The Consumer The Consumer Theory Theory

How Consumers Make How Consumers Make Choices under Income Choices under Income

Constraints Constraints

Some Questions Some Questions

What is behind a consumer’s What is behind a consumer’s demand curve? demand curve?

How do consumers choose from How do consumers choose from among various consumer “goods”? among various consumer “goods”?

What determines the value of a What determines the value of a consumer good? consumer good?

PreferencesPreferences

Behavioral Assumption: Each person Behavioral Assumption: Each person has his/her own preferences over has his/her own preferences over bundles.bundles.

A person can rank two bundles A and B. A person can rank two bundles A and B. EitherEither A is preferred to BA is preferred to B B is preferred to AB is preferred to A A is indifferent to BA is indifferent to B

One person may prefer A to B whilst One person may prefer A to B whilst another prefers B to A. another prefers B to A.

PropertiesProperties

The preferences are assumed to have The preferences are assumed to have the following reasonable properties: the following reasonable properties: I. More is better. If bundle A has strictly I. More is better. If bundle A has strictly

more of one good and does not have less of more of one good and does not have less of any good than bundle B, then all consumers any good than bundle B, then all consumers prefer A to B.prefer A to B.

II. Transitivity. A better than B better II. Transitivity. A better than B better than C means A better than C.than C means A better than C.

III. A preferred to B means B is not III. A preferred to B means B is not preferred to A.preferred to A.

More is BetterMore is Better

Bread

Wine

Point, A, in Bread-Wine space is a bundle

A

These points havemore bread or wine

or both.Every consumer prefers

them to A

Worse thanA

for all. ?

?

Indifference curves. Indifference curves.

Two bundles are indifferent (for a Two bundles are indifferent (for a particular consumer) if the consumer is particular consumer) if the consumer is equally happy with either bundle. equally happy with either bundle. (If one added the teeniest bit of any good to (If one added the teeniest bit of any good to

one of the bundles, then the consumer would one of the bundles, then the consumer would prefer it.) prefer it.)

Let A be a bundle. There is an Let A be a bundle. There is an indifference curve through A.indifference curve through A.

The indifference curve through A is the The indifference curve through A is the set of all bundles that makes the set of all bundles that makes the consumer just as happy as bundle A. consumer just as happy as bundle A.

Properties. Properties.

Indifference curves slope down. Indifference curves slope down. They do not cross. They do not cross. Higher indifference curves are better. Higher indifference curves are better. For reasons that I don't care to discuss, For reasons that I don't care to discuss,

I always draw them so that they look I always draw them so that they look like a crescent moon.like a crescent moon.

A DemonstrationA Demonstration

B

W

ab

c

Every point on the higher indifference curve is better because b is preferred to a by more is better, c is indifferentto b because they are on the same indifference curve and therefore c is preferred to a.

Indiff. Curves Don’t Indiff. Curves Don’t CrossCross

B

W

a

bc

Use more is betterand transitivity to construct the proof

Which Bundle?Which Bundle?

B

W

cd

e

f

Of the bundles a consumer canafford, the consumer choosesthe one the consumer likes most.

Remember: Higherindifference curve, likemore.

Inferior and NormalInferior and Normal

When income increases the quantity When income increases the quantity purchased of a normal good also purchased of a normal good also increases.increases.

When income increases, the quantity When income increases, the quantity purchased of an inferior good decreasespurchased of an inferior good decreases

B

W

Utility Utility The value a consumer places on a unit of a The value a consumer places on a unit of a

good or service depends on the pleasure or good or service depends on the pleasure or satisfaction he or she expects to derive form satisfaction he or she expects to derive form having or consuming it at the point of having or consuming it at the point of making a consumption (consumer) choice. making a consumption (consumer) choice.

In economics the satisfaction or pleasure In economics the satisfaction or pleasure consumers derive from the consumption of consumers derive from the consumption of consumer goods is called “utility”. consumer goods is called “utility”.

Consumers, however, cannot have every thing Consumers, however, cannot have every thing they wish to have. Consumers’ choices are they wish to have. Consumers’ choices are constrained by their incomes.constrained by their incomes.

Within the limits of their incomes, Within the limits of their incomes, consumers make their consumption choices consumers make their consumption choices by evaluating and comparing consumer by evaluating and comparing consumer goods with regard to their “utilities.” goods with regard to their “utilities.”

Our basic assumptions Our basic assumptions about a “rational” about a “rational” consumer:consumer: Consumers are utility maximizersConsumers are utility maximizers

Consumers prefer more of a good (thing) to less Consumers prefer more of a good (thing) to less of it. of it.

Facing choices X and Y, a consumer would either Facing choices X and Y, a consumer would either prefer X to Y or Y to X, or would be indifferent prefer X to Y or Y to X, or would be indifferent between them. between them.

Transitivity: If a consumer prefers X to Y and Y to Transitivity: If a consumer prefers X to Y and Y to Z, we conclude he/she prefers X to ZZ, we conclude he/she prefers X to Z

Diminishing marginal utility: As more and more Diminishing marginal utility: As more and more of good is consumed by a consumer, ceteris of good is consumed by a consumer, ceteris paribus, beyond a certain point the utility of each paribus, beyond a certain point the utility of each additional unit starts to fall.additional unit starts to fall.

How to Measure Utility How to Measure Utility

Measuring utility in “utils” (Cardinal): Measuring utility in “utils” (Cardinal): Jack derives 10 utils from having one slice of pizza but only 5 Jack derives 10 utils from having one slice of pizza but only 5

utils from having a burger. utils from having a burger.

In many introductory microeconomics textbooks this approach In many introductory microeconomics textbooks this approach to measuring utility is still considered effective for teaching to measuring utility is still considered effective for teaching purposes. purposes.

Measuring utility by comparison (Ordinal): Measuring utility by comparison (Ordinal): Jill prefers a burger to a slice of pizza and a slice of pizza to a Jill prefers a burger to a slice of pizza and a slice of pizza to a

hotdog. hotdog. Often consumers are able to be more precise in expressing their Often consumers are able to be more precise in expressing their

preferences.preferences.For example, we could say: For example, we could say: Jill is willing to trade a burger for four hotdogs but she will Jill is willing to trade a burger for four hotdogs but she will

give up only two hotdogs for a slice of pizza. give up only two hotdogs for a slice of pizza. We can infer that to Jill, a burger has twice as much utility as We can infer that to Jill, a burger has twice as much utility as

a slice of pizza, and a slice of pizza has twice as much utility as a slice of pizza, and a slice of pizza has twice as much utility as a hotdog. a hotdog.

Utility and Money Utility and Money Because we use money (rather than hotdogs!) in just Because we use money (rather than hotdogs!) in just

about all of our trade transactions, we might as well use about all of our trade transactions, we might as well use it as our comparative measure of utility. it as our comparative measure of utility.

(Note: This way of measuring utility is not much different(Note: This way of measuring utility is not much different

from measuring utility in utils) from measuring utility in utils) Jill could say: I am willing to pay $4 for a burger, $2 for Jill could say: I am willing to pay $4 for a burger, $2 for

a slice of pizza and $1 for a hotdog. a slice of pizza and $1 for a hotdog.

Note: Even though Jill obviously values a burger more Note: Even though Jill obviously values a burger more (four(four

times as much) than a hot dog, she may still choose to times as much) than a hot dog, she may still choose to buy abuy a

hotdog, even if she has enough money to buy a burger, or hotdog, even if she has enough money to buy a burger, or a a

slice of pizza, for that matter. (We will see why and how slice of pizza, for that matter. (We will see why and how shortly.) shortly.)

Total Utility versus Total Utility versus Marginal Utility Marginal Utility

Marginal utility is the utility a consumer Marginal utility is the utility a consumer derives from the last unit of a consumer derives from the last unit of a consumer good she or he consumes (during a good she or he consumes (during a given consumption period), ceteris given consumption period), ceteris paribus. paribus.

Total utility is the total utility a Total utility is the total utility a consumer derives from the consumption consumer derives from the consumption of all of the units of a good or a of all of the units of a good or a combination of goods over a given combination of goods over a given consumption period, ceteris paribus. consumption period, ceteris paribus.

Total utility = Sum of marginal Total utility = Sum of marginal utilitiesutilities

The Law of Diminishing The Law of Diminishing Marginal Utility Marginal Utility

Over a given consumption period, the more of a Over a given consumption period, the more of a good a consumer has, or has consumed, the good a consumer has, or has consumed, the less marginal utility an additional unit less marginal utility an additional unit contributes to his or her overall satisfaction contributes to his or her overall satisfaction (total utility). (total utility).

Alternatively, we could say: over a given Alternatively, we could say: over a given consumption period, as more and more of a consumption period, as more and more of a good is consumed by a consumer, beyond a good is consumed by a consumer, beyond a certain point, the marginal utility of additional certain point, the marginal utility of additional units begins to fall. units begins to fall.

Total and Marginal Utility Total and Marginal Utility for Ice Cream for Ice Cream Q ($) TU ($) MU0 01 40 402 85 453 120 354 140 205 150 106 157 77 160 38 160 09 155 -510 145 -10

145

Total Utility

0

50

100

150

200

1 2 3 4 5 6 7 8 9 10 11

($) MU

-20

-10

0

10

20

30

40

50

1 2 3 4 5 6 7 8 9 1 11

Q ($) TU ($) MU0 01 40 402 85 453 120 354 140 205 150 106 157 77 160 38 160 09 155 -510 145 -10

145

How much ice cream does Jill How much ice cream does Jill

buy in a month?buy in a month? Some facts of life: Some facts of life: Limited incomeLimited income Opportunity cost of making a choice:Opportunity cost of making a choice:

Buying ice cream leaves Jill less money Buying ice cream leaves Jill less money to to

buy other things: each dollar spent on buy other things: each dollar spent on ice cream could be spent on hamburger. ice cream could be spent on hamburger.

In fact, consumers compare the In fact, consumers compare the (expected) utility derived from one (expected) utility derived from one additional dollar spent on one good to additional dollar spent on one good to the utility derived from one additional the utility derived from one additional dollar spent on another good. dollar spent on another good.

More facts More facts The prices of hamburger and ice cream are The prices of hamburger and ice cream are

market-given; the consumer cannot change market-given; the consumer cannot change the price of a good.the price of a good.

Jill, like any other rational consumer, wishes Jill, like any other rational consumer, wishes to maximize her utility. to maximize her utility.

The opportunity cost of one dollar spent on The opportunity cost of one dollar spent on ice cream is the forgone utility of one dollar ice cream is the forgone utility of one dollar that could be on hamburger.that could be on hamburger.

If the utility of one additional dollar of ice If the utility of one additional dollar of ice cream is greater than the utility of the last cream is greater than the utility of the last dollar spent on hamburger, Jill can increase dollar spent on hamburger, Jill can increase her total utility by spending one dollar less her total utility by spending one dollar less on hamburger and one dollar more one ice on hamburger and one dollar more one ice cream. cream.

Hamburger or Hotdog Hamburger or Hotdog If based on their perceived marginal If based on their perceived marginal

utilities Jill values a hamburger four utilities Jill values a hamburger four times as much as a hotdog, but the times as much as a hotdog, but the market price of a burger is eight market price of a burger is eight times the price of a hotdog, she will times the price of a hotdog, she will buy a hotdog. That is because one buy a hotdog. That is because one dollar’s worth of hotdogs would dollar’s worth of hotdogs would give her more utility that one give her more utility that one dollar’s worth of burgers. That is:dollar’s worth of burgers. That is:

MUMUDD/P/PDD > MU > MUHH/P/PH H

Utility Maximizing Utility Maximizing Rules Rules A rational consumer would buy an A rational consumer would buy an

additional unit of a good as long as the additional unit of a good as long as the perceived dollar value of the utility of perceived dollar value of the utility of one additional unit of that good (say, its one additional unit of that good (say, its marginal dollar utility) is greater than marginal dollar utility) is greater than its market price. its market price.

The Two-Good Rule The Two-Good Rule

MUMUI I MU MUHH

--------- = ---------- --------- = ----------

$P$PII $P $PHH

Utility Maximization Utility Maximization under An Income under An Income

constraint constraint Consumers’ spending on consumer goods is Consumers’ spending on consumer goods is constrained by their incomes:constrained by their incomes:

Income = Px Qx + Py Qy + Pw Ow + ….+Pz Qz Income = Px Qx + Py Qy + Pw Ow + ….+Pz Qz While the consumer tries to equalize MUx/Px , While the consumer tries to equalize MUx/Px ,

MUy/ Py, MUw/Pw,………. and MUz/Pz , to MUy/ Py, MUw/Pw,………. and MUz/Pz , to maximize her utility her total spending cannot maximize her utility her total spending cannot exceed her income. exceed her income.

For example, with an and income of $86 Jill is For example, with an and income of $86 Jill is trying to decide how much ice cream and how trying to decide how much ice cream and how much hamburger she should buy.much hamburger she should buy.

Jill’s income = 5x10 + 6 x 6 = 86Jill’s income = 5x10 + 6 x 6 = 86

Optimal Purchase Mix: Ice Cream and Optimal Purchase Mix: Ice Cream and

HamburgerHamburger Q MUI PI MUI/PI MUH PH MUH/PH1 40 10 4 45 6 7.52 45 10 4.5 30 6 53 35 10 3.5 20 6 3.34 20 10 2 15 6 2.55 10 10 1 10 6 1.76 7 10 0.7 6 6 17 3 10 0.3 3 6 0.58 0 10 0 0 6 0

The Budget Line The Budget Line Income = QI.PI + QH.PH = (5 x 10)+(6 x 6) = 86

Ice Cream

Hamburger

o

8.6

14.33

5

6

86/10

86/6

Slope = PH/PI = 6/10 = 8.6/14.33 = 0.6

An Optimal Change An Optimal Change Recall that to maximize utility a Recall that to maximize utility a

consumer would set:consumer would set:

(MUx/Px) = (MUy/Py)(MUx/Px) = (MUy/Py)

If Px increases this equality would be If Px increases this equality would be disturbed: (MUx/Px) < (MUy/Py)disturbed: (MUx/Px) < (MUy/Py)

To return to equality the consumer To return to equality the consumer must adjust his/her consumption. must adjust his/her consumption. (Have in mind that the consumer (Have in mind that the consumer cannot change prices, and he/she has cannot change prices, and he/she has an income constraint.)an income constraint.)

What are the consumer’s options? What are the consumer’s options?

(MUx/Px) < (MUy/Py)(MUx/Px) < (MUy/Py)

In order to make the two sides of the In order to make the two sides of the above inequality equal again, given above inequality equal again, given that Px and Py could not be changed, that Px and Py could not be changed, we would have to increase MUx and we would have to increase MUx and decrease MUy. Recalling the law of decrease MUy. Recalling the law of diminishing marginal utility, we can diminishing marginal utility, we can increase MUx by reducing X and increase MUx by reducing X and decrease MUy by increasing Y. decrease MUy by increasing Y.

Price and the Shape of Price and the Shape of the Demand Curve the Demand Curve

The two effects of a price change:The two effects of a price change:

Income effect:Income effect:Normal good (-)Normal good (-)Inferior goods (+)Inferior goods (+)

Substitution effect Substitution effect Buying less X and substituting it with Y until the Buying less X and substituting it with Y until the

optimizing condition is restored (-) optimizing condition is restored (-)

As Px increases, Qx decreases As Px increases, Qx decreases

Consumer Surplus Consumer Surplus

The difference between what a The difference between what a consumer is willing to pay for an consumer is willing to pay for an addition unit of a good and the addition unit of a good and the market price that he/she actually market price that he/she actually pays is referred to as “consumer pays is referred to as “consumer surplus”.surplus”.

The area between the demand curve The area between the demand curve and the price (line) measures the and the price (line) measures the total consumer surplus. total consumer surplus.

Consumer Surplus Consumer Surplus

Price

DQx

0

P

Consumer Surplus Consumer Surplus

Price

DQx

0

P

D’

P’

An Alternative Approach An Alternative Approach to the Consumer Theory to the Consumer Theory

Indifference curves Indifference curves

An indifference curve is a line drawn in a An indifference curve is a line drawn in a two-dimensional space showing different two-dimensional space showing different combinations of two goods from which the combinations of two goods from which the consumer draws the same amount of utility consumer draws the same amount of utility and therefore he/she is “indifferent” about.and therefore he/she is “indifferent” about.

Budget linesBudget lines

A budget line is a line drawn in a two-A budget line is a line drawn in a two-dimensional space representing a certain dimensional space representing a certain level of income with which the consumer can level of income with which the consumer can purchase various combinations of two goods purchase various combinations of two goods at given prices. at given prices.

Properties of Properties of Indifference curves Indifference curves

Indifference curves for two “goods” are Indifference curves for two “goods” are generally negatively slopedgenerally negatively sloped

The slope of an indifference curve reflects the The slope of an indifference curve reflects the degree of substitutability of two goods for one degree of substitutability of two goods for one anotheranother

Indifference curves are generally convex, Indifference curves are generally convex, reflecting the principle of diminishing returnsreflecting the principle of diminishing returns

Indifference curves never crossIndifference curves never cross Indifference curves that are farther from the Indifference curves that are farther from the

origin represent higher levels of utilityorigin represent higher levels of utility Indifference curves for a “good” and a “bad” Indifference curves for a “good” and a “bad”

are positively slopedare positively sloped

Indifference CurvesIndifference Curves

X

Y

U1U2

U3

U4

O

Slope = Change in Y/Change in X= MUx/MUy

Budget LineBudget Line

X

Y

O

Income = Px .Qx + Py. Qy

I/Py

I/Px

Slope = Px/Py

Indifference CurvesIndifference Curves

X

Y

U1U2

U3

U4

O

a

b

c

d

e

MRS = MUx/MUy= Px/Py

A change in the price of X: Income and A change in the price of X: Income and substitution effectssubstitution effects

X

Y

U1

U2

U3

U4

O

a

b

c

d

e

U5C’

Xo X1

YoY1

c”

A change in the price of X: Income and A change in the price of X: Income and substitution effectssubstitution effects

X

Y

U1

U2

U3

U4

O

a

b

c

d

e

U5C’

Xo X1

YoY1

c”