Lecture 1 - Consumer choice

Assumptions about choice

• Consumers aim to maximise satisfaction

• Consumers can choose different combinations of the two goods and may be indifferent between certain combinations

• Indifference being the same level of satisfaction or utility

indifference curves

• A, B or C give the same satisfaction

• D gives more satisfaction than A, B or C

• The slope is the marginal rate of substitution (MRS) - rate at which the consumer is willing to substitute one good for another

• The value for one good equals the amount the other good the consumer is willing to sacrifice, for an additional unit

Four Properties

1. Higher curves are preferred to lower ones

2. Slopes downwards

3. Do not Cross

4. Convex to the origin

Perfect substitutes

• Identical utility: Each unit of good A gives the same satisfaction as a unit of good B.

• Constant marginal rate of substitution (MRS): The consumer is always willing to trade one good for the other at a fixed rate.

• Straight-line indifference curves: Indifference curves are linear with a constant slope.

• Corner solutions: Consumers buy only the cheaper good; if prices are equal, any combination is acceptable.

Examples

1. Bottled water

2. Sugar

Perfect Complements

• Fixed consumption ratio: Goods must be used in a specific proportion (e.g. 1:1).

• Zero substitutability: One good cannot replace the other.

• L-shaped indifference curves: Utility only increases when both goods increase together.

• No trade-off at the margin: The marginal rate of substitution (MRS) is not smooth and effectively undefined at the kink.

Example

1. Left shoes and right shoes

2. Printers and ink cartridges

3. Cars and fuel

The Consumers Optimum

• At the optimum point the slopes of the indifference curve and budget line are equal

• Therefore,

MRS = Relative price

• The rate at which the consumer wants to trade is equal to the rate at which the market will trade

What happens if Income Changes?

• Higher income consumers can afford more of both goods

• New optimum point depends on consumer’s preferences

• If the consumer buys more AS income increases the good becomes normal

Income effect on a Normal good

• As real income increases, quantity demanded increases.

• As real income falls, quantity demanded falls.

• The income effect is positive.

Example:

With higher income, a consumer buys more fresh food, branded clothing, or leisure services.

Income effect on an Inferior good

• As real income increases, quantity demanded decreases.

• As real income falls, quantity demanded increases.

• The income effect is negative.

Example:

When income rises, consumers switch away from budget supermarket brands or instant noodles toward higher-quality alternatives.

Effects of price change

Income effect: change in consumption that results from the consumer moving to a different indifference curve

Substitution effect: change in consumption that results from the consumer moving along the indifference curve in the direction of the good that has got relatively cheaper

Indifference Curve to a demand curve

Giffen goods

Giffen goods are a rare type of inferior good for which an increase in price leads to an increase in quantity demanded, violating the law of demand.

Why this happens

A price rise has two effects:

1. Substitution effect – consumers substitute away from the good (always negative).

2. Income effect – real income falls.

For a Giffen good, the negative income effect is so strong that it outweighs the substitution effect, causing demand to rise when price rises.

Key conditions for a Giffen good

• The good must be inferior.

• It must form a large proportion of the consumer’s income.

• There must be no close substitutes.

• Consumers are typically low-income, relying heavily on the good.

Example

• Staple foods such as bread, rice, or potatoes in very poor households.
  If the price of the staple rises, consumers cannot afford better foods and are forced to buy more of the staple to meet calorie needs.