1. ECON 211 ELEMENTS OF ECONOMICS I
Session 3– Consumer Choice (Part 1)
Lecturer: Dr. (Mrs.) Nkechi S. Owoo, Department of Economics
Contact Information:

2. Session Overview
This session analyzes choices faced by consumers and takes two approaches to analyzing the decisions of individual households- the Marginal Utility theory and the Indifference Curve theory.
Part 1 of the session introduces the consumer’s budget constraint and focuses on the marginal utility theory of consumer choice.

3. Session Outline
The key topics to be covered in the session are as follows:
The Budget Constraint
The Theory of Marginal Utility

4. Reading List
Hall and Lieberman
Chapter 5

5. Topic One
The Budget constraint

6. Consumer Choice People constantly making economic decisions such as:
How to spend money
How to spend time
In order to understand economic choices that people make, we need to know the following:
What are they trying to achieve?
What are constraints they face?
How can we identify different goals and constraints of millions of consumers, however?

7. Consumer Choice
Individuals have desires and constraints that are specific to each person
How can we identify the goals and constraints of millions of consumers?
In general...we are quite alike
All want to maximize our overall satisfaction
We are all faced by some type of constraint
Too little income or too little time
Let us begin discussion of consumers’ constraints…

8. The Budget Constraint All individuals face two facts of economic life
Have to pay for goods and services you buy
Have limited funds to spend

9. The Budget Constraint
These facts summarized by consumers budget constraint
Budget constraint identifies which combinations of goods and services the consumer can afford with a limited budget, at given prices

10. The Budget Constraint Consider this scenario
Kweku loves both movies and hiplife music
He has a total entertainment budget of Ghc150 to spend each month
Each movie costs Ghc10 and each live hiplife concert costs Ghc30
If Kweku spends his entire budget on movies, he can watch 15 movies a month; or attend 5 hiplife concerts if he spend his entire budget on music

11. The Budget Constraint However,
Kweku could spend budget on combination of movies and music

12. Kweku Consumption Possibilities with Income of Ghc150
The Budget Constraint
Kweku Consumption Possibilities with Income of Ghc150
Concerts at Ghc30
Movies at Ghc10
Qty
Total expenditure (Ghc)
Total expenditure
(Ghc) A 15
150 B 1 30 12
120 C 2 60 9 90 D 3 6 E 4 F 5

13. The Budget Constraint
The information in the table on Kweku’s constraint may be represented using a graph
Budget line
Graphical representation of a budget constraint

14. The Budget Constraint
Every time Kweku buys an additional concert, he must give up 3 movies per month
What concept is this?
This is the concept of opportunity cost
Slope of the budget line
Measures the trade-off between one good and another
i.e. the amount of one good that must be sacrificed in order to buy more of another good 15 A
Movies per month 12 B 9 C 6 D E 3 F 1 2 3 4 5
Concerts Per month

15. The Budget Constraint The concept of Relative price
This refers to the price of one good relative to the other
The relative price is calculated as ratio of prices
E.g. Relative price of concert= Pc/Pm= Ghc30/Ghc10= 3
Note: ‘3’ is also opportunity cost of concert
What is the relative price of a movie?
This would be given as the ration Pm/Pc= Ghc10/Ghc30= 1/3

16. General Relationship
If Py is the price of the good on the vertical axis and Px is the price of the good on the horizontal axis, then the slope of the budget line is Px/Py
Slope BL= Opportunity Cost= Relative Price of X

17. Changes in the Budget Line
Earlier budget line that we constructed assumed given/ fixed prices (of concerts and movies) and consumer income (Kweku income= Ghc150)
If any of these ‘givens’ change, the budget line will also change

18. Changes in the Budget Line: Changes in Income
Assume Kweku’s monthly income increases from Ghc150 to Ghc300
With a higher income level, he can afford to consume more movies, more concerts, or more of both
Assuming prices are constant and have not changed
i.e. Concert= Ghc30 and Movies= Ghc10
...Kweku can attend 10 concerts or watch 30 movies, if devoting entire income to either concerts only or movies only
What would the new budget line look like?

19. The Budget Constraint: Change in Income30
Old Income= 150
New Income= 300
Rightwards shift of BL
No change in slope
Pm= Ghc10
Pc= Ghc30
What is the new relative price of concerts?
Rel. price= Pc/Pm= Ghc30/Ghc10=3
i.e. relative price is unchanged 15 A
Movies per month 12 B 9 C 6 D E 3 F 1 2 3 4 5 10
Concerts Per month

20. The Budget Constraint: Changes in Price
Now, let us examine the effect on the budget line when there is a change in the price of movies, while the income level and price of concerts are unchanged
Assume Pm falls from Ghc10 to Ghc5
Original budget of Ghc150
Pc= Ghc30
What is the effect on the budget line?

21. The Budget Constraint: Change in Price (movie)30
Old Pm= Ghc10
New Pm= Ghc5
Pc= Ghc30
Income= 150
BL rotates outwards
Vertical intercept higher
No change in horizontal intercept
What is new BL slope/ OC/Relative Price of Concerts?
Pc= Pc/ Pm= 30/6= 5
Interpretation?
A consumer must give up 5 movies in order to attend 1 concert 15 A
Movies per month 12 B 9 C 6 D E 3 F 1 2 3 4 5 10
Concerts Per month

22. The Budget Constraint: Changes in Price
Now, let us examine the effect on the budget line when there is a change in the price of concerts, while the income level and price of movies are unchanged
Assume Pc falls from Ghc30 to Ghc10
Original budget of Ghc150
Price of movies is Ghc10
What is the effect on the budget line?

23. The Budget Constraint: Change in Price (concerts)
Pm= Ghc10
Old Pc= Ghc30
New Pc= Ghc10
Income= 150
BL rotates outwards
Vertical intercept unchanged
Horizontal intercept changes
What is new BL slope/ OC/Relative Price of Concerts?
Pc= Pc/Pm= 10/10= 1
Interpretation?
In order to see an additional concert, Kweku must give up 1 movie 15 A
Movies per month 12 B 9 C 6 D E 3 F 1 2 3 4 5 15
Concerts Per month

24. Changes in the Budget Line
In summary, we observe that:
Changes in income lead to a parallel shift the budget line
When income increases, there is an upward-rightward shift
When incomes decrease, there is a downward-leftward shift
However, the budget line’s slope/ opportunity cost/ relative price is unaffected
Changes in price of a product lead to an upward/downward rotation of the budget line
As one of the intercepts changes, the slope of the budget line changes

25. Preferences Budget Constraint is only one side of story
Indicates tradeoffs consumers are able to make
Preferences is other side of the story
Indicates tradeoffs consumer want to make

26. Preferences
How can we speak systematically about people’s preferences?
People are different; like different things...
Teenagers and social media; not very common among older folk
Some people like local dishes; others prefer continental...etc
However, some common denominators are true for most people
i.e. People are bounded by certain assumptions of
Rationality
Consumers can make a choice
Choices that consumers make are logically consistent
Consumers generally prefer more to less

27. Preferences: Rationality
Rationality is a critical assumption behind consumer theory
First, assumes people HAVE preferences
An individual can look at two goods and either state that prefers one to the other, or indifferent between the two
For example, in the earlier example of Kweku, Kweku should be able to say whether he prefers concerts to movies, movies to concerts, or is indifferent between movies and concerts
The model of consumer choice does not apply to those individuals who are incapable of making choices
E.g. Kweku says that he doesn’t know whether he prefers movies to concerts, or concerts to movies.

28. Preferences: Rationality
Second, the assumption of rationality assumes logical consistency
If Ama prefers a Toyota to a Honda, and a Honda to a Jeep, then she must prefer a Toyota to a Jeep!
This is the concept of logical consistency of consumers’ choices
When a consumer can make choices and is logically consistent, then we say s/he has rational preferences

29. Preferences: More is Better!
The second assumption is that most people feel that more is better
Caveat:
More of a GOOD thing is better
Consumers would not prefer more of a bad thing like diseases
…as long as nothing else is taken away
Consumers prefer more of a good thing some other consumption of goods and services are not taken away in exchange for more of the good
The model of consumer choice that we are about to discuss is designed for preferences that satisfy the ‘More is Better’ criteria
Let us examine the consequence of the ‘More is Better’ condition on the budget line…

30. Preferences: More is Better
Examine point G in diagram.... Do you think a consumer would ever consume at point G?
Although we have not fully developed the consumer choice model, we can say that a consumer would never consume anywhere below the BL, such as at point G
Why?
Because if we assume that more is preferred to less, then a consumer can afford, and is better off at points C or D, as opposed to point G
Although a consumer would prefer to consume at point H, again under the ‘more is better’ assumption, this point is unaffordable
Therefore, in reaching the optimal consumption bundle for Kweku, we can say that this will be found at some point along the budget line (i.e. point A, B, C, D, E or F)
In the next section, the Marginal Utility Approach will help to determine exactly which point along the budget line represents this optimal bundle. 15 A
Movies per month 12 B 9 C H G 6 D E 3 F 1 2 3 4 5
Concerts Per month

31. Marginal utility theory
Topic Two
Marginal utility theory

32. Utility and Marginal Utility
We assume that any decision maker tries to make the best out of every situation and maximize his/her satisfaction
According to the Marginal utility theory:
Consumers are constantly striving to maximize their utility
Consumers’ level of utility can be measured quantitatively
Anything that makes a consumer better off leads to an increases in utility
Anything that makes a consumer worse off leads to a decrease in utility

33. Utility and Marginal Utility
Assume a consumer, Ama, who likes ice cream cones
We can measure Ama’s satisfaction in “utils”
‘utils’ are the units of measurement of Ama’s satisfaction from eating ice cream cones

34. Utility and Marginal Utility- Tabular Illustration
Number of cones
Total Utility
(Utils)
Marginal Utility (Utils)
0 utils - 1 30 2 50 20 3 60 10 4 65 5 68 6
What do we notice about the table?
First, Ama’s total utility/ satisfaction increases with each cone consumed
However additional utility from each successive cone decreases, as Ama consumes more cones
This means that while the first cone brought Ama a large degree of satisfaction (30 utils), the fifth cone brought her a smaller (still positive!) level of satisfaction (3 utils).

35. Utility and Marginal Utility
Marginal utility is the change in utility that an individual enjoys from consuming an additional unit of a good
The Law of Diminishing marginal utility
As consumption of a good or service increases, marginal utility decreases
The marginal utility of a thing to anyone diminishes with every increase in the amount of it s/he already has
Why does marginal utility fall with each additional unit of the good consumed, however?
This is because as individuals consume more and more of a good, they begin to value it less, so that additional units consumed bring is smaller levels of satisfaction

36. Utility and Marginal Utility- Graphical Illustration
Utils
Total Utility 70
Number of cones
Total Utility
Marginal Utility
0 utils - 1 30 2 50 20 3 60 10 4 65 5 68 6 50 30 1 2 3 4 5 6
Ice cream cones per week
Utils 30
Given the ‘preferences’ assumptions of the Marginal Utility theory, would Ama ever consume more than 5 ice cream cones?
No. This is because we assume that ‘more is preferred to less’. When Ama consumes the 6th cone, her MU is zero, which violates the assumption.
Therefore, the MU theory that we are developing only holds for situations where ‘more is preferred to less’, or where the MU is positive and non-zero. 20 10
Marginal Utility 1 2 3 4 5 6
Ice cream cones per week

37. Combining the Budget constraint and Preferences
Now, we have learnt about both the Budget Constraint and consumers preferences, using marginal utility concepts
To recap:
Marginal Utility tells us about a person’s preferences
Budget Constraint tells us which combinations of goods s/he can afford
Combining the information on both preferences and budget constraint can yield an individual’s utility-maximising choice

38. Illustration
Go back to Kweku and his consumption of concerts and movies
We will use the same information about his budget constraint in the table in the next slide
I.e. Entertainment budget= Ghc150, prices of movies= Ghc10 and concerts= Ghc30
In the table on the next slide, we insert some additional information about preferences
We show that marginal utility decreases with increased consumption and increases with decreased consumption (Law of Marginal Utility)
We also introduce the concept of Marginal Utility Per Price (MU/P)

39. The Budget Constraint and Preferences
Kweku Consumption Possibilities with Income of Ghc150 per month
Point on Budget line
Concerts at Ghc30
Movies at Ghc10
No. of concerts / month
MU from last concert (MU)
MU per Ghc spent on last concert (MU/P)
No. of Movies / month
MU from last movie (MU)
MU per Ghc spent on last movie (MU/P) A - 15 50 5 B 1
1500 12
100 10 C 2
1200 40 9
150 D 3
600 20 6
200 E 4
450
350 35 F
360

40. Budget Constraint and Preferences
Marginal Utility per Price i.e. MU/P is the marginal utility per Ghc spent by Kweku on concerts or movies
It refers to the additional gain in utility for each ghana cedi that Kweku spends on concerts or movies
MU/P also decreases with increases in consumption
This is also as a result of the law of diminishing marginal returns
As consumption increases, marginal utility decreases
Since prices are assumed constant, as marginal utility decreases with increased consumption, so does the marginal utility per price

41. Budget Constraint and Preferences
Kweku’s aim is to find affordable combination of movies and concerts that gives him highest possible utility/ satisfaction
This is where the marginal utility per Ghc is the same for both goods
i.e. (MU/P) movies = (MU/P) concerts
Why is this so?
At points B and C, the MU/P for concerts is greater than the MU/P for movies
This implies that a consumer would derive greater satisfaction from spending his/her last ghana cedi on concerts than on movie, indicating that more concerts should be consumed
At points E, the MU/P for movies is greater than the MU/P for concerts
This implies that a consumer would derive greater satisfaction from spending his/her last ghana cedi on movies than on concerts, indicating that more movies should be consumed
At point D, the MU/P for movies= MU/P for concerts and there is no incentive to move.
This is the equilibrium/ optimal consumption bundle for Kweku, with 3 concerts and 6 movies.

42. The Budget Constraint and Preferences
Kweku Consumption Possibilities with Income of Ghc150 per month
Point on Budget line
Concerts at Ghc30
Movies at Ghc10
No. of concerts / month
MU from last concert (MU)
MU per Ghc spent on last concert (MU/P)
No. of Movies / month
MU from last movie (MU)
MU per Ghc spent on last movie (MU/P) A - 15 50 5 B 1
1500 12
100 10 C 2
1200 40 9
150 D 3
600 20 6
200 E 4
450
350 35 F
360

43. The Budget Constraint and Preferences
Therefore, if Kweku is at consumption points B or C, he will move downwards along the budget line, consuming more concerts, until he reaches point D
If Kweku is at E, he would move upwards along his budget line, consuming more movies, until he reaches point D
Kweku will continue to shift consumption until he is at point D where there is no longer any incentive to more up or down the budget line.
This is the optimal consumption point 15 A
(MU/P)c= 40; (MU/P)m= 15
Movies per month 12 B 9 C
(MU/P)c= 20; (MU/P)m= 20
(MU/P)c= 15; (MU/P)m= 35 6 D E 3 F 1 2 3 4 5
Concerts Per month

44. Budget Constraint and Preferences
Generalization
For any two goods x and y, with prices Px and Py,
Whenever MUx/Px > MUy/Py,
A consumer is made better off by shifting spending away from y and towards x
And whenever MUx/Px < MUy/Py,
A consumer is made better off by shifting spending away from x and towards y
A utility-maximising consumer will choose a point on the budget line where marginal utility per dollar is the same for both goods
i.e. where MUx/Px = MUy/Py

45. What happens when things change?
We arrived at Kweku’s optimal consumption bundle of 6 movies and 3 concerts under the assumptions that
Kweku’s total income is Ghc150
Price of movies is Ghc10
Price of concerts is Ghc30
Suppose Kweku’s income increases to Ghc300?
What do you think will happen to his budget line?
In the table on the next slide, we indicate that with a higher income, Kweku can afford more quantities of concerts and movies
The new optimal consumption point is found, again, where the marginal utilities for both concerts and movies are equal
i.e. 6 concerts and 12 movies

46. The Budget Constraint and Preferences
Kweku Consumption Possibilities with Income of Ghc300 per month
Concerts at Ghc30
Movies at Ghc10
No. of concerts / month
MU from last concert (MU)
MU per Ghc spent on last concert (MU/P)
No. of Movies / month
MU from last movie (MU)
MU per Ghc spent on last movie (MU/P) 3
600 20 21 2 4
450 15 18 30 5
360 12 50 6
300 10
100 7
180 9
150

47. The Budget Constraint and Preferences
Movies per month K 27
The increase in income may be represented graphically as a parallel shift of the budget line in an upward and outward motion
Kweku’s new consumption bundle would therefore be at any point along the higher budget line
At H, what type of a good is concerts? Movies?
Normal goods
At point J, what type of a good is concerts? Movies?
Concerts are normal goods; movies are inferior goods
At K, what type of a good is concerts? Movies?
Movies are normal goods; concerts are inferior goods H 12 D 6 J 3 3 6 9
Concerts Per month

48. The Budget Constraint and Preferences
Effects of a Change in income on the budget line
A rise in income with no change in prices leads to an upward and outwards shift of the budget line, and a new quantity demanded for each good.
Whether a particular good is normal (increase in quantity demanded) or inferior (quantity demanded decreases) depends on the individual’s preferences

49. What happens when Things Change?
What is the effect of a change in price on the budget line?
What happens to Kweku’s consumption when the price of a concert decreases from Ghc30 to Ghc10
Assume income and price of movies remains constant
When the price of concerts falls, in the table, we observe that Kweku can consume greater quantities of both concerts and movies
The new optimal consumption bundle is found, again, where the marginal utility per price for both concerts and movies are exactly the same
i.e. 7 concerts and 8 movies

50. The Budget Constraint and Preferences
Kweku Consumption Possibilities with Income of Ghc150 per month
Concerts at Ghc10
Movies at Ghc10
No. of concerts / month
MU from last concert (MU)
MU per Ghc spent on last concert (MU/P)
No. of Movies / month
MU from last movie (MU)
MU per Ghc spent on last movie (MU/P) 3
600 60 12
100 10 4
450 45 11
120 5
360 36
135
13.5 6
300 30 9
150 15 7
180 18 8
190 19
200 20
67.5
6.75
210 21

51. Deriving the Demand Curve
What happens if price of concerts falls further to Ghc5?
Illustrate with diagram
As illustrated on the next slide, a decrease in the price of concerts leads to a pivot of the budget line along the concerts axis
A further decrease in the price of concerts leads to a further pivoting of the budget line along the concerts axis
Each time the price of concerts changes, so does quantity demanded of concerts
This can be plotted on a graph at the bottom in order to derive the demand curve for concerts
A decrease in the price of concerts leads to an increase in the quantity demanded of concerts
i.e. downward sloping demand curve for concerts

52. Deriving the demand Curve
Movies per month 10 8 6
Price per Concert 3 7 10 15 30
Concerts Per month 30 10 5 3 7 10
Concerts Per month

53. Discuss: The Paradox of Value
Also known as the “Diamond-water” paradox
Why do many essential products that we use have relatively low prices?
On the other hand, luxury products like diamonds have very high prices.

54. The Paradox of Value Goods like water are readily available
As consumers consume more and more of them, their marginal utility falls
It is not total use of diamonds or water that matters
Use of each additional unit, rather
Since water so readily available, marginal utility from additional unit is low
Diamonds are not as available and therefore, consumption is low and additional unit worth more
People willing to pay higher price for it

55. References
Economics: Principles and Applications: Hall R.E. and Lieberman M. (2008), Thomson/ South Western (4th Edition)