0. Chapter 5 Consumer choice and demand decisions
David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,
8th Edition, McGraw-Hill, 2005
PowerPoint presentation by Alex Tackie and Damian Ward

1. Four key elements in consumer choice
Consumer’s income
Prices of goods
Consumer preferences
The assumption that consumers maximise utility
See Section 5-1 in the main text.

2. The budget line Consider a student with a budget of £50 to spend on
meals and films. Assume also that
Pfilm = £10; Pmeal=£5 A B C D E F G
Income and prices together determine the combinations of the goods that the consumer can afford.
The budget line separates the affordable from the unaffordable.
Slope BL = relative prices = Pmeal /Pfilm = PX /PY
See Section 5-1 in the main text

3. Modelling consumer preferences
Quantity
of meals
Quantity of films a b c
Assume the consumer prefers more to less.
Compared with point a:
the consumer would prefer to be to the north-east, e.g. at c
but prefers a to such points as b to the south-west.
See Section 5-1 in the main text

4. Modelling consumer preferences (2)
Quantity
of meals
Quantity of films a b c
Preferred
region
Dominated e d
a is preferred to all points in the dominated region
but the consumer would prefer any point in the preferred region to a
points like d and e involve more of one good and less of the other compared with a.
See Section 5-1 in the main text

5. Modelling consumer preferences (3)
An indifference curve like U2U2 shows all the consumption bundles that yield the same utility to the consumer
ICs slope downwards (given our assumptions)
their slope gets steadily flatter to the right
ICs cannot intersect
Quantity
of meals
Quantity of films U2
See Section 5-1 in the main text

6. Characteristics of Indifference Curves
ICs slope DOWNWARDS (given our assumptions)
If they were to slope upwards,
As one moves upward along the IC, the consumer would be consuming more and hence increasing her utility.
This would be against the definition of the IC.
Hence IC’s canNOT slope upwards.
Quantity
of meals
Quantity of films U2
Wrong!
See Section 5-1 in the main text

7. Characteristics of Indifference Curves
their slope gets steadily flatter to the right
This is due to the assumptionof DIMINISHING MARGINAL UTILITY: the more the consumer consumes of one good, the less the utility she derives from the consumption of each additional unit of that good.
i.e. The more meals she has, the more hungry she becomes for films, and vice versa.
Slope IC = MRS og good Y for good X = ∆ no of films/ ∆ no of meals
Quantity
of meals
Quantity of films U2
See Section 5-1 in the main text

8. Characteristics of Indifference Curves
ICs cannot intersect
Otherwise, the consumer would be
indifferent between consumption bundles B and C;
(as they both lie on U1U1)
indifferent between consumption bundles C and D;
(as they both lie on U2U2)
Yet B would be preferable to D
(as B lies to the Northeast of point D)
which is impossible
Quantity
of meals
Quantity of films U2 U1 B D C
See Section 5-1 in the main text U1

9. The consumer’s choice U2 U3 U1
The point at which utility is maximised is found by bringing
together the indifference curves (U) and the budget line (BL) U3
Quantity of meals
Quantity of films U2 U1 BL C E B
The choice point is at C
where the budget line is at a tangent to an IC
Points B and E are also affordable
but give lower utility,
being on a lower IC.
See Section 5-1 and Figure 5-6 in the main text.

10. Adjustment to an income change
A change in the consumer’s income shifts the budget line
without changing the slope
The change in the pattern of consumer choice depends on the nature of the two goods
See Section 5-2 in the main text.

11. Normal goods Films When both goods are NORMAL, an increaseU2 U1
Meals
Films
BL0
BL1 C C'
When both goods are
NORMAL, an increase
in income induces a new
choice point at C'
The quantity demanded
of each good increases
See Section 5-2 and Figure 5-8 in the main text.

12. An inferior good and a normal good
Meals
Films
BL0
BL1 U2 U1 C C'
When “meals” is an inferior good
the increase in income takes the
consumer from C to C'
The quantity of meals falls and
the quantity of films increases
See Section 5-2 and Figure 5-9 in the main text.

13. Adjustment to a price change
An increase in the price of one good shifts the budget line
altering its slope
which reflects relative prices.
See Section 5-3 and Figure 5-10 in the main text.

14. An increase in the price of meals (1)
The increase in price of meals shifts the
budget line from BL0 to BL1
Meals
Films
BL0
BL1
See Section 5-3 and Figure 5-10 in the main text.
The increase in price reduces purchasing power.

15. An increase in the price of meals (2)U1 E
The consumer moves from C to E as the price of meals rises
Films
The overall effect is a reduction in quantity of meals demanded C U2
See Section 5-3 and Figure 5-10 in the main text. H
BL1
BL0
Meals
Tracing out more of such points at different prices enables us to identify the Demand curve.

16. Response to a price change
The response to a price change comprises two effects:
The SUBSTITUTION EFFECT
is the adjustment to the change in relative prices
THE INCOME EFFECT
is the adjustment to the change in real income.
See Section 5-3 and Figure 5-11 in the main text.

17. The substitution effectD
The hypothetical budget line HH has the slope of the NEW relative prices and is tangent to the OLD indifference curve at D.
Films U2 U1
The SUBSTITUTION EFFECT is from C to D along U2U2. C E
See Section 5-3 and Figure 5-11 in the main text. U2
It is always negative. In this case an increase in the price of meals leads to a fall in demand as we move from C to D. U1
BL1
BL0
Meals

18. The income effect The INCOME EFFECT is from D to E
Meals
BL0
BL1 U2 U1 C E H D
Films
it reflects the fall in real income at constant relative prices
it may be positive or negative
depending on whether the good is normal or inferior
See Section 5-3 and Figure 5-11 in the main text.

19. Income and substitution effects for an inferior good
The INCOME EFFECT is from D to E H
Films
in this case, it is positive because the good is inferior
and income and substitution effects therefore have opposite effects on demand
but the substitution effect is greater, so the overall effect is a fall in demand D C
See Section 5-3 in the main text. U2 E H U1
BL1
BL0
Meals

20. Income and substitution effects for a Giffen good
The INCOME EFFECT is from D to E
Films
in this case, it is positive because the good is inferior
and income and substitution effects therefore have opposite effects on demand
but the substitution effect is smaller, so the overall effect is an increase in demand H D C U2
See Section 5-3 and Figure 5-12 in the main text. E U1 H
BL1
BL0
Meals

21. Transfers in cash and in kind10 F A 
AF is the initial budget constraint QF
An equivalent cash transfer gives a budget line of A'e1F' A'  e0 
On which the individual settles at e0 e2 
The individual can now be better off at e2 14 e1 F' 
Ae1F' is the new budget constraint 
Given A'e1F’, the best the individual can do is e1
Films
See Section 5-6 and Figure 5-16 in the main text. QM
Meals

22. Deriving the market demand curve
The market demand curve is the horizontal sum of the individual demand curves
Consumer 1 5 11
If at a price of £5, consumer 1 demands 11 units
Market 24
then market demand at a price of £5 will be 24 units.
Price
Consumer 2 13
and consumer 2 demands 13 units
See Section 5-4 in the main text.
Quantity