Theory of Consumer Choice
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The Individual Demand Curve
The Market Demand Curve
Utility Theory and Consumer Demand
Consumer Surplus
Consumer Choice Using Indifference Curves
The Individual Demand Curve
Bob’s Demand Curve for Hamburgers
b
3.00
Price of burgers ($)
The individual
demand curve shows
the relationship
between the price of a
good and the quantity
that a single
consumer is willing to
buy [quantity
demanded] during a
particular period of
time. The individual
demand curve is
negatively sloped,
consistent with the
law of demand.
c
2.00
8
11
Burgers per month
Income and Substitution Effects
• Substitution effect: The change in
consumption resulting from a change in the
price of one good relative to the price of
other goods.
• Income effect: The change in consumption
resulting from an increase in a consumer’s
real income.
• Real income: Consumer’s income
measured in terms of the goods it can buy.
Market Demand Curve with Two Consumers
Market demand
curve
g
3.00
Price of burgers ($)
To determine the
market demand at a
given price, we add
the quantities
demanded by all
consumers. For
example, at a price of
$3, Betty consumes 4
burgers (point g) and
Bob consumes 8
burgers (point b), so
the total quantity
demanded is 12
(point j).
b
j
2.00
Betty’s demand
Bob’s demand
curve
curve
4
8
12
Burgers per month
Market Demand Curve with Many Consumers
b
Quantity
($)
demanded
3.00
250
2.20
850
2.00
1,000
3.00
Price of burgers ($)
The market demand
curve shows, for each
price, the quantity of
the good demanded
by all consumers. A
decrease in the price
of burgers from $3 to
$2 increases the total
quantity demanded
from 250 (point b) to
1,000 (point c).
Price
d
2.20
c
2.00
250
850
Burgers per month
1,000
Total and Marginal Utility
Marginal Utility (Utils)
Total Utility (Utils)
182
152
140
50
26
1
2
1
2
26
24
7 8
Burgers per month
[A] Total Utility
12
8
Burgers per month
[B] Marginal Utility
14
In Panel A, as the
quantity of burgers
consumed increases,
the utility or
satisfaction increases
at a decreasing rate,
and eventually falls.
In Panel B, as the
quantity of burgers
increases, the
marginal utility (the
change in utility from
one more burger)
decreases. Both
curves reflect the law
of diminishing
marginal utility.
Marginal Utility and the Marginal Principle
Number of
Burgers
Marginal Benefit of
Burgers = Marginal
Utility of Burgers (Utils)
Number
of
Tacos
Marginal
Utility of
Tacos
Marginal Cost of
Burgers = 3 times the
Marginal Utility of
Tacos (Utils)
5
18
15
1
3
6
16
12
2
6
7
14
9
3
9
8
12
6
4
12
9
10
3
5
15
10
8
0
6
18
Marginal
cost
(utils)
5
18
3
6
16
6
7
14
9
8
12
12
r
18
Marginal benefit or marginal cost (utils)
Marginal
benefit
(utils)
Quantity
t
16
12
m
6
s
3
q
5
6
8
Burgers per month
Marginal Principle and Demand
The marginal benefit of burgers equals the marginal cost at 8 burgers, so the marginal
principle is satisfied at point m.
Consumer Surplus for an Individual Consumer
t
25
24
Price of CDs ($)
The individual
demand curve shows
how much a consumer
is willing to pay for
each unit of the good;
for example, $21 for
the first CD, and $18
for the second.
Consumer surplus
equals the difference
between the amount a
consumer is willing to
pay and the price; for
example, $11 for the
first CD, and $8 for
the second.
u
21
20
v
18
$11
15
15
12
10
109
w
$8
$5
x
$2
y
5
0
0
0
11
22
33
44
55
Number of CDs per month
Quantity Willing to Pay ($) Consumer Surplus when price = $10 ($)
0
24
1
21
11
2
18
8
3
15
5
4
12
2
5
9
Consumer Surplus for the CD
Market
A
25
h
Price of CDs ($)
20
i
15
The market demand curve shows how
much a marginal consumer is willing to
pay for the product. The market
consumer surplusis equal to the area
between the demand curve and the
horizontal price line.
B
10
Price =
$10
C
Market demand
curve
100
200
300
Numbers of CDs per month
Increase in Price Decreases
Consumer Surplus
A
Price of CDs ($)
25
The consumer surplus at a price of $10 is
shown by triangle ABC. The consumer surplus
at a price of $14 is shown by the smaller
triangle ADE. The loss of consumer surplus is
shown by the trapezoid EDBC.
D
14
Price = $14
B
10
Price = $10
C
Market demand
curve
100
200
300
Numbers of CDs per month
Quantity of tacos
30
Budget Set and Budget Line
y
The budget set (the shaded triangle) shows all
the affordable combinations of burgers and
tacos, and the budget line (with endpoints x
and y) shows the combinations that exhaust the
budget.
18
j
i
10
e
6
x
2
4
Quantity of burgers
8
10
Indifference Curve and the MRS
Quantity of tacos
The indifference curve shows the different combinations of
burgers and tacos that generate the same level of utility. The
slope (3.0 between points e and f) is the marginal rate of
substitution between the two goods.
h
f
9
e
6
g
7
Quantity of burgers
8
Indifference Map
An indifference map shows a set of indifference curves, with
utility increasing as we move “northeasterly” to higher
indifference curves.
C1
Quantity of tacos
C3
C2
h
11
6
5
e
g
7
Quantity of burgers
8
9
Consumer Maximizes Utility
Quantity of tacos
30
To maximize utility, the consumer finds the combination of
hamburgers and tacos which an indifference curve is
tangent to the budget line, meaning the MRS equals the
price ratio.
j C2
18
k
i
10
e
6
2
4
Quantity of burgers
8
10
Price of burgers ($)
Quantity of tacos
30
Consumer’s Response to a
Decrease in Price
y
C4
C2
e
8
6
n
x
8 10 11
3
z
15
Demand
Curve
b
2
c
8
11
Quantity of burgers
A decrease in the price of burgers
tilts the budget line outward. The
indifference vcurve is tangent to
the budget line at a larger
quantity of burgers (11 instead of
8). This is consistent with the law
of demand.
Individual Demand Curve
At a price of $3, Bob maximizes
his utility with 8 burgers (point e
above and point b below); at a
price of $2 Bob maximizes his
utility with 11 burgers (point n
and point c respectively).
The Marketplace as a Signaling Mechanism
Prices convey information to producers about the benefits
consumers receive from goods and services - and give
information to consumers about the costs of producing goods
and services.
Given our assumptions that producers are maximizing profits
and consumers are maximizing utility, we can infer that, as
firms and consumers respond to changing price signals, they
will achieve an efficient solution in the marketplace - provided
that prices confront decision-makers with the marginal benefits
and marginal costs of their choices. Economists refer to this
requirement as an efficiency condition.
Price Signals and Maximizing Behavior
S1
Price per pound (cents)
Market equilibrium
generates a price
that equates the
quantity demanded
to the quantity
supplied. It also
results in a price at
which the marginal
benefit of a pound of
tomatoes equals its
marginal cost. The
price of 69 cents
signals consumers
that 69 cents worth
of other goods and
services were given
up to produce the
last pound of
tomatoes.
69
D1
Q1
Pound of tomatoes per week
Price Signals and Maximizing Behavior
S1
Price per pound (cents)
Here we see that a
change in consumer
preferences reduces
the demand for
tomatoes from D1 to
D2, reflecting a
reduction in the
marginal benefit of
the good.
Producers will
reduce their
production to Q2,
freeing resources for
the production of
other goods and
services. The falling
price signals
producers that the
benefit of tomato
production has
fallen.
69
60
D1
D2
Q2 Q1
Pound of tomatoes per week
Price Signals and Maximizing Behavior
S2
Price per pound (cents)
Higher input costs
(fertilizer prices)
increase the
marginal cost of
producing
tomatoes, shifting
the supply curve
from S1 to S2. This
will result in an
increase in the
price of tomatoes,
signaling
consumers to
reduce their
consumption. In
the case shown
here, the price
rises to 65 cents
per pound.
S1
65
60
D2
Q3 Q2
Pound of tomatoes per week