Lecture 4 - Consumer Behaviour

One of the fundamental questions in microeconomics is how a consumer with limited

Consumer Preferences

Let’s start with a definition of a market basket. The market basket is a list of quantities of
one or more goods. The consumers selects market baskets basing on some preferences. They
are:
1. Completeness – a consumer can compare and rank all possible baskets. Therefore, for any
two baskets A and B, the consumer will prefer A to B, prefer B to A, or will be indifferent
between the two. Note that preferences ignore costs. The consumer may prefer steak to
hamburger but buy hamburger because it is cheaper.

2. Transitivity – if a consumer prefers basket A to basket B and basket B to basket C, then the
consumer also prefers A to C.

3. More is better than less – goods are assumed to be desirable, therefore a consumer always
prefer more of any good to less. The consumer is never satisfied: more is always better, even
if just a little better. Some goods may be undesirable and consumers will always prefer less,
for example air pollution. We call them bads and choose to ignore them in our further
analysis.

Indifference curves

We can present a consumer’s preferences graphically with the use of indifference curves. An
indifference curve represents all combinations of market baskets that give a person the
same level of satisfaction. That person is therefore indifferent among the market baskets
represented by the points graphed on the curve.

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In order to graph a consumer’s indifference curve, it helps first to graph his or her individual
preferences. For simplicity let’s assume that there are only two goods available for
consumption: X and Y. The horizontal axis in Figure 1 shows the number of units of good X
purchased, while the vertical axis measures the number of units of good Y.

Figure1. Description of individual preferences.

Market basket C is preferred to market basket H because it contains more of both goods.
Similarly, market basket F is preferred to C. Baskets D and E are also better than C, because
D contains the same amount of X but more Y, while E contains the same amount of Y but
more of good X. Note, however, that K contains more Y but less X. Likewise, L contains less
Y but more X in comparison to basket C. Therefore, comparisons of baskets K and L with C
are not possible without more information about a consumer’s ranking.
This additional information is provided in Figure 2, which shows an indifference curve O that
passes through points K, C and L. This curve indicates that a consumer is indifferent among
these three market baskets. It tells us that in moving from market basket C to market basket L
the consumer is neither better off nor worse off with his or her level of satisfaction. Note that
the indifference curve in Figure 2 slopes downward from left to right. To understand why this
must be the case, suppose instead that that it sloped upward from C to F (Figure 1). This

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would not be in line with an assumption that more of any good is preferred to less. Because
market basket F has more of both goods than basket C, it must be preferred to C and therefore
can not be on the same indifference curve as C.

Figure 2. Indifference curve.

To describe a person’s preferences for all combinations of X and Y, we can graph a set of
indifference curves called an indifference map (Figure 3).

Figure 3. Indifference map.

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Each indifference curve in the map shows the market baskets among which the person is
indifferent. Figure 3 shows four indifference curves that form a part of the indifference map.
Curve O4 present the highest level of satisfaction, followed by the curves O 3, and O2. Curve O1
represents the lowest level of a consumer’s satisfaction.

The marginal rate of substitution

Recall that indifference curves are downward sloping. When the amount of good X increases,
the amount of good Y decreases. To quantify the amount of one good that a consumer will
give up to obtain more of another, we use a measure called the marginal rate of substitution
(MRS). This is the amount of a good on the vertical axis that the consumer is willing to
give up to obtain an extra unit of the good on horizontal axis. Therefore, in Figure 4, MRS
refers to the amount of good Y that the consumer is willing to resign to get an additional unit
of good X. If we denote the change in Y by ∆Y and the change in X by ∆X, the MRS can be
written as ∆Y/∆X (remember that ∆Y is always negative as the consumer gives up good Y to
obtain good X). Thus the MRS at any point is equal (in magnitude) to the slope of the
indifference curve.

Figure 4. Marginal rate of substitution

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Also observe in Figure 4 that the MRS falls as we move down along the indifference curve.
This is so because indifference curves are convex. Why? As more and more of one good is
consumed, we can expect that a consumer will prefer to give up fewer and fewer units of a
second good to get additional units of the first one. As we move down the indifference curve
in Figure 4 and consumption of good X raises, the additional satisfaction that a consumer gets
from still more good X will diminish. So she or he will give up less and less of good Y to
obtain additional amount of good X.

Budget constraint

So far we discussed the first part of a consumer theory – consumer preferences. We found out
how indifference curves can be used to explain how consumers value different baskets of
goods. Now we turn to the second part o the theory: the budget constraints that consumers
face as a result of their limited incomes.
To see how a budget constraint limits a consumer’s choice, let’s consider a situation in which
a person has a fixed amount of income I that can be spent for goods X and Y. The prices of the
two goods are PX and PY respectively. In that case, PX·X (price times quantity) is the amount
of money spent on good X and PY·Y is the amount of money spent on good Y. The budget
line indicates all combinations of X and Y for which the total amount of money spent is
equal to income. Because we consider only two goods, the person will spent her/his entire
income on X and Y. As a result, the combinations of X and Y that she/he can buy will lie on
the line:
I = X · PX + Y · P Y

If we rearrange the above equation, we can solve it for Y:

Y = (I/ PY) – (PX / P Y) · X

A new equation is the equation for a straight line. It has a vertical intercept of I/P Y and a slope
of – (PX/P Y). The slope of the budget line is the negative of the ratio of the prices of the
two goods. The magnitude (absolute value) of the slope tells us the rate at which the two
goods can be substituted for each other without changing the total amount of money
spent. The vertical intercept represents the maximum amount of Y that can be

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purchased with income I. Finally, the horizontal intercept I/PX represents how many
units of good X can be purchased with income I.
Figure 5 shows the budget line which is a straight line with a negative slope. As a consumer
moves down along a line from basket B to basket A, she/he spends less on good Y and more
on good X.

Figure 5. Budget line

The effects of changes in income and prices

As we could see, both the position and the slope of the budget line depend on income and
prices of both goods. But of course prices and income often change. How will this affect the
budget line?

Income changes. What happens to the budget line when income changes? From the equation
Y = (I/ PY) – (PX / P Y) · X
we can see that a change in income alters the vertical intercept of the budget line but does not
change the slope (because the price of none good changed). Figure 5 shows that if income
increases, the budget line shifts outward, from B to B1. Note, however, that both lines are
parallel. On the other hand, if income falls, the consumer is able to buy less and the budget
line will shift inward, from B to B2.

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 Figure 5. Effects of a change in income on the budget line

Price changes. What happens to the budget line if the price of one good changes but the price
of the other does not? Again, we can use the equation Y = (I/ PY) – (PX / P Y) · X to describe the
effects of a change in the price of X on the budget line. Suppose the price of X falls, so the
slope of the budget line will become smaller in magnitude. In Figure 6 we obtain the new
budget line A2 by rotating the original line A outward, about the Y intercept. On the other
hand, if the price of X increases, the budget line rotates inward to line A 1 because the person’s
purchasing power diminished.
What happens if the price of both goods change but in a way that leaves the ratio of the two
prices unchanged? The slope of the line will remain the same, but the intercept of the budget
line has to shift so that the new line is parallel to the old one. For example, if the prices of
both goods fall by half, the slope of the budget line does not change. However, both intercepts
double, and the budget line will shift outward.

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 Figure 6. Effects of a change in price of good X on the budget line

Consumer choice

Given preferences and budget constraint, we can now determine how a consumer chooses
how much of each good to buy. We assume that the consumer makes this choice in a
rational way – she/he chooses goods to maximise satisfaction she/he can achieve, given
the limited income available. The maximising market basket must satisfy two conditions:

1. It must be located on a budget line. Any market basket below the budget line leaves some
income unallocated. This income, if spent, could increase the consumer’s satisfaction. Of
course, a consumer sometimes saves a part of his income, but we made an assumption that all
income is spent now. Note also that any market basket above the budget line can not be
purchased with available income. Therefore, the only rational choice is a basket on the budget
line.
2. It must give the consumer the most preferred combination of goods and services.
These two conditions reduce the problem of maximising consumer satisfaction just to find an
appropriate point on the budget line. Figure 7 shows graphically how the problem is solved.
Four indifference curves describe a consumer’s preferences for goods X and Y. Remember
that the curve O4 yields the greatest amount of satisfaction, and curve O1 the least. But curve
O4 as well as curve O3 are not attainable for a consumer as both lie above a budget line.

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Therefore any market basket on curves O4 and O3 can not be bought with current income. Let’s
turn now to curve O1. Consider the market basket lying on the intersection of curve O1 and the
budget line. This basket is available for the consumer as it lies on the budget line. But at the
same time it gives the consumer the lowest possible level of satisfaction (it is located on the
lowest indifference curve). By moving toward point E (Figure 7) the consumer spends the
same amount of money and obtains the increased level of satisfaction as point E lies on higher
curve O2. Note that this is the only point on curve O2 which is available for the consumer. Any
other points lying on curve O2 can not be purchased with the consumer’s income, because
they lie above the budget line. Therefore, the market basket which maximises consumer’s
satisfaction must lie on the highest indifference curve that touches the budget line. Point
E is the point of tangency between indifference curve O2 and the budget line. At E a slope of
the budget line is exactly equal to the slope of the indifference curve.
MRS = PX / P Y
So satisfaction is maximised when the marginal rate of substitution (slope of the indifference
curve) is equal to the ratio of prices (slope of the budget line).

Figure 7. Maximisation of consumer satisfaction – consumer choice

Marginal utility and consumer choice

The concept of marginal utility can be used to widen the above analysis. To begin, marginal
utility measures the additional satisfaction obtained from consuming an additional unit

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of a good. Marginal utility diminishes when consumption of a good increases. As more
and more of a good is consumed, consuming additional amounts will yield smaller and
smaller additions to utility.
We can relate the concept of marginal utility to the consumer’s choice problem. Consider a
small movement down along the indifference curve in Figure 4. The additional consumption
of good X, ∆X will generate marginal utility MUX. So, there is a total increase in utility of
utility MUX · ∆X. At the same time, the reduced consumption of good Y, ∆Y, will lower utility
per unit of a good by MUY, resulting in a total loss of MUY · ∆Y. Because all points on a given
indifference curve generate the same level of utility, the total gain in utility associated with the
increase in consumption of X is fully balanced by the loss of utility due to lower consumption
of Y. Formally,
MUX · ∆X + (-MUY · ∆Y) = 0 (1)
Now we can rearrange this equation so that
∆Y/∆X = MUX / MUY (2)
But because ∆Y/∆X is MRS, it follows that
MRS = MUX / MUY (3)
We saw earlier that in the point of maximum consumer’s satisfaction MRS equals the ratio of
prices. So
MRS = PX / PY (4)
Because MRS is also equal to the ratio of marginal utilities of consuming X and Y (equation
3), it follows that
MUX / MUY = PX / PY (5)
or
MUX / PX = MUY / PY (6)
Equation 6 is an important result. It tells us that satisfaction is maximised when the income
is allocated so that the marginal utility per zloty of expenditure is the same of each good.
To see why this principle must hold suppose that a person gets more utility from spending an
additional zloty on good X than on good Y. In this case, her utility will be increased by
spending more on good X. As long as her marginal utility of spending an extra zloty on X
exceeds the marginal utility of spending an extra zloty on Y, she can increase her utility by
shifting her income toward X and away from Y. Note that the marginal utility of X will
decrease (due to a principle of diminishing marginal utility) and the marginal utility of Y will
increase. Only when the consumer has satisfied the equal marginal principle, she would

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be maximising her total utility and would not be interested in changing the chosen
market basket.
Price-consumption curve

We will show how the demand curve of an individual consumer can be derived from the
consumption choices that a person makes when facing the budget constraint. We begin by
examining what happens to consumption of goods X and Y when the price of a good X
changes. We assume fixed income and fixed price of a good Y.

Initially, the price of the good X is relatively high, which is presented by the budget line A1.
The consumer’s choice is at point E1 in Figure 8. Suppose the price of the good X decreases
so that the budget line rotates outward about the vertical intercept, becoming less steep than
before. The consumption of the good X increases, and the choice of the consumer shifts to the
point E2 on the higher indifference curve. Next drop in the price of X results in shifting the
budget line to the position A3 and allows the consumer to buy goods lying on the highest
possible indifference curve O3. The baskets that maximize utility for different prices of the
good X illustrate the price-consumption curve. It shows the utility-maximising
combinations of X and Y at every possible price of X. But what happens to the
consumption of the good Y when the price of X falls? Figure 8 shows the increase of
consumption of the good Y, but the consumption of Y may either increase or decrease. But,
both X and Y consumption can increase because the decrease in the price of X increases the
consumer’s purchasing power-ability to purchase more of both goods.

Figure 8. Price-consumption curve

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Now look at Figure 9 which shows the relationship between the price the price of X and the
quantity demanded. The horizontal axis measures the quantity of the good X consumed, like
in Figure 8, but the vertical axis now measures the price of X. Point E1 in Figure 9
corresponds to point E1 in Figure 8. The same concerns points E2 and E3. The resulting curve
is an individual demand curve that relates the quantity of the good that a single
consumer will buy to the price of that good.

Figure 9. Individual demand curve

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Income-consumption curve

Now let’s see what happens to the consumption of goods X and Y when the consumer’s
income changes. The effect of changes in income can be analysed in much the same way as a
price change. Figure 10 shows the consumption choice that a consumer will make when
allocating his/her income to the goods X and Y.
Let’s assume that both goods are normal, their prices are fixed, and that the consumer’s
income increases. The raise in income will result in a parallel shift of the budget line to the
right (up). The utility-maximising points will move from E1 to E2 and E3. The consumer is
able to purchase the market baskets that yield higher total utility. The income-consumption
curve shows the utility-maximising combinations of X and Y at every possible income.
When the income-consumption curve has a positive slope, the demand increases with
income. In this case, the goods are normal: consumers demand to buy more of them as
their income increases.

Figure 10. Income-consumption curve for normal goods

In some cases, the demand falls as income increases. We describe the good as inferior. Figure
11 shows the income-consumption curve for an inferior good (good X). It has a negative
slope, as the consumption of X falls with the increase in income.

Figure 11. Income-consumption curve when X is an inferior good

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Income-consumption curve can be used to construct Engel curves, which relate the quantity
of a good consumed to an individual person’s demand. Figure 12 presents Engel curves for
normal goods, but for different income elasticities of demand. The first one shows that the
change in income is higher that the change in demand - the income elasticity of demand is
positive, but less than 1. This is a case of a necessity good. The next curve is a straight line
which informs that the income and the demand changes in the same relation - the income
elasticity of demand is equal to 1. The final curve presents a case of a luxury good - the
change in income is lower that the change in demand - the income elasticity of demand is
greater than 1.

Figure 12. Engel curves

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The goods may be normal at low income and may become inferior at high income. This case
is illustrated in Figure 13. At the levels of income lower than D0 an increase in income
causes a raise in demand – the Engel curve is upward sloping as the good is normal. As
income increases further, above D0, the consumption falls. The portion of the Engel
curve that slopes downward is for the income range in which the good is inferior.

Figure 13. Engel curve for a normal good at low income which becomes
an inferior good with high income

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