Microeconomics I

School of Economics and Business

Department of Economics

Prof. D. Manuel J. Ortega Tierra ([email protected])

Academic year 2022-23

5 – Consumer Behaviour

INDEX
5.1 – Indifference curves

5.2 – Budget constraints

5.3 – Consumer choice

2
5 – Consumer Behaviour
5.0 Theory of consumer behaviour

Theory of consumer behaviour Description of how consumers allocate incomes among

different goods and services to maximize their well-being

Three steps:
- Consumer preferences
- Budget constraints
- Consumer choices

We will consider rationality and perfect information

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5 – Consumer Behaviour
5.1 Indifference curves

Consumers will compare different sets of goods

So first, we must define market baskets (or bundles)

List with specific quantities of one or more goods

Consumers compare different market baskets and decide

which they prefer

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5 – Consumer Behaviour
5.1 Indifference curves

We will make some basic assumptions on preferences:

- Completeness: Consumers can compare and rank all possible baskets.

They either prefer one of two or are indifferent between them.

- Transitivity: If one prefers A to B and B to C, then one prefers A to C.

(Consistency and rationality.)

- Monotonicity: more is better than less

- Convexity: taste for variety

- Continuity

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5 – Consumer Behaviour
5.1 Indifference curves

We can graphically show the consumers’ preferences with indifference curves

Curve representing all combinations of market baskets
that provide a consumer with the same level of
satisfaction

Y We will consider two alternative goods

If we consider all possible

combinations of goods

Indifference map
Graph containing a set of indifference
curves showing the market baskets
among which a consumer is indifferent

0 X 6
 5 – Consumer Behaviour
5.1 Indifference curves

Properties of indifference curves:

- Ubiquity: There is an infinite number of indifference curves

- Indifference curves do not intersect (they would violate transitivity if

they did)

- The further from the origin, the better

Y
- Downward-sloping

- Convexity

0 X 7
5 – Consumer Behaviour
5.1 Indifference curves

The indifference curves’ downward-sloping property is related to the concept

of marginal rate of substitution
Maximum amount of a good that a consumer is willing to
give up in order to obtain one additional unit of another
good

Y So the MRS of X for Y is the maximum amount of Y

that a person is willing to give up to obtain one
additional unit of X

Therefore, the MRS of X for Y is the absolute value

of the indifference curve’s slope

0 X
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5 – Consumer Behaviour
5.1 Indifference curves

On the other hand, the indifference curves’ convexity property is related to

the diminishing marginal rate of substitution

As we consume more of a good X, we will be less willing to give up of

another good Y to keep increasing the consumption of X
Y

People like variety

0 X
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5 – Consumer Behaviour
5.1 Indifference curves

We can find two exceptions to the diminishing marginal return of substitution

Perfect substitutes
Y
Two goods for which the marginal rate of substitution
of one for the other is a constant

Perfect complements
Two goods for which the MRS is zero or infinite; the
indifference curves are shaped as right angles

0 X
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 5 – Consumer Behaviour
5.1 Indifference curves

There is also an exception to “the more, the better”:

Bad
Good
Good for which less is preferred
rather than more

0 Bad
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 5 – Consumer Behaviour
5.1 Indifference curves

There is also an exception to “the more, the better”:

Bad
Good
Good for which less is preferred
rather than more

The bad can be redefined as a good to

simplify calculations

0 Redefined bad
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5 – Consumer Behaviour
5.1 Indifference curves

A convenient feature of the theory of consumer behaviour is that it is not necessary

to associate a numerical level of satisfaction with each market basket consumed

Y
It is sufficient that we can rank them

To ease the ranking, we may

assign numerical values

Then, we will assign a score to the levels of

satisfaction associated with each indifference curve

This is called utility

Numerical score representing the satisfaction that
a consumer gets from a given market basket

0 X
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5 – Consumer Behaviour
5.1 Indifference curves

Utility is an ordinal value, not a cardinal value. It is used for ranking and has no
meaning in itself.

Y
We define the utility function

Formula that assigns a level of utility to individual

market baskets

We may consider different equations

for the utility function

Remember that it is an ordinal utility

function

0 X
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5 – Consumer Behaviour
5.1 Indifference curves

We could not only consider the total utility obtained by a basket, but the additional
satisfaction obtained from consuming one additional unit of a good

And that will be called…

Marginal utility 𝑑𝑈
𝑀 𝑈 𝑋=
𝑑𝑥

What do you usually enjoy more? The first unit you consume? Or the millionth unit?

And that concept is called diminishing marginal utility

Principle that as more of a good is consumed, the consumption
of additional amounts will yield smaller additions to utility

This was first thought by Gossen, as Gossen’s first law (or the law of saturation)

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5 – Consumer Behaviour
5.1 Indifference curves

So we can algebraically express the Marginal Rate of Substitution as:

𝑴𝑹𝑺=−
∆𝑌
∆𝑋
( 𝑓𝑜𝑟 𝑎 𝑓𝑖𝑥𝑒𝑑𝑙𝑒𝑣𝑒𝑙 𝑜𝑓 𝑈 ) ¿−
𝒅𝒀
𝒅𝑿 |
𝑼

It is possible to express the MRS on utility terms:

Y
Additional utility from
increased consumption of Y ¿ ( 𝑀 𝑈𝑌 ) (∆ 𝑌 )

Reduction in utility from

reduced consumption of X ¿ ( 𝑀 𝑈 𝑋 ) (∆ 𝑋 )

( 𝑀𝑈 𝑌 ) ( ∆ 𝑌 ) ¿ ( 𝑀 𝑈 𝑌 ) ( − 𝑀𝑅𝑆 ) ⇒ ( 𝑀 𝑈 𝑋 ) =𝑀𝑅𝑆
−1=
( 𝑀𝑈 𝑋 ) ( ∆ 𝑋 ) ( 𝑀 𝑈 𝑋 ) (𝑀 𝑈𝑌 )

X
0 16
5 – Consumer Behaviour
5.2 Budget constraints

Can consumers buy as much as they want to maximise their utility?

No, they are constrained by their income
Y
We will represent this with the budget line
All combinations of goods for which the total
amount of money spent is equal to income
𝑃 𝑋 𝑋 +𝑃 𝑌 𝑌 = 𝐼

What happens if income increases?

What if one price increases?

What if both increase proportionally?

This gives us some insight into

purchasing power, which depends on
0 X both prices and income
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5 – Consumer Behaviour
5.3 Consumer choice
Now that we take into account budget constraints, we can maximise
consumer’s utility
If consumers are rational, what should be the
Y
conditions that the maximising basket must satisfy?

1) It must be located on the budget line

2) It must give the consumer the most

preferred combination of goods and
services
The maximising basket will be the basket that
lies on the budget line and for which its IC’s slope
is equal to the budget line’s

So…
𝑃𝑋
X
𝑀𝑅𝑆=
0 𝑃𝑌
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5 – Consumer Behaviour
5.3 Consumer choice
This previous equation can be rewritten, as we know, as:
𝑃𝑋 𝑀𝑈 𝑋 𝑃 𝑋
𝑀𝑅𝑆= ⇔ =
𝑃𝑌 𝑀𝑈 𝑌 𝑃 𝑌

And this as:

𝑀𝑈 𝑋 𝑀𝑈 𝑌 And this tells us that utility maximisation is achieved when
=
𝑃𝑋 𝑃𝑌 the budget is allocated so that the marginal utility per
monetary unit of expenditure is the same for each good

For many goods:

𝑀𝑈 𝑋 𝑀𝑈 𝑌 𝑀𝑈 𝑍
= =…=
𝑃𝑋 𝑃𝑌 𝑃𝑍

This was also first thought by Gossen, as Gossen’s second law

(or the equal marginal principle)

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5 – Consumer Behaviour
5.3 Consumer choice
It is possible for consumers not to maximise utility when the MRS is equal to
the price ratio

Y
This will happen with extreme utility functions and is called a corner solution

You could also think of other examples in

which the MRS is not equal to the slope of
the budget line

Could you tell of some previously explained

utility functions for which this will
happen?

0 X
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 End of
chapter

Thank you