Consumer Behavior and Utility Analysis

The Budget Line

The

budget line depicts the consumption bundles that a consumer can afford.

People consume less than they desire because their spending is constrained, or limited, by their income.

The Consumers Budget Line...

Quantity of Pepsi 500

250

Consumers Budget line

A 100

50

Quantity of Pizza

The Consumers Budget Line

The

slope of the budget 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 will trade one good for the other.

Preferences: What the Consumer Wants

A consumers preference among consumption bundles may be illustrated with indifference curves. An indifference curve shows bundles of goods that make the consumer equally happy.

The Consumers Preferences...

Quantity of Pepsi C

I2
A 0 Indifference curve, I1 Quantity of Pizza

The Consumers 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 substitute 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.

The Consumers Preferences...

Quantity of Pepsi C

B
MRS

D 1 A

I2
Indifference curve, I1 Quantity of Pizza

Properties of Indifference Curves

Higher indifference curves are

preferred to lower ones. Indifference curves are downward sloping. Indifference curves do not cross. Indifference curves are bowed inward.

Property 1: Higher indifference curves are preferred to lower ones.

Consumers

usually prefer more of something to less of it. 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.

Property 3: Indifference curves do not cross.

Quantity of Pepsi C

A
B

Quantity of Pizza

Property 4: Indifference curves are bowed inward.

Quantity of Pepsi 14

MRS = 6
8 1 A

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.

4 3 0 2 3

MRS = 1

1
6

Indifference curve Quantity of Pizza

Perfect Substitutes
Nickels

6 4

I1

I2
2

I3
3 Dimes

Perfect Complements
Left Shoes

7 5

I2 I1

Right Shoes

The Consumers Optimum...

Quantity of Pepsi

Optimum B A

I3

I1
Budget constraint 0

I2

Quantity of Pizza

How Changes in Income Affect the Consumers Choices

An

increase in income shifts the budget line outward.

The consumer is able to choose a better combination of goods on a higher indifference curve.

An Increase in Income...
Quantity of Pepsi New budget line 1. An increase in income shifts the budget line outward New optimum 3. and Pepsi consumption.
Initial budget line

Initial optimum

I2 I1
0 2. raising pizza consumption Quantity of Pizza

How Changes in Prices Affect Consumer Choices

A fall in the price of any good rotates the budget constraint outward and changes the slope of the budget line.

A Change in Price...
Quantity of Pepsi 1,000 New budget constraint

3. and raising Pepsi consumption.

500

New optimum 1. A fall in the price of Pepsi rotates the budget constraint outward

I2
I1
100 Quantity of Pizza 2. reducing pizza consumption

Initial budget constraint 0

Income and Substitution Effects

A

price change has two effects on consumption.

An income effect A substitution effect

The income effect is the change in consumption that results when a price change moves the consumer to a higher or lower indifference curve. The substitution effect is the change in consumption that results when a price change moves the consumer along an indifference curve to a point with a different marginal rate of substitution.

X2

The new optimum is Eb on I2. The Total Price Effect is xa to xb Ea xa Eb I2

I1
xb

X1

X2

Draw a line parallel to the new budget line and tangent to the old indifference curve Eb

Ea xa

I2

I1
xb

X1

X2

Ea xa xc

The new optimum on I1 is at Ec. The movement from Ea to Ec (the increase in quantity demanded from Xa to Xc) is solely in response to a change in Eb relative prices I2 Ec I1 xb

X1

X2

This is the substitution effect.

Ea Ec

Eb

I2

I1

Xa

Substitution Effect

Xc

X1

THE HICKSIAN METHOD

X2
Optimal bundle is Ea, on indifference curve I1.

Ea

I1
xa

X
1

THE HICKSIAN METHOD

X2
P A fall in the price of X1

*
Ea

The budget line pivots out from P

I1
xa

X
1

THE HICKSIAN METHOD

X2

The new optimum is Eb on I2. The Total Price Effect is xa to xb

Ea

Eb

I2

I1
xa xb

X
1

THE HICKSIAN METHOD

To isolate the substitution effect we ask. what would the consumers optimal bundle be if s/he faced the new lower price for X1 but experienced no change in real income? This amounts to returning the consumer to the original indifference curve (I1)

THE HICKSIAN METHOD

X2

The new optimum is Eb on I2. The Total Price Effect is xa to xb

Ea

Eb

I2

I1
xa xb

X
1

X2

THE HICKSIANa line parallel to the METHOD Draw

new budget line and tangent to the old indifference curve

Ea

Eb

I2

I1
xa xb

X
1

X2

THE HICKSIANnew optimum on I METHOD The

is at Ec. The movement from Ea to Ec (the increase in quantity demanded from Xa to Xc) is solely in response to a change in relative prices
1

Ea Ec xa xc

Eb I1 xb

I2

X
1

THE HICKSIAN METHOD

X2
This is the substitution effect.

Ea Ec

Eb

I2

I1

Xa

Substitution Effect

Xc

X
1

THE HICKSIAN METHOD

To isolate the income effect Look at the remainder of the total price effect This is due to a change in real income.

X2

THE HICKSIAN METHOD total The remainder of the

effect is due to a change in real income. The increase in real income is evidenced by the movement from I1 to I2

Ea Ec

Eb

I2

I1

Xc

X
Income Effect

Xb

THE HICKSIAN METHOD

X2

Ea Ec

Eb

I2

I1
xa xc xb

X
1

Sub Income Effect Effect