1. CONSUMER THEORY

2. Consumer Choice
• Consumers decide on what to consume and
how much
• This decision can be translated into the
demand of a product
• How do consumers allocate income to the
purchase of different goods?

3. Consumer Theory
Theory of consumer behavior
The explanation of how consumers allocate income
to the purchase of different goods and services

4. Aspects of Consumer Choice
• Consumer Preferences: To describe how and why
people prefer one good to another(Unlimited Wants)
• Budget Constraints : Representation of Resource
constraints (Limited Resources)
• Consumer Choice : What combination of goods will
consumers buy to maximize their satisfaction?
Maximizing Preferences subject to Budget Constraint.
• Consumer Choice is Individual demand at that price

5. CONSUMER PREFERENCES

6. Consumption
• What does a typical purchase at a grocery
store look like?
• One purchases many goods.
• How to rank preferences over different groups
/bundles of products.

7. Bundles
• Bundle/ Market Basket : Group of items and
their quantity
• Bundle may be different food products. Meat
and Vegetables
• Individuals can choose between market
baskets containing different goods
• Measure each good in terms of the units of
commodity

8. Commodity Space
Y (units) B
10
3 A
2 10 X (Units)

9. Consumer Preferences
• What can you say about your preference for
the two bundles?
• Can you make a generic assumption about the
preferences of consumers?

10. Assumptions
• Completeness: Any consumer can compare
and rank any two given bundles
• More is Better: More of any good is always
better than less.
• Transitivity: If a consumer prefer bundle A
over B, Bundle B over C. Then it must prefer
bundle A over C.

11. Indifference Curve
A curve that represents all bundles that give the
individual the same level of satisfaction.
Given our assumptions of preferences, how
does the indifference curve look like?

12. Indifference Curves:
An Example
Market Basket Units of Food Units of Clothing
A 20 30
B 10 50
D 40 20
E 30 40
G 10 20
H 10 40
12

13. Indifference Curves:
An Example
Clothin 50 B
The consumer prefers
A to all combinations
g in the yellow box, while
40 all those in the pink
H E box are preferred to A.
30 A
20 D
G
10
Food
10 20 30 40
13 .

14. Indifference Curves:
An Example
• Points such as B & D have more of one good
but less of another compared to A
– Need more information about consumer ranking
• Consumer may decide they are indifferent
between B, A and D
– We can then connect those points with an
indifference curve
14

15. Indifference Curves:
An Example
•Indifferent
50 B between points
Clothin B, A, & D
g H •E is preferred
40 E to points on U1
•Points on U1
A are preferred to
30
H&G
D
20
G U1
10
Food
10 20 30 40
15

16. Indifference Curves
• Any market basket lying northeast of an
indifference curve is preferred to any market
basket that lies on the indifference curve
• Points on the curve are preferred to points
southwest of the curve
16

17. Properties of ICs
1. Slope downward to the right
– If they sloped upward, they would violate the
assumption that more is preferred to less
• Some points that had more of both goods would be
indifferent to a basket with less of both goods
17

18. Indifference Maps
• An indifference curve only represents limited
preferences
• It represents bundles that give same utility for
“some” bundles.
• How to represent preferences over other
bundles.

19. Indifference Maps
• To describe preferences for all combinations
of goods/services, we have a set of
indifference curves – an indifference map
• Each indifference curve in the map shows the
market baskets among which the person is
indifferent
• An indifference Map will have thousand of such
curves. Representing an indifference curve for
each point
19

20. Indifference Map
Clothing
Market basket A
is preferred to B.
Market basket B is
D preferred to D.
B A
U3
U2
U1
Food
20

21. Properties of Indifference Curve
1. Downward Sloping: More is better
2. Never Crosses:

22. Indifference Maps
U1
U •B is preferred to D
Clothing
2 •A is indifferent to B & D
•B must be indifferent to
D but that can’t be if B is
preferred to D
A
B
U2
D
U1
Food
22

23. Indifference Curve
• How does the indifference curve of two goods
that are perfect substitute look like?
• How does the indifference curve of two goods
that are perfect compliment look like?

24. Perfect Substitutes
Y (units)
IC3
IC2
A
IC1
B
X (Units)

25. Perfect Compliments
Y (units)
IC2
IC1
A
X (Units)

26. Consumer Preferences
• The theory of consumer behavior does not
require assigning a numerical value to the
level of satisfaction
• Although ranking of market baskets is good,
sometimes numerical value is useful
26

27. Utility
– A numerical score representing the satisfaction
that a consumer gets from a given market basket
– If buying 3 copies of Microeconomics makes you
happier than buying one shirt, then we say that
the books give you more utility than the shirt
27

28. Utility Function
– Formula that assigns a level of utility to individual
market baskets
– If the utility function is
U(F,C) = F + 2C
A market basket with 8 units of food and 3 units of
clothing gives a utility of
18 = 8 + 2(5)
28

29. Utility - Example
Market Food Clothing Utility
Basket
A 8 5 8 + 2(5) = 18
B 6 4 6 + 2(4) = 14
C 4 3 4 + 2(3) = 10
Chapter 3

30. Utility
• Although we numerically rank baskets ,
numbers are ONLY for ranking
• There are two types of rankings
– Ordinal ranking
– Cardinal ranking
30

31. 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
31

32. Utility
• The actual unit of measurement for utility is
not important
• An ordinal ranking is sufficient to explain how
most individual decisions are made
32

33. 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
33

34. Utility -Example
• Can you find out points on the indifference
curve which represents utility function, U=FC
and gives utility 25?

35. Utility - Example
Clothing Basket U = FC
C 25 = 2.5(10)
15 A 25 = 5(5)
B 25 = 10(2.5)
C
10
A U3 = 100
5
B U2 = 50
U1 = 25
Food
0 5 10 15
35

36. Marginal Utility
• Volunteer who is hungry
• Rate your level of satisfaction for
every unit of candy that you consume
• How does your happiness level change with
every unit of candy?
• How does your change in happiness change
with every unit of candy?

37. Marginal Utility
Units Total Utility Change in Utility

38. Marginal Utility
• Marginal Utility : Change in total happiness or
utility with a unit change in consumption
• Marginal Utility is for one good, keeping all
other things constant
• What can you say about the sign of MU with
an increase in consumption?

39. Marginal Utility
• As consumption increases, Total Utility always
increases, from our assumption More is
Better.
• Thus, MUX >0

40. Law of Diminishing Marginal Utility
Law of Diminishing Marginal Utility : With an
increase in consumption of a good, Marginal
Utility from consuming one more unit of that
product, decreases.
• An assumption on preferences of consumers.
• Which goods do not follow Law of DMU?

41. Indifference Curves
A
Clothing 16
14 Observation: The amount
-6 of clothing given up for
12 1 unit of food decreases
from 6 to 1
10 B
1
8 -4
D
6 1
-2 E
4 G
1 -1
1
2
Food
1 2 3 4 5
41

42. Indifference Curves
• The shapes of indifference curves describe
how a consumer is willing to substitute one
good for another
– A to B, give up 6 clothing to get 1 food
– D to E, give up 2 clothing to get 1 food
• The more clothing and less food a person
has, the more clothing they will give up to get
more food
42

43. Indifference Curves
• Marginal rate of substitution (MRS):
– It quantifies the amount of one good a consumer
will give up to obtain more of another good
– It is measured by the slope of the indifference
curve
43

44. Marginal Rate of Substitution
Clothing 16 A
MRS = 6 MRS C
14 F
12
-6
10 B
1
8 -4 MRS = 2
D
6
1
-2 E
4 G
1 -1
2 1
Food
1 2 3 4 5
44

45. Indifference Curve
• How does utility change when you move along
the IC?
U ( X ,Y )
• When one moves along the IC curve:
U 0
MU X X MUY Y 0
Y MU X
( )
X MUY

46. Indifference Curves
Marginal rate of substitution (MRS):
Y MU X
( ) MRS XY
X MU Y
46

47. Marginal Rate of Substitution
Clothing 16 A
MRS = 6 MRS C
14 F
12
-6
10 B
1
8 -4 MRS = 2
D
6
1
-2 E
4 G
1 -1
2 1
Food
1 2 3 4 5
47

48. Marginal Rate of Substitution
• Compare the MRS at point B and D
B
Y MU B X B
( ) B
MRS XY
X MU Y
D
Y MU D X
( ) D
MRS D XY
X MU Y

49. Marginal Rate of Substitution
MU B X MU D X
B D
MU Y MU Y
B D
MRS XY MRS XY

50. Properties of Indifference Curve
1. Downward Sloping: More is better
2. Never Crosses:
3. Indifference Curves are Convex
As more of one good is consumed, a consumer would
prefer to give up fewer units of a second good to
get additional units of the first one

51. Law of Diminishing Marginal Rate of
Substitution
• The MRS decreases as we move down the
indifference curve
– Along an indifference curve there is a diminishing
marginal rate of substitution.
– The MRS went from 6 to 4 to 1
51

52. Polar Cases
• Indifference curves with different shapes
imply a different willingness to substitute
• Two polar cases are of interest
– Perfect substitutes
– Perfect complements
52

53. Consumer Preferences
Apple
4
Juice
(glasses)
Perfect
3 Substitutes
2
1
Orange Juice
0 1 2 3 4 (glasses)
53

54. Marginal Rate of Substitution
• Perfect Substitutes
– Two goods are perfect substitutes when the
marginal rate of substitution of one good for the
other is constant
– Example: a person might consider apple juice and
orange juice perfect substitutes
• They would always trade 1 glass of OJ for 1 glass of
Apple Juice
54

55. Consumer Preferences
Left
Shoes Perfect
4 Complements
3
2
1
0 1 2 3 4 Right Shoes
55

56. Consumer Preferences
• Perfect Complements
– Two goods are perfect complements when the
indifference curves for the goods are shaped as
right angles
– Example: If you have 1 left shoe and 1 right shoe,
you are indifferent between having more left
shoes only
• Must have one right for one left
56

57. Bads
• We have assumed all our commodities are
“goods”
• There are commodities we don’t want more of
- bads
– Things for which less is preferred to more
• Examples
– Air pollution
– Asbestos
57

58. BUDGET CONSTRAINT

59. Budget Constraints
• Preferences do not explain all of consumer
behavior
• Budget constraints also limit an individual’s
ability to consume in light of the prices they
must pay for various goods and services
59

60. 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
60

61. 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
61

62. 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)
62

63. The Budget Line
• Different choices of food and clothing can be
calculated that use all income
– These choices can be graphed as the budget line
• Example:
– Assume income of $80/week, PF = $1 and PC = $2
63

64. Budget Constraints
Market Food Clothing Income
Basket 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
Chapter 3

65. The Budget Line
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)
65

66. The Budget Line
• 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
66

67. The Budget Line
• What does the Y axis of the budget line
represent?
• What does the X axis of the budget line
represent?

68. Budget Constraints
• The Budget Line
– 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
68

69. The Budget Line
• As we know, income and prices can change
• As incomes and prices change, there are
changes in budget lines
• How does budget line change with a change in
Income?
69

70. The Budget Line - Changes
Clothing
(units
per week) An increase in
income shifts
80
the budget line
outward
60
A decrease in
40 income shifts
the budget line
inward
20 L3
(I = L1 L2
$40) (I = $80) (I = $160)
Food
0 40 80 120 160 (units per week)
70

71. The Budget Line - Changes
• 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).
– Can buy more of both goods with more income
71

72. The Budget Line - Changes
• The Effects of Changes in Income
– A decrease in income causes the budget line to
shift inward, parallel to the original line (holding
prices constant)
– Can buy less of both goods with less income
72

73. The Budget Line
• As we know, income and prices can change
• As incomes and prices change, there are
changes in budget lines
• How does budget line change with a change in
Price?
73

74. The Budget Line - Changes
• 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.
74

75. The Budget Line - Changes
• The Effects of Changes in Prices
– 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.
75

76. The Budget Line - Changes
Clothing
(units
A decrease in the
per week)
price of food to
Rs.50 changes
the slope of the
budget line and
rotates it outward.
An increase in the
40 price of food to
Rs2.00 changes
the slope of the
budget line and
rotates it inward.
L3 L1 L2
(PF = 1) (PF = 1/2)
(PF = 2) Food
40 80 120 160 (units per week)
76

77. The Budget Line - Changes
• 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
77

78. The Budget Line - Changes
• The Effects of Changes in Prices
– 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
78