1. Chapter 5 Theory of Consumer Behavior

2. Learning Objectives
Explain the concept of utility and basic assumptions underlying consumer preferences
Define the concept of indifference curves and explain the properties of indifference curves and maps
Construct a consumer’s budget line and explain how to rotate or shift the line when prices or income change
Derive/interpret equilibrium conditions for a consumer to be maximizing utility subject to a budget constraint
Use indifference curves to derive a demand curve for an individual consumer and construct a market demand curve by horizontally summing individual demands
Define a corner solution and explain the condition that creates a corner solution

3. The Consumer’s Optimization Problem
Individual consumption decisions are made with the goal of maximizing total satisfaction from consuming various goods and services
Subject to the constraint that spending on goods exactly equals the individual’s money income

4. Consumer Theory Assumes buyers are completely informed about:
Range of products available
Prices of all products
Capacity of products to satisfy
Their incomes
Requires that consumers can rank all consumption bundles based on the level of satisfaction they would receive from consuming the various bundles

5. Typical Consumption Bundles for Two Goods, X & Y (Figure 5.1)

6. Properties of Consumer Preferences
Completeness
For every pair of consumption bundles, A and B, the consumer can say one of the following:
A is preferred to B
B is preferred to A
The consumer is indifferent between A and B
Transitivity
If A is preferred to B, and B is preferred to C, then A must be preferred to C
Nonsatiation
More of a good is always preferred to less

7. Utility
Benefits consumers obtain from goods & services they consume is utility
A utility function shows an individual’s perception of the utility level attained from consuming each conceivable bundle of goods
U = f(X, Y)

8. Indifference Curves
Set of points representing different bundles of goods & services, each of which yields the same level of total utility
Downward-sloping & convex

9. Typical Indifference Curve (Figure 5.2)

10. Marginal Rate of Substitution
MRS measures the number of units of Y that must be given up per unit of X added so as to keep utility constant
Negative of the slope of the indifference curve
Diminishes along the indifference curve as X increases & Y decreases
Ratio of the marginal utilities of the goods

11. Slope of an Indifference Curve & the MRS (Figure 5.3)
600
800 A B T T’
Quantity of good Y
C (360,320)
320
360
Quantity of good X

12. Indifference Maps
An indifference map consists of several indifference curves
The higher (or further to the right) an indifference curve, the greater the level of utility associated with the curve
Combinations of goods on higher indifference curves are preferred to combinations on lower curves

13. Indifference Map (Figure 5.4)II
III IV
Quantity of Y
Quantity of X

14. Marginal Utility
Addition to total utility attributable to the addition of one unit of a good to the current rate of consumption, holding constant the amounts of all other goods consumed

15. Consumer’s Budget Line
Shows all possible bundles of goods that can be purchased at given prices if the entire income is spent or

16. Consumer’s Budget Constraint (Figure 5.5)

17. Typical Budget Line (Figure 5.6)• A B
Quantity of Y
Quantity of X

18. Shifting Budget Lines (Figure 5.7)
120
240 A
Panel B – Changes in price of X
200
100 A B
100
250 D
125 C F Z 80
160
Quantity of Y
Quantity of Y B
200
Quantity of X
Quantity of X
Panel A – Changes in money income

19. Utility Maximization
Utility maximization subject to a limited income occurs at the combination of goods for which the indifference curve is just tangent to the budget line

20. Utility Maximization
Consumer allocates income so that the marginal utility per dollar spent on each good is the same for all commodities purchased

21. Constrained Utility Maximization (Figure 5.8)50 A • I • E
III • D IV 45
Quantity of pizzas C • B II R T 40 30 20 15 10 10 20 30 40 50 60 70 80 90
100
Quantity of burgers

22. Utility Maximization, N Goods
The utility maximization principle is easily extended to cover any number of goods

23. Individual Consumer Demand
An individual’s demand curve for a specific commodity relates utility-maximizing quantities purchased to market prices
Income & prices held constant
Slope of demand curve illustrates law of demand—quantity demanded varies inversely with price

24. Deriving a Demand Curve (Figure 5.9)
100
Quantity of Y
Px=$10
Px=$8
Px=$5 50 65 90
100
125
200
Quantity of X 10 8
Price of X ($) 5
Demand for X 50 65 90
Quantity of X

25. Market Demand & Marginal Benefit
List of prices & quantities consumers are willing & able to purchase at each price, all else constant
Derived by horizontally summing demand curves for all individuals in market
Because prices along market demand measure the economic value of each unit of the good, it can be interpreted as the marginal benefit curve for a good

26. Derivation of Market Demand (Table 5.1)
Quantity demanded
Price
Consumer 1
Consumer 2
Consumer 3
Market demand $6 3 12 13 5 8 10 7 10 1 3 5 6 8 1 4 3 5 6 4 12 3 19 2 25 1 31

27. Derivation of Market Demand Figure (5.10)

28. Corner Solution
In many cases consumers spend their entire budget and choose to purchase none of some specific good
A corner solution exists when the utility maximizing bundle lies at one of the endpoints of the budget line and the consumer chooses to consume zero units of a good

29. Corner Solution: X* = 0 Figure (5.11)

30. Corner Solution
For goods X and Y, a corner solution, in which the consumer purchases none of good X, results when
In general, a corner solution, in which the consumer purchases none of good X, results when

31. Summary Basic premise for analyzing consumer behavior
Individuals make consumption decisions with the goal of maximizing their total satisfaction from consuming various goods and services, subject to the constraint that their spending on goods exactly equals their incomes
The benefit consumers obtain from the goods and services they consume is called utility
The utility function shows an individual's perception of the level of utility from consuming each conceivable bundle of goods
Marginal utility is the addition to total utility attributable to adding one unit of a good, holding constant the amounts of all other goods consumed
The marginal rate of substitution (MRS) shows the rate at which one good can be substituted for another while keeping utility constant

32. Summary
An indifference curve is a set of points representing different bundles of goods and services, each of which yields the same level of total utility
The consumer’s budget line shows the set of all consumption bundles that can be purchased at given prices and income if the entire income is spent
A consumer maximizes utility subject to a limited income at the combination of goods for which the indifference curve is just tangent to the budget line
At this combination, the MRS is equal to the price ratio

33. Summary
An individual consumer’s demand curve relates utility-maximizing quantities to market prices, holding constant income and prices of all other goods
The slope of the demand curve illustrates the law of demand: quantity demanded varies inversely with price
Market demand is derived by horizontally summing the demand curves for all individuals in the market
When a consumer spends the entire budget and chooses to purchase none of a specific good, this outcome is called a corner solution