1 Chapter 3: Theory of Consumer Behavior

2 Indifference Curves and Budget Constraints Individuals seek to maximize utility by allocating income across a range of purchases subject to the constraints of their budgets Indifference curves represent all the different allocations of purchases where an individual is equally satisfied – Shape of the indifference curves describe whether goods are goods or bads –We usually assume diminishing marginal utility implies convex indifference curves Perfect substitutes and perfect complements are special cases –Intersecting indifference curves represent inconsistent behavior Budget constraints determine the allocations of purchases available to consumer and the budget line describes the maximum that can be purchased if consumer expends all his/her income

3 Indifference Curves Convex shape indicates diminishing MRS U1 U2 U3 Good X Good Y Utility increases moving up indifference curves in the northeast direction (U1<U2<U3) Slope of indifference curves indicates MRS

4 The Marginal Rate of Substitution (MRS) The MRS at any point on the IC represents the amount of one good (on the vertical axis) that a consumer is willing to trade for another (the good on the horizontal axis) to make her/him indifferent (same utility function) between two allocations –The absolute value of the the slope of the IC at a given point The MRS is (usually) different at different points on the IC because of the law of diminishing marginal utility (marginal utility declines as consumption of a good increases)

5 Budget Constraints Good Y Good X Intercepts where all income is Spent on one good or the other Budget line shows all consumption baskets that are possible with the given income

6 Utility Maximization With Constraint U2 U1 U3 Apples Oranges O* A*

7 Perfect Substitutes U1 U2 U3 Land O’ Lakes Butter Darigold Butter Note: Indifference curves have a slope of -1 (i.e. a one- to-one trade off)

8 Perfect Complements U1 U2 U3 Left Shoes Right Shoes

9 Effect of a Income Change: Normal Goods apples All other goods

10 Effect of a Income Change: Inferior Goods Spam All other goods

11 How Much of Each Good Should a Consumer Purchase to Maximize Utility ApplesOranges Total Utility Marginal Utility Marginal Utility/dollar Total Utility Marginal Utility Marginal Utility /dollar Apples= $2.00/lb Oranges=$1.50/lb

12 The Effect of Changes in Price on Demand ApplesOranges Total Utility Marginal Utility Marginal Utility/dollar Total Utility Marginal Utility Marginal Utility /dollar Apples= $2.50/lb Oranges=$1.50/lb

13 Sample Problem Assume both demand and supply have constant slopes Questions: 1What are the demand and supply equations? 2What are the equilibrium quantity and price levels? 3What are the new equilibriums if the product is found to be good for your health such that demand at every price increases by 10? PQdQd QsQs