Consumer Choice and Utility

Consumer Choice

• Focuses on how individuals make decisions and how this affects demand.

• Aims to model the underlying behavior behind individual demand curves.

• Framework to understand consumer behavior regarding price and income changes.

Consumer Theory

• Examines how individuals make decisions under scarcity.

• Step 1: Preferences (what the individual wants).

• Step 2: Constraints (what the individual can do, e.g., income and prices).

• Step 3: Optimal decision (providing the most satisfaction).

• Consumer demand curves are derived in Step 3.

Utility

• Satisfaction from consuming a product.

• Total Utility: Total satisfaction from all units of a product.

• Marginal Utility: Change in satisfaction from consuming one more or one less unit.

Diminishing Marginal Utility

• Marginal utility decreases as consumption of a product increases, holding other consumption constant.

Paradox of Value

• Products that are widely available and heavily consumed have low marginal utility and price.

• Products with limited availability have high marginal utility and price.

• Example: Bread (vital, widely available) vs. Ferraris (not widely available).

• Adam Smith's original example: Water vs. Diamonds

Consumer Preferences

• Consumers allocate income to maximize satisfaction/utility.

• Basic assumption: Consumers are rational.

• Rational buyer:

  • All bundles of goods can be compared and ranked.

  • Consistency in ranking (similar bundles have similar rankings).

  • More is better.

  • Averages are preferred to extremes.

Modelling Consumer Preferences

• Assume the consumer prefers more to less.

• A bundle is a combination of quantities of different goods.

Indifference Curve (IC)

• Shows consumption bundles that yield the same utility.

• ICs slope downwards and cannot intersect.

• Slope gets flatter as you move to the right (convex to the origin).

Marginal Rate of Substitution (MRS)

• Slope of an IC.

• MRS = - (Marginal Utility of good X) / (Marginal Utility of good Y).

• Units of good Y a consumer can give up for 1 extra unit of good X while maintaining the same utility.

Budget Constraint

• Expenditure cannot exceed income.

• M ≥ PX X + PY Y where:

  • M = Income

  • P_X = Price of good X

  • X = Quantity of good X

  • P_Y = Price of good Y

  • Y = Quantity of good Y

• Consumer choice is limited by income and prices.

Budget Line

• Separates affordable from unaffordable bundles.

• Vertical intercept: Max QY = \frac{Income}{PY}

• Horizontal intercept: Max QX = \frac{Income}{PX}

• Slope of the budget line: -\frac{PX}{PY}

Changes in Budget Line

• Increase in income shifts the budget constraint to the right (slope remains constant).

• Increase in price pivots the budget constraint inward.

Optimal Choice

• Occurs where the budget line is tangent to the highest possible indifference curve.

Income Changes and Goods

• Normal Goods: Consumption increases when income increases (income elasticity > 0).

• Inferior Goods: Consumption decreases when income increases.

Price Changes

• A change in the price of one good rotates the budget line, changing its slope.

Price-Consumption Curve

• Shows how optimal consumption varies with price.

Individual Demand Curve

• Derived from the price-consumption curve.

Substitutes and Complements

• Substitutes: A fall in the price of product B leads to less of product A being bought.

• Complements: A fall in the price of product B leads to more of both products A and B being bought.

Maximizing Utility

• Occurs where MRS = -\frac{MUX}{MUY} = -\frac{PX}{PY}

• Equi-marginal condition: \frac{MUX}{PX} = \frac{MUY}{PY}

• Consumers adjust expenditure until the marginal utility per pound is equal for all goods.

Corner Solution

• When a good is not consumed, the tangency between IC and budget line is violated.

• Equilibrium where a consumer only consumes one of the two goods.