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CHAPTER 5
Consumer choice and
demand decisions
©McGraw-Hill Education, 2014
Four key elements in consumer
choice
• Consumer’s income
• Prices of goods
• Consumer preferences
• The assumption that consumers maximize utility
©McGraw-Hill Education, 2014
The budget line
Consider a student with a
budget of £50 to spend on
meals and films.
• Income and prices
together determine the
combinations of the
goods that the student
can afford.
• The budget line separates
the affordable (A to F)
from the unaffordable (G).
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Modelling consumer preferences
• Assume the consumer
prefers more to less.
• Compared with point a:
– the consumer would
prefer to be to the
north-east, e.g. at c
– but prefers a to such
points as b to the
south-west.
c
a
b
Quantity
of meals
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Modelling consumer
preferences (2)
• a is preferred to all points
in the dominated region
Preferred
region
d
c
b
Dominated
region
• but the consumer would
prefer any point in the
preferred region to a
• points like d and e involve
more of one good and
less of the other
compared with a.
e
Quantity of meals
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Modelling consumer
preferences (3)
U2
U2
Quantity
of meals
• An indifference curve (IC)
like U2U2 shows all the
consumption bundles that
yield the same utility to the
consumer
– ICs slope downwards
(given our
assumptions)
– their slope gets steadily
flatter to the right
– ICs cannot intersect
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The consumer’s choice
The point at which utility is maximized is found by bringing
together the indifference curves (U) and the budget line (BL)
• The choice point is at C,
• where the budget line is at
a tangent to an IC.
B
• Points B and E are also
affordable,
C
• but give lower utility,
E
• being on a lower IC.
BL
Quantity of meals
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Adjustment to an income change
• A change in the consumer’s income shifts the
budget line,
• without changing the slope.
• The change in the pattern of consumer choice
depends on the nature of the two goods.
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Films
Normal goods
BL1
When both goods are
NORMAL, an increase
in income induces a new
choice point at C‘.
BL0
C'
The quantity demanded
of each good increases.
C
Meals
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Films
An inferior good and a normal
good
BL1
When “meals” is an inferior
good, the increase in income
takes the consumer from C to
C’.
BL0
C'
The quantity of meals falls and
the quantity of films increases
C
Meals
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Adjustment to a price change
• An increase in the price of one good shifts the
budget line
– altering its slope
– which reflects relative prices.
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Films
An increase in the price of meals (1)
The increase in price of meals shifts the
budget line from BL0 to BL1
BL1
BL0
Meals
The increase in price reduces purchasing power.
©McGraw-Hill Education, 2014
Films
An increase in the price of meals (2)
The consumer moves from C to
E as the price of meals rises
The overall effect is a
reduction in quantity of meals
demanded
C
E
BL1
BL0
Meals
Tracing out more of such points at different prices enables us
to identify the demand curve.
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Response to a price change
• The response to a price change comprises two
effects:
• The SUBSTITUTION EFFECT
– is the adjustment to the change in relative
prices
• The INCOME EFFECT
– is the adjustment to the change in real
income.
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The substitution effect
H
Films
The hypothetical budget line
HH has the slope of the NEW
relative prices and is tangent to
the OLD indifference curve at
D.
The SUBSTITUTION EFFECT is
from C to D along U2U2.
D
E
C
BL1
H
BL0
Meals
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It is always negative. In this
case an increase in the
price of meals leads to a fall
in demand as we move
from C to D.
The income effect
Films
H
D
C
E
H
BL1
BL0
Meals
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The income effect is
from D to E.
• It reflects the fall in
real income at
constant relative
prices.
• It may be positive
or negative,
depending on
whether the good is
normal or inferior.
Income and substitution effects for
an inferior good
H
Films
The income effect is from D to E.
• In this case, it is positive
because the good is inferior.
• Income and substitution
effects therefore have
opposite effects on
demand.
• But the substitution effect
is greater, so the overall
effect is a fall in demand.
D
C
E
H
BL1
BL0
Meals
©McGraw-Hill Education, 2014
Films
Income and substitution effects for
a Giffen good
The income effect is from D to E.
H
D
C
E
H
BL1
BL0
Meals
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•In this case, it is positive
because the good is inferior.
•Income and substitution
effects therefore have
opposite effects on
demand.
• But the substitution effect
is smaller, so the overall
effect is an increase in
demand.
Transfers in cash and in kind
QF

A
Films
AF is the initial budget constraint
on which the individual settles at e0.
e0
Ae1F' is the new budget constraint.
e2
e
Given A'e1F’, the best the individual
can do is e1.
1
An equivalent cash transfer gives a
budget line of A'e1F'.
The individual can now be better
off at e2.
F
10
14
Meals
QM
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Deriving the market demand curve
Price
The market demand curve is the horizontal sum of the
individual demand curves.
Consumer 1
Consumer 2
5
Market
11
13
24
Quantity
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If, at a price of £5,
consumer 1
demands 11 units,
and consumer 2
demands 13 units,
then market
demand at a price
of £5 will be 24 units.
Revealed preference
• Consumers’ preferences are determined by
observing consumers behaviour.
• Suppose that a consumer faces two bundles, X
and Y. If the consumer chooses X when also Y
was affordable, then we may say that bundle X
is revealed preferred to Y.
• If our consumer behaves according to our
theory, then we should expect her/him to
always choose X instead of Y when both
bundles are affordable.
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Revealed preference (2)
• If we see our consumer choosing Y instead of X it
should be the case that X has become not
affordable, otherwise our consumer does not
behave according to our theory.
• The important aspect of revealed preferences is
that if consumer behaviour satisfies some
properties (known as the axioms of revealed
preferences), then the consumer is indeed a
utility maximizing agent.
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Concluding comments (1)
Given the budget constraint, the theory of
demand assumes a consumer seeks to reach
the maximum possible level of utility.
• The budget line shows the maximum affordable
quantity of one good for each given quantity of
the other good.
• Consumer tastes can be represented by a map
of non-intersecting indifference curves.
• Utility-maximizing consumers choose the
consumption bundle at which the highest
reachable indifference curve is tangent to the
budget line.
•
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Concluding comments (2)
• A change in the price of one good generates
an income effect and a substitution effect.
• The income effect of a price increase is to
reduce the quantity demanded for all normal
goods.
• The substitution effect leads consumers to
substitute away from the good whose relative
price has increased.
• The market demand curve is the horizontal sum
of individual demand curves, at each price
adding together the individual quantities
demanded.
©McGraw-Hill Education, 2014