Consumer Choice

Peng Shen

October 18, 2021

Peng Shen Consumer Choices October 18, 2021 1 / 27

Where does a market demand curve come from?

Previously, we learnt how the competitive equilibrium is determined by the

market demand curve and market supply curve.
We did not explain where the market demand curve curve come from.
Today’s goal: where the market demand curve comes from.

How every individual’s demand curve is determined (holding other

factors constant, how each individual’s quantity demanded is
determined at each price)
How to construct the market demand curve from the individual
demand curve.

Peng Shen Consumer Choices October 18, 2021 2 / 27

Origins of Demand

Buy’s Reservation Price and Marginal Benefit

We know: demand curve actually lists the buyer’s reservation prices
or marginal benefits of buying one more unit of the product.
You will not buy that one unit of product if the market price exceeds
your reservation price (or the marginal benefit you get from buying it).

Peng Shen Consumer Choices October 18, 2021 3 / 27

Origins of Demand

Buy’s Reservation Price and Marginal Benefit

We know: demand curve actually lists the buyer’s reservation prices
or marginal benefits of buying one more unit of the product.
You will not buy that one unit of product if the market price exceeds
your reservation price (or the marginal benefit you get from buying it).

Wants (also called “Preferences” or “Tastes”)

This is an important determinant of a consumer’s reservation price
(or marginal benefit) for a good.

Where are wants, tastes, or preferences come from?

Biological needs, Cultural influences, and Peer behavior
Want, tastes, and preferences may change over time

Peng Shen Consumer Choices October 18, 2021 3 / 27

Wants and Demand

Needs versus Wants

1 Goods or services that are required for subsistence are needs

They are required for survival: food, shelter, and clothing

2 Goods or services beyond needs are wants, which depend on price
Unlimited wants
People always want more things, better quality things
They want all kinds of services, including entertainment and travel

Peng Shen Consumer Choices October 18, 2021 4 / 27

Wants and Demand

Needs versus Wants

1 Goods or services that are required for subsistence are needs

They are required for survival: food, shelter, and clothing

2 Goods or services beyond needs are wants, which depend on price
Unlimited wants
People always want more things, better quality things
They want all kinds of services, including entertainment and travel

Limited resources
Money (including income and wealth), Time and Energy

Peng Shen Consumer Choices October 18, 2021 4 / 27

Wants and Demand

Needs versus Wants

1 Goods or services that are required for subsistence are needs

They are required for survival: food, shelter, and clothing

2 Goods or services beyond needs are wants, which depend on price
Unlimited wants
People always want more things, better quality things
They want all kinds of services, including entertainment and travel

Limited resources
Money (including income and wealth), Time and Energy

Prioritize wants
Allocate resources accordingly
Demand those that you are willing and able to pay

Peng Shen Consumer Choices October 18, 2021 4 / 27

Translate wants into demand

We assume consumers are rational

Consumers choose to buy the combination of goods and services that
makes them as well off (satisfies their wants as much) as possible given
their limited income.

Peng Shen Consumer Choices October 18, 2021 5 / 27

Translate wants into demand

We assume consumers are rational

Consumers choose to buy the combination of goods and services that
makes them as well off (satisfies their wants as much) as possible given
their limited income.
Maximize consumer’s “well off” or “wants”, against their “limited income”
Utility: the enjoyment or satisfaction people receive from consuming
goods and services.
Budget constraint: the limited amount of income available to
consumers to spend on goods and services.

Peng Shen Consumer Choices October 18, 2021 5 / 27

Utility

Example of utility: Jack’s utility from

1 bottle of water is 10.
1 bottle of soda water is 15.
Jack receives more satisfaction from drinking soda.

Peng Shen Consumer Choices October 18, 2021 6 / 27

Utility

Example of utility: Jack’s utility from

1 bottle of water is 10.
1 bottle of soda water is 15.
Jack receives more satisfaction from drinking soda.

Utility measures people’s well-being and happiness.

larger utility ⇒ happier, more satisfaction and well-being.
It can (at least currently) only be measured indirectly
we pretend it is subjective and observable
we maintain that it cannot be compared among different people
Utility is unit free
in the textbook, utility is measured in units called “utils” (“utils/day”,
“utils/hour”, etc.) just to help you understand.

Peng Shen Consumer Choices October 18, 2021 6 / 27

Utility

Peng Shen Consumer Choices October 18, 2021 7 / 27

Marginal utility (MU)

Marginal utility: the change in total utility one gets from consuming an
additional unit of a good or service. Or, the additional satisfaction (utility)
gained from consuming an additional unit of a good or service.

Figure 1: Total and marginal utility from eating pizza

Peng Shen Consumer Choices October 18, 2021 8 / 27

Diminishing marginal utility (MU)

Law of Diminishing Marginal

Utility: tendency for the additional
utility gained from consuming an
additional unit of a good to
diminish as consumption increases
during a given period of time.
Or
the principle that consumers
experience diminishing additional
satisfaction as they consume more
of a good or service during a given
period of time.

Peng Shen Consumer Choices October 18, 2021 9 / 27

Exceptions to diminishing marginal utility (MU)

There are exceptions to the law of diminishing MU:

Marginal utility can increase at low levels of consumption
Some unfamiliar product or service, such as new song

Peng Shen Consumer Choices October 18, 2021 10 / 27

Exceptions to diminishing marginal utility (MU)

There are exceptions to the law of diminishing MU:

Marginal utility can increase at low levels of consumption
Some unfamiliar product or service, such as new song

But as you continue consuming the good or service, eventually the MU

will decline.

Peng Shen Consumer Choices October 18, 2021 10 / 27

Exceptions to diminishing marginal utility (MU)

There are exceptions to the law of diminishing MU:

Marginal utility can increase at low levels of consumption
Some unfamiliar product or service, such as new song

But as you continue consuming the good or service, eventually the MU

will decline.
We apply the Cost-Benefit Principle
Consume an additional unit of good or service as long as the MU
(benefit) is greater than the actual price you pay (cost)

Peng Shen Consumer Choices October 18, 2021 10 / 27

Allocate your resources between two goods

You want to buy Pizza and Coke.

Budget constraint: $10
Utility:

Peng Shen Consumer Choices October 18, 2021 11 / 27

Allocate your resources between two goods

The prices are given:

price of Pizza: $2 per slice
price of Coke: $1 per cup

Peng Shen Consumer Choices October 18, 2021 12 / 27

Allocate your resources between two goods

The prices are given:

price of Pizza: $2 per slice
price of Coke: $1 per cup

Goal: choose the Optimal Combination that

you can afford
maximize your total utility
Optimal Combination: the affordable combination that yields the highest
total utility

Peng Shen Consumer Choices October 18, 2021 12 / 27

Marginal utility per dollar

Since we are buying two goods with different prices, instead of comparing
the MU, we need to compare the marginal utility per dollar (MU/dolalr).

Peng Shen Consumer Choices October 18, 2021 13 / 27

Rational Spending Rule

Suppose the marginal utility per dollar obtained from pizza was greater
than that obtained from Coke.
Then you should eat more pizza and drink less Coke.

This implies the rule of equal marginal utility per dollar spent:
the last slice of Pizza and the last cup of Coke up to the point where
the last slice of pizza and the last cup of Coke give you equal
marginal utility per dollar.

Peng Shen Consumer Choices October 18, 2021 14 / 27

Rational Spending Rule

Suppose the marginal utility per dollar obtained from pizza was greater
than that obtained from Coke.
Then you should eat more pizza and drink less Coke.

This implies the rule of equal marginal utility per dollar spent:
the last slice of Pizza and the last cup of Coke up to the point where
the last slice of pizza and the last cup of Coke give you equal
marginal utility per dollar.

Rational Spending Rule: Spending should be allocated across goods so

that the marginal utility per dollar is the same for each good. That is, the
rule of equal marginal utility per dollar spent on each good.

Peng Shen Consumer Choices October 18, 2021 14 / 27

Conditions for maximizing utility

This gives us two conditions for maximizing utility:

Satisfy the rational spending rule:
MUpizza MUcoke
=
Ppizza Pcoke

Exhaust your budget:

Spending on pizza + Spending on Coke = Budget

Peng Shen Consumer Choices October 18, 2021 15 / 27

Conditions for maximizing utility

This gives us two conditions for maximizing utility:

Satisfy the rational spending rule:
MUpizza MUcoke
=
Ppizza Pcoke

Exhaust your budget:

Spending on pizza + Spending on Coke = Budget

Pizza and coke example =⇒ consume 3 slices of pizza and 4 cups of coke
Rational spending rule: from table of MU/dollar, the matching values
are 10, 5, 3 (utils/$).
Exhaust the budget: 3 · $2 + 4 · $1 = $10 at MU/dollar = 5 utils/$.

Peng Shen Consumer Choices October 18, 2021 15 / 27

Reaching the optimal combination

Suppose you consume 4 slices and 2 cups, MU/dollar is

3 per dollar, for the fourth slice of pizza
15 per dollar, for the second cup of coke
How to adjust:
Increase (resp. decrease) MU/dollar for pizza (resp. coke)
Buy less pizza and more coke, using the law of diminishing MU

Peng Shen Consumer Choices October 18, 2021 16 / 27

Reaching the optimal combination

Suppose you consume 4 slices and 2 cups, MU/dollar is

3 per dollar, for the fourth slice of pizza
15 per dollar, for the second cup of coke
How to adjust:
Increase (resp. decrease) MU/dollar for pizza (resp. coke)
Buy less pizza and more coke, using the law of diminishing MU

At optimum, any small rearrange will not change the total utility, and it is
impossible for you to rearrange the spending to increase total utility:
if you buy 0.1 less slice of pizza and 0.2 more cups of coke
then you get 2 · 0.1 · 5 = 1 less util of utility from the reduced 0.1
slice of pizza, however, this is exactly compensated by 1 · 0.2 · 5 = 1
more util you get from additional 0.2 cups of coke

Peng Shen Consumer Choices October 18, 2021 16 / 27

Price change

If the price of pizza decreases

price of Pizza: $2 −→ $1.5 per slice
price of Coke: $1 −→ $1 per cup

Peng Shen Consumer Choices October 18, 2021 17 / 27

Price change

If the price of pizza decreases

price of Pizza: $2 −→ $1.5 per slice
price of Coke: $1 −→ $1 per cup

Peng Shen Consumer Choices October 18, 2021 17 / 27

Price change: Substitution Effect Revisited

When price of a good rises, other goods are relatively more attractive
At the higher price, less is demanded because some buyers switch to
other goods

Substitution effect: The change in the quantity demanded of a good

that results from a change in price making the good more or less expensive
relative to other goods, holding constant the effect of the price change on
consumer purchasing power.
If the price of pizza falls, pizza becomes cheaper relative to coke.
Marginal utility per dollar for each slice of pizza increases.
The substitution effect from the decreasing price suggests you to
consume more pizza and less coke.

Peng Shen Consumer Choices October 18, 2021 18 / 27

Price change: Income Effect Revisited
Changes in price affect the buyers’ purchasing power
This acts like a change in income

Income effect: The change in the quantity demanded of a good that

results from the effect of a change in price on consumer purchasing power,
holding all other factors constant.
If pizza is a normal good, the income effect from this decreasing price
makes you to consume more pizza.
If pizza is an inferior good, the income effect from this decreasing
price makes you to consume less pizza.

Peng Shen Consumer Choices October 18, 2021 19 / 27

Price change: Income Effect Revisited
Changes in price affect the buyers’ purchasing power
This acts like a change in income

Income effect: The change in the quantity demanded of a good that

results from the effect of a change in price on consumer purchasing power,
holding all other factors constant.
If pizza is a normal good, the income effect from this decreasing price
makes you to consume more pizza.
If pizza is an inferior good, the income effect from this decreasing
price makes you to consume less pizza.

Nominal Price v.s. Real Price

Nominal price: the absolute price of a good in terms of dollars, the
price you see at stores.
Real price: the nominal price of a good relative to the average dollar
price of all other goods, the price that is adjusted for inflation.
Peng Shen Consumer Choices October 18, 2021 19 / 27
Price change and Giffen Good

When price of pizza decrease, the quantity demanded of pizza

Income effect Substitution effect
Normal good ↑ ↑
Inferior good ↓ ↑

Peng Shen Consumer Choices October 18, 2021 20 / 27

Price change and Giffen Good

When price of pizza decrease, the quantity demanded of pizza

Income effect Substitution effect
Normal good ↑ ↑
Inferior good ↓ ↑
For an inferior good, if the magnitude of the income effect is larger than
the magnitude of the substitution effect:
Giffen good: price ↓, quantity demanded ↓, i.e. it has an upward
sloping demand curve (very rare: economists are debating on whether
it can be found in reality)

Peng Shen Consumer Choices October 18, 2021 20 / 27

Price change and Giffen Good

When price of pizza decrease, the quantity demanded of pizza

Income effect Substitution effect
Normal good ↑ ↑
Inferior good ↓ ↑
For an inferior good, if the magnitude of the income effect is larger than
the magnitude of the substitution effect:
Giffen good: price ↓, quantity demanded ↓, i.e. it has an upward
sloping demand curve (very rare: economists are debating on whether
it can be found in reality)
Distinguish this with Veblen good: upward sloping demand, but it is a
luxury good (does not have income and substitution effects)

Peng Shen Consumer Choices October 18, 2021 20 / 27

Price change and rational spending

Price of Pizza: $2 per slice −→ $1.5 per slice

1 At the original optimal combination
MUpizza MUcoke
=
Ppizza Pcoke
2 With the decrease in Ppizza

MUpizza MUcoke
>
Ppizza Pcoke
3 If you buy more pizza and less coke, MUpizza ↓ and MUcoke ↑
To reach new optimal combination: buy more pizza and less coke, and
stop when MU/dollar is the same.

Peng Shen Consumer Choices October 18, 2021 21 / 27

Price change and individual demand

Suppose Pizza is a normal good and Budget constraint is $ 10

Price of Pizza: $2 per slice −→ $1.5 per slice; Price of Coke: $1
Quantity of Pizza: 3 slices −→ 4 slices

Peng Shen Consumer Choices October 18, 2021 22 / 27

Market demand
Each individual has a demand curve for pizza. By adding the individual
demand at each price (horizontal sum), we get market demand for pizza.
Market demand: the demand of all buyers of a given good or service.

Peng Shen Consumer Choices October 18, 2021 23 / 27

Budget Constraint Graph

Budge constraint (BC) line: Px · X + Py · Y = M, if X is coke and Y is

pizza, then X + 2Y = 10, rearrange we obtain Y = 5 − 1/2X

Peng Shen Consumer Choices October 18, 2021 24 / 27

Preference in graph: Indifference Curve

Indifference curves describe the set of bundles you’d be indifferent

between

Suppose X is coke and Y is

pizza
MUy
Slope is MUx = MRS
MRS: marginal rate of
substitution

A higher indifference curve is

preferred to a lower one

Peng Shen Consumer Choices October 18, 2021 25 / 27

Optimal Bundle

The budget constraint are affordable, higher indifference curves are better

So the point on the highest

indifference curve you can
reach with your BC is your
optimal bundle
Optimal bundle is also called
the best affordable bundle
P
We must have MRS = Pyx (X
is coke, Y is pizza), the same
as the rational spending rule

Peng Shen Consumer Choices October 18, 2021 26 / 27

Optimal Bundle and Price Change

When price of pizza decreases: we have income and substitution effects

Price of pizza decreases from

$2 to $1
BC line tilted from dark red
line to the fresh red line
Income effect: change from
point F to e’ (the dashed line is
parallel to the original BC)
Substitution effect: change
from point e’ to E

Peng Shen Consumer Choices October 18, 2021 27 / 27