NAVOTAS POLYTECHNIC COLLEGE

Subject: APPLIED ECONOMICS

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 Module 5:

Intended Learning Outcomes (ILO)

After this chapter you should be able to:

1. Explain the law of diminishing marginal returns

2. Define and graph the budget line and indifference curve
3. Determine the optimum combination and the marginal rate of substitution

Lecture Proper and Discussion

Consumer Behavior Theory

Theory of consumer behavior is the description of how consumers allocate incomes among di
fferent goods and services to maximize their well-being.

Consumer behavior is best understood in three distinct steps:

1. Consumer Preferences: The first step is to find a practical way to describe the reasons pe
ople might prefer one good to another. This will show how a consumer’s preferences for vari
ous goods can be described graphically and algebraically.

Market Baskets. This refers to such a group of items. Specifically, a market basket is
a list with specific quantities of one or more goods. A market basket might contain the variou
s food items in a grocery cart.

Some Basic Assumptions about Preferences

The theory of consumer behavior begins with three basic assumptions about people’s prefere
nces for one market basket versus another. We believe that these assumptions hold for most p
eople in most situations.

Completeness: Preferences are assumed to be complete. In other words, consumers c

an compare and rank all possible baskets. Thus, for any two market baskets A and B, a consu
mer will prefer A to B, will prefer B to A, or will be indifferent between the two. By indiffere
nt we mean that a person will be equally satisfied with either basket. Note that these preferen
ces ignore costs. A consumer might prefer steak to hamburger but buy ham- burger because it
is cheaper.

Transitivity: Preferences are transitive. Transitivity means that if a consumer prefers

basket A to basket B and basket B to basket C, then the consumer also prefers A to C. For exa
mple, if a Porsche is preferred to a Cadillac and a Cadillac to a Chevrolet, then a Porsche is al
so preferred to a Chevrolet. Transitivity is normally regarded as necessary for consumer consi
stency.

More is better than less: Goods are assumed to be desirable—i.e., to be good. Conse
quently, consumers always prefer more of any good to less. In addition, consumers are never
satisfied or satiated; more is always better, even if just a little better. This assumption is made
for pedagogic reasons; namely, it simplifies the graphical analysis.
 Indifference Curves
To show a consumer’s preferences graphically, we can use indifference curves. An indifferen
ce curve represents all combinations of market baskets that provide a consumer with the same
level of satisfaction.

Figure 3.1 shows the horizontal axis measures the number of units of food purchased each
week; the vertical axis measures the number of units of clothing.

Market basket A, with 20 units of food and 30 units of clothing, is preferred to basket G beca
use A contains more food and more clothing (recall our third assumption that more is better t
han less).

Similarly, market basket E, which contains even more food and even more clothing, is preferr
ed to A. In fact, we can easily compare all market baskets in the two shaded areas (such as E
and G) to A because they contain either more or less of both food and clothing.

Note, however, that B contains more clothing but less food than A. Similarly, D contains mor
e food but less clothing than A. Therefore, comparisons of market basket A with baskets B, D,
and H are not possible without more information about the consumer’s ranking.
 Marginal Rate of Substitution (MRS)

Maximum amount of a good that a consumer is willing to give up in order to obtain one addit
ional unit of another good.

2. Budget Constraints: Consumers also consider prices, therefore, it will take into account th
e fact that consumers have limited incomes which restrict the quantities of goods they can bu
y.

3. Consumer Choices: Given their preferences and limited incomes, consumers choose to bu
y combinations of goods that maximize their satisfaction. These combinations will depend on
the prices of various goods. Thus, understanding consumer choice will help understand the de
mand—i.e., how the quantity of a good that consumers choose to purchase depends on its pric
e.

4. Diminishing marginal rate of substitution: Indifference curves are usually convex, or bo

wed inward. The term convex means that the slope of the indifference curve increases (i.e., b
ecomes less negative) as we move down along the curve. In other words, an indifference curv
e is convex if the MRS diminishes along the curve.

Utility Approach

UTILITY - Numerical score representing the satisfaction that a consumer gets from a given
market basket.

UTILITY FUNCTIONS - A utility function is a formula that assigns a level of utility to each
market basket.

Suppose, for example, that Phil’s utility function for food (F) and clothing (C) is u(F,C) = F +
2C. In that case, a market basket consisting of 8 units of food and 3 units of clothing generate
s a utility of 8 + (2)(3) = 14. Phil is therefore indifferent between this market bas-
ket and a market basket containing 6 units of food and 4 units of clothing [6 + (2)(4) = 14].

On the other hand, either market basket is preferred to a third containing 4 units of food and 4
units of clothing. Why? Because this last market basket has a utility level of only 4 + (4)(2) =
12.

The utility function u(F,C) = FC tells us that the level of satisfaction obtained from consumin
g F units of food and C units of clothing is the product of F and C. Figure 3.8 shows indiffere
nce curves associated with this function. The graph was drawn by initially choosing one parti
cular market basket—say, F = 5 and C = 5 at point A. This market basket generates a utility l
evel U1 of 25. Then the indifference curve (also called an iso utility curve) was drawn by find
ing all market baskets for which FC = 25 (e.g., F = 10,C = 2.5 at point B; F = 2.5,C = 10 at po
int D). The second indifference curve, U2, contains all market baskets for which FC = 50 and
the third, U3, all market baskets for which FC = 100.
Suggested Teaching Activities (TAs)

Essay:

Assessment Tasks / Output (ATOs)

Powerpoint Presentation
Facilitated Discussion
Q and A (students pose questions)

Readings and Other References

Mankiw, Nicholas Gregory. Microeconomics. Ninth ed., Cengage Learning, 2013. Retrieved
from: https://www.cengageasia.com/