Topic 1

The Consumer
 Topic 1. The Consumer.
2.1. Budget constraint
2.2. Consumer preferences: Indifference curves
2.3. Consumer optimal choice
2.4. The price-consumption function
2.5. Deduction of consumer demand
2.6. The substitution effect and income effect
2.7. The consumption function and Engel curves
 The Budget Constraint
◼ The budget constraint requires that the cost of a
consumer’s consumption bundle be no more than the
consumer’s total income.
◼ The budget constraint depicts the limit on the
consumption bundles (combinations of goods and
services) that a consumer can afford.
◼ A consumer’s budget set is the set of all consumption
possibilities that is all consumption bundles that can be
consumed given the consumer’s income and prevailing
prices.
◼ A consumer’s budget line shows the consumption
bundles available to a consumer who spends all of his or
her income.
x1·p1 + x2·p2 + x3·p3 + ... + xn·pn = m
x1·p1 + x2·p2 = m
The Budget Constraint

The Budget Line

 The Slope of the Budget Constraint

◼ The slope of the budget constraint line

equals the relative price of the two
goods, that is, the price of one good
compared to the price of the other.
◼ It measures the rate at which the
consumer can trade one good for the
other.
Changes in Income Shift the Budget Line
 Exercises

◼ Exercise 1
The consumer initial income is 500 monetary units (m.u.), the price
of food is 25 m.u. per unit of product and the price of other goods
is 50 m.u. per unit.
◼ a) Draw the budget line with food on the horizontal axis and
the rest of goods on the vertical axis
◼ b) Assume that the price of food increases to 50 m.u. Draw the
new budget line and interpret the change of the budget line
 Exercises

◼ Exercise 2 (at home)

Maria consumes two goods: pizzas and books. Let's consider the
following consumer baskets:
 X = basket containing 5 units of each of the two goods.
 Y = basket containing 10 pizzas and 2 books.
 Z = basket containing 3 pizzas and 6 books.
Represent the budget line of Mary (putting pizzas on the x-axis
and books in the y-axis) and tell which of these three baskets are
affordable in the following cases:
◼ a) When Mary has an income of 60€, the price of pizzas is 10€ per unit and
the price of books is 2€ per unit
◼ b) When Mary has an income of 110€, the price of pizzas is 10€ per unit and
the price of books is 5€ per unit
◼ c) When Mary has an income and prices of goods are such that the basket Z
is on its budget line, assuming that the opportunity cost of a pizza is one book.
 Consumption and Utility
◼ The utility of a consumer is a measure of the satisfaction
the consumer derives from the consumption bundles.
◼ An individual’s utility function gives the total utility
generated by his or her consumption bundle: more
preferred bundles have a higher utility
◼ The marginal utility of a good or service is the change in
total utility generated by consuming one additional unit of
that good or service. The marginal utility curve shows
how marginal utility depends on the quantity of a good or
service consumed.
◼ The principle of diminishing marginal utility says that
each successive unit of a good or service consumed
adds less to total utility than the previous unit.
 Total
(a) Cassie’s Utility Function
utility
(utils)
70 Total Marginal
Quantity
utility utility per
60 of clams
Utility (utils) clam (utils)
50 function 0 0
40 15
30 1 15
13
20 2 28
10 11
3 39
0 1 2 3 4 5 6 7 8 9 9
Quantity of clams 4 48
Marginal 7
utility per 5 55
(b) Cassie’s Marginal Utility Curve 5
clams 6 60
(utils) 3
7 63
16 1
14 8 64
12 –1
10 9 63
8 Marginal
6
Utility
4
2 Curve
0
–2 1 2 3 4 5 6 7 8 9
Quantity of clams
Preferences: Indifference Curves

◼ A consumer’s preference among

consumption bundles may be
illustrated with indifference curves.
◼ An Indifference Curve is a curve that
shows consumption bundles that give
the consumer the same level of utility.
 Preferences: Indifference Curves

An Indifference Curve
Indifference Curve Map
Preferences: Indifference Curves
 Four Properties of Indifference Curves

1. Higher indifference curves are

preferred to lower ones.
2. Indifference curves cannot cross
3. Indifference curves are downward
sloping.
4. Indifference curves are bowed inward
–convexity- (due to the principle of
diminishing marginal rate of
substitution)
Four Properties of Indifference Curves
◼ cannot cross
◼ prefer more of something to less of it.
Four Properties of Indifference Curves
◼ downward sloping.
◼ bowed inward (convex curve)
 The Marginal Rate of Substitution (MRS)

The Changing Slope of an Indifference Curve

→ the principle of diminishing Marginal Rate of Substitution.
 Exercise 3 (at home)

Maria has 14 hours per week to watch films or go to the gym. To watch a film she needs
2 hours and to go the gym also 2 hours. The table below gives the utility that she obtains
each time that she watches a film and goes to the gym per week. (Hint: the time that she
has is equivalent to the income that she can spend, and the hours that she needs to see
a film or go to the gymnasium are the price of these activities)
◼ a) Represent her budget line, putting the visits to the gym on the horizontal axis
and the films on the vertical axis. Indicate in the table the combinations that are
feasible if she uses all the 14 hours to go to the gym and watch films.
◼ b) Calculate the marginal utility of each visit to the gym and of each film that she
watches; and the marginal utility of each hour that she allocates to go to the gym
and to watch films.
 Consumer’s Optimal Choice

Tangency Condition
Consumer’s Equilibrium
 Consumer’s Optimal Choice
Tangency Condition (tangency between the
budget line and the indifference curve). The
marginal rate of substitution equals the relative
price.
MRS = P1 / P2

The Proportionality Rule or Consumer’s Optimal

Choice: equalization of the Marginal Utility of
each good weighted by its price

MU1 / P1 = MU2 / P2
The Law of Equalising
the Weighted Marginal Utilities
Perfect Substitutes

• Straight-line
Indifference Curves
• Constant MRS
Perfect Substitutes
Perfect Complements
• Right-angle
Indifference Curves
 Continuation of Exercise 3 (at home)

◼ c) Taking into account the rule of optimum consumption, how should she to
use her time?
 Exercise 4 (at home)

For the following situations, write the utility function and graphically
represent indifference curves that correspond to the following preferences:
◼ a) For Maria, cars and tires are perfect complements but at a ratio 1: 4 i.e., for each
car, Maria wants exactly 4 tires. Represent the tires on the horizontal axis and the
cars on the vertical axis
◼ b) When Maria drinks a soft drink, she only gets utility from caffeine ingested. She
can choose the soft drink A and the soft drink B, but the latter contains twice the
caffeine than the former. Represent soft drink B on the horizontal axis and soft
drink A on the vertical axis.
◼ c) The consumption of soda water brings utility to Mary, while water has no utility to
her. Draw water on the horizontal axis and soda water on the vertical axis.
◼ d) Maria likes burgers but dislikes soup. In order to incentivize Maria to eat soup,
her mother tells her that for every bowl of soup she can eat two hamburgers. Draw
the burgers on the horizontal axis and the bowls of soup on the vertical axis.
Effect of a change in income
The Income-Consumption Curve
The Engel Curve
The Income-Consumption Curve and
the Engel Curve
C de Engel
Q2 m

204
204

120

120
B 2,5 5 Q1
84 CRC

A U1
60

U0

2,5 5=120/24 8,5=204/24

Q1
The Income-Consumption Curve

◼ How do changes in income affect on

consumption of goods and services:
↳ Normal versus Inferior Goods and Services
 If a consumer buys more of a good when his or
her income rises, the good is called a normal
good or service.
 If a consumer buys less of a good when his or
her income rises, the good is called an inferior
good or service.
Inferior good
Effect of a change in prices
The Price-Consumption Curve
and the Demand Curve
The Price-Consumption Curve
and the Demand Curve
Q2 P1
120
24

12
D
60 A
2,5 7 Q1

U0 B CPC
36
U1

2,5 5=120/24 7 10=120/12

Q1
The Substitution Effect (SE)
and The Income Effect (IE)

◼ A price change has two effects on

consumption.
 A substitution effect (SE)
 An income effect (IE)
 The Substitution Effect (SE)
and The Income Effect (IE)

◼ The Substitution Effect (SE) is the variation

in the consumption of a good or service as a
result of the change in relative prices.
Specifically, we replace the relatively
expensive good or service with the relatively
cheap good or service:
 keeping utility constant (according to
HICKS)
 The Substitution Effect (SE)
and The Income Effect (IE)

◼ The Income Effect (IE) is the change in

consumption as a result of a change in
purchasing power due to price changes.
That is, a variation of a price causes a
change in real income mR.
 The Substitution Effect (SE)
and The Income Effect (IE)
◼ SE: ↓P1 → ↑Q1 (The SE is always positive)

◼ IE: ↓P1 → ↑mR → ↑Q1

(For normal goods and services, the IE is positive)
↓P1 → ↑mR → ↓Q1
(For inferior goods and services, the IE is negative)
◼ TE = SE + IE
 Normal goods and services: ↓P1 → ↑Q1
 Inferior goods and services:
◼ If |SE|>|IE|, then ↓P1 → ↑Q1
◼ If |SE|<|IE|, then ↓P1 → ↓Q1
 The Substitution Effect (SE)
and The Income Effect (IE)
◼ SE: ↑P1 → ↓Q1 (The SE is always negative)
◼ IE: ↑P1 → ↓I → ↓Q1
(For normal goods and services, the IE is negative)
↑P1 → ↓I → ↑Q1
(For inferior goods and services, the IE is positive)
◼ TE = SE + IE
 Normal goods and services : ↑P1 → ↓Q1
 Inferior goods and services:
◼ If |SE|>|IE|, then ↑P1 → ↓Q1
◼ If |SE|<|IE|, then ↑P1 → ↑Q1
Substitution and
Income Effects
 Exercise 5
Maria's breakfast consists of coffee with milk and cookies. She has 8.00€ to spend on the two goods.
Assume that she can measure the satisfaction that she receives from the consumption of both goods.
In the following table we have the values of total utility that she gets from the consumption of the
different combinations of two goods:

a) If a cookie is priced at 2.00€ and a cup of

coffee with milk is priced at 2.00€, what are the
combinations she can consume? Represent
the budget line, put cookies on the horizontal
axis and coffee with milk on the vertical axis.
Given the level of total utility of each basket,
what is her optimal basket?
b) The price of the cookies increases at 4.00€,
while the price of coffee is kept at 2.00€; what
are the baskets on the budget line? What is
her new best?
c) Compare the results of sections a) and b).
When cookies price increases, what
is the effect on the quantity of cookies
consumed? Describe the substitution
effect and the income effect of this increase in
the price of cookies.