The Theory of Consumer Choice

Introduction
How are consumer preferences used to
determine demand?
How do consumers allocate income to the
purchase of different goods?
How do consumers with limited income decide
what to buy?

Consumer Behavior - Applications

1. How would General Mills determine the price
to charge for a new cereal before it went to
the market?
2. To what extent did the food stamp program
provide individuals with more food versus
merely subsidizing food they bought anyway?

Consumer Behavior
The theory of consumer behavior can be used
to help answer these and many more questions
Theory of consumer behavior
The explanation of how consumers allocate income
to the purchase of different goods and services

Consumer Behavior

There are three steps involved in the study of

consumer behavior

1. Consumer Preferences
To describe how and why people prefer one good to
another

2. Budget Constraints
People have limited incomes

Consumer Behavior
3. Given preferences and limited incomes, what
amount and type of goods will be purchased?

What combination of goods will consumers buy to

maximize their satisfaction?

Consumer Preferences
How might a consumer compare different
groups of items available for purchase?
A market basket is a collection of one or more
commodities
Individuals can choose between market baskets
containing different goods

 You do not require assigning a numerical value

to the level of satisfaction.
Although ranking of market baskets is good,
sometimes numerical value is useful.

Utility
Although we numerically rank baskets and
indifference curves, numbers are ONLY for
ranking
A utility of 4 is not necessarily twice as good as a
utility of 2
There are two types of rankings
Ordinal ranking
Cardinal ranking

Utility
Ordinal Utility Function
Places market baskets in the order of most preferred
to least preferred, but it does not indicate how much
one market basket is preferred to another

Cardinal Utility Function

Utility function describing the extent to which one
market basket is preferred to another

Utility
The actual unit of measurement for utility is not
important
An ordinal ranking is sufficient to explain how
most individual decisions are made

Consumer Preferences
So, Utility is:
A numerical score representing the satisfaction that
a consumer gets from a given market basket
If buying 3 copies of Stardust makes you happier
than buying one shirt, then we say that the books
give you more utility than the shirt

Utility
Utility function
Formula that assigns a level of utility to individual
market baskets
If the utility function is

U(Food, Cloth) = F + 2C
A market basket with 8 units of food and 3 units of clothing
gives a utility of

14 = 8 + 2*3

Utility - Example
Market
Basket

Food

Clothing

Utility

8 + 2(3) = 14

6 + 2(4) = 14

4 + 2(4) = 12

Consumer is indifferent between A & B and

prefers both to C

Copyright2004 South-Western

Utility - Example
Baskets for each level of utility can be plotted
to get an indifference curve
To find the indifference curve for a utility of 14, we
can change the combinations of food and clothing
that give us a utility of 14.

Utility - Example
Clothing

Basket
C
2.5(10)
A
B
10(2.5)

15

10

25 = 5(5)
25 =

U3 = 100

U = FC
25 =

10

U2 = 50

15

U1 = 25
Food

The Budget Line

Let F equal the amount of food purchased, and
C is the amount of clothing
Price of food = PF and price of clothing = PC
Then PFF is the amount of money spent on
food, and PCC is the amount of money spent on
clothing.

The Budget Line

The budget line then can be written:

PF F PC C I
All income is allocated to food (F) and/or clothing (C)

THE BUDGET CONSTRAINT: WHAT

THE CONSUMER CAN AFFORD
The budget constraint depicts the limit on the
consumption bundles that a consumer can
afford.
People consume less than they desire because their
spending is constrained, or limited, by their income.

THE BUDGET CONSTRAINT: WHAT

THE CONSUMER CAN AFFORD

Thus it shows the various combinations of

goods the consumer can afford given his or her
income and the prices of the two goods.

The Consumers Budget Constraint

THE BUDGET CONSTRAINT: WHAT

THE CONSUMER CAN AFFORD
The Consumers Budget Constraint
Any point on the budget constraint line indicates the
consumers combination or tradeoff between two
goods.
For example, if the consumer buys no pizzas, he can
afford 500 pints of Pepsi (point B). If he buys no
Pepsi, he can afford 100 pizzas (point A).

Figure 1 The Consumers Budget Constraint

Quantity
of Pepsi
500

Consumers
budget constraint

A
0

100

Quantity
of Pizza
Copyright2004 South-Western

Figure 1 The Consumers Budget Constraint

Alternately, the consumer can
buy 50 pizzas and 250 pints of
Pepsi.

Quantity
of Pepsi
500

250

C
Consumers
budget constraint

A
0

50

100

Quantity
of Pizza
Copyright2004 South-Western

THE BUDGET CONSTRAINT: WHAT

THE CONSUMER CAN AFFORD
The slope of the budget constraint line equals
the relative price of the two goods, that is, the
price of one good compared to the price of the
other.
It measures the rate at which the consumer can
trade one good for the other.

PREFERENCES: WHAT THE

CONSUMER WANTS

A consumers preference among consumption

bundles may be illustrated with indifference
curves.

Representing Preferences with Indifference

Curves
An indifference curve is a curve that shows
consumption bundles that give the consumer
the same level of satisfaction.

Figure 2 The Consumers Preferences

Quantity
of Pepsi
C

D
I2
A

Indifference
curve, I1
Quantity
of Pizza
Copyright2004 South-Western

 The Consumers 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

The slope at any point on an indifference curve is
the marginal rate of substitution.
It is the rate at which a consumer is willing to trade 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.

Figure 2 The Consumers Preferences

Quantity
of Pepsi
C

B
MRS

D
I2

1
A

Indifference
curve, I1
Quantity
of Pizza
Copyright2004 South-Western

Four Properties of Indifference Curves

Higher indifference curves are preferred to

lower ones.
Indifference curves are downward sloping.
Indifference curves do not cross.
Indifference curves are bowed inward.

 Property 1: Higher indifference curves are

preferred to lower ones.
Consumers usually prefer more of something to less
of it.
Higher indifference curves represent larger
quantities of goods than do lower indifference
curves.

 Property 2: Indifference curves are downward

sloping.
A consumer is willing to give up one good only if he
or she gets more of the other good in order to remain
equally happy.
If the quantity of one good is reduced, the quantity of
the other good must increase.
For this reason, most indifference curves slope
downward.

 Property 3: Indifference curves do not cross.

Points A and B should make the consumer equally
happy.
Points B and C should make the consumer equally
happy.
This implies that A and C would make the consumer
equally happy.
But C has more of both goods compared to A.

Figure 3 The Impossibility of Intersecting Indifference

Curves
Quantity
of Pepsi
C
A

Quantity
of Pizza
Copyright2004 South-Western

 Property 4: Indifference curves are bowed

inward.
People are more willing to trade away goods that
they have in abundance and less willing to trade
away goods of which they have little.
These differences in a consumers marginal
substitution rates cause his or her indifference curve
to bow inward.

Figure 4 Bowed Indifference Curves

Quantity
of Pepsi
14
MRS = 6
A

4
3

MRS = 1
1

Indifference
curve
7

Quantity
of Pizza
Copyright2004 South-Western

 Perfect substitutes
Perfect complements

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.

The Consumers Optimal Choices

Combining the indifference curve and the
budget constraint determines the consumers
optimal choice.
Consumer optimum occurs at the point where
the highest indifference curve and the budget
constraint are tangent.

Figure 6 The Consumers Optimum

Quantity
of Pepsi

Optimum
B

A
I3
I1

I2

Budget constraint
0

Quantity
of Pizza
Copyright2004 South-Western

How Changes in Income Affect the

Consumers Choices
An increase in income shifts the budget
constraint outward.
The consumer is able to choose a better
combination of goods on a higher
indifference curve.

Figure 7 An Increase in Income

Quantity
of Pepsi

New budget constraint

New optimum

Initial
optimum

I2

I1
0

Quantity
of Pizza

Copyright2004 South-Western

THREE APPLICATIONS
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 goods for which an increase in the price
raises the quantity demanded.
The income effect dominates the substitution effect.
They have demand curves that slope upwards.

THREE APPLICATIONS
How do wages affect labor supply?
If income effect is greater than the substitution
effect, he or she works less.

Consumer Choice:
An Application Revisited
Consider two groups of consumers, each
wishing to spend $10,000 on the styling and
performance of a car
Each group has different preferences

Consumer Preferences:
An Application
In designing new cars, automobile executives
must determine how much time and money to
invest in restyling versus increased
performance
Higher demand for car with better styling and
performance
Both cost more to improve

Consumer Preferences: An Application

An analysis of consumer preferences would
help to determine where to spend more on
change: performance or styling
Some consumers will prefer better styling and
some will prefer better performance

Consumer Preferences:
An Application
Styling
These
consumers
place a greater
value on
performance
than styling

Performance

Styling
These consumers
place a greater
value on styling
than performance

Performance

Consumer Preferences:
An Application
Knowing which group dominates the market
will help decide where dollars should go
A recent study in the US shows that over the
past two decades, most consumers have
preferred styling over performance

 By finding the point of tangency between a

groups indifference curve and the budget
constraint, auto companies can see how much
consumers value each attribute

These
consumers
want
performance
worth $7000
and styling
worth $3000

Styling
$10,000

$3,000

$7,000

$10,000 Performance

These
consumers
want styling
worth $7000
and
performance
worth $3000

Styling
$10,000
$7,000

$3,000

$10,000 Performance

Consumer Choice:
An Application Revisited
Once a company knows preferences, it can
design a production and marketing plan
Company can then make a sensible strategic
business decision on how to allocate
performance and styling on new cars

MARGINAL UTILITY

Marginal Utility and Consumer

Choice
Marginal utility measures the additional
satisfaction obtained from consuming one
additional unit of a good
How much happier is the individual from
consuming one more unit of food?

Marginal Utility
The principle of diminishing marginal utility
states that as more of a good is consumed, the
additional utility the consumer gains will be
smaller and smaller
Note that total utility will continue to increase
since consumer makes choices that make them
happier

Marginal Utility and Consumer

Choice
Rearranging, gives the equation for utility
maximization:

MU F /MU C PF /PC