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Consumer Theory and preferences:
a microeconomic application
by
Devon Swan
Mael-yann Le Capitaine
Consumer Theory
• Consumer theory is a theory of microeconomics that relates
preferences to consumer demand curves. The link between personal
preferences, consumption, and the demand curve is one of the most
complex relations in economics. Implicitly, economists assume that
anything purchased will be consumed, unless the purchase is for a
productive activity.
• Preferences are the desires by each individual for the consumption of
goods and services, and ultimately translate into employment choices
based on abilities and the use of the income from employment for
purchases of goods and services to be combined with the consumer's
time to define consumption activities.
• Prominent variables used to explain the rate at which the good is
purchased (demanded) are the price per unit of that good, prices of
related goods, and wealth of the consumer.
Application
• Suppose Devon and Mael have decided to
allocate $2,000 per year on alcoholic
beverage during parties or Travelling.
Devon and Mael differ substantially in their
preferences for these two forms of leisure.
Devon prefers alcoholic beverages, while
Mael prefers travelling.
Indifference Curve
• In microeconomic theory, an indifference curve is a graph
showing different units of goods, each measured as to
quantity, between which a consumer is indifferent. That is,
at each point on the curve, the consumer has no
preference for one unit over another. In other words, they
are all equally preferred. One can equivalently refer to
each point on the indifference curve as rendering the
same level of utility (satisfaction) for the consumer. Utility
is then a device to represent preferences rather than
something from which preferences come. The main use of
indifference curves is in the representation of potentially
observable demand patterns for individual consumers
over commodity units.
Application
Draw a set of indifference curves for Devon and a second set for Mael
Devon
Mael
Al.Bev
Al.Bev
Travel.
Travel.
Application
Discuss why the two sets of curves are different from each other using the concept of marginal
rate of substitution.
• Let’s look first at Devon, she strongly prefers the
alcoholic option. Here she is willing to give up less
travelling to get many alcoholic beverages (or
conversely would be willing to give up more
travelling for just one unit of Alcoholic beverage) and
remain just as happy. Thus, her marginal rate of
substitution (The rate at which she is willing to give
up Alc.bev to travel) is very low. Or, she is willing to
give up only a small number of Alc.Bev (it could be
less than one) to get one more unit of travel. Mael
on the other hand is willing to give up many Alc.Bev
to gain one more unit of travelling. Thus, his
marginal rate up substitution is high.
Marginal Rate of Substitution (MRS)
• In economics, the marginal rate of substitution is the
rate at which a consumer is ready to give up one good
in exchange for another good while maintaining the
same level of satisfaction.
• Under the standard assumption of neoclassical
economics that goods and services are continuously
divisible, the marginal rates of substitution will be the
same regardless of the direction of exchange, and will
correspond to the slope of an indifference curve (more
precisely, to the slope multiplied by -1) passing
through the consumption unit in question.
MRS and Slope of Budget constraint
• When consumers maximize utility (preferences) with respect to
a budget constraint, the indifference curve is tangent to the
budget line, therefore, with m representing slope:
Px= Price/unit of X
Py= Price/unit of Y
• Therefore, when the consumer is choosing his utility maximized
market basket on his budget line,
MU= Marginal Utility
• This important result tells us that utility is maximized when the
consumer's budget is allocated so that the marginal utility to
price ratio is equal for each good.
Application
If Devon and Mael pay the same prices (per year) for their leisure, will their marginal
rates of substitution of Alc.Bev or Travelling be the same or different?
• Their marginal rates of substitution will be the
same. Although the unit that each consumer will
be different, the MRS must be the same. We know
that each will chose the units that place them on
their highest indifference curve given their budget
constraint. We also know that for those units or at
this point, the slope of the budget constraint is
equal to the MRS. Since Devon and Mael pay the
same for Alc.Bev and Travelling, their budget
constraints must have the same slope and
therefore their MRS must be the same.
Application
Numerical example
• Suppose the budget is $2000 per year a unit of
alc.bev cost $20 and a unit of travelling cost
$500.
• So: - Budget = $2000/year
- Price of Alc.Bev. = Pa = $20/unit
- Price of Trav. = Pt = $500/unit
Application
Units of
Alc. Bev
120
Budget / Pa = $2000/$20 = 100
100
A
Budget Constraint
80
Mael Indifference Curve
60
Devon Indifference Curve
40
20
Point A and B are the best
consumer possibilities for
Mael and Devon.
B
Units of Trav.
0
0
0.5
1
1.5
2
2.5
3
3.5
Budget / Pt = $2000/$500= 4
4
4.5
Application
• The slope (so the MRS) at point A (Devon) is :
Pt/Pa = 500/20 = 25
• The slope (so the MRS) at point B (Mael) is
also: Pt/Pa = 500/20 = 25
• So the marginal rate of substitution for Devon
and Mael is the same even if there
preferences are different.
Thank you !!!
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