When two goods are easily substitutable, such as nickels and dimes, the indifference curves
are straight lines, as shown in panel (a). When two goods are strongly complementary, such
as left shoes and right shoes, the indifference curves are right angles, as shown in panel (b).
Indifference Curve
• Exercise
Suppose Caroline is indifferent between tea and coffee as long as she consumes
an equivalent amount of caffeine. Suppose that coffee has twice as much
caffeine as tea. Which graph would illustrate a representative indifference curve
Tea Tea
9 9
a. 8 b. 8
7 7
6 6
5 5
4 4
3 3
2 2
1 1
1 2 3 4 5 6 7 8 9 Coffee 1 2 3 4 5 6 7 8 9 Coffee
Tea Tea
c. 9
8
d. 9
8
7 7
6 6
5 5
4 4
3 3
2 2
1
1
1 2 3 4 5 6 7 8 9 Coffee
1 2 3 4 5 6 7 8 9 Coffee
Indifference Curve
• Exercise
A consumer has preferences over two goods: pizza and beer. The four bundles
shown in the table below lie on the same indifference curve for the consumer
Bundle Pizza Beer
A 2 8
B 2 2
C 9 2
D 6 2
Which of the following statements regarding these bundles is correct?

a.The goods are perfect substitutes for this consumer.
b.The goods are perfect complements for this consumer.
c.These bundles violate the property that indifference curves are bowed
inward.
d.These bundles violate the property that indifference curves do not cross.
Budget Constraint
• Notice that so far,
• We have not talked about prices.
• This is because we assume that consumers’ preferences
do not depend on how much the goods cost or how much
money he has, but simply depend on taste
• Next, we will talk about how
prices/money affect consumer’s
consumption choices
Budget Constraint
• Budget constraint (piece #2: what the consumer can
afford)
– The set of consumption bundles that a
consumer can afford
– Depends on:
consumer's income
prices of the goods
• Example: two goods, coke and pizza
– income=1000, price of pizza=10, price of coke=2
Figure 1
The Consumer’s Budget Constraint
Quantity
of Pepsi
If spend all the income on pizzas,

how many can she buy?
A
0 100 Quantity of Pizza
The budget constraint shows the various bundles of goods that the consumer can
buy for a given income. Here the consumer buys bundles of pizza and Pepsi. The
table and graph show what the consumer can afford if her income is $1,000, the price
of pizza is $10, and the price of Pepsi is $2.
Figure 1
Quantity
of Pepsi If spend all the income on Pepsi,
500 B

A
Figure 1
Quantity
of Pepsi If spend all the income on Pepsi,
500 B
Consumer’s
budget constraint

A
Figure 1
Quantity
of Pepsi A: spend all the income on pizzas
B: spend all the income on Pepsi
500 B
C: split the income between pizza and Pepsi
D: not spending all the income
D
C
250
Consumer’s
budget constraint
A
0 50 100 Quantity of Pizza
Budget Constraint
• Extra Question:
– If a consumer has no budget constraint,
what would happen?
Budget Constraint
• Slope of the budget constraint
– Equals: relative price of the two goods
– Rate at which the consumer can trade one

good for the other
Figure 1
Quantity rise 500
of Pepsi slope = =− = −5 = − ratio of prices
run 100
500 B (drop the negative sign)
price of good on horizontal axis (good 1)
slope =
price of good on vertical axis (good 2)
C
250
Consumer’s
budget constraint
A
Budget Constraint
• Exercise y
40
30
20
10
10 20 30 40 50 60 70 80 90 x
If the price of X is $5, what is the price of Y?

a.$2
b.$10
c.$30
d.$300
Budget Constraint
• Exercise
Which of the following could explain the change in the budget line from A to B?
a.a decrease in the price of X
b.an increase in the price of Y
c.a decrease in the price of Y
d.More than one of the above could explain this change.
Budget Constraint
• Exercise
Suppose a consumer has an income of $800 per month and that she spends her
entire income each month on beer and bratwurst. The price of a pint of beer is $5,
and the price of a bratwurst is $4. Which of the following combinations of beers
and bratwursts represents a point that would lie directly on the consumer’s budget
constraint?
a.160 beers and 200 bratwursts
b.40 beers and 50 bratwursts
c.80 beers and 100 bratwursts
d.80 beers and 0 bratwursts
Optimization
• Now that we have the two pieces of
puzzle that we need…
1. What the consumer likes
2. What can the consumer afford
• …we can do “optimization”.
Optimization
• What is Optimization?
– The consumer can choose between so
many different consumption bundles
(points) on and below the budget
constraint.
– Which point will he eventually choose to
purchase and consume? --use IC
– This point of choice is called the
“optimum”, and the process of finding the
optimum is called “optimization”
Figure 1
Quantity
of Pepsi Consumer can afford any point on or
below the budget.
500 B
Would he choose point D?
No, because “more is always better”.
D
C
250
Consumer’s
budget constraint
A
Optimization
• Optimum
– Has to be on the budget constraint
* but which point on the budget constraint?
– Use indifference curve!
– Higher indifference curve means higher utility

– Consumer maximizes utility
– So to find the optimum, we need to do find the
point on the budget constraint that belongs to
the highest indifference curve
Figure 6
The Consumer’s Optimum
The consumer chooses the point

Quantity
on her budget constraint that lies
of
on the highest indifference curve.
Pepsi
Budget constraint At this point, called the optimum,
the marginal rate of substitution
Optimum equals the relative price of the
two goods. Here the highest
indifference curve the consumer
A
B can reach is I2. The consumer
prefers point A, which lies on
I3 indifference curve I3, but she
cannot afford this bundle of pizza
I2
C and Pepsi. By contrast, point B is
I1 affordable, but because it lies on
0 Quantity a lower indifference curve, the
of Pizza consumer does not prefer it.
Optimization
• Optimum
– Point where indifference curve and budget
constraint touch (or, “tangency” point)
– Affordable and brings the highest utility
– This happens when the slope of
indifference curve equals slope of budget
constraint (that is, they are tangent)
Optimization
• Optimum
– |Slope of indifference curve|
= marginal rate of substitution
– |Slope of budget constraint|
= relative price of the two goods
– So the tangent point is where
marginal utility of good 1 price of good 1
=
Optimization
• Therefore, the optimum is:

1. On the budget constraint, that is, all
money is spent
2. At the tangency point, that is,
=
Optimization
• Exercise
Quantity of Quantity of MU of MU of
Pizza Pepsi Pizza Pepsi
1 6 10 3
3 4 6 9
4 5 4 6
6 2 2 12
8 1 1 15
•Now, the price of pizza is $10, and the price of Pepsi $15.
The kid has $90 in his pocket.
•What is his optimal choice?
Optimization
• Exercise
Quantity of Quantity of MU of MU of MRS Cost
Pizza Pepsi Pizza Pepsi
1 6 10 3 10/3 100
3 4 6 9 2/3 90
4 5 4 6 2/3 115
6 2 2 12 1/6 90
8 1 1 15 1/15 95
•Now, the price of pizza is $10, and the price of Pepsi $15.
The kid has $90 in his pocket.
•What is his optimal choice?
Optimization
• Exercise
Traci consumes two goods, lemonade and popcorns. Lemonade costs $2 per
glass, and she consumes it to the point where the marginal utility she receives
from her last glass of lemonade is 4. Popcorns cost $3 per bag. The relationship
between the marginal utility Traci gets from eating a bag of popcorns and the
number of bags she eats per month is as follows
Bags of Popcorns 1 2 3 4 5 6
Marginal Utility 30 20 12 6 2 0
If Traci is maximizing her utility, how many bags of popcorns does she buy each
month?
a. 3 b. 4
c. 5 d. 6
Optimization
• Exercise
Bundle B represents a point where the consumer

a. is currently maximizing satisfaction.
b. could increase satisfaction by consuming more X and less Y.
c. could increase satisfaction by consuming less X and more Y.
d. could purchase more X and more Y and increase total satisfaction.
Optimization
• Exercise
Given the budget constraint depicted in the graph, the consumer will choose
bundle
a. B b. C
c. D d. E
Deriving the Demand Curve
• Deriving the demand curve
– Demand of X is the relation between
quantity demanded and price of good X
– For a given set of prices, the optimal
point tells us the quantity demanded of
good X
– If price of good X changes, optimization
gives us the new quantity demanded of
good X.
Figure 11
(a) The Consumer’s Optimum (b) The Demand Curve for Pepsi
Quantity of Pepsi Price of Pepsi
New budget constraint
B A
750 $2
I2
B
1
A
250 Demand
I1
0 Initial budget Quantity 0 250 750 Quantity

constraint of Pizza of Pepsi
Panel (a) shows that when the price of Pepsi falls from $2 to $1, the consumer’s optimum moves
from point A to point B, and the quantity of Pepsi consumed rises from 250 to 750 liters. The
demand curve in panel (b) reflects this relationship between the price and the quantity demanded.
Figure 11
• Exercise
Consumer theory provides the foundation for understanding demand
curves because
a. each point on a demand curve represents an optimal choice point.
b. consumers purchase more inferior goods than normal goods.
c. increases in income cause the budget constraint to rotate inward

along one axis, which changes the consumer’s purchases.
d. increases in income cause the budget constraint to rotate outward

along one axis, which changes the consumer’s purchases.
• Exercise
If the consumer's income and all prices simultaneously
double, then the optimum consumption bundle will
a. shift outward relative to the old optimum.
b. move leftward along the old budget constraint.
c. not change.
d. shift inward relative to the old optimum.

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PowerPoint Slides prepared by:

• Common to have: “diminishing marginal utility”

– At any point on an IC, the slope tell us:

– MRS is not the same along an IC. Why?

Which of the following statements regarding these bundles is correct?

If spend all the income on pizzas,

If spend all the income on pizzas,

If spend all the income on pizzas,

– Rate at which the consumer can trade one

If the price of X is $5, what is the price of Y?

– Higher indifference curve means higher utility

The consumer chooses the point

• Therefore, the optimum is:

Bundle B represents a point where the consumer

New budget constraint

0 Initial budget Quantity 0 250 750 Quantity

a. each point on a demand curve represents an optimal choice point.

b. consumers purchase more inferior goods than normal goods.

c. increases in income cause the budget constraint to rotate inward

d. increases in income cause the budget constraint to rotate outward

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