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Economics Lecture III

The Theory of Consumer Behaviour

So far we have taken the demand curve to be downward sloping on the basis of our
common sense and our everyday observation. Now we will proceed to build up an
analytical model to prove that demand curves for normal goods will always have an
inverse relation with price. The model will establish that for an average rational
individual the demand curve for a normal good will slope downward.

Please keep in mind, however, that this model will not have anything to say about the
elasticity of demand for that commodity.

First we will make some very general assumptions regarding the rationality of the
consumer and to keep the model as simple as possible.

 Two commodities, food and clothing, are in the market for sale at a given set of
prices, and a consumer has a range of choices to buy different combinations of
the two commodities.

 The consumer either prefers one given two different combinations, or he is

indifferent between the two combinations. For example, when asked to choose
between 1 unit of food and 6 units of clothing (combination A) or 2 units of food
and 3 units of clothing (combination B), the consumer either prefers A over B, or
B over A, or is indifferent between the two combinations.

 The consumer always tries to maximise his utility through his choices.

Let’s start our analysis by assuming that the consumer is indifferent between the two
combinations A and B. Let’s also put together all the other combinations to which he is
indifferent as he is between A and B. Let us plot all these combinations in the form of a
curve in a diagram so we can see how the consumer moves from one combination to the
other while being indifferent among the combinations. We will find that among all the
combinations that he is indifferent toward, he has increased the amount of one of the
goods and decreased that of the other. That is, between food and clothing, he has either
increased the amount of food and decreased that of clothing, or increased the amount of
clothing and decreased that of food. It will go against our assumption of rationality if the
consumer is indifferent between two combinations where one of the combinations
contains more of both the goods as compared to the other. That is, if A contains 3 units
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of food and 5 units of clothing, and B contains 5 units of food and 8 units of clothing,
then the consumer cannot be indifferent between A and B.

Let us now look at a diagram that presents this scenario.

This is a curve on which we have plotted the points A, B, C and D, while we measure
units of clothing along the vertical axis and the units of food along the horizontal axis.
Do keep in mind that A, B, C and D are by no means the only combinations to which the
consumer is indifferent. It is a continuous curve, so there can be an infinite number of
combinations that we can choose along that curve. For the purpose of simplicity, we
have chosen 4 discrete points to make our case.

The curve linking up the 4 points is called an Indifference curve, because the consumer
is indifferent among the combinations of goods found along this curve.

The Law of Substitution

Indifference curves are convex to the origin. Hence, as we move downward and to the
right along the curve – which implies a reduction in clothing and an increase in food –
the curve becomes gradually flatter. Mathematically, this means that the value of the
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slope of the curve decreases. Economists would explain this gradual decrease of the
slope as reflecting the Law of Substitution, which states:

The scarcer a good, the greater its relative substitution value; its marginal utility
rises relative to the marginal utility of the good that has become plentiful.

Thus, in going from the point A to B in the above diagram, the consumer substitutes 1
unit of food for giving up 3 units of clothing. But from B to C, he gives up only 1 unit of
clothing for one extra unit of food, which is a 1:1 exchange as compared to the
movement from A to B which was a 1:3 exchange. For a fourth unit of food, he would
sacrifice only ½ unit of clothing.

We can see that the value of the slope of the indifference curve decreases as we move
from A to B to C to D. These values represent the substitution ratio or the marginal
rates of substitution between the two goods. It is called thus because the slope of the
indifference curve is the measure of the goods’ relative marginal utilities or of the terms
of substitution at which the consumer would be willing to exchange a marginal quantity
of one good in exchange for a little more of the other one.

To put it in simpler language, as the amount of food the consumer uses goes up and
correspondingly the quantity of clothing goes down, food must come to have relatively
lesser utility for the consumer. So he would not want to give up too much clothing now
for an extra unit of food.

The precise shape and slope of the indifference curve will, of course, vary from one
consumer to the next, but it will always be convex to the origin with a declining slope.

The Indifference Map

Any particular indifference curve provides us with a particular level of utility. But a
consumer can have several indifference curves for various levels of utility. If instead of
increasing one good to compensate for decreasing the other, the consumer increases his
consumption of both goods, then he will be reaching a higher level of utility which we
can represent by another indifference curve at a higher level. Conversely, if the
consumer reduces his consumption of both the goods, he will slip down to a lower level
of indifference curve. For example, the consumer will be on one indifference curve with
a combination of 2 units of food and 7 units of clothing, but he will be on a higher level
indifference curve with 3 units of food and 8 units of clothing.

In the following diagram we portray such a collection of indifference curves for a

consumer. This is a family of indifference curves where as long as the consumer is
changing his combinations of food and clothing along a single indifference curve he
remains on the same level of utility but when he increases his combination by
increasing the units of both goods he will be on a higher level of utility. He may,
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however, choose to remain on that higher level by again substituting one good for the
other.

We have labelled the curves as U1, U2, U3 and

U4 respectively. We notice that our original
curve here is in the third position with the
combinations A, B, C and D marked on it. It is
above two other curves and below one. All
the combinations on the curves below
contain less of both food and clothing as
compared to any combination on the curve
U3, but all combinations on U3 contain less of
both the goods than any combination on the
curve U4.

We now have a complete map of the consumer’s preferences. We know all the possible
choices he would like to make and what level of utility he will derive from them. But
simply by knowing ones choices one cannot decide exactly which combination to choose
that will maximise his utility. To make that decision, he needs to have a budget and also
know the market prices for the two goods. In the diagram below, we have derived his
budget line on the basis of his income and the prices of the two goods he will be
consuming in a particular combination.

The diagram supposes that the consumer has an income of Rs. 6 per day to spend, and
he is faced with given market prices of the two goods, Rs. 1.50 for one unit of food and
Rs. 1 for clothing. At one extreme, he can buy only food with his Rs. 6, buy 4 units of food
and no clothing, or buy only clothes, buy 6 units of clothes and no food. By joining these
two points on the two axes, we find the budget line, NM, for the consumer where he
can consume anywhere on the budget line or anywhere below it, but he cannot
consume any combination outside of it. The slope of the budget line is the ratio of the
two prices of the two goods, in other words the price of food to that of the price of
clothing, PF/PC.
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The Equilibrium Position of Tangency

We are now ready to put together the two parts, the range of choices and utility levels
depicted by the various levels of indifference curves and the budget constraint defined
by the prices of the two products. By putting them together we can determine his
equilibrium position where he maximizes his utility.

In the diagram below, we have superimposed the budget line NM upon the consumer
indifference map. We know that the consumer is free to move anywhere along the
budget line NM. Positions to the right and above NM are not allowed because that would
require more than Rs. 6 income per day. Positions to the left and below NM are
irrelevant because the consumer is assumed to spend the full Rs. 6.

So the question for us now is, where will the consumer move? Obviously, to that point
which yields the greatest satisfaction – that is, to the highest possible indifference curve.

From the diagram we see that

the highest level of utility
attainable for the consumer is at
point B. At that point the budget
line NM is tangential to the
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indifference curve U3. If he chooses any other point on the NM, then he will be on a
lower level indifference curve.

His point of equilibrium and utility maximization therefore is the point where the slope
of the indifference curve is equal to the slope of the budget line.

The slope of the indifference curve, as we remember, is the ratio of the marginal utilities
of the two goods, food and clothing, i.e., MUF/MUC. The slope of the budget line is PF/PC.

At the point of maximisation of utility given the budget constraint and the market prices
of the two goods, MUF/MUC = PF/PC.

At any other point on the budget line, the two above ratios will not be equal. If the
consumer chooses a point on the budget line where MU F/MUC ≠ PF/PC then he will be on
a lower indifference curve. To come up to the highest indifference curve accessible to
him he will therefore have to change the values of the marginal utilities of the goods. To
change the values of the marginal utilities, he can increase or decrease his consumption
of one of the products, and thereby decrease or increase the MU of that particular good
for himself, until he comes to the point where the two ratios are equal.

Changes in Income and Price and how it Changes the Equilibrium

We can now proceed to establish that the law of demand holds in the case of an
individual consumer by changing the level of income and the prices of the goods in our
model.

Change in Income: If we assume that the consumer’s daily income is halved – from Rs.
6 per day to Rs. 3 per day – while the two prices remain unchanged, we will have a new
budget line parallel to the old one (NM) as the new budget line shifts to the left. The new
line will be parallel to the old line because the slope of the budget line, P F/PC, has not
changed as the prices of the goods are being held constant. But now that his income has
been halved, the consumer can only afford half the amount of the two goods that he
could afford before. Let’s name the new budget line as N’M’ and find the new
equilibrium position in the diagram below.
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We find that the new equilibrium point is B’, where the new budget line N’M’ is
tangential to a lower indifference curve U1. We find that at the new equilibrium, he is
consuming less of both the goods but the proportion of his consumption of the two
goods has stayed the same because the price ratio of the two goods has remained
unchanged.

This is in conformity with the law of demand which tells us that if price stays unchanged
but income decreases, then with less money in hand the consumer will demand less of
the commodity than before.

Single Price Change: How does the point of equilibrium change if the price of one of
the goods changes but his income stays unchanged.

In this situation the income of the consumer is the same as before, i.e., Rs. 6. But let’s say
the price of food doubles from Rs. 1.50/unit to Rs. 3/unit. But the price of clothing stays
unchanged. In this case the slope of the budget line will change because P F/PC has
increased. The change in slope will be reflected in a rotation of the budget line where
the point on the Cloth axis will stay unchanged (because the price of Cloth is
unchanged) but the point on the Food axis will move inward to the left because now
with his income of Rs. 6/day he can afford only half the amount of food than before. We
will therefore name the new budget line as NM’’.

Let’s look at the diagram below now to figure out how the change in the price of one of
the goods with income being kept constant will affect the point of equilibrium.

The new budget line now is

NM’’ with an inward rotation
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of the original budget line NM, and now the slope of the budget line is higher with a
higher PF/PC. We find that at this new price, the point of tangency between NM’’ and the
indifference curve is B’’, where the consumer is on the indifference curve U 2. At this
equilibrium he is consuming less of food (since the price of food has increased) and a
little more of clothing.

Deriving the Demand Curve

We are now in a position to derive the demand curve.

The price of food has increased now from Rs. 1.50/unit to Rs. 3/unit. We have held all
other things constant. But all other factors that affect demand are held constant. Income
is constant at Rs. 6/day, so the budget line has not shifted. It has only acquired a new
and higher slope because the price of food has doubled. Taste is held unchanged
because the indifference map is unchanged. And price of its substitute, i.e., clothing is
unchanged.

We find that at the new equilibrium point B’’, the consumer’s consumption of food is
reduced and his consumption of clothing is marginally increased.

If we continue with this exercise and try out various other prices of food which would
be different from the original price, we would find that we can derive a neat downward
sloping demand curve.

For example, if we try an exercise where the price of food is halved, then the NM line
will rotate outward to the right because now at Rs. 6/day income the consumer can
afford double the amount of food with PF/PC now lower. We will find that the
consumer’s new equilibrium will be at a higher utility level where the budget line will
be tangential with a higher indifference curve. At that point, the combination of food
and clothing will be such that he will be consuming more food and possibly more
clothing.

Continuing with this exercise at various price levels of food and holding all other factors
constant, we will be able to derive a downward sloping demand curve.

This demand curve will represent the demand of a consumer who is rational and tries to
maximise his utility given the market prices of the goods. He changes his combination of
consumption as and when prices of the goods change in accordance with the law of
demand. If this is an average customer, then adding the demand curve of all the average
customers in a market we can derive the market demand curve.

Substitution Effect and Income Effect

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As prices of goods change, two effects take place in the demand of a consumer. One is
the substitution effect and the other is the income effect.

If we look closely at the effect of a price change, two things happen: First, an increase in
the price of a commodity relative to other prices induces the consumer to move away
from the comparatively expensive commodity to the relatively cheaper one. This is the
substitution effect. Second, the price change affects the real income of a person. If price
increases, the consumer has less money to spend if he continues to buy the good in the
same amount as before the price change. If price decreases, he has more money to
spend if he buys the good in the same quantity as before. This is the income effect.

For example, suppose the initial prices of the two goods, food and clothing, are (10, 20)
and the consumer demands (7, 8) units given these prices. The consumer then will be
spending a total of Rs. 230 on this bundle. If the price of the first good falls to 8, then the
consumer will want to buy more of the first good (a) because it is relatively cheap and
(b) he now has more real income in his hand to buy more of the cheaper product.
Suppose the new bundle the consumer chooses is (8, 7). At the new price, the consumer
spends Rs. 220 on the total bundle and still has a surplus income of Rs. 10. This is the
increase in his real income, even though his nominal income is still the same. He can
therefore use this extra real income in hand to buy more of both goods or simply more
of the cheaper good. Either way the demand for the cheaper good will increase.

This explains the law of demand. The demand curve of a good slopes downward in
relation to price due to the substitution effect and the income effect.