The Consumer Theory

How Consumers Make Choices under

Income Constraints
The Theory of Consumer Choice addresses
the following questions:
 Do all demand curves slope downward?
 How do consumers choose the optimum
bundle of goods?
 How does a change in relative prices
affect their choice?
 How does a change in income affect their
choice?
utility:
 The value a consumer places on a unit of a good or service
depends on the pleasure or satisfaction he or she expects
to derive from its consumption.

 In economics the satisfaction or pleasure consumers derive

from the consumption of consumer goods is called “utility”.

 Consumers, however, cannot have every thing they wish to

have. Consumers’ choices are constrained by their
incomes.

 Within the limits of their incomes, consumers make their

consumption choices by evaluating and comparing
consumer goods with regard to their “utilities.”
Cardinal vs Ordinal Utility:
 Cardinal utility theory is based on actual
measurement of utility in units called “utils”.
 Total and marginal utility analysis is based on
cardinal theory.
 Ordinal utility implies that utility cannot be
measured but can be compared. Hence one
can rank ones preferences according to
satisfaction but cannot measure it.
 Indifference curve theory is based on ordinal
analysis.
Our basic assumptions about a
“rational” consumer:
 Consumer maximizes utility
 Consumers prefer more of a good (thing) to
less of it.
 Facing choices X and Y, a consumer would
either prefer X to Y or Y to X, or would be
indifferent between them.
 Transitivity: If a consumer prefers X to Y and
Y to Z, we conclude he/she prefers X to Z
Total utility and Marginal utility
 Marginal utility is the utility a consumer derives from
the last unit of a consumer good she or he consumes
(during a given consumption period), ceteris paribus.
 Total utility is the total utility a consumer derives from
the consumption of all of the units of a good or a
combination of goods over a given consumption
period, ceteris paribus.

Total utility = Sum of marginal utilities

Total and Marginal Utility for pepsi
Q ($) TU ($) MU
0 0
1 40 40
2 85 45
3 120 35
4 140 20
5 150 10
6 157 7
7 160 3
8 160 0
9 155 -5
10 145 -10
145
Law of Diminishing Marginal Utility:
 Over a given consumption period, the more of
a good a consumer has, or has consumed,
the less marginal utility an additional unit
contributes to his or her overall satisfaction
(total utility).

 Alternatively, we could say: over a given

consumption period, as more and more of a
good is consumed by a consumer, beyond a
certain point, the marginal utility of additional
units begins to fall.
 Total Utility ($) M U

200 50

40
150
30

100 20

10
50 0
1 2 3 4 5 6 7 8 9 1 11
0 -10

1 2 3 4 5 6 7 8 9 10 11 -20
Disadvantages of the law:
 Measurement of utility not always possible.
Hence – ordinal utility : comparison of utility is
more realistic.
 Utility of x need not be independent of y.
 To assume independent utilities is to assume
zero cross price elasticity.
Why Demand curve slopes down?
 A consumer compares his satisfaction to the
price he has to pay.
 If price is greater than marginal utility, he
reduces consumption and vice versa.
 When price = MU, he is in equilibrium.
 If price falls, to re-establish eqm, MU must fall
which is possible if qty rises.
 Hence a fall in price leads to increase in
demand
Utility Maximizing Rules
 A rational consumer would buy an additional
unit of a good as long as the perceived rupee
value of the utility of one additional unit of that
good (say, its marginal rupee utility) is greater
than its market price.
 The Two-Good Rule

MUx MUy
--------- = ----------
Px Py
UNIT OF MUX MUY MUZ
GOODS

1 12 60 70

2 11 55 60

3 10 48 50

4 9 40 40

5 8 32 30

6 7 24 25

7 6 21 18

8 5 18 10

9 4 15 3

10 3 12 1
Consumer- Preferences:

A consumer’s preference among

consumption bundles may be
illustrated with indifference curves.

An indifference curve is a combination of

different bundles of the goods that give the
consumer the same level of satisfaction
 The Indifference Curves...
Quantity
of y

B D
I2

A Indifference
curve, I1
0 Quantity
of x
The Consumer’s Preferences

 The consumer is indifferent, or equally happy,

with the combinations shown at points A, B,
and C because they are all on the same
curve.
 The Marginal Rate of Substitution

 Theslope at any point on an indifference

curve is the marginal rate of substitution.
 It is the rate at which a consumer is willing to
substitute one good for another.
 It is the amount of one good that a consumer
requires as compensation to give up one unit of
the other good.
 The Consumer’s Preferences...
Quantity
of y

B D
MRS I2
1
A Indifference
curve, I1
0 Quantity
of x
Properties of Indifference Curves

1. Higher indifference curves are

preferred to lower ones.
2. Indifference curves are downward
sloping.
3. Indifference curves do not cross.
4. Indifference curves are convex to
origin.
 Property 3: Indifference curves do not
cross.
Quantity
of y

0 Quantity
of x
 Property 4: Indifference curves are convex
to origin.
People are more willing to trade
Quantity
of y away goods that they have in
abundance and less willing to
14
trade away goods of which
MRS = 6 they have little.

8 A
1

4 MRS = 1 B
3 Indifference
1
curve

0 2 3 6 7 Quantity
of x
The Budget Constraint
The budget constraint depicts the
consumption “bundles” that a consumer
can afford.
 People consume less than they desire
because their spending is constrained, or
limited, by their income.
 A consumer cannot cross his budget line
Perfect Substitutes
kinley

I1 I2 I3
0 1 2 3 aquafina
Perfect Complements

Left
Shoes

I2
7
5 I1

0 5 7 Right Shoes
The Consumer’s Budget Constraint
 The slope of the budget line equals the
relative price of the two goods, that is, the
price of one good compared to the price of
the other.
 Slope = PX / PY.
 The Consumer’s Budget Constraint...

Quantity
of y
B
500

C
250
Consumer’s
budget constraint

A
0 50 100 Quantity
of x
 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

An Increase in Income...

Quantity
of Y New budget constraint

1. An increase in income shifts

the budget constraint outward…

New optimum

Initial
optimum
I2
Initial
budget
constraint I1
0 Quantity
of X
A change in prices:
 A change in relative prices rotate the budget
line.
 If price of X falls the budget line rotates with
the vertical axis intercept remaining the
same.
 Optimization: What the Consumer
Chooses
 Consumers want to get the combination of goods on
the highest possible indifference curve.
 However, the consumer must also end up on or
below his budget constraint.
 Combining the indifference curve and the budget
constraint determines the consumer’s optimal
choice.
 Consumer optimum occurs at the point where the
highest indifference curve and the budget constraint
are tangent.
 The Consumer’s Optimum...

Quantity
of y

Optimum: tangency between I and budget

B line
A

I3
I2
I1
Budget constraint
0 Quantity
of x
OPTIMIZATION
 TANGENCY IMPLIES THAT THE SLOPE OF
THE INDIFFERENCE CURVE = SLOPE OF
BUDGET LINE.
 MRS = RELATIVE PRICE RATIO
 MRS = dy/dx =du/dx /du/dy
 =ratio of marginal utility
How Changes in Income Affect the
Consumer’s Choices

An increase in income shifts the budget

constraint outward. There is no change in
slope as the relative prices are unchanged
The consumer is able to choose a better
combination of goods on a higher
indifference curve.
Normal versus Inferior Goods

 If a consumer buys more of a good when

his or her income rises, the good is called
a normal good.
 If a consumer buys less of a good when
his or her income rises, the good is called
an inferior good.
 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

An Inferior Good...
Quantity
of y

Initial
optimum

New optimum

Initial
budget
constraint I1 I2
0 Quantity
of X
 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

A Change in Price...
Quantity
of y
1,000 New budget constraint

New optimum

500

I2

Initial budget I1
constraint
0 100 Quantity of x
 Income and Substitution Effects
A price change has two effects on
consumption.
 An income effect
 A substitution effect

 The income effect is the change in consumption that

results when a price change moves the consumer to a
higher or lower indifference curve.
 The substitution effect is the change in consumption
that results when a price change moves the consumer
along an indifference curve to a point with a different
marginal rate of substitution.
A Change in Price:
Substitution Effect

A price change first causes the consumer to

move from one point on a indifference curve to
another on the same curve.
 Illustrated by movement from point A to point
B.
 A Change in Price:
Income Effect
After moving from one point to another on the
same curve, the consumer will move to another
indifference curve.
 Illustrated by movement from point B to point
C.
 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Income and Substitution Effects...

Quantity
of y

New budget constraint

C New optimum
Income effect B
Initial optimum
Substitution
effect
I2
A
Initial I1
budget
constraint 0 Quantity of x
Substitution effect
Income effect
 Deriving the Demand Curve...
(a) The Consumer’s Optimum (b) The Demand Curve for y
Quantity
of y Price of y
New budget constraint

B $2
A
150
I2
1
B

A
50 I1
0 0
Quantity 50 150 Quantity
Initial budget of x of y
constraint
Do all demand curves slope
downward?
 Demand curves can sometimes slope
upward.
 This happens when a consumer buys
more of a good when its price rises.
 Giffen Goods

 Economists use the term Giffen good to

describe a good that violates the law of
demand.
 Giffen goods are inferior goods for which the
income effect dominates the substitution
effect.
 They have demand curves that slope
upwards.
 Quantity of
A Giffen Good...
Potatoes Initial budget constraint
B

Optimum with high

price of potatoes
2...which Optimum with low
D price of potatoes
increases
E
potato
C 1. An increase in the price of
consumption
potatoes rotates the budget...
if potatoes
are a Giffen I1
good. New budget I2
constraint
0 A Quantity
of Meat
How do wages affect labor supply?
 If the substitution effect is greater than the
income effect for the worker, he or she
works more.
 If income effect is greater than the
substitution effect, he or she works less.
 The Work-Leisure Decision...
income

$5,000

Optimum
I3
2,000

I2
I1

0 60 100 Hours of Leisure

 An Increase in the Wage...
(a) For a person with these . . . the labor supply curve slopes
preferences… upward.

Wage
income

1. When the
wage rises…

I2
BC1
BC2

I1
0 0
Hours of Hours of Labor
Leisure
2. …hours of leisure decrease… Supplied
3. ...and hours of labor increase.
 An Increase in the Wage...
(b) For a person with these . . . the labor supply curve slopes
preferences… backward.

Wage
BC2

1. When the
wage rises…

BC1 I2
I1

0 0
Hours of Hours of Labor
Leisure Supplied
2. …hours of leisure increase… 3. ...and hours of labor decrease.
Summary

 A consumer’s budget constraint shows the

possible combinations of different goods he
can buy given his income and the prices of
the goods.
 The slope of the budget constraint equals
the relative price of the goods.
 The consumer’s indifference curves
represent his preferences.
Summary
 Points on higher indifference curves are
preferred to points on lower indifference
curves.
 The slope of an indifference curve at any
point is the consumer’s marginal rate of
substitution.
 The consumer optimizes by choosing the
point on his budget constraint that lies on the
highest indifference curve.
Summary
 When the price of a good falls, the impact on the
consumer’s choices can be broken down into 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.
 The income effect is reflected by the movement
from a lower to a higher indifference curve.
Summary
 The substitution effect is the change in
consumption that arises because a price
change encourages greater consumption of
the good that has become relatively cheaper.
 The substitution effect is reflected by a
movement along an indifference curve to a
point with a different slope.