Consumer Theory
(Introduction)

What is consumer theory?
Budget Constraint
Changes in budget line
Consumer Preferences
Indifference Curves—properties
Utility and preferences
Marginal rate of substitution
How to find best combination
Lecture outline

By the end of this lecture, students can be able
to;
explain the consumer theory and why we study
understand and explain the concepts/terms
used in consumer theory
Illustrate an understanding of simple consumer
theory models
Lecture Outcomes

Study of how people use their limited means to make
rational choices.
Assumes that consumers understand their choices
(possibilities) and the prices (opportunity costs) associated
with each choice.
Assumes that consumers consider the alternatives and
choose the one they like best (optimal).
What is Consumer Theory?

2 important reasons:
I. to understand the foundations of market
demand
II. to address several interesting consumer theory
issues that are best understood using this
model rather than the aggregate demand
model.
Why Study Consumer Theory?

1. Opportunities:
◦ What can the consumer afford?
◦ What are the consumption possibilities?
◦ These questions are summarized by the budget
constraint.
2. Preferences:
◦ What does the consumer likes?
◦ How much of a good does a consumer like ?
◦ These questions are summarized by the utility function
2 Components of Consumer Demand

Budget constraint
◦ shows a consumer’s purchase opportunities for any
combinations of two goods that can be bought at given prices
using a given amount of income.
◦ measures the combinations of purchases that a person can
afford to make with a given amount of monetary income.
What is a Budget Constraint?

8
Budget Set
Rice
(kg)/month
Wheat kg/ per month
Budget Lines
i. Budget set—is the graph
showing a series of budget
lines.
ii. Budget set here shows 4
different budget lines
iii. Higher budget lines implies
combinations of goods
consumed at higher budgets
or incomes
iv. Higher budgets also means
more goods can be consumed
at same old prices
BL4
BL3
BL2
BL1

9
Budget Line
Rice
(kg)/month
Wheat kg/ per month
Not affordable
affordable
Budget Line
i. Budget line—a line showing
various baskets/combinations of
two goods that can be consumed
with a given budget/income
ii. All combinations of these two
goods that lie on or inside the
budget line are affordable
iii. All combinations of these two
goods outside the budget line are
unaffordable
B
C
D
E
A
F
G
H

I=Px X + Py Y; Where;
I=income
Px = price of good X
X=quantity of good X purchased
Py = price of good Y
Y=quantity of good Y purchased
Px / Py = slope (economic rate of substitution--ERS)
General budget equation

Lia’s demand for wheat and rice depends upon the
prices for these goods, her income, and her preferences.
Suppose we look first at her budget constraint:
◦ Wheat costs K4/kg.
◦ Rice costs K2/kg.
◦ Lia has income of K40.
Lia’s Demand for Wheat and Rice

The mathematical expression for Lia’s budget constraint
is:
I = PW
W + PR
R
Where; Pw=price of wheat,
W= quantity of wheat purchased
PR = price of rice
R= quantity of rice purchased
Lia’s Budget Constraint

R = I/PR
- (PW
/ PR
)W
We like to refer to the slope of the budget line as the
ERS=Economic Rate of Substitution
In this case it is PW
/ PR
,
For Lia: PW
=K4 PR
=K2 I=K40
ERS= 4/2=2 or (2:1)
Economic rate of substitution—the rate at which one good can be traded
for another for a given amount of income/budget.
E.g.
Given an of income K40, K2 worth of wheat must be traded with K1 worth of rice or K2
worth of wheat must be given up to get K1 worth of rice and vice versa.
Lia’s Budget Constraint

Lia’s table of Budget Constraint
Schedule with the income of K40

Graph of Lia’s Budget Constraint
The graph to the right
shows a picture of Lia’s
budget constraint.
Each blue diamond is a
point from the table.
❖ Combination above Lia’s
budget line is unattainable (D)
❖ Along budget line all income
is exhausted—no saving or
borrowing
❖ Under the budget line, part of
the income is saved (C).
❖ C
❖ D

Changes in budget line
An increase or decrease in income causes shifts.
An increase in income will shift budget line to the right—more
consumed at same prices
A decrease in income will shift budget line to the left—less
consumed at same prices
An increase or decrease in the price of wheat only will pivot and
rotate.
A decrease/increase in the price of rice only pivot and rotate.
Note: Changes in the price of wheat relative to the price of rice
will change the ERS.

Changes in the Budget Lines
BL1
BL2
Rice
(kg/week)
Wheat kg/week
Effect of an increase in the income
Wheat kg/week
Rice
(kg/week)
BL2
BL1
Effect of a fall in income
Effects of Changes in Income

Changes in the Budget Lines
BL1
BL2
Rice
(kg/week)
Wheat kg/week
Effect of a fall in the price of wheat
Wheat kg/week
Rice
(kg/week)
BL2
BL1
Effect of an increase in the price of rice
Effects of Changes in Prices

To explain consumer behaviour, economists
assume that consumers have a set of tastes or
preferences that they use to guide them in
choosing between goods.
Goods are ranked according to how much
pleasure or utility or satisfaction a consumer gets
from consuming each good/service.
Preferences and Utility

A person’s preferences can be represented by a
preference map that consists of a series of
indifference curves.
An indifference curve is a line that shows a
consumer’s combinations/baskets of two goods which
a consumer is indifferent.
Indifferent = a consumer does not care whichever
combination of two good she consumes as she gets
the same level of satisfaction/utility.
Preferences and Utility

An indifference curve is the locus of points
representing all the different combinations of two
goods which yield equal level of utility to the
consumer.
Indifference schedule is a list of various
combinations of commodities which are equally
satisfactory to the consumer concerned.
Preferences and Utility

Utility is the way economists represent
preferences.
Among two bundles, the one with the
higher utility is the preferred bundle.
If two bundles have the same utility, we
say that the consumer is indifferent.
Utility and Preferences

Indifference Schedule
Combinations Oranges Mangoes
A 15 1
B 11 2
C 8 3
D 6 4
E 5 5
Various combinations of fruits (oranges and mangoes) for a given level of satisfaction/utility

Indifference Curve
A
B
C
D
E
1, 15
2, 11
3, 8,
4, 6
5, 5
mangoes
Oranges
Combinations like A, B or C are
referred to as bundles or baskets
Bundles/baskets on an indifference
curve contain combinations two
goods in various amount that yields
the same level of utility.
For a consumer with this
indifference curve , consuming
basket A or B or E would yield
equal level of satisfaction so he
would be indifferent.

Indifference Curve
A
B
C
D
E
1, 15
2, 11
3, 8
4, 6
5, 5
mangoes
Oranges
• This IC shows all possible
combinations of mangoes and
oranges between which a
person is indifferent.
• Point A shows consumption
bundle consisting of 1 mango
and15 oranges.
• Moving from point A to Point B,
we are willing to give up 4
oranges to get a second mango
(total utility is the same at points
A , B, C or along the IC ).

Marginal Rate of Substitution–the slope of the indifference
curve in absolute values.
The maximum amount of one good a consumer would
willingly trade for one more unit of another good and remain
at the same level of utility (satisfaction).
Or the maximum amount of good X a consumer is willing to
trade for one more unit of good Y and derive the same level of
satisfaction as before.
It tells us how much of one good a consumer would willingly
trade for an incremental unit of the other good and remain
indifferent.
Indifference Curve

Different combinations of two goods that yield the
same level of utility can be represent with
indifference curves.
An indifference curve connects all of the bundles
that a consumer likes equally.
We assume only two goods when using
indifference curve analysis.
Indifference Curves

Preference or Indifference Map
• The set of all indifference
curves that describe an
individual’s preferences
are referred to as an
indifference curve map or
preference map.
• A preference map is
made of so many
indifference curves

Preferences in Indifference Map
● An indifference curve
connects all the bundles
that have the same utility.
● Higher indifference
curves indicate more
utility (IC3
≻ IC2
).
● Lower indifference
curves indicate less
utility (IC1
≺ IC2
).
● The preference map is
FULL of indifference
curves.

IC are negatively sloped
IC are convex to the origin
IC can never intersect each other
IC are never thick
Indifference Curve - Properties

We summarise a consumer’s preference ranking as:
Let ≈ to mean “at least as good as”
B1 ≈ B2 means: B1 is at least as good as B2
Let ≡ to mean “indifferent to”
B1 ≡ B2 and B2 ≡ B1, implies B1 is indifferent to B2 or B2
indifferent to B1
Let ≻ to mean “strictly preferred to”
B1 ≻ B2 implies B1 strictly preferred to B2 and not B2 strictly
preferred to B1 (not B2 ≻ B1 )
Assumptions on Consumer Preferences

Basic assumptions about an individual’s
preferences over bundles
◦ more is better than less:
If B1
has more in it than B2,
then B1
≻ B2
◦ transitivity: If B1
≻ B2
and B2
≻ B3
then B1
≻ B3
◦ average bundles are at least as good as extreme
bundles:
If B1
≡ B2,
and B3
is an “average” of B1
and B2 then B3
≻B1
and B2
E.g.
B1( 10 oranges, 6apples) , util=8; B2 (8 0ranges, 8 apples), utill=8
average (A=B1+B2)= B3 (18, 14), so B3 > B1 and B3>B2
Assumptions on Consumer Preferences

Lia’s optimal amount of wheat and rice to consume
is the amount that maximizes her utility subject to
her budget constraint.
On the graph...
◦ Get to the highest indifference curve possible.
◦ But stay on the budget constraint
Optimal Consumption

Bundle Z is on highest IC but not
within the budget.
Bundle X is right on the budget but
not on the highest IC. Bundle X is not
the best because Lia has spent all her
income but is not on the highest
indifference curve possible or does
not yields the highest level of
satisfaction.
Bundle V is within the budget but not
on the highest IC.
Bundles on IC0 under the budget line
are affordable but not better.
The bundle Y is best because it is on
the budget and on the highest IC.
How to Find Lia’s Best Combination
Whea
t
Ric
e
2
0
1
0
IC
0
IC
1
IC2
W
*
R
*
X
Y
V
Z

At bundle Y she is doing
the best she can subject to
her budget constraint.
Bundle Z is preferable but
unattainable
How to Find Lia’s Best Combination

Utility is maximized when:
◦ the indifference curve is just tangent to the budget
line.
Utility is maximized when:
◦ you are on the budget line and
◦ the slope of the indifference curve equals the slope of
the budget line
Utility is maximized when:
◦ Income = PR
R + PW
W
◦ MRS = ERS
How to Find the Best Combination

1. Differentiate between budget line and indifference curve.
2. Differentiate between economic rate of substitution and marginal
rate of substitution.
3. If Joe preference ranking is such that oranges≡ mangoes. State a
preference order for orange-mango mix juice.
4. Jossy likes orange over pineapple over pawpaw. Which is true
about the preferences of Jossy?
a. Jossy likes orange over pawpaw.
b. Jossy is indifferent between pineapple and orange
c. If is offered pineapple, pawpaw and orange, she would choose
orange.
Tutorial 3

5. Lia is indifferent in the consumption of locally
grown orange
and imported apple.
a.The exchange rate falls and price of apples rises.
Draw a graph to illustrate the effect of the rise in
the price of apples on the budget line and
indifference curve.
b.On the same graph illustrate effect of an income
tax rebate.
Tutorial 3

6. Which of the following
is true.
a.E≻A
b.E≡A
c.B≈A
d.E best choice and
affordable
e.A best choice and
affordable
f.F≻G≻H
g.F≻B≻K
h.H≡D≡I
Tutorial 3
A
B
C
D
E
F
G
H
I
J
K

7. Lia’s budget constraint function for the consumption of orange
and apple is given by I=P1
Q1
+P2
Q2
where p1=
price of orange,
Q1
=quantity of orange purchased given budget constraint, P2 =
price of apple and Q2
=quantity of apple purchased given budget
constraint.
a.Find the expression for ERS with respect to orange.
b.Find the expression for ERS with respect to apple.
c.If P1= K2,
Q1=5
, P2=K3,
Q2=3 and I=K35
i.Find the ERS with respect to orange.
ii.Find the ERS with respect to apple.
Tutorial 3