Economic Principles I

Lecture 7:
Consumer Choice: Behind the
Demand Curve
What this Lecture is About
The theory about how consumers make
decisions about what to buy
Deriving the demand curve by looking at
the consumer decisions behind it
How consumers face trade-offs in their
decisions
How Much Would you Spend?
Drinks 2
Pizzas 10
Budget 1000
Table sets out
how much the
consumer can
afford
Soft
Drinks

Pizzas

Spending
on drinks

Spending
on pizzas

Total

0
50
100
150
200
250
300
350
400
450
500

100
90
80
70
60
50
40
30
20
10
0

0
100
200
300
400
500
600
700
800
900
1000

1000
900
800
700
600
500
400
300
200
100
0

1000
1000
1000
1000
1000
1000
1000
1000
1000
1000
1000

The Consumers Budget
Constraint
Soft
Drinks
Pizzas
0 100
500
300
40
Interpreting Budget Constraints
At the point shown in the previous slide, the
consumer allocates 600 to soft drinks and 400
to pizzas
The slope of the budget constraint (ignoring the
minus sign) equals the relative price of the two
goods
In this case 10/2 = 5, so 1 pizza costs 5 soft
drinks
Assumptions about Choice
The aim of consumers is to maximise satisfaction
How can we represent the consumers
preferences?
The consumer can choose different combinations
of the two goods and may be indifferent between
certain combinations
Indifference means she/he gets the same level of
satisfaction (or utility)
Indifference Curves
Combinations of
goods that make
the consumer
equally happy
Soft
Drinks
Pizzas 0
I
1

I
2

A


D


B
C
Interpretation: a Recap
A, B or C give the same satisfaction
D gives more satisfaction than A, B or C
The slope of the curve is the rate at which the
consumer is willing to substitute one good for the
other the Marginal Rate of Substitution (MRS)
The value of one good equals how much of the
other the consumer is prepared to sacrifice for
one more unit of it
Four Properties of Indifference
Curves
Higher curves are preferred to lower ones
Indifference curves slope downwards
Indifference curves do not cross
Indifference curves bow inwards (convex to
the origin)
Indifference Curves Cannot Cross
Here consumer is
indifferent
between A and
B,
and indifferent
between B and
C,
but prefers C to A
(!?)
C
Soft
Drinks
Pizzas
0
A


B
4
3
6 7
Indifference Curves Bow Inwards
Convexity
implies the
MRS changes
At A consumer
will need 6
more drinks to
give up 1 pizza
At B only 1
more drink
14
8
2 3
Soft
Drinks
Pizzas
0

MRS = 6
A

MRS = 1
B
Perfect Substitutes
50
pence
coins
1 coins
0
I
1

2
1
I
2

4
2
I
3

6
3
Perfect Complements
Left
Shoes
Right Shoes 0 5
5
I
1

I
2

Conclusions
We have covered:
What the consumer can afford the budget
constraint
What the consumer would prefer
indifference curves
Properties and types of indifference curves
Lecture 2 will look at how the consumer makes
choices
Quick test
1. Indifference curves always slope downwards to
the right if the consumer prefers more to less.
2. Indifference curves never intersect if the
consumer has consistent preferences.
3. The slope of the budget line depends only upon
the relative prices of the two goods.
4. The budget constraint shows the maximum
quantity of one good that can be afforded given
the quantity of the other good that is being
purchased.
Quick test (continued)
5. A change in money income alters the slope and
position of the budget line.
6. The marginal rate of substitution can be found
by measuring the slope of the budget line.
7. The marginal rate of substitution for two goods
that are perfect substitutes is zero.
Economic Principles I
Lecture 7:
Consumer Choice: Behind the
Demand Curve