Consumer Behavior:

Indifference Curves and

Budget Constraints

Lecture 5-6

by: PM Mercado || DLSU

CONSUMER BEHAVIOR – INTRODUCTORY PRINCIPLE

Utility refers to the satisfaction levels

consumers receive from buying and
using a product or service. According
to utility theory, people make purchase
decisions based on the degree of
satisfaction they get from an item or
service

But consumers are constrained with the

budget that they have (scarcity)
CONSUMER BEHAVIOR – I CAN GET NO SATISFACTION (?)

What do you think is the

combination of goods that
you will receive from
Basket G?

Consumer preferences tell us how an individual would rank (i.e., compare the desirability of ) any two baskets, assuming the
baskets were available at no cost.
CONSUMER BEHAVIOR

Working Assumptions for Consumer Preference.

Preferences are complete. That is, the consumer is able to rank any two baskets. For baskets A and B, for
example, the consumer can state her preferences according to one of the following possibilities: A>B, B>A,
A=B.

Preferences are transitive. By this we mean that the consumer makes choices that are consistent with each
other. Suppose that a consumer tells us that she prefers basket A to basket B, and basket B to basket E. We can
then expect her to prefer basket A to basket E. Using the notation we have just introduced to describe
preferences, we can represent transitivity as follows: If A>B and if
B>E, then A>E.

More is better. In other words, having more of a good is better for the consumer.
CONSUMER BEHAVIOR

We know that when we buy fries it will provide us with utility. The same can be said when we
buy shirts. How do we illustrate the relationship between these two goods and the combined
utility that they provide?

Utility from X (Fries), Y (Shirt) or Both X, Y (Fries, Shirt)

Utility Function - A function that measures the level of satisfaction a consumer receives from
any basket of goods and services.
CONSUMER BEHAVIOR

Marginal Utility The rate at which total utility changes as the

level of consumption rises
CONSUMER BEHAVIOR

Indifference Curve
A set of points, each point
representing a combination of
goods X and Y, all of which yield
the same total utility.
i = 40
Why do we call it indifference
curve?
CONSUMER BEHAVIOR

A Preference Map:
Each consumer has a unique
family of indifference curves
called a preference map. Higher
indifference curves represent
higher levels of total utility.

The higher the IC, the higher the

Utility. I4 has higher Utility than
I3.
Technical note: Since ICs are not straight lines,
you cannot use the slope formula for linear
equations.
CONSUMER BEHAVIOR

Working Assumptions

In analyzing how utility affects how consumers make decisions we will work with the following assumptions:

• We assume that this analysis is restricted to goods that yield positive marginal utility, or, more simply, that “more is better.”

• The Marginal Rate of Substitution (MRS) is defined as MUX/MUY, or the ratio at which a household is willing to substitute
Y for X. We will use the concept of diminishing returns to explain the shape of the Indifference Curve (IC).

• We assume that consumers have the ability to choose among the combinations of goods and services available. Confronted
with the choice between two alternative combinations of goods and services, A and B, a consumer responds in one of three
ways: (1) They prefer A over B, (2) They prefer B over A, or (3) they are indifferent between A and B—that is, they like A and
B equally.

• We assume that consumer choices are consistent with a simple assumption of rationality. If a consumer shows that he prefers
A to B and subsequently shows that he prefers B to a third alternative, C, he should prefer A to C when confronted with a
choice between the two.
CONSUMER BEHAVIOR

Properties of the Indifference Curve

• Higher indifference curves are preferred to lower ones.

• Indifference curves slope downward

• Indifference curves do not cross.

• Indifference curves are bowed inward.

CONSUMER BEHAVIOR – ANU PO BUDGET NIYO MAMSIR?

A budget constraint separates those combinations of goods

and services that are available, given limited income, from
1500 = 30X + 20Y those that are not. The available combinations make up the
Brand Y opportunity set.
M = PXX + PYY

M = Income
PX = Price of X (Brand A)
X = Quantity of X
PY = Price of Y (Brand B)
Y = Quantity of Y

Brand X Rearranging the constraint to Budget Line:

Item Cost (PhP)
M 1,500 Y = M/PY – (PX/PY)X

PX 30 Slope interpretation: IF slope is 1.5 then you are willing to

PY 20 give up 1.5 units of Y for every additional unit of X.
Slope -(PX/PY) -1.5 (30/20)
CONSUMER BEHAVIOR

I = 30X + 20Y I = 30X + 15Y

Brand Y Brand Y

Brand X Brand X

What do you think is the difference between the two opportunity sets?
CONSUMER BEHAVIOR

Brand Brand
Y 100 Y 75
M0 = 30X + 20Y
M0 = 30X + 20Y M1 = 30X + 25Y
75 M1 = 30X + 15Y
60

Brand X Brand X
50 50

Whenever there is a reduction of Price (PY from 20 – 15), If the opposite happens (i.e PY from 20 to 25),
consumers will appear ‘richer’ because they can afford there will be a reduction in Real Income.
more with their income. This is an improvement in Real
Income
CONSUMER BEHAVIOR

Brand
A household/consumer could experience a boost in
A 50
Income, this will increase the size of the Budget
constraint, and as such, will improve the opportunity set as
well.

What do you think will

happen when there is an
inflation?

Brand
75 B
CONSUMER BEHAVIOR – We are combining concepts now 

As discussed in Demand, Utility - a measure of happiness or satisfaction. Consumers maximize Utility. You can show the
relationship of Utility and the amount of consumed Brand A, as seen in the Total Utility graph on the left.

Law of Diminishing Marginal Utility (LDMU) states that the more of any one good consumed in a given period, the less
satisfaction (utility) generated by consuming each additional (marginal) unit of the same good.
CONSUMER BEHAVIOR

Combining IC and Budget Constraint

When consumers buy products, they consider the cost given that they have limited money to
work with. At the same time consumers don’t just buy products just because it is cheap; they
buy the best from what their money can offer. As such, a consumer maximizes their utility at

Utility-Maximizing rule!

SAMPLE PROBLEM

Consumer A purchases food (measured by x) and clothing (measured by y) and has the utility
function U(x, y) = xy. His marginal utilities are MUx = y and MUy = x. He has a monthly
income of PhP800. The price of food is Px = $20, and the price of clothing is PY = $40.

Since, M = Pxx + PyY therefore: 800 = 20X+40Y

We know that –MUX/MUY = -PX/PY

Then:
-y/x = -20/40
Cross-multiplying will lead to:
x = 2y (Utility maximizing rule!)
CONSUMER BEHAVIOR

You will have two equations: (1) 800 = 20X+40Y and (2) x = 2y
Solve for the unknowns x and y. To get Y, substitute equation 2 in the x variable of equation 1,
the budget constraint. You will get:
• 800 = 20(2y)+40Y Using equation (2) cause it
• 800 = 40Y+40Y is easier:
• 800 = 40Y • x = 2y
• 800/40 = 40Y/40 • x = 2(10)
• Y* = 10 • X* = 20
.: You can use Y* in
equations 1 and 2 to solve
for X*
CONSUMER BEHAVIOR

Point B (point of
tangency) is where you
maximize utility. This What if you move a little bit
shows the number of Y away from Point B?
and X that is within the
budget and maximizes
utility.

10 This means that buying 10

units of Y and 20 units of X
maximizes utility given the
consumer’s budget
constraint.

20
PRICE DYNAMICS
CONSUMER BEHAVIOR

Product Y As we discussed, as income increases, the

budget line will shift outward. As such, it can
touch higher ICs, which means

More products = More satisfaction.

As people gain more money, do you notice that

they tend to buy more of things that they like?
- Make-up
- Games
- Good food?
.: Relate this to Normal Goods.

Product X
CONSUMER BEHAVIOR

Inferior Goods
Normal Goods
CONSUMER BEHAVIOR

Substitution effect - The movement along a

given indifference curve that results from a
change in the relative prices of goods, holding
real income constant (A to B).

Income effect - The movement from one

indifference curve to another that results from
the change in real income caused by a price
change (A to C)
Thanks! 