6 Consumer Choice

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Consumer ChoiceConsumer Choice

Hall and Lieberman, 3rd edition,

Thomson South-Western, Chapter 5



2

Overview Overview

You will learn from this chapter

1. Budget constraint, interpretation

of its slope and components2. Marginal utility and the law of

diminishing marginal utility

3. Assumptions economists makeabout preferences

4. Utility maximization and thesolution derivation logic



3

Consumer Theory Consumer Theory

You are constantly making economic decisions

At the highest level of generality, we are all verymuch alike

² Come up against the same constraintsToo little income or wealth

Too little time to enjoy it all

The theory of individual decision making is

called ́ consumer theoryµ



4

Part I. The Budg et ConstraintPart I. The Budg et Constraint

Virtually all individuals must face two facts ofeconomic life

² Have to pay prices for the goods andservices they buy

² Have limited funds to spend A consumer·s budget constraint identifies which

combinations of goods and services the consumercan afford with a limited budget

Mathematical expression:² Px * X + Py * Y = m² Where m is budget, Px and Py are prices for

good X and good Y respectively



5

The Budg et Constraint The Budg et Constraint

Graphical representation of a budget constraint:budget line

² The price of one good relative to the price of

another

² Interpretation on the vertical / horizontal intercepts

² The slope of the budget line indicates the spendingtrade-off between one good and another

Amount of one good, that must be sacrificed inorder to buy more of another good

If PY is the price of the good on the vertical axis,then the slope of the budget line is ²PX / PY



Figure 1: The Budg et LineFigure 1: The Budg et Line

x P

m

Slope is - Px/Py

(a)

Good X

Good Y

y P

m



7

Figure 1( a): The Budg et Constraint-- Example


Max·s entertainment budget:

² m = $150

Max is making choice to go to a localrock concert (Good X) or see a movie(Good Y):

² A movie ticket (Px) = $10² A concert ticket (Py) = $30



8



A

B

G

H

Number ofConcerts

per Month

Number ofMovies per

Month

15

12

9

6

3

1 2 3 4 5

With $150 per month, Maxcan afford 15 movies andno concerts, . . .

12 movies and 1 concert or any other

combination on the budget line.

Points below the line arealso affordable.

But not points

above the line.

D

F

E

C



9

Chang es in the Budg et LineChang es in the Budg et Line

Changes in income

² Increase in income will shift the budget lineupward (and rightward)

² A decrease in income will shift the budgetline downward (and leftward)

² Shifts are parallel

Changes in income do not affect the budget

line·s slope



10

Figure 2a: Income Chang es in theBudg et LineFigure 2a: Income Chang es in theBudg et Line

1. An increase in income shiftsthe budget line rightward,with no change in slope.

(a)

Number ofConcerts per

Month

5

15

15

Number of Moviesper Month

30

10



11

Chang es in the Budg et LineChang es in the Budg et Line

Changes in pr ice

² In each case, one of the budget

line·s intercepts will change, aswell as its slope

When the price of a good

changes, the budget line rotates²Both its slope and one of its

intercepts will change



12

Figure 2b: Price Chang es in the Budg etLineFigure 2b: Price Chang es in the Budg etLine

2. A decrease in the price of moviesrotates the budget line u pwar d. Movie ticket pr ice dr o p f or m $10 to $5

(b)


Month

5

15

15


30



13

Figure 2c: Price Chang es in the Budg et LineFigure 2c: Price Chang es in the Budg et Line

3. while a decrease in the price of concer ts rotates it r ightwar d.C oncer t ticket pr ice dr o ps f r om $30 to $10


Month

5

15

15


30

(c)



14

Part II. PreferencesPart II. Preferences

How can we possibly speak systematicallyabout people·s preferences?

² People are different Despite differences in preferences, can find

some important common denominators

² something true for a wide variety of people

They are focus in our theory ofconsumer choice



15

Assumptions on Preferences-- (1 ) R ationality

Assumptions on Preferences-- (1 ) R ationality

People have preferences² We assume that you can look at two

alternatives and state either that you prefer

one to the other or entirely indifferentbetween the Preferences are logically consistent, or

transitive Rational preference: choices can be made and

they are logically consistent Rationality is a matter of how you make your

choices, and not what choices you make² What matters is that you make logically

consistent choices



16

Assumptions on Preferences-- (2 ) More Is Better

Assumptions on Preferences-- (2 ) More Is Better

We generally feel that more is better

The model of consumer choice in thischapter is designed for preferences thatsatisfy the ´more is betterµ condition² It would have to be modified to take

account of exceptions

The consumer will always choose a point onthe budget line² Rather than a point below it



17

Consumer Choice: Tw o TheoriesConsumer Choice: Tw o Theories

Theories of consumer decision making

² Marginal utility

² Indifference curveBoth assume that preferences are rational

Both assume that consumer would be betteroff with more of any good

Both theories come to same general

conclusions about consumer behavior² However, to arrive at those conclusions

each theory takes a different road



18

Part III. Consumer Decisions: TheMarg inal Utility ApproachPart III. Consumer Decisions: TheMarg inal Utility Approach

Utility: a quantitative measure of pleasureor satisfaction obtained from consuminggoods and services

Assume that consumers as striving tomaximize their utility

² any decision maker tries to make thebest out of any situation

Anything that makes the consumer betteroff is assumed to raise his utility

² Anything that makes the consumerworse off will decrease his utility



19

Marg inal Utility Marg inal Utility

Marginal utility (MU) of an additional unit

² Change in utility derived from consuming

an additional unit of a good The law of diminishing marginal utility, as

defined by Alfred Marshall (1842-1924) statesthat

² Marginal utility of a thing to anyonediminishes with every increase in theamount of it he / she already has



20

Example: Total And Marg inal Utility -- Ice Cream Consumption

Example: Total And Marg inal Utility -- Ice Cream Consumption

Number ofcones

TotalUtility

MarginalUtility

0 0 -

1 30 30

2 50 20

3 60 10

4 65 5

5 68 3

6 68 0



21

Figure 3: Total And Marg inal Utility Figure 3: Total And Marg inal Utility

Total Utility

Marginal Utility

Utils 302010

Ice Cream Cones per Week1 2 3 4 5 6

Utils605040

70

302010

Ice Cream Cones per Week1 2 3 4 5 6

1. The change in total utility from

one more ice cream cone . . .

2. is called the mar ginal utility

of an additional cone.3. Marginal utility

falls as more conesare consumed.



22

Marg inal Utility Approach-- Central Idea

Marg inal Utility Approach-- Central Idea

An individual·s utility-maximizing choice

² What is the best affordable combination ofthe two goods?

² Considering both marginal utility values andthe budget constraint

Central idea:

² Highest possible utility will be point at whichmarginal utility per dollar is the same forboth goods

² Otherwise, individual has incentive to deviate,i.e., chooses alternative combination



23

Figure 4: Consumer Decision Mak ing Figure 4: Consumer Decision Mak ing

A

B

C

D

E

G

F

15

12

9

6

3

1 2 3 4 5 Number ofConcerts per

Month

Number ofMovies per

Month 15 P

MU 40,

P

MU

movies

movies

concerts

concerts

!!

2 0 P

MU 2 0,

P

MU

movies

movies

concerts

concerts

!!

35 P

MU 15,

P

MU

movies

movies

concerts

concerts

!!



24

Marg inal Utility Approach-- Ho w does it w ork?

Marg inal Utility Approach-- Ho w does it w ork?

For any two goods x and y, with prices Px and PY,whenever MUx / Px > MUY / PY, a consumer ismade better off shifting away from y and toward x

² Vice versa Leads to an important conclusion

² A utility-maximizing consumer will choose thepoint on the budget line where marginal utility

per dollar is the same for both goods (MUX / PX= MUY / PY)

² At that point, there is no further gain fromreallocating expenditures in either direction



25

Marg inal Utility Approach-- Utility Maximization Condition

Marg inal Utility Approach-- Utility Maximization Condition

Utility will be maximized where

MUX / PX = MUY / PY for any pair of

goods x and y² If this condition is not satisfied, consumer

will be better off consuming more of one andless of the other good in the pair



26

W hat Happens W hen Things Chang e:Chang es In Income W hat Happens W hen Things Chang e:Chang es In Income

A rise in income³with no change in price³leadsto a new quantity demanded for each good

² Whether a particular good is normal (quantitydemanded increases) or inferior (quantitydemanded decreases) depends on theindividual·s preferences

As represented by the marginal utilities foreach good, at each point along the budgetline



27

Figure 5: Effects of an Increase in IncomeFigure 5: Effects of an Increase in Income

1. When Max'sincome risesto $300, hisbudget lineshiftsoutward.

H'

H''

H

30

27

15

12

9

6

3

1 2 3 4 5 6 7 8 9 10 Number of Concertsper Month

Number ofMovies per

Month

2. If his preferences are as given inthe table, he'll choose point H

3.But di ff er ent marginalutility numbers couldlead him to H' or H''

A

B

C

D

EF



28

Chang es In PriceChang es In Price

A drop in the price of concerts rotates thebudget line rightward, pivoting around itsvertical intercept

The consumer will select the combination ofmovies and concerts on his budget line thatmakes him as well off as possible

² Will be combination at which marginalutility per dollar spent on both goods is thesame



29

The Individual·s Demand Curve The Individual·s Demand Curve

Curve showing quantity of a good orservice demanded by a particular

individual at each different price



30

Figure 6: Deriving the Demand CurveFigure 6: Deriving the Demand Curve

J D

D

J K

2. If the price falls to$10, Max's budgetline rotatesrightward, and hechoose point J .

3. And if the price dropsto $5, he chooses pointK .

Price perConcert

$30

105

3 7 10 Number of Concertsper Month

15

6

3 5 15 300

108

7 10

Number ofMovies per

Month K

4. The demand curve showsthe quantity Max choosesat each price.

1. When the price of concerts is$30, point D is best for Max.

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6 Consumer Choice