The Theory of Consumer

Choice

Dr Ashikur Rahman
Utility, Total Utility and Marginal Utility
• In economics, the satisfaction or pleasure consumers derive from
the consumption of goods is called “utility”.

• Total utility is the total utility a consumer derives from the

consumption of all units of a good over a given consumption
period.

• Marginal utility is the utility a consumer derives from the last unit of
a good she or he consumes during a given consumption period.

• Total utility = Sum of marginal utilities

• The Law of Diminishing Marginal Utility
Over a given consumption period, as more and more of a good is
consumed by a consumer, beyond a certain point, the marginal
utility of additional units begins to fall.
 Total and Marginal Utility for Ice Cream
Total Utility Q ($) TU ($) MU
200
0 0
150
1 40 40
2 85 45
100
3 120 35
50
4 140 20
0
1 2 3 4 5 6 7 8 9 10 11 5 150 10
6 157 7
Marginal Utility 7 160 3
50
8 160 0
40 9 155 -5
30
20
10 145 -10
10 145
0
1 2 3 4 5 6 7 8 9 10 11
-10
How much ice cream does Jill buy
-20
in a month?
BUDGET CONSTRAINT: What a consumer can afford

• The budget constraint depicts the limit on the consumption

“bundles” that a consumer can afford.

• People consume less than they desire because their

spending is constrained by their income.

• Budget constraint shows various combinations of goods

the consumer can afford given his or her income and the
prices of the two goods.

• If a consumer wants to spend $ 1,000 on Pepsi and pizza,

where price of Pepsi is $ 2 and Pizza is $10, then probable
combinations would be:
Probable combinations of Pepsi and Pizza
under Budget Constraint
Figure 1 The Consumer’s Budget Constraint

Quantity
of Pepsi
B
500

E
Cannot be E

C
250

Consumer’s
budget constraint

A
0 50 100 Quantity of Pizza
• Illustration of Figure 1 (Consumer’s Budget Constraint)
• For example, if the consumer buys no pizzas, he can afford 500
pints of Pepsi (point B). If he buys no Pepsi, he can afford 100 pizzas
(point A).
• Alternately, the consumer can buy 50 pizzas and 250 pints of Pepsi
(point C).
• But the consumer cannot go out of the inner boundary of budget
line (point E).
• Any point on the budget line indicates the consumer’s
combination or tradeoff between two goods
• The slope of the budget line equals the relative price of the two
goods, that is, the ratio of price of one good compared to the
price of the other.
• It measures the rate at which a consumer trade a good for other
PREFERENCES: What a consumer wants

• 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 satisfaction
 Figure 2 The Consumer’s Preferences

Quantity
of Pepsi
C

B D
I2
Indifference
A
curve, I1
0
Quantity of Pizza
Representing Preferences with Indifference Curves
• The Consumer’s Preferences
• The consumer is indifferent, or equally happy, with the
combinations shown at points A, B, and C because they
are all on the same curve.
• The Marginal Rate of Substitution
• The slope at any point on an indifference curve is the
marginal rate of substitution.
• It is the rate at which a consumer is willing to trade one good for
another.
• It is the amount of one good that a consumer requires as
compensation to give up one unit of the other good.
 Figure 2 The Consumer’s Preferences

Quantity
of Pepsi MRS = MU (Piz) / MU (Pep)
= Change in Pepsi/Change in Pizza
C

B D
MRS I2
1
Indifference
A
curve, I1
0
Quantity of Pizza
 Four Properties of Indifference Curves
• Property 1: Higher indifference curves are
preferred to lower ones.
• Consumers usually prefer more of something to get.
• Higher indifference curves represent larger quantities of goods than
do lower indifference curves.

• Property 2: Indifference curves are downward

sloping.
• A consumer is willing to give up one good only if he or she gets
more of the other good in order to remain equally happy.
• If the quantity of one good is reduced, the quantity of the other good
must increase.
• For this reason, most indifference curves slope downward.
 Figure 2 The Consumer’s Preferences

Quantity
of Pepsi
C

B D
I2
Indifference
A
curve, I1
0
Quantity of Pizza
 Four Properties of Indifference Curves

• Property 3: Indifference curves do not cross.

• Points A and B should make the consumer equally happy.
• Points B and C should make the consumer equally happy.
• This implies that A and C would make the consumer equally happy.
• But C has more of both goods compared to A.
• Property 4: Indifference curves are bowed inward.
• People are more willing to trade away goods that they have in
abundance and less willing to trade away goods of which they have
little.
• These differences in a consumer’s marginal substitution rates cause
his or her indifference curve to bow inward.
 Figure 3 The Impossibility of Intersecting Indifference Curves

Quantity
of Pepsi

0
Quantity of Pizza
 Figure 4 Bowed Indifference Curves

Quantity
of Pepsi

14

MRS = 6

A
8
1

4 B
MRS = 1
3
1
Indifference
curve

0 2 3 6 7
Quantity of Pizza
 OPTIMIZATION: What the consumer chooses
• Consumers want to get the combination of goods on
the highest possible indifference curve.
• However, the consumer must also end up on or below
his budget constraint.

The Consumer’s Optimal Choices

• Combining the indifference curve and the
budget constraint determines the consumer’s
optimal choice.
 Figure 6 The Consumer’s Optimum

Quantity
of Pepsi
MRS =
MUPiz /MUPep= PPiz /PPep
Optimum

B
A

I3
I2
I1

Budget constraint
0
Quantity of Pizza
 The Consumer’s Optimal Choice
• Consumer optimum occurs at the point where the highest indifference
curve and the budget constraint are tangent.
• The consumer chooses consumption of the two goods so that the
marginal rate of substitution equals the relative price.
• For Two-Good Rule
MUPep $PPep
--------- = ----------
MUPiz $PPiz
How Changes in Income Affect the Consumer’s
Choices
• An increase in income shifts the budget constraint
outward.
• The consumer is able to choose a better combination of
goods on a higher indifference curve.
• Normal versus Inferior Goods
• If a consumer buys more of a good when his or her income
rises, the good is called a normal good (+)
• If a consumer buys less of a good when his or her income
rises, the good is called an inferior good (-).
Figure 7 An Increase in Income

Quantity
of Pepsi New budget constraint

1. An increase in income shifts the

budget constraint outward . . .

New optimum

3. . . . and
Pepsi
consumption. Initial
optimum I2

Initial
budget
I1
constraint

0 Quantity
of Pizza
2. . . . raising pizza consumption . . .
Figure 8 An Inferior Good

Quantity
of Pepsi New budget constraint

1. When an increase in income shifts the

3. . . . but budget constraint outward . . .
Initial
Pepsi
optimum
consumption
falls, making
New optimum
Pepsi an
inferior good.

Initial
budget I1 I2
constraint
0
Quantity of Pizza
2. . . . pizza consumption rises, making pizza a normal good . . .
How Changes in Prices Affect Consumer’s
Choices
• A fall in the price of any good rotates the budget constraint outward
and changes the slope of the budget constraint.
• Substitute the cheaper goods if price of one goods increase relative
to another
Figure 9 A Change in Price

Quantity
of Pepsi

New budget constraint

1,000 D

New optimum
B 1. A fall in the price of Pepsi rotates
500
the budget constraint outward . . .
3. . . . and
raising Pepsi Initial optimum
consumption.
Initial I2
budget I1
constraint A
0 100
Quantity of Pizza
2. . . . reducing pizza consumption . . .
 Summary
• A consumer’s budget constraint shows the possible
combinations of different goods he can buy given his income
and the prices of the goods.
• The slope of the budget constraint equals the relative price of
the goods.
• The consumer’s indifference curves represent his preferences.
• Points on higher indifference curves are preferred to points on
lower indifference curves.
• The slope of an indifference curve at any point is the
consumer’s marginal rate of substitution.
• A consumer optimizes by choosing the point on his budget
constraint that lies on the highest indifference curve.
 Summary
• When the price of a good falls, the impact on the
consumer’s choices can be broken down into an income
effect and a substitution effect.
The two effects of a price change:
• Income effect:
Normal good (+)
Inferior goods (-)
• Substitution effect
Happens as Price of Pepsi decreases, Pizza became
comparatively expensive
Consumer buy less Pizza and substituting it with Pepsi until
the optimizing condition is restored (-)