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The Consumer Theory: How Consumers Make Choices Under Income Constraints
The Consumer Theory: How Consumers Make Choices Under Income Constraints
20
8 160 0
10 9 155 -5
0
-10
1 2 3 4 5 6 7 8 9 1 11 10 145 -10
-2 0 145
How much ice cream does Jill buy in a month?
Some facts of life:
• Limited income
• Opportunity cost of making a choice:
Buying ice cream leaves Jill less money to
buy other things: each dollar spent on ice
cream could be spent on hamburger.
• In fact, consumers compare the (expected)
utility derived from one additional dollar
spent on one good to the utility derived from
one additional dollar spent on another good.
More facts
• The prices of hamburger and ice cream are market-
given; the consumer cannot change the price of a good.
• Jill, like any other rational consumer, wishes to
maximize her utility.
• The opportunity cost of one dollar spent on ice cream is
the forgone utility of one dollar that could be on
hamburger.
• If the utility of one additional dollar of ice cream is
greater than the utility of the last dollar spent on
hamburger, Jill can increase her total utility by spending
one dollar less on hamburger and one dollar more one
ice cream.
Hamburger or Hotdog
• If based on their perceived marginal utilities
Jill values a hamburger four times as much
as a hotdog, but the market price of a burger
is eight times the price of a hotdog, she will
buy a hotdog. That is because one dollar’s
worth of hotdogs would give her more
utility that one dollar’s worth of burgers.
That is:
MUI MUH
--------- = ----------
$PI $PH
Utility Maximization under An
Income constraint
• Consumers’ spending on consumer goods is constrained by
their incomes:
Income = Px Qx + Py Qy + Pw Ow + ….+Pz Qz
• While the consumer tries to equalize MUx/Px , MUy/ Py,
MUw/Pw,………. and MUz/Pz , to maximize her utility her
total spending cannot exceed her income.
86/10
8.6 Slope = PH/PI = 6/10
= 8.6/14.33 = 0.6
5 86/6
Hamburger
o 6 14.33
An Optimal Change
Recall that to maximize utility a consumer
would set:
(MUx/Px) = (MUy/Py)
If Px increases this equality would be
disturbed: (MUx/Px) < (MUy/Py)
To return to equality the consumer must adjust
his/her consumption. (Have in mind that the
consumer cannot change prices, and he/she has
an income constraint.)
What are the consumer’s options?
(MUx/Px) < (MUy/Py)
– Income effect:
Normal good (-)
Inferior goods (+)
– Substitution effect
Buying less X and substituting it with Y until the optimizing
condition is restored (-)
Price
D
Qx
0
P Consumer Surplus
Price
P’
D D’
Qx
0
An Alternative Approach to the
Consumer Theory
• Indifference curves
An indifference curve is a line drawn in a two-
dimensional space showing different combinations of
two goods from which the consumer draws the same
amount of utility and therefore he/she is “indifferent”
about.
• Budget lines
A budget line is a line drawn in a two-dimensional
space representing a certain level of income with which
the consumer can purchase various combinations of
two goods at given prices.
Properties of Indifference curves
• Indifference curves for two “goods” are generally
negatively sloped
• The slope of an indifference curve reflects the degree of
substitutability of two goods for one another
• Indifference curves are generally convex, reflecting the
principle of diminishing returns
• Indifference curves never cross
• Indifference curves that are farther from the origin
represent higher levels of utility
• Indifference curves for a “good” and a “bad” are
positively sloped
Indifference Curves
Y
Slope = Change in Y/Change in X
= MUx/MUy
U4
U3
U2
U1 X
O
Budget Line
Y
Slope = Px/Py
X
O I/Px
Indifference Curves
Y
c
U4
U3
d
U2
e U1
X
O
A change in the price of X: Income and substitution effects
Y
a
b
Y1 C’ U5
c
Yo c” U4
U3
d
U2
e
U1 X
O Xo X1
A change in the price of X: Income and substitution effects
Y
a
b
C’ U5
Y1 c U4
Yo c”
U3
d
U2
e
U1 X
O Xo X1