Consumer Choice:

Indifference Theory
Chapter 5

LIPSEY & CHRYSTAL

ECONOMICS 12e
 Introduction
• In this chapter we look more closely at the
determinants of consumer demand. In
particular, we discuss the concept of utility
and use it to gain insights into how
consumers allocate their spending.
• We show how indifference curves can be
used to describe consumers’ tastes and then
introduce a budget line to describe the
consumption possibilities open to a consumer
who has a given income.
 Learning Outcomes
• In particular, you will learn that:
• Consumers will maximize their overall satisfaction when
the marginal utility per pound spent is equal for all
products purchased.
• A theory of demand can be built by focusing on bundles
of goods between which the consumer is indifferent.
• Indifference curves show combinations of goods that
give the same level of satisfaction.
• A budget constraint shows what the consumer could buy
with a given income.
• A consumer optimizes by moving to the highest
indifference curve that is available with a given budget
constraint.
 Learning Outcomes
• In particular, you will learn that (cont’d):
• The response to a price change can be decomposed into
an income and a substitution effect.
• For a good to have a negatively sloped demand curve it
is necessary (but not sufficient) that it be an inferior
good.
• The basic assumption here is that consumers
are motivated to make themselves as well off
as they can, or as economists like to put it: to
maximize their satisfaction, or utility.
• All units of the same product are identical but
the satisfaction that a consumer gets from
each unit of a product in not the same.
• This suggests that the satisfaction that people
get from consuming a unit of any product
varies according to how many of this product
they have already.
• Economists and philosophers thinking about
consumer choice and satisfaction in the
nineteenth century developed the concept of
utility and were hence sometimes called
utilitarians.
• But the big breakthrough for economics came
in the 1870s with what is known as the
marginal revolution, which gave birth to
neoclassical economics.
 Marginal and total utility
• The satisfaction a consumer receives from
consuming that product is called utility.
• Total utility refers to the total satisfaction
derived from all the units of that product
consumed.
• Marginal utility refers to the change in
satisfaction resulting from consuming one
unit more or one unit less of that product.
 Diminishing marginal utility
• A basic assumption of utility theory, which is
sometimes called the law of diminishing
marginal utility, is as follows:

The marginal utility generated by additional

units of any product diminishes as an
individual consumes more of it, holding
constant the consumption of all other
products.
 Maximizing utility
• We can now ask: what does diminishing
marginal utility imply for the way a consumer
who has a given income will allocate
spending in order to maximize total utility?
• How should a consumer allocate his or her
income in order to get the greatest possible
satisfaction, or total utility, from that
spending?
• If all products had the same price, the answer
would be easy.
• A consumer should simply allocate spending
so that the marginal utility of all products was
the same.
• If the marginal utility of all products were not
equal then total utility could be increased by a
different spending pattern.
 For example!
• If one product had a higher marginal utility
than the others, then expenditure should be
reallocated so as to buy more of this product,
and less of all others that have lower
marginal utilities.
• By buying more, its marginal utility would fall.
This continues until the consumer's utility
equates to his/her expenditure and utility is
maximized.
• How does this work if products have different
prices?
• Again, the same principles apply but now the
best a consumer can do is to rearrange
spending until the last unit of satisfaction per
pound spent on each product is the same.
 Note!

To maximize utility consumers allocate

spending between products so that equal
utility is derived from the last unit of
money spent on each.
 Conditions for maximising utility
• The conditions for maximizing utility can be
stated more generally.
• Denote the marginal utility of the last unit of
product X by MUX and its price by pX.
• Let MUY and pY refer, respectively, to the
marginal utility of a second product, Y, and its
price.
• The marginal utility per pound spent on X will
be MUX/pX.
• The condition required for any consumer to
maximize utility is that the following
relationship should hold, for all pairs of
products:
 Note!
• This is the fundamental equation of utility
theory.
• Each consumer demands each good up to
the point at which the marginal utility per
pound spent on it is the same as the marginal
utility of a pound spent on each other good.
• When this condition is met, the consumer
cannot shift a pound of spending from one
product to another and increase total utility.
 Consumers choose quantities not
prices
• If we rearrange the terms in previous
equation we can gain additional insight into
consumer behaviour:
• The right-hand side of this equation states the
relative price of the two goods.
• It is determined by the market and is beyond
the control of individual consumers, who react
to these market prices but are powerless to
change them.
• The left-hand side of the equation states the
relative contribution of the two goods to add
to satisfaction if a little more or a little less of
either of them were consumed, a choice that
is available.
 Note!
• If the two sides of eqn (5.2) are not equal, the
consumer can increase total satisfaction by
changing the spending pattern.
• Assume, for example, that the price of a unit
of X is twice the price of a unit of Y (pX/pY =
2), while the marginal utility of a unit of X is
three times that of a unit of Y (MUX/MUY = 3).
• Reducing purchases of Y by two units frees
enough purchasing power to buy a unit of X.
• Since one extra unit of X bought yields 1.5
times the satisfaction of two units of Y
forgone, the switch is worth making.
• What about a further switch of X for Y?
• As the consumer buys more X and less Y, the
marginal utility of X falls and the marginal
utility of Y rises.
• In this example the consumer will go on
rearranging purchases—reducing Y
consumption and increasing X consumption—
until the marginal utility of X is only twice that
of Y.
• At this point, total satisfaction cannot be
further increased by rearranging purchases
between the two products.
 Note!
• It shows that an equilibrium position reached
when decision-takers have made the best
adjustment they can to the external forces
that constrain their choices.
• When they enter the market, all consumers
face the same set of market prices.
• When they are fully adjusted to these prices,
each one of them will have identical ratios of
their marginal utilities for each pair of goods.
• A rich consumer may consume more of each
product than a poor consumer and get more
total utility from them.
• However, the rich and the poor consumer
(and every other consumer who is maximizing
utility) will adjust their relative purchases of
each product so that the relative marginal
utilities are the same for all.
• Thus, if the price of X is twice the price of Y,
each consumer will purchase X and Y to the
point at which his or her marginal utility of X is
twice the marginal utility of Y.
• Consumers with different tastes will, however,
derive different marginal utilities from their
consumption of the various commodities.
• So they will consume differing relative
quantities of products
 Note!
• But all will have declining marginal utilities for
each commodity and hence, when they have
maximized their utility, the ratios of their
marginal utilities will be the same for all of
them.
 Income and Substitution Effects
of Price Changes
• Let s consider Tristan, a student who loves to
eat and especially loves to eat ice cream. A
fall in the price of ice cream affects Tristan in
two ways.
– It provides an incentive to buy more ice cream.
– Tristan has more purchasing power or real income
available to spend on all products.
• real income income expressed in terms of the
purchasing power of money income that is, the
quantity of goods and services that can be purchased
with the money income.
 The Substitution Effect
• Suppose the monthly allowance for ice cream is reduced when
ice cream price is decreased. Tristan can buy the same amount
of ice cream as before, no longer maximizing utility.
• Recall that utility maximization requires that the ratio of marginal
utility to price be the same for all goods. In our example, with no
change in behavior, the quantities (and hence marginal utilities)
and the prices of all goods other than ice cream are unchanged.
The quantity of ice cream is also unchanged, but the price has
fallen.
• To maximize his utility after the price of ice cream falls, Tristan
must therefore increase his consumption (reduce his marginal
utility) of ice cream and reduce his consumption of other goods.
In other words, he must substitute away from other goods and
toward ice cream.
 The Substitution Effect
• The change in the quantity of a good
demanded resulting from a change in its
relative price (holding real income constant).
• The substitution effect increases the quantity
demanded of a good whose price has fallen
and reduces the quantity demanded of a
good whose price has risen.
 The Income Effect
• Now we want to see the effect of the change
in purchasing power, holding relative prices
constant at their new value.
• Tristan s money income is returned to its
original level. If we assume that ice cream is
a normal good, Tristan will increase his
consumption of ice cream (even beyond the
increase we have already seen as a result of
the substitution effect).
 The Income Effect
• Income effect: The change in the quantity of a
good demanded resulting from a change in
real income (holding relative prices constant).
• The income effect leads consumers to buy
more of a product whose price has fallen,
provided that the product is a normal good.
• Notice that the size of the income effect
depends on the amount of income spent on
the good whose price changes and on the
amount by which the price changes.
 Consumer Surplus
• Suppose, I buy 1 lt of ice cream for $ 10, but I
only pay $ 6 (sale). The $4 “saved” in ice
cream buying is the “consumer surplus”.
• The difference between the total value that
consumers place on all units consumed of a
commodity and the payment that they
actually make to purchase that amount of the
commodity.
• Consumer surplus is a direct consequence of
negatively sloped demand curves.
• For any unit consumed, consumer surplus is
the difference between the maximum amount
the consumer is prepared to pay for that unit
and the price the consumer actually pays.
• The market demand curve shows the
valuation that consumers place on each unit
of the product. For any given quantity, the
area under the demand curve and above the
price line shows the consumer surplus
received from consuming those units.
 Consumers’ Surplus for the Market
Price

0 Quantity
Price
Consumers’ Surplus for the Market

Market price

p0

0 Quantity q0
 Consumers’ Surplus for the Market

· The area under the demand curve shows the total valuation
that consumers place on all units consumed.
· For example, the total value that consumers place on q0 units
is the entire area shaded red and green under the demand
curve up to q0.
· At a market price of p0 the amount paid for q0 units is the red
area.
· Hence consumers surplus is the green area under the
demand curve and above p0.
 The Paradox of Value
• Many necessary products, such as water,
have prices that are low compared with the
prices of luxury products, such as diamonds.
Water is necessary to our existence, whereas
diamonds are used mostly for luxury
purposes and are not in any way essential to
life.
• The first step in resolving this paradox is to
use the distinction between the total and
marginal values of any product.
 The Paradox of Value
• The second step in resolving the paradox is
to recognize that supply plays just as
important a role in determining market price
as does demand.
• Because the market price of a product
depends on both demand and supply, there is
nothing paradoxical in there being a product
on which consumers place a high total value
(such as water) selling for a low price and
hence having a low marginal value.
The Paradox of Value
Indifference Curves
 Indifference Curves
• The consumer is indifferent between the
combinations indicated by any two points on
one indifference curve.
• Any point above an indifference curve is
preferred to any point along that same
indifference curve; any point on the curve is
preferred to any point below it.
 Diminishing Marginal Rate of
Substitution
• The marginal rate of substitution (MRS) is the amount
of one product that a consumer is willing to give up to
get one more unit of another product.
• The first basic assumption of indifference theory is
that the algebraic value of the MRS between two
goods is always negativeto increase consumption
of one product, Hugh is prepared to decrease
consumption of a second product negative slope of
indifference curve
• Diminishing marginal rate of substitution (MRS) is the
second basic assumption of indifference theory.
Diminishing Marginal Rate of Substitution
The Indifference Map
 An Indifference Map

· A set of indifference curves is called an indifference map.

· The further the curve from the origin, the higher the level of
satisfaction it represents.
· Moving along the arrow is moving to ever-higher utility levels.
 Shapes of Indifference Curves

Perfect Substitutes Perfect Complements A good that gives zero

utility

Left hand gloves

Vegetables
I2
I2
I2 I1
I1
I1
0 0 0
[i]. Packs of green pins [ii]. Right hand gloves [iii]. Meat
 Shapes of Indifference Curves

A good that confers a negative utility A good that is

An absolute necessity after some level of consumption not consumed
I2 I1
a

All other goods

All other goods

All other goods

I2
I1 0 I2
w f0 0 b I1
0
[iv]. Water [v]. Food [vi]. Good X
 The Budget Line
• The budget line shows all combinations of
products that are available to the consumer
given his money income and the prices of the
goods that he purchases.
The Budget Line
 Property of Budget Line
• Points on the budget line indicate bundles of
products that use up the consumer s entire
income. (Try, for example, the point 20C, 20F.)
• Points between the budget line and the origin
indicate bundles of products that cost less than
the consumer s income. (Try, for example, the
point 20C, 10F.)
• Points above the budget line indicate
combinations of products that cost more than the
consumer s income. (Try, for example, the point
30C, 40F.)
 The Budget Line
• Let E stand for Hugh s money income, which
must be equal to his total expenditure on food
and clothing.
• If pF and pC represent the money prices of food
and clothing, respectively, and F and C represent
the quantities of food and clothing that Hugh
chooses, then his spending on food is equal to
pF times F, and his spending on clothing is equal
to pC times C.
• Thus the equation for the budget line is
 The Slope of the Budget Line
• The opportunity cost of food in terms of clothing is
measured by the (absolute value of the) slope of the
budget line, which is equal to the relative price ratio,
pF/pC.
• In the example, with fixed income and with the relative
price of food in terms of clothing (pF/pC) equal to 2, Hugh
must forgo the purchase of 2 units of clothing to acquire 1
extra unit of food. The opportunity cost of a unit of food is
thus 2 units of clothing. Notice that the relative price (in
our example, pF/pC * 2) is consistent with an infinite
number of absolute prices. If pF * $40 and pC * $20, it is
still necessary to sacrifice 2 units of clothing to acquire 1
unit of food.4 Thus relative, not absolute, prices determine
opportunity cost.
The Consumer s Utility-Maximizing Choices
 The Consumer s Utility-Maximizing
Choices
• The consumer s utility is maximized at the
point where an indifference curve is tangent
to the budget line. At that point, the consumer
s marginal rate of substitution for the two
goods is equal to the relative prices of the two
goods.
 The Consumer s Reaction to a
Change in Income
• A change in Hugh’s money income will,
ceteris paribus, shift his budget line.
• For each level of Hugh s income, there will be
a utility-maximizing point at which an
indifference curve is tangent to the relevant
budget line Hugh is doing as well as
possible at that level of income.
• Hugh s consumption bundle changes as his
income changes, with relative prices being
held constant.
 The Consumer s Reaction to a
Change in Price
• a change in the relative prices of the two
goods changes the slope of the budget line.
• Given the price of clothing, for each possible
price of food there is a different utility-
maximizing consumption bundle for Hugh. If
we connect these bundles, at a given money
income, we will trace out a price consumption
line
Income and Substitution Effects