Recall: Consumer behavior
• Why are we interested?
– New good in the market. What price should be
charged? How much more for a premium
brand?
– Subsidy program: in cash or in kind? Which
will make consumers better off? Which will
help achieve social objectives?
Understand consumer behavior in
3 steps
1. Budget constraints – what can people afford?
2. Preferences – how to describe how people might
prefer one good (or consumption bundle) to
another? (Concept of utility function)
3. Choice: given preferences and limited budgets,
what combinations of goods will consumers buy
to maximize their satisfaction?
Assumptions on preferences
impose a degree of rationality
• Complete – consumers can compare and
rank all consumption bundles (regardless of
cost), e.g. one is preferred to another or
indifferent between the two
• Reflexive – consumption bundle is at least
as good as itself
• Transitive – ensures that consumer
preferences are rational (consistent)
Indifference curves
• Indifference curve represents all combinations of
consumption bundles that provide the same level
of satisfaction to a person. A person is indifferent
among the bundles represented by the locus of
points on the curve.
• Indifference map: a set of ICs to describe person’s
preference for all combinations of good 1 and 2
• Weakly preferred set: bundles weakly preferred to
X
• Indifference curves cannot cross (or what will
happen?)
a
b
c
d
e
f
books CDs
20
30
10
50
40
20
30
40
10
20
10
40
We know A is preferred to E.
And D is preferred to A.
But comparison with others needs
more information
60
50
cd
40
30
bundles
20
10
0
0
20
40
60
books
Say, IC connects A, B and C.
Means consumer feels neither better nor
worse off giving up 10 units of books to get 20
units of CDs (from A to B) …
Well-behaved preferences
• More of any good is preferred to less (ignoring
“bads”) – monotonicity
– Implication : IC slopes downward from left to
right.
• Averages preferred to extremes – convexity
– Consumers generally prefer a balanced
consumption bundle
– Implication: set of bundles weakly preferred to
X is a convex set
Marginal rate of substitution
• People face trade-offs when choosing between goods. IC help
to show these trade-offs.
• MRS: maximum amount of good 2 that a person is willing to
give up to obtain one additional unit of good 1 (-  CD/  B)
• The MRS at any point is equal in absolute value to the slope
of the IC at that point.
– Slope of the IC becomes less negative (increases) as we
move down the IC. That is, MRS diminishes. (As
consumption of good 1 increases, consumers desire for
still more should diminish. So should be willing to give up
less and less of good 2 to obtain it)
Budget constraint
• Budget line indicates all combinations of good 1 and good
2 for which total money spent is equal to income.
• Slope of the budget line is the negative of the ratio of the
prices of the two goods. Magnitude tells us the rate at
which the two goods can be substituted for each other
without changing the total amount of money spent.
• Purchasing power of consumer (ability to buy goods) is
determined not only by income but also by prices.
Purchasing power can double either because income
doubles OR because prices of all goods falls by half.
• A inflation in which all prices and income levels rise
proportionately will not affect the consumers budget line or
purchasing power.
Consumer Choice
• We assume consumers maximize the satisfaction
they can achieve, given their budget constraint.
– Bundle must be located on the budget line
– Bundle must give the consumer the most
preferred combination of goods and services
(We assume that all income is spent now)
• Can determine graphically how individual
consumers choose how much of each good to buy.
CDs
B
C
A
books
Therefore
• The bundle that maximizes satisfaction
must lie on the highest IC that touches the
budget line.
• At A, slope of budget line = slope of the IC.
• Result: given budget constraint, satisfaction
is maximized at point where
MRS = Pb/Pcd
examples
• NG-LGU dynamics: Non-matching vs.
matching grants
• College trust funds
Note: Corner solution – MRS not equal to
price ratio. Impossible to consume negative
amounts of good 2.
Assuming consumers can rank alternatives, IC allow
us to describe consumer preferences graphically.
Consumer preferences can also be described using
the concepts of utility and marginal utility
Utility
• Utility is the level of satisfaction that a person gets from
consuming a good or undertaking an activity.
• In economic analysis, utility is most often used to
summarize the preference ranking of consumption bundles.
• Utility function is obtained by attaching a number to each
consumption bundle, so that if bundle A is preferred to
bundle B, the number will be higher for A than for B.
• Utility function provides the same information about
preferences that an indifference map does. Both order
consumer choices in terms of level of satisfaction.
Ordinal properties
• Levels of utility associated with bundles A, B and
C might be 4, 2, and 1. Or may be 3, 2, 1.
• Because most choices can be explained simply by
the ordinal ranking of utility levels, both sets of
indicators provide the same information.
• In other words, what is important is the relative
rankings that are given. Actual numbers attached
to the IC are for convenience only.
Marginal utility
• When analyzing costs and benefits of public
projects, valuable to use some of the cardinal
properties of utility functions.
• Marginal utility measures the additional
satisfaction obtained from consuming an
additional amount of a good.
• Diminishing marginal utility: as more and more of
a good is consumed the process of consumption
will (at some point) yield smaller and smaller
additions to utility. (example – TV).
Relating ‘marginal utility’ to
consumer utility max problem:
• A small movement down and along an IC:
additional consumption of books,  B, will
generate marginal utility MUb for each unit. This
results in total increase in utility of MUbB.
• At the same time, the loss of consumption of CD,
,will lower utility by MUcd CD
• Since all points on an indifference curve generate
the same level of utility, the total gain in utility
associated with increase in B must balance the loss
due to lower consumption of CD.
Formally
0

MU
(

B
)

MU
(

CD
)
B
CD
MU

CD




B
B
MRS
MUB
MUCD
MUCD
and
MUB
PB

MUCD
PCD
Utility maximization is achieved when the budget
is allocated so that the MU per peso of
expenditure is the same for each good.