Chapter 5: Theory of

Consumer Behavior

McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
 The Consumer’s
Optimization Problem
• Individual consumption decisions are
made with the goal of maximizing total
satisfaction from consuming various goods
and services
• Subject to the constraint that spending on
goods exactly equals the individual’s money
income

5-2
 Consumer Theory
• Assumes buyers are completely informed about:
• Range of products available
• Prices of all products
• Capacity of products to satisfy
• Their income
• Requires that consumers can rank all
consumption bundles based on the level of
satisfaction they would receive from consuming
the various bundles

5-3
Typical Consumption Bundles for
Two Goods, X & Y (Figure 5.1)

5-4
 Properties of Consumer
Preferences
• Completeness
• For every pair of consumption bundles, A and B,
the consumer can say one of the following:
 A is preferred to B
 B is preferred to A
 The consumer is indifferent between A and B
• Transitivity
• If A is preferred to B, and B is preferred to C,
then A must be preferred to C
• Nonsatiation
• More of a good is always preferred to less
5-5
 Utility
• Benefits consumers obtain from goods &
services they consume is utility
• A utility function shows an individual’s
perception of the utility level attained from
consuming each conceivable bundle of
goods

5-6
 Indifference Curves
• Locus of points representing different
bundles of goods, each of which yields
the same level of total utility
• Negatively sloped & convex

5-7
Typical Indifference Curve
(Figure 5.2)

5-8
Marginal Rate of Substitution
• MRS shows the rate at which one good can
be substituted for another while keeping
utility constant
• Negative of the slope of the indifference curve
• Diminishes along the indifference curve as X
increases & Y decreases
• Ratio of the marginal utilities of the goods

Y MU X
MRS   
X MUY
5-9
Slope of an Indifference Curve &
the MRS (Figure 5.3)

A
600
Quantity of good Y

C (360,320)
320
I
T’

B
0 360 800
Quantity of good X

5-10
Indifference Map (Figure 5.4)

Quantity of Y

IV

III

II

Quantity of
X 5-11
 Marginal Utility
• Addition to total utility attributable to the
addition of one unit of a good to the
current rate of consumption, holding
constant the amounts of all other goods
consumed

MU  U X

5-12
 Consumer’s Budget Line
• Shows all possible commodity bundles
that can be purchased at given prices
with a fixed money income

M  PX X  PY Y
or
M PX
Y  X
PY PY
5-13
Consumer’s Budget Constraint
(Figure 5.5)

5-14
Typical Budget Line (Figure 5.6)

M
PY
•A

M PX
Quantity of Y

Y  X
PY PY

B
•
M
Quantity of PX
X 5-15
 Shifting Budget Lines (Figure 5.7)

R
120
A A

Quantity of Y
Quantity of Y

100 100
F
80

Z B N C B D
16 20 24 12 20 25
0 0 0 5 0 0
Quantity of X Quantity of X

Panel A – Changes in money income Panel B – Changes in price

of X

5-16
 Utility Maximization
• Utility maximization subject to a limited
money income occurs at the combination
of goods for which the indifference curve
is just tangent to the budget line

Y MU X PX
MRS    
X MUY PY

5-17
 Utility Maximization
• Consumer allocates income so that the
marginal utility per dollar spent on each
good is the same for all commodities
purchased

MU X MUY

PX PY

5-18
Constrained Utility Maximization
(Figure 5.8)

50
45 •A
•B
Quantity of pizzas

40
•D
E IV
30
R
•
III
20
C
15 • II
T
10
I

0 10 20 30 40 50 60 70 80 90 100

Quantity of
burgers 5-19
Individual Consumer Demand
• An individual’s demand curve for a
specific commodity relates utility-
maximizing quantities purchased to
market prices
• Money income & prices held constant
• Slope of demand curve illustrates law of
demand—quantity demanded varies
inversely with price

5-20
Deriving a Demand Curve
(Figure 5.9)
100
Quantity of Y

Px=$10

Px=$8

Px=$5

0
50 65 90 100 125 200
Quantity of X

10
Price of X ($)

Demand for X

0 50 65 90
Quantity of X 5-21
Market Demand & Marginal Benefit
• List of prices & quantities consumers are
willing & able to purchase at each price, all
else constant
• Derived by horizontally summing demand
curves for all individuals in market
• Because prices along market demand
measure the economic value of each unit of
the good, it can be interpreted as the
marginal benefit curve for a good
5-22
 Derivation of Market Demand
(Table 5.1)

Quantity demanded
Market
Price Consumer 1 Consumer 2 Consumer 3
demand

$6 3 0 0 3

5 5 1 0 6

4 8 3 1 12

3 10 5 4 19

2 12 7 6 25

1 13 10 8 31

5-23
Derivation of Market Demand
Figure (5.10)

5-24
Substitution & Income Effects
• When price changes, total change in
quantity demanded is composed of two
parts
• Substitution effect
• Income effect

5-25
Substitution & Income Effects
• Substitution effect
• Change in consumption of a good after a
change in its price, when the consumer is
forced by a change in money income to
consume at some point on the original
indifference curve
• Income effect
• Change in consumption of a good resulting
strictly from a change in purchasing power

5-26
 Income & Substitution Effects:
A Decrease in Px (Figure 5.12)
Total effect of Total effect of = Substitution + Income
price = Substitutio + Incom price decrease effect effect
n effect e
decrease 3 = 5 + (-2)
= 5 + effect
4
9

5-27
Substitution & Income Effects
• Consider the substitution effect alone:
• Amount of good consumed must vary
inversely with price
• Income effect reinforces the substitution
effect for a normal good & offsets it for an
inferior good

5-28
 Summary of Substitution &
Income Effects (Table 5.2)

Substitution Effect Income Effect

Price of X decreases:

Normal Good X rises X rises

Inferior Good X rises X falls
Price of X increases:

Normal Good X falls X falls

Inferior Good X falls X rises

5-29