Week 6:

Consumer Behaviour
ECO 101: INTRODUCTION TO MICROECONOMICS
This Week’s Class
◦Lecture:
◦ What is Utility?
◦ How do consumers actually choose between consumption bundles they can
afford?
◦ What is “optimal” consumer behaviour?
◦ How can we aggregate individual choices to market demand?
◦Tutorial:
◦ Practice solving for Optimal Choices using Marginal Utilities.
 Budget Constraint Example
◦ Recall the budget constraint (BC)
outlines all of the consumption
Food

A E
bundles a household can afford.
◦ Any bundle on the BC is affordable.
◦ Note that A, B, C are all affordable.
Bu
D d ge ◦ But A & C are unlikely to actually be
tC desirable consumption bundles.
on
str
ain B ◦ So how do households actually
t
choose which of these bundles to
purchase and consume?
C
Clothes
Utility
◦ We typically use the economic concept of utility.
◦ Any bundle of goods delivers a certain amount of utility.
◦ For example, 2 units of clothes and 5 units of food might deliver 10
utility (or 10 “utils”).
◦ Consumers like utility and seek to maximize it.
◦ We assume that a consumer’s utility is both:
◦ Complete: any possible combination of goods delivers a utility value.
◦ Ordinal: the absolute value of utility (e.g. 10 utils) has no meaning on its
own, but it is meaningful for comparisons.
◦ If Bundle 1 had higher utility than bundle 2, then Bundle 1 is preferred.
 Adding in Utility Values
◦ Suppose that each of these five bundles
A vs B? deliver these utility values.
Food

35 55 ◦ Out of the 5 bundles, which would a

A E consumer prefer to consume?
A vs C?
D ◦ Out of the 5 bundles, which would a
consumer end up consuming?
Bu
37 d ge A vs D? ◦ Typically seeks out the highest utility bundle
tC that they can afford.
on
str ◦ Can always just get higher utility by
ain 45 consuming more, but we are bounded by
t
our resources/income/wealth.
B
◦ Allows us to order all bundles in terms
C
of preference.
35 ◦ (𝐸 ≻ 𝐵 ≻ 𝐷 ≻ 𝐶 ∽ 𝐴)
Clothes
Marginal Utility
◦ Marginal Utility: how much additional utility does an individual
gain from consuming an additional unit of a good.
◦ Economic decision making is often made on the margin.
◦ When deciding between two goods, and individual will choose
whichever delivers the high marginal utility per dollar spent.
◦ Suppose there are two goods (1 & 2):
𝑀𝑈! 𝑀𝑈"
>
𝑝! 𝑝"
Which would the consumer spend their money on?
Diminishing Marginal Utility
Total Utility
◦ We generally assume that

Utility
marginal utility is diminishing
as the quantity of a good
consumed increases.
◦ The added enjoyment from
each successive unit is less.
◦ Examples of goods that
might exhibit this?
Marginal Utility

Quantity
Marginal Utility Example
Good 1 (p1 = $5) Good 2 (p2 = $2.5)
Quantity MU Total Spent Quantity MU Total Spent
1 10 $5 1 7 $2.5
2 9 $10 2 6.5 $5
3 8 $15 3 6 $7.5
4 7 $20 4 5 $10
5 6 $25 5 4 $12.5
6 5 $30 6 3 $15
7 4 $35 7 2 $17.5
8 3 $40 8 0.5 $20
Utility Maximization
◦This implies that an individual is only maximizing their utility
if:
𝑴𝑼𝟏 𝑴𝑼𝟐
=
𝒑𝟏 𝒑𝟐
◦This maximization condition can be rewritten as:
𝑴𝑼𝟏 𝒑𝟏
=
𝑴𝑼𝟐 𝒑𝟐
◦ The ratio of marginal utilities between (any) two goods must be
equal to their ratio of prices.
Diminishing Marginal Utility
◦Suppose that:
MU! MU" MU! MU"
> and we want to go to =
p! p" p! p"
◦Why is the first (left) inefficient?
◦How do they re-arrange spending?
◦ We generally assume that consumers are price takers, so p1 & p2 are
fixed.
◦ Diminishing Marginal Utility tells us how to do this!
◦ Increasing Q1 will decrease MU1 and decreasing Q2 will increase
MU2.
Indifference Curves (IC)
◦Completeness: every possible bundle of goods should
deliver a utility value.
◦All bundles that deliver exactly the same amount of utility
will be on the same Indifference Curve (IC).
◦ An individual IC will exist for each value if utility.
◦ For any given bundle, all of the other points on the same
Indifference Curve deliver the same utility, and therefore a
consumer is indifferent between any of these points.
◦Every bundle is on an Indifference Curve!
 Back to Our Utility Example
IC!"#$%'' ◦ Note that A & C both deliver 35 Utils.
IC!"#$%&(
35 ◦ ⇒ same Indifference Curve.
IC!"#$%&' E 55
◦ Likewise, there exists:
A
◦ An IC for Utility = 37, and
Food

D
◦ An IC for Utility = 55.
37 ◦ Every point in this x-y space is on an IC.
55
F ◦ An individual maximizes their utility
45 (subject to their budget) at the highest
B feasible IC (In this case, at point F).
◦ This IC will necessarily be tangent to the BC.
C ◦ This is the highest utility point still within the
35
budget set.
Clothes
 Utility Example
◦ Suppose that we are at Point A.
Preferred Set ◦ Can this individual be made better
off?
◦ Certainly! Anywhere above the Indifference
Food

Curve will deliver higher utility (NE).

◦ This is the preferred set for this Indifference
A Pre Curve.
Af fer
fo re
rd d
◦ But can the individual afford to be
ab &
le made better off?
◦ Still yes, but in a more limited set of points.
◦ Anywhere in the preferred set that is also
on or below the budget constraint is
affordable and preferred.
◦ Optimization occurs at the tangency!
Clothes
 Marginal Rate of Substitution (MRS)
◦ Can move along the IC by giving up some
amount of X and receiving an amount of Y.
◦ Marginal Rate of Substitution (MRS): The
rate at which you can trade off X for Y and
Food (Y)

stay just as well off.

𝑴𝑼𝑿
𝑴𝑹𝑺 = −
𝑴𝑼𝒀
◦ The MRS is shown on the graph as the
slope of the Indifference Curve.
◦ Note that this ratio of Marginal Utilities
decreases as you move SE on the IC. Why?
IC!"#$%'' ◦ Diminishing Marginal Utility gives
individuals a preference for variety.
Clothes (X) ◦ This is why (typically) curved inwardly.
 Indifference Curves Cannot Cross
IC* ◦ Indifference Curves cannot cross.
IC)
◦ Why not? Suppose they do.
◦ The argument is centered around the
B
“preferred set”.
Food

A
◦ Recall that anything NE of an Indifference
Curve is (strictly) preferred to anything on the
curve.
◦ Note that B ≻ A and also C ≻ D.
C ◦ But also that B & D and C & A are on the
same ICs, so we must be indifferent
D between them.
◦ This would imply: B ≻ A ∼ C ≻ D.
◦ Which gives us: B ≻ D (which cannot be)
Clothes
 Substitutability of Products
◦ As products become close substitutes,
the IC will get straighter.
◦ E.g. blackboards versus whiteboards.
◦ Perfect Substitutes: Constant MRS.
Food

◦ Manifests as a linear line.

◦ The Utility tradeoff remains constant.
◦ Perfect Complements: Zero MRS, then
infinity.
◦ Manifests as an L-Shape.
◦ No tradeoff – must be consumed in fixed
proportions to deliver utility.
◦ How do we optimize on either of these?
Clothes
Utility: As A (Useful) Concept?
◦ The general framework for economic choice theory involves:
◦ Consumers choosing their optimal consumption bundles that maximize
their own personal utility functions, subject to:
◦ Their own resource constraints and market prices (budget constraint)
◦ How plausible is this? Is it convincing?
◦ People do not know their own utility functions.
◦ Precisely inaccurate – but predictions bear out.
◦ Generally plausible in the sense that people think critically and try to do their best
with the resources and information available to them.
◦ People are generally “boundedly rational”, but almost surely not “perfectly rational”.
◦ This weeks podcast thinks about how much we really do optimize in our lives.
10-minute Break
The Effect of an Income Increase
◦ Suppose that somebody is utility maximizing and income
increases:
MU" MU#
We start from =
p" p#
◦ How should a utility-maximizing consumer react?
◦ Still price-taking, but just have more money to spend.
◦ As you spend money on each good, their MU will drop (Dim MU)
◦ Therefore, you need to spend money on all goods such that all
their marginal utilities drop and maintain this equality.
The Income Effect
◦We call the demand effects of an increase in consumer
income the income effect.
◦How a consumer’s demand for a good changes with
increased income holding the relevant prices of all good
constant.
◦Normal goods: demand increases when income increases.
◦Inferior goods: demand decreases when income increases.
◦ Examples of inferior goods: McDonalds, bus tickets, potatoes.
 The Income Effect Graphically
◦ An Increase in Income manifests in a
parallel shift outwards in the budget
constraint.
◦ The new point of tangency moves us
Food

from point A → point B.

◦ Notice that Income has increased,
B and so has demand for both goods.
◦ Assuming both are Norma Goods.
A
◦ This demand increase for these
goods is the income effect.

Clothes
The Effect of a Price Increase
◦ Suppose that somebody is utility maximizing and p1 increases:
MU" MU# MU" MU#
We go from = to <
p" p# p" p#
◦ How should a utility-maximizing consumer react?
◦ Should adjust consumption to re-establish this equality.
◦ To re-reach equality, we need MU2 ↓ and MU1 ↑.
◦ Therefore, an increase in p1 should lead to:
◦ A decrease in the demand for good 1 (MU1 ↑), and
◦ An increase in the demand for good 2 (MU2 ↓).
The Substitution Effect
◦Changes in prices actually have two effects:
◦ The Income Effect: If the price of a good increases, it reduces the set
of goods you can afford.
◦ The Substitution Effect: changes in the demand for a good when its
price changes, holding income constant.
◦The substitution is the pure effect of the change in relative
prices, if you could maintain a consumer’s purchasing power.
◦ This is a theoretical idea.
Income Versus Substitution Effects
◦ How demand reacts to price changes depends on the net impact of
both the income and substitution effects.
◦ Suppose that the price of Good A decreases. Which way do the
effects go?
◦ If Good A is a Normal Good:
◦ Income has increased ⇒ Income↑ leads to Quantity demanded ↑
◦ Good A is also relatively cheaper ⇒ Quantity demanded ↑
◦ Both income and substitution effects go in the same direction.
◦ If Good A is an Inferior Good:
◦ Income has increased ⇒ Income↑ leads to Quantity demanded ↓
◦ Good A is also relatively cheaper ⇒ Quantity demanded ↑
◦ The income and substitution effects work against each other.
 The Substitution Effect Graphically
In this case, for clothes, ◦ A decrease in the price of clothes manifests in a
which effect dominates? pivoting in the budget constraint.
◦ The new point of tangency moves us from point
A → point C.
Food

◦ Note that:
◦ The increase in clothes is large.
◦ The increase in food is very slight, but positive.
C ◦ Note that there are both effects here for both
goods:
A 1. The Income Effect (Income increases for both)
2. The Substitution Effect (↑ clothes, ↓ food)
◦ For Clothes, they both move together (↑).
◦ For Food, they move against each other.
Clothes
 Price Changes: Income & Sub. Effects
◦ This is an example where pX has dropped.
◦ The substitution effect shows how we
Food (Y)

would change consumption choices if we

held purchasing power constant.
◦ Note here that we are just richer.
◦ The way we do this is to say suppose that
we are not made better off by this price
A change.
C ◦ We should remain on the same IC then.
◦ Where would be the point of tangency be
B on IC1 with the new prices.
𝑴𝑼𝑿 𝒑𝑿
𝑴𝑹𝑺 = − =−
𝑴𝑼𝒀 𝒑𝒀
Clothes (X)
 Price Changes: Income & Sub. Effects
◦ A → B is now the pure substitution effect.
◦ pX ↓ and QX ↑ (Sub effect).
Food (Y)

◦ pY ↑ and QY ↓ (Sub effect).

◦ Then B → C is the income effect.
◦ Gotten richer and QX ↑ (Income effect).
◦ Gotten richer and QY ↑ (Income effect).
A ◦ Note here: this picture is depicting positive income
C
effects for X & Y, so both normal goods.
◦ This (theoretical) decomposition lets us
B think about the impacts of these two
forces.
◦ In reality: we only ever observe A & C.
Clothes (X)
 Demand Curves for Ordinary Goods
◦ We can show why Demand is (typically) downward sloping using Indifference Curves.
P
A
Food

B
A
B
C C

Clothes D1
Q
Ordinary & Giffen Goods
◦ Ordinary Goods: Demand P
decreases as price increases.
◦ Giffen Goods: The demand for a
good increases as its price
increases.
◦ (Flawed) observations of increases in
price and quantity in 19th Century C.E.
◦ May not actually exist.
◦ Luxury Goods: The demand for a
good increases as it gets more
expensive.
◦ Similar to the idea of Giffen Goods.
Q
Individual to Market Demand
◦We have spent a lot of time on individual demand.
◦When we start thinking about firms, we care about the total
demand in the market.
◦Therefore, the market demand is the sum of all individual
demands for a single product.
◦Therefore, demand can increase through two means:
◦ Intensive Margin: Individual existing consumers buying more.
◦ Extensive Margin: New (more) consumers entering the market.
Market Demand Example: Identical Demands
◦Suppose that we have 3 P
individuals with Demand: 12.5
◦ QD = 25 – 2p
◦If price = $10, how many
will we sell?

◦So we get the market

demand here:
◦ QDM = 3QD = 3(25-2p)
◦ QDM = 75 – 6p Q
25 75
Market Demand Example: Different Demands
◦Suppose that we have 2 P 60 − 2𝑝 𝑖𝑓 𝑝 < 25
𝑄+, = '35 − 𝑝 𝑖𝑓 ( 𝑝 ≥ 25 𝑎𝑛𝑑 𝑝 ≤ 35 )
different Demand: 0 𝑖𝑓 𝑝 > 35
◦ QD1 = 25 – p 35
◦ QD2 = 35 – p
◦Here, we need to divide 25
market demand into 2 parts
◦ Will produce a kink in demand.
◦ Will need to define market demand
on either side of this kink.
10 25 35 60 Q
Conclusion
◦Utility is a theoretical tool used to measure consumer
preferences.
◦Consumers maximize their utility by setting their
Indifference Curves tangent to their Budget
Constraints.
◦Consumers react to price and income changes with
substitution effects and income effects.