An Introduction

to Economic
Rationality:
Consumer
Behaviour
Prof. Anamika Srivastava
Jindal Global Law School
A Prelude
• Let us begin with the definition of economics-
• “Economics is the study of how individuals and societies choose to use the
scarce resources…”
• Economic theory assumes as a first approximation that individuals and
societies choose rationally.
• Consequently, it carefully formulates principles of rational decision making.
• Before we begin deconstructing what is economic rationality-let us
understand the implication of “rationality” as a moral value-
• When we say that it is rational for individuals to have medical insurance, we
are expressing approval of doing so and suggesting that people ought to
make sure they are insured. Similarly, to characterize a choice as irrational
is usually to condemn it, and not simply to describe it.
A Prelude
• Not only are morality and rationality alike in these ways, but
“rational” is often used (as in the previous example) as a synonym for
“prudent,” and prudence is a morally admirable character trait or
moral virtue.
• Yet morality and rationality are of course not the same thing.
A Shocking Memorandum
• In December of 1991, Lawrence Summers (then the World Bank’s
chief economist) sent the following memorandum to some
colleagues.
• In that memorandum, he was proposing shouldn’t the World Bank
be encouraging more migration of the dirty industries to the LDCs
[less developed countries]?
• It seems that Summers wrote this memorandum as a provocative
exploration of the implications of “economic logic” rather than as a
serious proposal for a World Bank program to export pollution to the
LDCs. Nevertheless.
Summer’s arguments
• 1. The measurement of the costs of health-impairing pollution depends on
the foregone earnings from increased morbidity and mortality. From this
point of view a given amount of health-impairing pollution should be done
in the country with the lowest cost, which will be the country with the
lowest wages.
• 2. The costs of pollution are likely to be non-linear as the initial increments
of pollution probably have very low cost. LDCs are underpolluted and has
inefficienly low quality of air (polluted by non-tradable industries).
• 3. The demand for a clean environment for aesthetic and health reasons is
likely to have very high income-elasticity. The concern over an agent that
causes a one-in-a-million change in the odds of prostate cancer is obviously
going to be much higher in a country where people survive to get prostate
cancer than in a country where under-5 mortality is 200 per thousand.
Welfare Economic Analysis of Summer’s
Argument
1. Rational agents in LDCs would accept pollution from developed countries for less

compensation than rational agents in developed countries would be willing to

pay to get rid of the pollution. In other words, for some compensation C – which

lies between the least that agents in LDCs will accept and the most that agents in

rich countries will offer – all rational individuals, whether in developed countries

or in LDCs, would prefer to transfer pollution from a developed country to an LDC

(premise).
Welfare Economic Analysis of Summer’s
Argument
1. On the previous slide…
2. Whatever individuals prefer makes them better-off or increases
their welfare (premise).
3. Shifting pollution to LDCs from developed countries and paying
some compensation C makes everyone better-off (from 1 and 2).
4. One should adopt policies that make people better-off (premise).
5. One should adopt policies that shift pollution to LDCs and pay
compensation C (from 3 and 4).
Is Summers Right? Should the World Bank Encourage
Migration of Dirty Industries to LDCs?

• The uproar caused by this memo suggests that many people are not
willing to accept its conclusion.
• But this may be a thoughtless first reaction.
• Why shouldn’t the World Bank encourage migration of dirty
industries?
• Since the argument is logically valid, those who reject the conclusion
must reject at least one of its premises.
A few possible objections
• Premises 1 and 3 tacitly assume that the consequences of pollution are
local and that the amount of pollution is independent of where the
pollution takes place.
• Even though people in both developed economies and LDCs would be
happy to shift pollution to LDCs for some reasonable compensation, the
exchange is unfair. Interpersonal comparison of preferences.
• Summers’s analysis compares only one possible alternative to the status
quo: shifting pollution to LDCs. But there may be other policies that
would be better still. Why not transferring wealth from rich to poor
countries might well be much more welfare enhancing than transferring
pollution.
A few possible objections
• What about premise 1, that all rational and well-informed agents
would prefer to make the exchange? This premise is itself the
conclusion of an argument from the fact that the (economic) costs of
pollution are lower in LDCs than in developed countries. But do the
economic costs and benefits capture what is morally relevant?
• The moral relevance of market prices is questionable, even when they
do not reflect any ignorance or irrationality. Individuals need not
accept the market’s evaluation of the consequences of pollution.
• Thus, the relationship between morality and rationality is a complex
one.
Rationality: A Folk Psychology Approach
• The theory of rational choice that dominates economics derives from
an everyday theory of human choice, which has been called “folk
psychology.”
• So, for example, when one rainy Friday night a hungry student named
Ellen takes a frozen pizza out of the refrigerator, unwraps it, puts it in
a stove, and turns knobs on the stove, we folk psychologists explain
Ellen’s action by Ellen’s beliefs – including especially her beliefs that
turning the knobs will cause the stove to heat the pizza – and by her
desire to eat hot pizza.
Rationality: A Folk Psychology Approach
• This sort of explanation is familiar but not very satisfactory.
• Ellen might also like to eat her pizza frozen, or she might also have a
desire to reheat some leftover meatloaf.
• Or she might rather skip dinner and keep studying decision theory.
• What explains her action is not merely wanting to eat hot pizza (plus
possessing the requisite beliefs) but also wanting to do this as much
or more than she wants to do any of the feasible alternatives.
Enter “Preferences”!
• One way to tighten up the folk-psychological account of action is to
replace the non-comparative notion of a “desire” with the
comparative notion of “preference.”
• One can then explain the interaction between Ellen and her stove in
terms of physical constraints, Ellen’s beliefs about the outcomes of
the alternative actions she can undertake that Friday night, and her
over- all ranking of those outcomes.
• One explains the actual pizza warming by showing that Ellen ranks it
at least as highly as any feasible alternative.
Preferences determine choice
• In taking “preferences” to incorporate everything relevant to choice,
one has arrived at the view of preference and choice that economists
have generally adopted.
• Economists regard choices not as mental determinations but rather
as actions that arise from constraints, preferences, and expectations
(or beliefs).
• Economists typically take preferences to be predetermined or “given”
facts about individuals and not themselves in need of explanation.
• Preferences are ex-ante to the market.
Rational Choice
• Economic analyses begin with an individual’s preferences, whatever
they may be.
• Rationality enters the picture as soon as one examines the relations
among choices, preferences, and beliefs.
• Choice is rational when it is determined by a rational set of beliefs
and preferences.
• The rationality of sets of preferences and beliefs is defined within
“utility theory.”
Certainty and Ordinal Utility Theory
• Suppose one is concerned with the choices, preferences, and beliefs
of an agent named “Q.”
• In circumstances of complete certainty, Q chooses rationally if her
preferences are rational and if there is nothing available that Q
prefers to what she chooses.
• Except in the case of ties, one can simplify: Q is rational if her
preferences are rational and she chooses what she most prefers
among those things she can obtain.
Anamika’s Rationality!
Constraint

• Example-

Available options
Depends on her preferences

Do not judge me!

1
2
3
Rational Preferences
• Q’s preferences are rational if they are transitive and complete.
• Q’s preferences are transitive if and only if, for all objects of choice (or
“alternatives”) x, y, and z, if Q prefers x to y and y to z then Q prefers
x to z.
• Similarly, if Q is indifferent between x and y and between y and z,
then she is indifferent between x and z.
Explaining Transitivity
• It is plausible to require that rational preferences be transitive.
Suppose:
• Q has intransitive preferences (she prefers x to y and y to z, but she
prefers z to x);
• Q already has some of y; and
• Q is willing to pay a penny to trade what she has for something she
• prefers.
Intransitivity and Irrationality
• Q will then pay a penny to trade y to get x, another penny to trade x
to get z, another penny to trade z to get y, another penny to trade y
to get x, and so on until Q realizes that her preferences leave her
vulnerable to manipulation.
• Hence Q will not cling to intransitive preferences. Since rational
choices should further one’s ends, intransitive choices are not
rational. This argument showing the irrationality of intransitive
preferences is called “the money pump argument.”
Explaining Complete
• Q’s preferences are complete if, for all options x and y, either Q
prefers x to y or Q prefers y to x or Q is indifferent between x and y.
• If Q’s preferences are complete then Q is never unable to rank x and y.
• If asked to choose between two sealed shoeboxes, one of which
contains $10 and the other $1, Q will not be indifferent; but if she
doesn’t know which box contains the $10 then she may not be able to
form a preference.
• Such problems will not come up in conditions of certainty, and
completeness may be a reasonable simplification when there are no
uncertainties.
Preferences to Choice or from Choice to
Preferences?
• We regard Q’s preferences as a subjective state of Q: Q’s evaluation of
states of affairs with respect to everything relevant to choice.
• Q’s preferences and Q’s beliefs then jointly explain her choices. But
many economists would disagree.
• In accordance with the theory of “revealed preference,” they instead
attempt to define preference in terms of choice.
• Provided that consistency requirements are met, choosing x when
one might have had y at a lower cost reveals a preference for x over
y.
Why study Preferences?
• Preferences, as we conceive of them, coincide with revealed preferences when the
alternatives are restricted to just those things among which an agent chooses.
• In the example, Ellen’s preferences for putting the pizza in the oven and turning its knobs are
revealed preferences.
• If economists never needed to refer to people’s evaluative attitudes over things other than
those among which they are directly choosing, then the theory of revealed preference would
be a convenient simplification.
• In everyday consumer choice – the realm in which the theory of revealed preference is most
often used – this condition is sometimes reasonably well met.
• But economists need to be able to predict how people’s choices will change when they
acquire new information, and in order to do this they need a more general and less
behavioristic notion of preference.
• Therefore, preferences are studied separately.
Rational Choice Revealed Preference

Preferences Belief Choice

Preference, belief, choice
• Keeping them distinct is useful-
• (1) For clarity about what preference and choice mean.
• (2) To permit preferences to explain choices and to show how choices
depend on beliefs.
• (3) To leave space for the possibility that agents may choose actions
that do not maximally satisfy preferences.
Introducing the case of consumer
rationality
A textbook version of consumer behaviour
• Consumer preferences
• Budget constraint
• Consumer choice

• In the textbook version of micro-economics, consumer chooses what

combination of good A and good B should be consumed given her
budget constraint and her preferences.
Market basket: A combination of two or more goods.

Market Basket Pizza Bite Diet Coke Can

A 1 14
B 2 9
C 3 6
D 4 4
E 5 2.5
F 1 16
G 2 12
H 2 14
I 5 20
Consumer Preferences
 MB PB DC
• Systematic representation of a particular consumer C
preferences would require ranking of such market
basket.
• Now consider market baskets- B,G,H A 1 14
• How do we rank these market baskets? B 2 9
• Ask the consumer
C 3 6
• Rank ourselves on the basis of stylised assumptions.
• What do you think? D 4 4
• (2, 14) ⧽ (2, 12) ⧽ (2,9) E 5 2.5
• H⧽G ⧽B F 1 16
G 2 12
• This is essentially because, apart from transitivity and completeness, we also
H 2 14
assume that consumer preferences are monotonous.
I 5 20
• Also, known “as more is better” assumption!
 MB PB DC
C

• But what about other market baskets. How do we rank them?A 1 14

• I is easy. Because of monotonicity- B 2 9
• I⧽H⧽G ⧽B C 3 6
• But what about- A, C, D, E and F? How do we compare it with D 4 4
respect to each other and with respect to I, H, G, B?
E 5 2.5
F 1 16
G 2 12
H 2 14
I 5 20
 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1
units of can
Graphical
representation
of preferences

A
(8,5)

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17
Units of pizza bite
Indifference curve (IC)
• An indifference curve is a curve that shows consumption bundles that
give the consumer the same level of satisfaction.
• Why indifference curves are downward sloping?
• Why indifference curves are convex to the origin?
• In other words, why the free hand curve which we draw across all the
market baskets amongst which the consumer is indifferent, is convex
shaped, downward sloping curve?
• Why downward sloping? Had it been upward sloping then…
• Why convex?
Why ICs are downward sloping?
Clothing

U1
40

30

20
A
B

0 20 40 80 Food
Why indifference curves are convex to the
origin? Clothing
U1
40

30
Concave
curve
20

Convex
curve

U1
0 20 40 80 Food
Slope of a line: A Deour
• The main characteristic which distinguishes one line from another is
its steepness or the slope of the line.
• Easiest measure is to start from any point on the line and move along
so that the x coordinate increases by 1 unit.
• The corresponding change in the y coordinate is the slope.

o Differences between y = x; y = 2x; y = 2x + 1

o Let slope = m, y-intercept = (0,c) and an arbitrary point on the line =
(x,y). What is the equation of this line?
 Positive & decreasing Negative & increasing Positive then negative

Negative & decreasing Positive & increasing Negative then positive

Changing slopes along curves

 Indifference Curve Convex to the Origin
• The MRS from bundle a to bundle
Pepsi b is -3.
From bundle a to bundle b,
Lisa is willing to give up 3 • This is the same as the slope
units of Pepsi in exchange of the indifference curve
a for 1 more Pizza… between those two points.
8
From bundle b to bundle c,
–3 Lisa is willing to give up 2 • From b to c,
units of Pepsi in exchange
• MRS = -2.
b for 1 more Pizza…
5 • This is the same as the slope
1
of the indifference curve
-2 From bundle c to bundle
between those two points.
c d, Lisa is willing to give
3 up 1 Pepsi in exchange
1
-1 d for 1 more Pizza…
2 • From c to d,
1
I • MRS = -1.
Pizzas • This is the same as the slope
0 3 4 5 6
of the indifference curve
between those two points.

The slope of the indifference curve is called the marginal rate of substitution (MRS).
marginal rate of substitution: how much of one good the consumer is willing to give up to get more of another
Why diminishing marginal rate of
substitution?
• Diminishing marginal utility
Clothing

• To describe preferences for all

combinations of goods, we have a
D set of indifference curves – an
B A indifference map.
U3
• Each IC in the map shows the
market baskets among which the
U2 person is indifferent.

U1

Food

Indifference Map
Budget Constraint
• 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 shows the various combinations of goods the

consumer can afford given his or her income and the prices of the two
goods.
THE BUDGET CONSTRAINT:
WHAT THE CONSUMER CAN
AFFORD
Budget Constraints
The Budget Line

• Indicates all combinations of two commodities for which total money spent
equals total income.
• We assume only 2 goods are consumed, so we do not consider savings.
The Consumer’s Budget Constraint
THE BUDGET CONSTRAINT:
WHAT THE CONSUMER CAN AFFORD
• Let’s draw a consumer’s budget constraint on a graph.

• Any point on the budget constraint line indicates the consumer’s combination
or trade-off 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).
FigureQuantity
1 TheofConsumer’s
Pepsi
Budget Constraint

B
500

Consumer’s
budget constraint

A
0 Quantity of Pizza
100

The Consumer’s Budget Constraint

Quantity of Pepsi

B
500

Alternately, the
consumer can
buy 50 pizzas and
250 pints of Pepsi
C in the same
250
budget. (point C)
Consumer’s
budget constraint

A
0 Quantity of Pizza
50 100

The Consumer’s Budget Constraint

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.

• Therefore, it measures the rate at which the consumer can trade one
good for the other.

• Let’s take another example. Let this consumer use her income on two
goods - food and clothing.
The Budget Line
• Let F equal the amount of food purchased, and C is the amount of
clothing.
• Income I is allocated to F and/or C.
• Let price of food = PF and price of clothing = PC
• Then PFF is the amount of money spent on food, and PCC is the
PF F  P C  I
amount of money spent on clothing.
C

• The budget line in this case is (algebraically) written as:

• Different choices of food and clothing can be
calculated that use all income.
• These choices when graphed give us the budget line.
• Example: Assume income of $80/week, PF = $1; PC =
$2

Market Basket, Food (F) Clothing (C) Income (I)

(F,C) PF = $1 PC = $2 I = PFF + PCC
A 0 40 $80
B 20 30 $80
D 40 20 $80
E 60 10 $80
G 80 0 $80

Lets see how this looks on a graph…

The Budget Line: Choices

 Clothing
A
(I/PC) = 40 C 1 PF
Slope   -  -
B F 2 PC
30
10
D
20
20
E
10
G
Food
0 20 40 60 80 = (I/PF)

The Budget Line: Graphical

• As consumption moves along a budget line from
the intercept, the consumer spends less on one
item and more on the other.
• The slope of the line measures the relative cost
of food and clothing.
• The slope is the negative of the ratio of the prices
of the two goods.
• The slope indicates the rate at which the two
goods can be substituted without changing the
amount of money spent.
The Budget Line: Interpretation
• The vertical intercept, I/PC, illustrates the maximum
amount of C that can be purchased with income I.
• The horizontal intercept, I/PF, illustrates the
maximum amount of F that can be purchased with
income I.

• What happens when income and/or prices change?

• As incomes and prices change, there are changes in
budget lines.
Let’s see how these changes affects the budget line.

The Budget Line: Constraints

• The Effects of Changes in Income

• An increase in income causes the budget line to shift

outward, parallel to the original line (holding prices
constant).
 Consumer can buy more of both goods with more income.

• A decrease in income causes the budget line to shift

inward, parallel to the original line (holding prices
constant).
 Consumer can buy less of both goods with less income.

The Budget Line : Income

 Clothing
(units
per week)
80
An increase in
income shifts
60 the budget line
outward

40
A decrease in
income shifts
20 L3
the budget line L1 L2
inward Food
(I = $40) (I = $80) (I = $160)
(units per week)
0 40 80 120 160

The Budget Line: Shifts

• The Effects of Changes in Prices

• If the two goods increase in price, but the ratio of the

two prices is unchanged, the slope will not change.
• However, the budget line will shift inward parallel to
the original budget line.
• If the two goods decrease in price, but the ratio of the
two prices is unchanged, the slope will not change.
• However, the budget line will shift outward parallel
to the original budget line.

The Budget Line - Changes

 Clothing
(units
per week)

A decrease in the
price of food to
$.50 changes
the slope of the
40 budget line and
An increase in the L2 rotates it outward.
price of food to
$2.00 changes L1
the slope of the L3
budget line and
rotates it inward.
(PF = 1) (PF = 1/2)
(PF = 2) Food
40 80 120 160 (units per week)

The Budget Line - Shifts

• The Effects of Changes in Prices

• If the price of one good increases, the budget line shifts inward,
pivoting from the other good’s intercept.
• If the price of food increases and you buy only food (x-intercept),
then you can’t buy as much food. The x-intercept shifts in.
• If you buy only clothing (y-intercept), you can buy the same
amount. No change in y-intercept.
• If the price of one good decreases, the budget line shifts outward,
pivoting from the other good’s intercept.
• If the price of food decreases and you buy only food (x-intercept),
then you can buy more food. The x-intercept shifts out.
• If you buy only clothing (y-intercept), you can buy the same
amount. No change in y-intercept.

The Budget Line – Prices

The Consumer’s Optimal Choices
• 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.
Consumer Choice
• Graphically, we can see different indifference curves of a consumer
choosing between clothing and food.
• Remember that U3 > U2 > U1 for our indifference curves.
• Consumer wants to choose highest utility within their budget.
Clothing
•A, B, C on budget line
•D highest utility but not
40
affordable
A •C highest affordable utility
•Consumer chooses C
30 D

20 C

U3
U2
U1
B
0 20 40 80 Food (units per week)

Consumer Choice
Consumer Choice
• Consumer will choose highest IC on budget line.
• In previous graph, point C is where the indifference curve is just
tangent to the budget line.
• Slope of the budget line equals the slope of the indifference curve at
this point.
• The consumer chooses consumption of the two goods so that the
marginal rate of substitution equals the relative price. Why?
• Because at the consumer’s optimum, the consumer’s valuation of the
two goods equals the market’s valuation.
Consumer Choice
C
MRS  
F
• Recall, the slope of an indifference curve is:
PF
Slope  
PC
• Further, the slope of the budget line is:
PF
MRS 
• Therefore, it can be said at consumer’s PC
optimal consumption point:
 Clothing
Point B does not
maximize satisfaction
40 because the
MRS = -10/10 = 1
is greater than the
B
30 price ratio = 1/2

-10C
20
Consumer Choice
+10F U1
0 20 40 80 Food
Consumer Choice
• It can be said that satisfaction is maximized when marginal rate of
substitution (of F and C) is equal to the ratio of the prices (of F and
C).
• Note this is ONLY true at the optimal consumption point.
• If MRS ≠ PF/PC then individuals can reallocate basket to increase
utility
• If MRS > PF/PC
• Will increase food and decrease clothing until MRS = PF/PC
• If MRS < PF/PC
• Will increase clothing and decrease food until MRS = PF/PC
How Changes in Income Affect the Consumer’s 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.
 Quantity
of Clothing
New budget constraint

1. An increase in income shifts the

budget constraint outward . . .

New optimum

3. . . . and
Clothing
consumption. Initial
optimum I2

Initial
budget
I1
constraint

0 Quantity
of Food
An Increase in Income
2. . . . raising Food consumption . . .
How Changes in Income Affect the Consumer’s Choices

• 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.
 Quantity
of Clothing New budget constraint

1. When an increase in income shifts the

3. . . . but budget constraint outward . . .
Initial
Clothing
optimum
consumption
falls, making
New optimum
Clothing an
inferior good.

Initial
budget I1 I2
constraint
0 Quantity
of Food
2. . . . Food consumption rises, making Food a normal good . . .
An Inferior Good
How Changes in Prices Affect Consumer’s Choices

• A fall in the price of any good…

… rotates the budget constraint outward and changes the slope of the
budget constraint.
 Quantity
of Clothing

New budget constraint

1,000 D

New optimum
B 1. A fall in the price of Clothing rotates
500
the budget constraint outward . . .
3. . . . and
raising Clothing Initial optimum
consumption.
Initial I2
budget I1
constraint A
0 100 Quantity
A Change in Price
2. . . . reducing Food consumption . . .
of Food
Deriving the Demand Curve

• A consumer’s demand curve can be viewed as a summary of the

optimal decisions that arise from his or her budget constraint and
indifference curves.
 (a) The Consumer
’ s Optimum (b) The Demand Curve for Pepsi
Quantity Price of
of Clothing Clothing

New budget constraint

B A
750 $2

I2
B
1
A
250 Demand
I1

0 Initial budget Quantity 0 250 750 Quantity

constraint of Food of Clothing

Deriving the demand curve