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2. Four key elements in consumer choice
Consumer’s income
Prices of goods
Consumer preferences
The assumption that consumers maximize utility
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3. ©McGraw-Hill Education, 2014
The budget line
Consider a student with a
budget of £50 to spend on
meals and films.
Income and prices together determine the combinations of the goods that the student can afford.
The budget line separates the affordable (A to F) from the unaffordable (G).
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4. 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.
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5. Modelling consumer preferences (2)
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.
Quantity of meals
Quantity of films a b c
Preferred
region
Dominated e d
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6. Modelling consumer preferences (3)
Quantity
of meals
Quantity of films U2
An indifference curve (IC) 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
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The consumer’s choice
The point at which utility is maximized 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.
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8. 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.
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Normal goods U2 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.
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10. An inferior good and a normal good
Meals
Films
BL0
BL1 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 U2 U1
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11. Adjustment to a price change
An increase in the price of one good shifts the budget line
altering its slope
which reflects relative prices.
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12. 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
The increase in price reduces purchasing power.
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13. An increase in the price of meals (2)
Films E
The consumer moves from C to E as the price of meals rises
The overall effect is a reduction in quantity of meals demanded C U2 U1
BL1
BL0
Meals
Tracing out more of such points at different prices enables us to identify the demand curve.
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14. 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.
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15. 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
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. U2 U1
BL1
BL0
Meals
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The income effect H D
The income effect is from D to E.
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.
Films U2 U1 C E U2 U1
BL1
BL0
Meals
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17. Income and substitution effects for an inferior goodH
The income effect is from D to E.
In this case, it is positive because the good is inferior.
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.
Films D C U2 E H U1
BL1
BL0
Meals
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18. Income and substitution effects for a Giffen good
The income effect is from D to E.
In this case, it is positive because the good is inferior.
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.
Films H D C U2 E U1 H
BL1
BL0
Meals
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19. Transfers in cash and in kind F A QF
AF is the initial budget constraint
on which the individual settles at e0.
Ae1F' is the new budget constraint.  A' e2   
Given A'e1F’, the best the individual can do is e1. e0 e1 
Films
An equivalent cash transfer gives a budget line of A'e1F'.
The individual can now be better off at e2. F’  10 14 QM
Meals
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20. 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, and consumer 2 demands 13 units, then market demand at a price of £5 will be 24 units.
Price
Market 24
Consumer 2 13
Quantity
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Revealed preference
Consumers’ preferences are determined by observing consumers behaviour.
Suppose that a consumer faces two bundles, X and Y. If the consumer chooses X when also Y was affordable, then we may say that bundle X is revealed preferred to Y.
If our consumer behaves according to our theory, then we should expect her/him to always choose X instead of Y when both bundles are affordable.
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22. Revealed preference (2)
If we see our consumer choosing Y instead of X it should be the case that X has become not affordable, otherwise our consumer does not behave according to our theory.
The important aspect of revealed preferences is that if consumer behaviour satisfies some properties (known as the axioms of revealed preferences), then the consumer is indeed a utility maximizing agent.
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23. Concluding comments (1)
Given the budget constraint, the theory of demand assumes a consumer seeks to reach the maximum possible level of utility.
The budget line shows the maximum affordable quantity of one good for each given quantity of the other good.
Consumer tastes can be represented by a map of non-intersecting indifference curves.
Utility-maximizing consumers choose the consumption bundle at which the highest reachable indifference curve is tangent to the budget line.
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24. Concluding comments (2)
A change in the price of one good generates an income effect and a substitution effect.
The income effect of a price increase is to reduce the quantity demanded for all normal goods.
The substitution effect leads consumers to substitute away from the good whose relative price has increased.
The market demand curve is the horizontal sum of individual demand curves, at each price adding together the individual quantities demanded.
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