Consumer Preference

& The Theory of Demand

Dr. Gong Jie

Agenda

Consumer Preference
♦ What do you like?
Consumer Choice
♦ How much of what you like should you buy?
Demand Theory
♦ Where does the demand curve come from?
Consumer Surplus
♦ How much net benefit does the consumer gain from a
purchase?
Part I: Consumer Preference
Consumer Preference

Tells us how the consumer would rank (compare the

desirability of) any two combinations of goods.
♦ These combinations of goods are referred to as baskets or
bundles.

Three properties of consumer preference

♦ Completeness
♦ Transitivity
♦ Monotonicity
Three Properties of Consumer Preference

1. Completeness
♦ Given any 2 bundles of goods a consumer either
 Prefers bundle A to bundle B: A ≻ B.
 Or prefers bundle B to bundle A: A ≺ B.
 Or is indifferent between the two: A ~ B.

Completeness implies that consumers can compare

and rank all possible baskets.
2. Transitivity
♦ A consumer who prefers basket A to basket B, and basket
B to basket C also prefers basket A to basket C, i.e. if A ≻
B, and B ≻ C, then A ≻ C.
Transitivity is normally necessary for preference
consistency.
♦ No transitivity  no choice among three or more options!
3. Monotonicity (More is Better)
♦ A basket with more of at least one good and no
less of any good is preferred to the original basket.
♦ Example:
 X, Y two goods in a bundle
 Bundle A: (5, 6), Bundle B: (5, 5), Bundle C: (4, 6):
 Then A is preferred to B and C by monotonicity.
 How about B vs. C?
♦ Monotonicity doesn’t apply!
♦ It depends on how much satisfaction a consumer
derives from a bundle of X and Y.
♦ We need more information on consumer preference.
Utility Function

Utility is a numerical score representing the level of

satisfaction that a consumer receives from a given
basket of goods.
Utility function assigns a number to each basket to
measure the level of satisfaction that a consumer
receives from the basket of goods.
U =U (x)
One example:
U ( x) = x
Graphical Illustration of Utility Function
This curve states the functional
relationship between the utility
 Marginal utility: the and the consumption of x,
U: utility
additional utility one holding other factors constant.
receives from (one)
additional unit of
consumption of the goods. C
•
MU x =
ΔU B
• U ( x) = x

ΔX
•
A
 Marginal utility is
represented by the slope of
the curve.
X: weekly consumption of Coke
Diminishing Marginal Utility

With the increase in consumption, does the curve

become steeper or flatter?
♦ Apparently, it gets flatter, but why?
The principle of diminishing marginal utility states
that the marginal utility falls as the consumer
consumes more of a good.
Managerial Insights
♦ Compensate frequent customers
Utility Function with Two Goods: Example

X,Y two goods in a bundle

Compare bundles
♦ A: (5,6), B: (5,5), C: (4,6), and D (3,10)
His utility function is
U ( x, y) = xy
A ~ D ≻ B ≻ C since:
U (5,6) =U (3,10) = 30 >U (5,5) =5 >U (4,6) = 24
Can we visualize the level of satisfaction from these
bundles?
Indifference Curves

 An indifference curve plots all Good Y

the combinations of goods U ( x, y) = xy
that give a consumer the same
level of satisfaction.
 The consumer is equally
100 E
satisfied with all combinations
of goods on one indifference F U=20
curve. 50
G
100/3
 One indifference curve 25
H U=15
represents one level of utility. U=10

1 2 3 4 Good X
The Shape of Indifference Curves

 The slope of the indifference curve measures the rate at

which the consumer will give up one good to get more of
another, holding the level of utility constant.
-From bundle E to F the consumer must give Good Y
up 50 units of Y to get one more unit of X.
-From bundle F to G the consumer must give
100 E
up 16.67 units of Y to get one more unit of X.
-From bundle G to H the consumer must give
F
up 8.33 units of Y to get one more unit of X. 50
G
-As the consumer obtains more X, the amount 33.33 H
25 U=10
of Y she is willing to give up to obtain another
unit of X decreases.
1 2 3 4 Good X
Diminishing Marginal Rate of Substitution

The marginal rate of substitution(MRS) is the

absolute value of the slope of the indifference curve.
Δy MU x MU x  x  MU y  y  0
MRS  - 
Δx MU y
The MRS of one good(x) for another good(y)
diminishes as the consumption of x increases.
♦ Thus the indifference curve gets flatter as x increases.
Special Preferences

Perfect substitutes
♦ Consumers are always willing to substitute good x
for good y at a constant rate.
 Coke and Pepsi
Perfect complements
♦ Consumers are completely unwilling to substitute
one good for another.
 Left shoe and right shoe
y Indifference curves for perfectly
substitutable goods:
Constant Marginal Rate of Substitution

U=aX+bY
MUx=a, MUy=b
MRS=a/b

IC1 IC2 IC3

0 x
 Indifference Curves for
y Perfect Complements

One left shoe, U=min{X,Y}

two right shoe

IC2

IC1

One left shoe, one

right shoe
0 x
Where are we?

We’ve described consumer preferences without any

restrictions imposed by budget.
How do consumers behave under budget constraints?
Part II: Consumer Choice
Budget Constraint

Represents the goods and services consumers

can afford.
Assume a consumer may purchase two goods, x
and y. The price of x is Px and the price of y is
PY, while the consumer has an income of I.
Then total expenditure on the basket can not
exceed the income I, i.e.

PX X +PY Y ≤I
Budget Set and Budget Line
 Budget set
♦ The set of all bundles consumers can afford
PX X +PY Y ≤I
 Budget line
♦ The bundles of goods that exhaust a consumer’s income
PX X + PY Y = I
♦ Or,
I PX
Y= - X
PY PY
 Slope of Budget Line
𝑃𝑥
 The budget line has a slope of − Y
𝑃𝑦
 The slope represents the rate at
which two goods can be Budget Line:
substituted without changing the I/PY
Y = I/PY – (PX/PY)X
income.
♦ If good x is twice as expensive
as good y, then a consumer
must give up 1 unit of x to gain
unaffordable
2 units of y to remain on the
budget line. I/PX
X
 Market rate of substitution
affordable
Changes in the Budget Line
Budget Line:
Y
 Changes in Income I1/PY Y = I/PY – (PX/PY)X
 Increases lead to a parallel,
outward shift in the budget I0/PY
line (I1 > I0).
 Decreases lead to a parallel, I2/PY
downward shift (I2 < I0).

 Changes in Price I2/PX I0/PX I1/PX

X
Y
• A decrease in the price of New Budget Line for
good X rotates the budget line I /P a price decrease
0 Y
counter-clockwise (PX0 > PX1).
• An increase rotates the budget
line clockwise (not shown).

I0/PX0 I0/PX1
X
Consumer Choice

A rational consumer chooses the basket that

maximizes his/her utility (satisfaction) given
the budget constraint.
Consumer’s problem
MaxU ( x, y )
( x, y )
Px x + Py y ≤I
 What would consumers choose?

The optimal consumption Y

bundle is the affordable Consumer
bundle that yields the highest I/PY
Equilibrium
level of satisfaction.
Consumer chooses the bundle B
C
♦ On the budget line V.
♦ On the highest indifference III.
A
curve II.
I.
I/PX
X
Condition for Optimal Choice

The budget line is tangent to the indifference curve.

♦ The slope of the indifference curve is the same as
the slope of the budget line.
MU X PX
=
MU Y PY
The rate at which the consumer would be willing to
exchange X for Y is the same as the rate at which
they are exchanged in the marketplace.
Consumers’ Decision Rule

How to judge if a consumption bundle is the optimal?

MU X PX MU X MU Y
= =
 PX PY
MU Y PY

The money spent on good x must brings the same

amount of additional utility as the money spent on
good y does, vice versa.
Interior and Corner Solution

An optimal bundle in which all goods are consumed

in positive amount is an interior solution.
But: in some cases, the optimal bundle is not interior.
♦ e.g., you derive the same utility from Coke and Pepsi, and you
have $5. What’s the optimal bundle?
Corner solution is an optimal bundle at which the
consumption of at least one product is 0.
♦ Here, MRS does not equal to the price ratio.
How Do Income Changes Affect Consumer
Choice?
Normal Goods
♦ Good X is a normal good if an increase
(decrease) in income leads to an increase
(decrease) in its consumption.
Inferior Goods
♦ Good X is an inferior good if an increase
(decrease) in income leads to a decrease
(increase) in its consumption.
Normal Goods

Y
An increase in
income increases
the consumption of I1/Y

normal goods.

(I0 < I1).

B
Y1
I0/Y
II
A
Y0
I
X0 I0/X X1 I1/X X
0
How Do Price Changes affect Consumer
Choice?
Substitute Goods
♦ An increase (decrease) in the price of good X leads
to an increase (decrease) in the consumption of
good Y.
 Coke and Pepsi, Starhub and MobileOne.
Complementary Goods
♦ An increase (decrease) in the price of good X leads
to a decrease (increase) in the consumption of
good Y.
 DVD and DVD players, Computer CPUs and monitors.
Complementary Goods

When the price of

Pretzels (Y)
good X falls and the
consumption of Y
rises, then X and Y I/PY
1
are complementary
goods. (PX1 > PX2)

B
Y2

Y1 A II

I
0 X1 I/PX1 X2 I/PX2 Beer (X)
Part III: Demand Theory
& Consumer Surplus
 Where does individual demand curve
come from?
Y

 When price of x decreases from

P0 to P1: the budget constraint B
changes from I to II; optimal A
II
bundle moves from A to B; I
quantity demanded for x
X0 X1
increases from x0 to x1. $ X

 An individual’s demand curve

is derived from each new P0
equilibrium point found on the D
P1
indifference curve as the price
X0 X1
of good X varies. X
 Where does individual demand curve
come from? Cont’
Y

 The consumer is maximizing

utility at every point along the B
demand curve. A
II

I
 As the price of x falls, utility
X0 X1
increases along the demand $ X
curve.

P0

P1 D

X0 X1 X
From Individual to Market Demand
 The market demand curve is the horizontal summation
of individual demand curves.
 It indicates the total quantity all consumers would
purchase at each price point.

$ Individual Demand $ Market Demand Curve

Curves
50

40

D1 D2 DM
1 2 Q 1 2 3 Q
Consumer Surplus

Definition: The net economic benefit to the consumer

due to a purchase (i.e. the willingness to pay of the
consumer net of the actual expenditure on the good)
is called consumer surplus.
P
♦ The area under an ordinary
demand curve: the benefit
from certain consumption
♦ The area under an ordinary
demand curve and above the
market price provides a
measure of consumer surplus.
P*

Q
The Discrete Case
Suppose there are 4 consumers with
Price different willingness to pay for houses and
each can buy at most 1 house:

Consumer 1 values the house at 8 million

8 Consumer 2 values the house at 6 million
Consumer 3 values the house at 4 million
6 Consumer 4 values the house at 2 million

2
Demand
1 2 3 4 5 Quantity
The Discrete Case
Suppose the market price is 2 million.
Price
Consumer Surplus is the value
10 received but not paid for.
CS= (8-2) + (6-2) + (4-2) + (2-2)
8
= $12.
6

1 2 3 4 5 Quantity
Notes on Discrete Market Demand

Represents consumers’ willingness to pay for the

product in decreasing order
As the number of consumers with different
willingness-to-pay increases, market demand curve
will become smoother.
With a large number of consumers, market demand
can be modeled as a smooth curve.
 The Continuous Case

Price $

10
Value
Consumer 8 of 4 units = $24
Surplus =
$24 - $8 =
$16
6

4 Expenditure on 4 units =
$2 x 4 = $8

2
D
1 2 3 4 5 Quantity
I got a great deal!

That company offers a lot

of bang for the buck!
Dell provides good value.
Total value greatly exceeds
total amount paid.
Consumer surplus is large.
I got a lousy deal!

That car dealer drives a

hard bargain!
I almost decided not to
buy it!
They tried to squeeze the
very last cent from me!
Total amount paid is
close to total value.
Consumer surplus is low.
Takeaway

Consumer preference is described by utility functions.

Consumer choice is modeled by utility maximization
problem with budget constraint.
A consumer is maximizing utility at every point along
the demand curve.
We use consumer surplus to measure how much
economic value is captured by consumers through
their market transactions.