Economics 1: Lectures 8-10

Consumer Choice: Indierence Theory

Ioana R. Moldovan
University of Glasgow
Utility

Utility is a measure of a persons satisfaction from the consumption of goods and

services. Consumers make their consumption choices in order to maximize their utility.

The marginal utility of a good represents the change in total utility from consuming an
additional unit of that good. In general, each successive unit of a good consumed adds
less to total utility than the previous unit (so marginal utility diminishes as the quantity
consumed of the good increases). This is the principle of diminishing marginal utility.
In some cases, marginal utility could become negative, if by increasing consumption
beyond a certain level leads to a decrease in utility.

Total Marginal
utility utility

0 Q 0 Q
Maximizing total utility

Assumptions: (i) we consider two goods, X and Y , and total utility U is increasing in
the consumption of X and Y ; (ii) the marginal utility for each good, denoted by M UX
and M UY , is positive but decreasing; (iii) income I is constant; (iv ) the prices of the
two goods are PX and PY , respectively.

If PX = PY , total utility U is maximized when M UX = M UY . If this equality does

not hold, then total utility can be increased by choosing a dierent combination of the
two goods. For example, if M UX > M UY , then more should be spent on X and less
on Y . Given that marginal utility is decreasing, as X ": M UX # and Y #: M UY ",
until M UX = M UY .

If PX 6= PY , total utility U is maximized when

M UX M UY
=
PX PY
where MPUX is the marginal utility from consuming X per spent. If MPUX > MPUY ,
X X Y
then the consumer should spend more on the X good and less on Y . By doing so,
his/her total utility rises. As X ": M UX # and Y #: M UY ", until MPUX = MPUY .
X Y
An alternative way of writing the above expression is the following: multiply both sides
by PX and divide both sides by M UY to get
M UX PX
= (1)
M UY PY

PX
PY : the relative price of X in terms of Y . (e.g. PX = $4 and PY = $2, then the
relative price is 2 units of Y for one X .)

M UX
M UY : the relative contribution to utility of an additional unit of X and Y (for example,
a value of 2 would say that an additional unit of X brings a gain in utility that is twice
as much as the gain from an additional unit of Y ).

The prices of the two goods are determined in the market (i.e. they are out of the
control of the individual consumer). So, if the equality in (1) does not hold, then the
quantities of X and Y consumed will need to be changed. For example, if the inequality
is such that M UX
M UY > PX
PY , then consumers should increase the quantity of X consumed
and decrease the quantity of Y (which leads to a fall in M UX and a rise in M UY ),
until the equality is re-established.
Indierence Curves

One important assumption: other things being equal, having more of a good is preferred
to having less of that same good.

An indierence curve is a line that shows all the combinations of goods (consumption
bundles) that give the same total utility for an individual. A consumer is indierent
between two consumption bundles situated on the same indierence curves.

Indierence curves show the rate at which an individual is willing to exchange dierent
goods. This is the marginal rate of substitution (MRS) which gives the amount of
one good that must be given to compensate for giving up one unit of another good. It
is measured by the slope of a line tangent to the indierence curve.

Indierence curves reect peoples preferences and they are not the same for everyone.
However, some general properties apply:

(i) indierence curves do not cross

(ii) a higher indierence curve means higher utility, as more is preferred to less. A set
of indierence curves is called an indierence map.
In addition, for most goods:

(iii) indierence curves are downward sloping: to consume more of X without gaining
utility, you must give up some of the Y consumption.

(iv ) indierence curves are convex: this reects the notion of diminishing marginal rate
of substitution. In the gure below, the slope of the indierence curve gets atter as
the amount of X consumed increases and the amount of Y declines. This says that,
the less you are consuming of a good, the smaller is the amount that you are willing to
give up to increase consumption of the other good.

A
Increasing utility

B I3
I2

I1

X
Other shapes of indierence curves:

* perfect substitutes: indierence curves are straight lines, the slope of which indicates
the rate of substitution between the goods. Always willing to substitute between the
goods, no matter how much you are consuming of one or the other.

* perfect complements: indierence curves are L-shaped. The goods are only consumed
in xed proportions.

Y Y

IC2

IC2 IC1
IC1

0 X 0 X

Perfect substitutes Perfect complements

Budget Constraints and Budget Lines

In making consumption decisions, we are constrained by the available income and by

the prices of goods. The cost of the consumption bundle cannot exceed the amount of
money we have to spend. This is known as the consumers budget constraint.

T otal Expenditure T otal available income

The budget line represents all the possible combinations of quantities of X and Y
that can be purchased if we spend all income. Example: I = $20, PX = $4,
PY = $2. We have the following consumption bundles that fully use the available
income (X; Y ) = f(0; 10) ; (1; 8) ; (2; 6) ; (3; 4) ; (4; 2) ; (5; 0)g and we can draw the
budget line through these points.

The budget line can be expressed algebraically as

X PX + Y PY = I
where I is income, and PX and PY are the prices of the two goods consumed. If we
consume only the X good (and nothing of Y ), then the most we can purchase is I=PX
units of X , while if we only consume Y , then we can buy a maximum of I=PY units
of Y:
An increase in income shifts the budget line outwards meaning that more can be pur-
chased of each of the goods. A decrease in income shifts it inwards. To nd the change
in the budget line,
I = X PX + Y PY

where : I = I2 I1; X = X2 X1; Y = Y2 Y1

Now assume income is constant, implying that its change is zero ( I ). Then, to
purchase more of one good, one must decrease the amount bought of the other good
(move along the budget line). The rate at which the goods can be exchanged is given
by their relative price. To fully use all income (and stay on the budget line), it must be
that the savings on Y equal the additional expenditure on X:
X PX + Y PY = 0
Y PY = X PX
Y PX
=
X PY
PX
Note that PY is the slope of the budget line. You can also compute the slope by
looking at the points where the budget line intercepts the horizontal and vertical axes,
I=PY PX
slope = =
I=PX PY
A change in the price of one good, with all else constant, tilts the budget line inwards
or outwards, changing its slope. Suppose the price of X has dropped (PX #). If we
only consume X , then we can buy more of X . If we consume both goods, then we can
consume more of both.

Y Y

10 10

5 X 5 X
Increase in income Decrease in Px
Optimal Consumption Choice

To maximize utility, one must choose a consumption bundle that is feasible, while being
on the highest indierence curve possible. This is where the rate at which the consumer
is willing to exchange between goods exactly matches the rate at which he is able
to do so, as given by the market prices and his available income. Graphically, this is
where the indierence curve is tangent to the budget line (point E on the graph below).
Algebraically, the tangency condition is

M RS = relative price

35
Quantity of good Y per week

30
A

25

20
E

15

I3
10

I2
5 B

I1

5 10 15 20 25 30 35

Quantity of good X per week

Income, prices and demand

Income change: an increase in income, with prices remaining unchanged, implies that
more can be purchased of all goods. The budget line shifts outwards and we nd the
optimal consumption bundle on a higher indierence curve.

Income-consumption line

E3

E2

E1

I3

I2

I1

0 X
Price change: a change in the price of one good, say a decrease in PX , causes a
rotation of the budget line and usually an increase in the consumption of good X .

Price-consumption
line

E1

E2 E3

I3

I2
I1

c d X
b
Income and Substitution Eects (Hicks decomposition)

A change in the price of one good (relative to the price of others and keeping nominal
income unchanged) has two eects: it makes the good cheaper (or more expensive)
relative to other goods and induces a substitution eect, for example the fall in the price
of good X will make consumers want to purchase more of good X . At the same time,
the price change aects what can be bought with the available income, e.g. a price
decrease implies that more can be spent on all goods, so the consumer can increase its
purchases of both X and the other goods in his consumption bundle. The amount of
goods that can be purchased with a given nominal income represents the real income.

Economists have tried to decompose the eects of a price change into substitution and
income eects and so identify the change in quantity that is due purely to the change
in relative prices and the change in quantity due to changes in income only.

Consider the Hicks decomposition with a decrease in the price of X (see gure below):
(1) Once PX declines, adjust (reduce) money income until the original indierence
curve can just be obtained. Rotate the budget line to be parallel to the new budget line
(which reects the new relative price) but remain tangent to the original indierence
curve. This gives us the consumption bundle that makes the consumer as happy as
before, but given the new relative prices.
The substitution eect is the response in quantity demanded (q1 q0) that results
from a change in the relative price, with real income held constant so as to be able to
enjoy the same level of utility (i.e. remain on the same indierence curve)

(2)Then, given the new relative price, increase the money income to reach the new
budget line. The associated response in quantity demanded (q2 q1) is the income
eect.

For normal goods, the income eect is positive and reinforces the substitution eect.
For inferior goods, the income eect is negative and goes against the substitution eect.
If the income eect is strong enough, it can even outweigh the substitution eect so
that a decrease in price is associated with a decrease in the quantity demanded. The
goods with such a property are called Gien goods.

Slutsky decomposition: separates the substitution eect by adjusting income such that
the old consumption bundle is still available. In that case, the budget line pivots to
reect the new relative price - the old consumption bundle is still on the budget line but
it no longer is the optimal bundle.
Hicks substitution and income eects

E0

E2

E1

I2

I1

q0 q1 q2 X
Substitution effect Income effect