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 0 1 2 3 4 5 6 7 8 9 10 ($) TU 0 40 85 120 140 150 157 160 160 155 145 ($) MU 40 45 35 20 10 7 3 0 -5 -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
200 150 100 50 0 1 2 3 4 5 6 7 8 9 10 11
50 40 30 20 10 0 1 -10 -20 2 3 4

($) M U

11

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 GOODS 1 2 3

MUX

MUY

MUZ

12 11 10

60 55 48

70 60 50

4
5 6 7 8 9 10

9
8 7 6 5 4 3

40
32 24 21 18 15 12

40
30 25 18 10 3 1

Consumer- Preferences:
A consumers 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 C

I2
A 0 Indifference curve, I1 Quantity of x

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
It

slope at any point on an indifference curve is the marginal rate of substitution.

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 Consumers Preferences...

Quantity of y C

B
MRS

D 1 A

I2
Indifference curve, I1 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 C

A
B

Quantity of x

Property 4: Indifference curves are convex to origin.

Quantity of y 14

MRS = 6
8 1 A

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.

4 3 0 2 3

MRS = 1

1
6

Indifference curve 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

3 2

I1

I2
2

I3
3 aquafina

Perfect Complements
Left Shoes

7 5

I2 I1

Right Shoes

The Consumers 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 Consumers Budget Constraint...

Quantity of y 500

250

Consumers budget constraint

A 100

50

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

The Consumers Optimum...

Quantity of y

Optimum: tangency between I and budget line A

I3

I1
Budget constraint 0

I2

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 Consumers 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
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 constraint 0

I1
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 Substitution effect B Initial optimum

Initial budget constraint 0

I2 I1
Quantity of x

Substitution effect Income effect

Deriving the Demand Curve...

(a) The Consumers Optimum Quantity of y
New budget constraint

(b) The Demand Curve for y Price of y

150

$2

I2
1 50 0
Initial budget constraint

I1
Quantity of x 0 50 150 Quantity of y

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 Potatoes B

A Giffen Good...
Initial budget constraint

2...which D increases potato consumption if potatoes are a Giffen good. 0

Optimum with high price of potatoes Optimum with low price of potatoes C 1. An increase in the price of potatoes rotates the budget...

New budget constraint

A

I2

I1
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 2,000

I3
I2 I1

60

100

Hours of Leisure

An Increase in the Wage...

(a) For a person with these preferences income . . . the labor supply curve slopes upward.

Wage

1. When the wage rises

I2 BC1 BC2 I1
Hours of Leisure 2. hours of leisure decrease 0

Hours of Labor Supplied 3. ...and hours of labor increase.

An Increase in the Wage...

(b) For a person with these preferences . . . the labor supply curve slopes backward.

BC2

Wage

1. When the wage rises

BC1 I1
0

I2

Hours of Leisure 2. hours of leisure increase

Hours of Labor Supplied 3. ...and hours of labor decrease.

Summary
A consumers 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 consumers 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 consumers 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 consumers 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.