Consumer Choice

A consumer is one who takes decisions about what to buy for satisfaction of wants, both as an individual and as a
Member of household, is called a consumer.

A consumer is considered to be rational which means he is someone who seeks to maximise his/her satisfaction
(utility) in spending his/her income.

Equilibrium is a state of rest when the entity concerned (for example the consumer or the producer) achieve their
objective and stop further action.

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The Study of Choices
• We shall see how a consumer with a limited budget chooses between
two goods X and Y to maximize his/her satisfaction (utility).
HOUSEHOLD CHOICE IN OUTPUT MARKETS
Every household must make three basic decisions:

1. How much of each product, or output, to

demand

2. How much labor to supply

3. How much to spend today and how much to

save for the future
HOUSEHOLD CHOICE IN OUTPUT MARKETS
THE BUDGET CONSTRAINT

Information on household income and wealth, together

with information on product prices, makes it possible to
distinguish those combinations of goods and services
that are affordable from those that are not.

budget constraint The limits imposed on

household choices by income, wealth,
and product prices.
HOUSEHOLD CHOICE IN OUTPUT MARKETS

TABLE Possible Budget Choices of a Person Earning $1,000 Per Month After Taxes
MONTHLY OTHER
OPTION RENT FOOD EXPENSES TOTAL AVAILABLE?
A $ 400 $250 $350 $1,000 Yes
B 600 200 200 1,000 Yes
C 700 150 150 1,000 Yes
D 1,000 100 100 1,200 No

choice set or opportunity set The set of options that is

defined and limited by a budget constraint.
HOUSEHOLD CHOICE IN OUTPUT MARKETS
THE EQUATION OF THE BUDGET CONSTRAINT

In general, the budget constraint can be

written:

PXX + PYY = I,

where PX = the price of X, X = the quantity of

X consumed, PY = the price of Y, Y = the
quantity of Y consumed, and I = household
income.
 Budget Line
Example
A consumer has gone to the market to buy apples and oranges. Oranges are selling at Rs. 100 per kg and apples for Rs.
200 per kg. His budget is Rs.1000. Draw the budget line and graphically represent it. How would the graph change if
the price of apple increased to Rs. 250 per kg. A
10

X and Y stand for consumption of apples and oranges respectively.

PX = Price of Apple = Rs. 200 per kg
8 PXX + PYY = I,
PY = Price of Orange = Rs.100 per kg

ORANGES
Budget Line Equation is PX X+ Py Y = B 6
P (2 g of apples, 5 kg of oranges)
200X+100Y = 1000 5
X=0, 100Y = 1000, Y=10. The consumer can invest his/her full budget in Budget Line
buying oranges alone. S/he would get 10 kg of oranges. 4
Y=0, 200X = 1000, X=5. The consumer uses the full budget to buy
apples and gets 5 kg of apples.

New Budge Line 250X+100Y=1000 2 Choice set

B
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APPLES 1 2 3 4 5 7 9
HOUSEHOLD CHOICE IN OUTPUT MARKETS
The Budget Constraint More Formally

FIGURE Budget Constraint and Opportunity Set for Ann and Tom
Explanation
B = Budget
Px = Price of item X
Py = Price of item Y
X = Consumption of X
Y = Consumption of Y

Money spent on X = XPx

Money remaining = B – XPx = Money spent on Y = YPy
Hence XPx + YPy = B

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HOUSEHOLD CHOICE IN OUTPUT MARKETS
Budget Constraints Change When Prices Rise or Fall

FIGURE The Effect of a Decrease in

Price on Ann and Tom’s Budget
Constraint

The budget constraint is defined by income, wealth, and prices. Within those limits, households are free to
choose, and the household’s ultimate choice depends on its own likes and dislikes.
THE BASIS OF CHOICE: UTILITY

utility The satisfaction, or reward, a product yields

relative to its alternatives. The basis of choice.
THE BASIS OF CHOICE: UTILITY
DIMINISHING MARGINAL UTILITY
marginal utility (MU) The additional satisfaction gained by the
consumption or use of one more unit of something.
MC = d(TC)/dQ
total utility The total amount of satisfaction obtained from MU = d(TU)/dQ
consumption
of a good or service.

law of diminishing marginal utility The more of any one good

consumed in a given period, the less satisfaction (utility)
generated by consuming each additional (marginal) unit of the
same good.
THE BASIS OF CHOICE: UTILITY
TABLE Total Utility and Marginal
Utility of Trips to the Club
Per Week
TRIPS TOTAL MARGINAL
TO CLUB UTILITY UTILITY
1 12 12
2 22 10
3 28 6
4 32 4
5 34 2
6 34 0

FIGURE Graphs of Frank’s Total and

Marginal Utility
 Trade off Example

Change in Change in
Chocolates Balloons chocolates Balloons

10 0

9 1 1 1

8 3 1 2

7 6 1 3

law of diminishing marginal utility The more of any one good consumed in a given
period, the less satisfaction (utility)
generated by consuming each additional (marginal) unit of the same good.
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THE BASIS OF CHOICE: UTILITY
DIMINISHING MARGINAL UTILITY AND DOWNWARD-SLOPING DEMAND

FIGURE Diminishing Marginal Utility and

Downward-Sloping Demand
INCOME AND SUBSTITUTION EFFECTS
THE INCOME EFFECT

When the price of something

we buy falls, we are better off.
When the price of something
we buy rises, we are worse off.
INCOME AND SUBSTITUTION EFFECTS
THE SUBSTITUTION EFFECT

Both the income and the substitution effects imply a negative relationship between
price and quantity demanded—in other words, downward-sloping demand. When the
price of something falls, ceteris paribus, we are better off, and we are likely to buy more
of that good and other goods (income effect). Because lower price also means “less
expensive relative to substitutes,” we are likely to buy more of the good (substitution
effect). When the price of something rises, we are worse off, and we will buy less of it
(income effect). Higher price also means “more expensive relative to substitutes,” and
we are likely to buy less of it and more of other goods (substitution effect).
Customer Satisfaction (Indifference) Curves -
Assumptions
1. We assume that consumers have the ability to choose among the combinations of goods and
services available.

2. We assume that consumer choices are consistent with a simple assumption of rationality (to
maximize his satisfaction).
Deriving Customer Satisfaction (Indifference) Curve

An indifference curve is a set

1,9
of points, each point
representing a combination
3,8 of goods X and Y, all of which
chocolates
yield the same total
6,7 satisfaction (utility).

Change in Change in
Chocolates Balloons chocolates Balloons
10 0
9 1 1 1
Balloons 8
7
3
6
1
1
2
3

FIGURE An Indifference Curve

 Consumer Satisfaction Curve
• I went to the market to buy apples and oranges. I was fourth in the
queue. The seller asked me how many of each I wanted and I replied “
1 kg apples and 5 kg oranges.” (1,5)
• There was a shortage of oranges. After the first customer, the seller
told me over the queue that he probably be able to give only 4 kg
oranges (as the previous buyer has presumably bought 1 kg oranges).
“Sir” he shouts “I shall give you one extra kg of apples.” I say “Yes.”
(2,4)

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Consumer satisfaction Curve
• After the second customer he says “ Sorry, Can give you only 3 kg
oranges. May I add one extra kilo apple?”
• What do I do with so many apples? I came here for only 1 kg apples?
• “Sir, please take 1.5 kg apples instead.” I accept. (3.5,3)
• Finally when I am at his counter, he says “Sir, I can only give you 2 kg
oranges. To compensate for this 1 kg (of oranges), I shall give you 2 kg
extra apples instead. (5.5,2)
Customer Satisfaction (Indifference)
Curve
• (1,5), (2,4), (3.5, 3) and (5.5, 2) represent four points of equal
satisfaction for the consumer. A curve connecting the four points is
the consumer satisfaction curve or the indifference curve. The
customer is indifferent to the four options before him.
Consumer Satisfaction (Indifference) Curves - Properties

1. It slopes downwards from left to right

2. It is convex to the origin

3. It cannot intersect with another indifference curve

 Indifference Curves
Indifference Curves are convex to origin (that is they bulge towards the origin.)

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Indifference Curves
They occur in a series with higher curves representing higher levels of consumer satisfaction.

orange

P3

P1
P
apple
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Indifference Curves
They curves DO NOT intersect each other.

oranges

apples

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Indifference Curves
Indifference Curves DO NOT touch the axes.

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Consumer Equilibrium
CONSUMER CHOICE

FIGURE: Consumer Utility-Maximizing

Equilibrium
I/Py’ D

I/Px’

As long as indifference curves are convex to the origin, utility maximization will take place at the point at
which the indifference curve is just tangent to the budget constraint.
THE BASIS OF CHOICE: UTILITY
THE UTILITY-MAXIMIZING RULE

In general, utility-maximizing consumers spread out their

expenditures until the following condition holds:

MU X MU Y
utility - maximizing rule :  for all pairs of goods
PX PY
Law of Equi-Marginal Utility
• Indifference Curve equation : TUx + TUy = constant
• d(TUx)/dx+ d(TUy)/dx = 0
• Mux + Muy (dy/dx) =0 d(Tuy)/dx = d(Tuy)/dy*dy/dx = Muy*dy/dx
• Mux/Muy = - dy/dx = Px/Py
• Mux/Px = Muy/Py d(Tuy)/dx =
d(Tuy)/dy*dy/dx = Muy*dy/dx

PXX + PYY = I,
 Law of Equi-marginal utility
• Let us say Mux / Px > Muy / Py
• This means Mux > Px * Muy / Py
• If the consumer buys 1 unit of X he gets additional utility Mux and pays a
price of Px.
• With Py he could have got one unit of Y and enjoyed a utility of Muy; a
utility per rupee of Muy / Py.
 Practice Question -1
Use consumer theory to explain the law of demand.

Law of demand states increase in price leads to decrease in demand.

Law of Equimarginal utility, Mux / Px = Muy / Py for equilibrium of consumption in a situation of choice.

Px increases. Equilibrium is disturbed.

Left hand side (LHS) is lower in value. As a consequence, the customer consumer more of item y, ignoring
Item X.

The demand for X goes down with its increase in price.

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 Practice Question-2
The customer challenged the fruit-seller. “Man, you just cheated the previous customer. You charged him higher for
apples. The standard rate of apples is Rs. 200 per kg. You charged him Rs. 250. This is unfair business practice.”
The fruit-seller angrily retorted “Gentleman, you might have put on expensive clothes. But you seem to know nothing
economics. You probably did not notice that I sold him oranges at a lower price. The market is running short of apples.
By altering the prices, I changed his Budget line and delivered his intended total satisfaction. His position might have
changed, but he still stayed on the same Indifference curve. Go figure.”

B/Papple Original Budget Line

Papple *Qapple + Porange * Qorange = B

Apples P1

P2

B/Porange
Oranges
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THANK YOU