2. Overview
I. Consumer Behavior
Indifference Curve Analysis
Consumer Preference Ordering
II. Constraints
The Budget Constraint
Changes in Income
Changes in Prices
III. Consumer Equilibrium
IV. Indifference Curve Analysis & Demand Curves
Individual Demand
Market Demand
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3. Consumer Behavior
• Consumer Opportunities
The possible goods and services consumer can afford to
consume.
• Consumer Preferences
The goods and services consumers actually consume.
• Given the choice between 2 bundles of
goods a consumer either
Prefers bundle A to bundle B: A B.
Prefers bundle B to bundle A: A B.
Is indifferent between the two: A B.
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4. Indifference Curve Analysis
Indifference Curve
A curve that defines the
combinations of 2 or more goods
that give a consumer the same
level of satisfaction.
Marginal Rate of
Substitution
The rate at which a consumer is
willing to substitute one good for
another and maintain the same
satisfaction level.
I.
II.
III.
Good Y
Good X
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6. Complete Preferences
• Completeness Property
Consumer is capable of
expressing preferences (or
indifference) between all possible
bundles. (“I don’t know” is NOT
an option!)
• If the only bundles available
to a consumer are A, B, and
C, then the consumer
– is indifferent between A and
C (they are on the same
indifference curve).
– will prefer B to A.
– will prefer B to C.
I.
II.
III.
Good Y
Good X
A
C
B
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7. More Is Better!
• More Is Better Property
Bundles that have at least as much of
every good and more of some good
are preferred to other bundles.
• Bundle B is preferred to A since
B contains at least as much of
good Y and strictly more of good
X.
• Bundle B is also preferred to C
since B contains at least as much
of good X and strictly more of
good Y.
• More generally, all bundles on
ICIII are preferred to bundles on
ICII or ICI. And all bundles on
ICII are preferred to ICI.
I.
II.
III.
Good Y
Good X
A
C
B
1
33.33
100
3
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8. Diminishing Marginal Rate of
Substitution
• Marginal Rate of Substitution
The amount of good Y the consumer is
willing to give up to maintain the same
satisfaction level decreases as more of
good X is acquired.
The rate at which a consumer is willing to
substitute one good for another and
maintain the same satisfaction level.
• To go from consumption bundle A to
B the consumer must give up 50 units
of Y to get one additional unit of X.
• To go from consumption bundle B to
C the consumer must give up 16.67
units of Y to get one additional unit of
X.
• To go from consumption bundle C to
D the consumer must give up only
8.33 units of Y to get one additional
unit of X.
I.
II.
III.
Good Y
Good X
1 3 4
2
100
50
33.33
25
A
B
C
D
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9. Consistent Bundle Orderings
• Transitivity Property
For the three bundles A, B, and C,
the transitivity property implies
that if C B and B A, then C
A.
Transitive preferences along with
the more-is-better property imply
that
• indifference curves will not
intersect.
• the consumer will not get
caught in a perpetual cycle of
indecision.
I.
II.
III.
Good Y
Good X
2
1
100
5
50
7
75
A
B
C
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10. The Budget Constraint
• Opportunity Set
The set of consumption bundles
that are affordable.
• PxX + PyY M.
• Budget Line
The bundles of goods that exhaust a
consumers income.
• PxX + PyY = M.
• Market Rate of Substitution
The slope of the budget line
• -Px / Py
Y
X
The Opportunity Set
Budget Line
Y = M/PY – (PX/PY)X
M/PY
M/PX
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11. Changes in the Budget Line
• Changes in Income
Increases lead to a parallel,
outward shift in the budget
line (M1 > M0).
Decreases lead to a parallel,
downward shift (M2 < M0).
• Changes in Price
A decreases in the price of
good X rotates the budget
line counter-clockwise (PX0
>
PX1
).
An increases rotates the
budget line clockwise (not
shown).
X
Y
X
Y
New Budget Line for
a price decrease.
M0/PY
M0/PX
M2/PY
M2/PX
M1/PY
M1/PX
M0/PY
M0/PX0
M0/PX1
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12. Consumer Equilibrium
• The equilibrium
consumption bundle is
the affordable bundle
that yields the highest
level of satisfaction.
Consumer equilibrium
occurs at a point where
MRS = PX / PY.
Equivalently, the slope of
the indifference curve
equals the budget line. I.
II.
III.
X
Y
Consumer
Equilibrium
M/PY
M/PX
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13. Price Changes and Consumer
Equilibrium
• Substitute Goods
An increase (decrease) in the price of good X leads to
an increase (decrease) in the consumption of good Y.
• Examples:
– Coke and Pepsi.
– Verizon Wireless or AT&T.
• Complementary Goods
An increase (decrease) in the price of good X leads to a
decrease (increase) in the consumption of good Y.
• Examples:
– DVD and DVD players.
– Computer CPUs and monitors.
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14. Complementary Goods
When the price of
good X falls and the
consumption of Y
rises, then X and Y
are complementary
goods. (PX1
> PX2
)
Pretzels (Y)
Beer (X)
II
I
0
Y2
Y1
X1 X2
A
B
M/PX1
M/PX2
M/PY1
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15. Income Changes and Consumer
Equilibrium
• Normal Goods
Good X is a normal good if an increase (decrease) in
income leads to an increase (decrease) in its
consumption.
• Inferior Goods
Good X is an inferior good if an increase (decrease) in
income leads to a decrease (increase) in its
consumption.
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16. Normal Goods
An increase in
income increases
the consumption of
normal goods.
(M0 < M1).
Y
II
I
0
A
B
X
M0/Y
M0/X
M1/Y
M1/X
X0
Y0
X1
Y1
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17. Decomposing the Income and
Substitution Effects
Initially, bundle A is consumed.
A decrease in the price of good
X expands the consumer’s
opportunity set.
The substitution effect (SE)
causes the consumer to move
from bundle A to B.
A higher “real income” allows
the consumer to achieve a
higher indifference curve.
The movement from bundle B to
C represents the income effect
(IE). The new equilibrium is
achieved at point C.
Y
II
I
0
A
X
C
B
SE
IE
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19. Individual Demand Curve
• An individual’s
demand curve is
derived from each new
equilibrium point
found on the
indifference curve as
the price of good X is
varied.
X
Y
$
X
D
II
I
P0
P1
X0 X1
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20. Market Demand
• The market demand curve is the horizontal
summation of individual demand curves.
• It indicates the total quantity all consumers would
purchase at each price point.
Q
$ $
Q
50
40
D2
D1
Individual Demand
Curves
Market Demand Curve
1 2 1 2 3
DM
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21. Conclusion
• Indifference curve properties reveal information
about consumers’ preferences between bundles of
goods.
Completeness.
More is better.
Diminishing marginal rate of substitution.
Transitivity.
• Indifference curves along with price changes
determine individuals’ demand curves.
• Market demand is the horizontal summation of
individuals’ demands.
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