1. Chapter 5: Theory of Consumer Behavior
McGraw-Hill/Irwin
Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

2. 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

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

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

5. 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

6. 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

7. Indifference Curves
Locus of points representing different bundles of goods, each of which yields the same level of total utility
Negatively sloped & convex

8. Typical Indifference Curve (Figure 5.2)

9. Marginal Rate of Substitution
MRS shows the rate at which one good can be substituted for another while keeping 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

10. 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

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

12. 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

13. Consumer’s Budget Line
Shows all possible commodity bundles that can be purchased at given prices with a fixed money income or

14. Consumer’s Budget Constraint (Figure 5.5)

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

16. 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

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

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

19. 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

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

21. 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

22. 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

23. 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

24. Derivation of Market Demand Figure (5.10)

25. Substitution & Income Effects
When price changes, total change in quantity demanded is composed of two parts
Substitution effect
Income effect

26. Substitution & Income Effects
Substitution effect
Change in consumption of a good after a change in its price, when the consumer is forced by a change in money income to consume at some point on the original indifference curve
Income effect
Change in consumption of a good resulting strictly from a change in purchasing power

27. Income & Substitution Effects: A Decrease in Px (Figure 5.12)
Total effect of price decrease =
Substitution effect +
Income effect 9 5 4
Total effect of price decrease =
Substitution effect +
Income effect 3 5
(-2)

28. Substitution & Income Effects
Consider the substitution effect alone:
Amount of good consumed must vary inversely with price
Income effect reinforces the substitution effect for a normal good & offsets it for an inferior good

29. Summary of Substitution & Income Effects (Table 5.2)
Substitution Effect
Income Effect
Price of X decreases:
Normal Good
Inferior Good
Price of X increases:
X rises
X rises
X rises
X falls
X falls
X falls
X falls
X rises