Household as a consumer:

behind the demand curve

The decision making process of
the consumer
Consumer Behavior
Preference set

Constraints
Optimal decision

Assumptions
Completeness: ability to express
rational decision when confronted
with a choice between two
goods/baskets of goods:
I prefer A to B; B to A; am
indifferent between A & B

Assumptions
Transitivity or consistence: If a
consumer prefers A to B and B to C,
he will prefer A to C

Non satiation: a rational consumer
prefers more of a good to less of a
good

Utility and Optimization
Utility (Jeremy Bentham):
- reflects a rank ordering of
preferences.
- is a magnitude indicating the
direction of preferences
Constraints: income and prices
Optimization:
- Cardinal Approach and Ordinal
Approach
Optimization
The Cardinal Approach
Utility is cardinally measurable and
the objective is to maximize utility
The Law of Diminishing Marginal
Utility
Optimization Rule 1:
When only one good is consumed
and is available for free, consume till
MU
x
= 0
Optimization
Optimization Rule 2:
When only one good is consumed
and is available for a price:
Consume till MU
x
= Price
x

Optimization Rule 3:When more than one
good is consumed and the prices of goods
vary:
Consume till MU
x
/P
x
= MU
y
/P
y
= MU
z
/P
z
Deriving the demand curve:
cardinal approach
Marginal utility Schedule
Units of X MU of X
1. 10 utils
2 8
3 5
4 3
5 0
Combinations of quantity
& Price

Price of X Units of X
Rs.10 1
Rs.8 2
Rs.4 3
Cardinal approach, criticism
The coordinal approach suffers from the
criticism that utility being subjective, it can not
therefore be measured objectively. It is nearly
impossible for an average consumer to draw his
utility schedules for different commodities and
then optimize, rather maximize his total utility by
equating the marginal utility of a rupees worth
in all directions.


Cardinal approach, criticism
Being subjective utility varies from person
to person and even for the same person.
Even experts can not derive utility
schedules for different products
Hence it is not possible to arrive at
marginal utilities of different goods and
then equate the same to arrive at
maximum total utility.
Ordinal Approach
The ordinal utility analysis is also known
as indifference curve approach to utility
maximization
An indifference curve is the locus of
infinite combinations of two commodities
or bundles of commodities which yield the
same total utility to the consumer

Preference Set- Indifference Curves
Indifference Curve:
Combination of goods that yield the same
level of satisfaction.
Properties of Indifference curves:
- Slope downward
- Convex to the origin
- Non intersecting
Shapes of Indifference curves


MRS decreasing MRS Constant=1 One fixed proportion
Normal substitutes perfect substitutes Complements
Rate of commodity substitution
Since an indifference curve is convex to
the origin, movements away from origin
on X-axis yield declining marginal rate of
commodity substitution
This happens because of additions to the
stock of commodity represented on X-axis
and decreases in the stock of commodity
represented on Y-axis.
Total utility on an IC curve can remain
constant only when the absolute value of
the RCS diminishes as we move away
from origin
Opportunity Set
Defined by Budget Constraint.
6x + 3y = 60
Given P
x
= 6 and P
y
= 3
Graphically,

-P
x
/P
y
is the Slope
10
Y

20
X
Consumers Equilibrium- The
Optimal Combination
e
x
y
At e slope of the budget line is equal to the slope
of the Indifference curve.
Consumers Equilibrium
Slope of the budget line: - P
x
/P
y

Slope of Indifference curve: MUx/MUy

Equilibrium : MUx/MUy = P
x
/P
y
or MUx/P
x
= MUy/P
y