HO CHI MINH CITY OPEN UNIVERSITY
ADVANCED STUDY PROGRAM
CHAPTER 21: THE THEORY OF
CONSUMER CHOICE
The theory of consumer choice
In this chapter, look for the answers to these
questions:
 To explain why consumers, make choices: one
good or bundle of goods over another good or
bundle of goods
 How do indifference curves represent the
consumer’s preferences?
 What determines how a consumer divides her
resources between two goods?
 How does the budget constraint represent the
choices a consumer can afford?
CHAPTER OUTLINE
I
Utility and marginal utility
II
Consumer preferences
III
Indifference curve
IV
Budget constraint
V
Consumer’s optional choice
I. UTILITY AND MARGINAL UTILITY
1.1 Utility:
Util: unit of pleasure, level of satisfaction
Utility is an idea that people get a certain level of
satisfaction/ happiness/ utility from consuming
goods and service
Utility: a number that represents the level of
satisfaction that the consumer derives from
consuming a specific quantity of a good.
I. UTILITY AND MARGINAL UTILITY
1.2. Total utility, Marginal utility
 TU (total utility):
◦ The total amount of satisfaction that you get from
consuming a product.
TU = U1+ U2+U3+U4….+ Un
 MU (marginal utility):
◦ The increase in TU that comes about as a result of
consuming one more unit of the product.
◦ The slope of the total utility function
I. UTILITY AND MARGINAL UTILITY
1.3. Marginal utility
MU (marginal utility):
If one more unit of a good is consumed, the
marginal utility is equal to the increased utility from
that extra good
Mathematically:
change in total utility
Marginal utility =
change in quantity
MUx=∂ TU/∂ Qx
I. UTILITY AND MARGINAL UTILITY
1.3. Marginal utility
 The MU (marginal utility) of a good or service
will decline as more units of that good or service
are consumed.
Marginal utility is what counts for rational
consumer decisions.
 The “More is Better” assumption is violated if MU
ever becomes negative (ie: eating 23 pieces of
pizza
I. UTILITY AND MARGINAL UTILITY
Law of Diminishing MU
The law of diminishing MU is the basis of the
theory of consumer behavior, which explains
how consumers spend their incomes for
particular goods and services
II. CONSUMER PREFERENCE
 Consumer preferences
To describe how and why people prefer one
good to another
 Baskets or bundles is a collection of goods or
services that an individual might consume
 Consumer preferences
tell us how the consumer would rank any two
baskets of goods, assuming these allotments
were available to the consumer at no cost
II. CONSUMER PREFERENCE
Consumer preferences
How might a consumer compare different groups
of items available for purchase?
 A market basket is a collection of one or more
commodities
 Individuals
can choose between
baskets containing different goods
market
II. CONSUMER PREFERENCE
Some basic assumptions
1.Preference are COMPLETE
Three basic
assumptions
2.Preference are TRANSITIVE
3.Consumers always prefer more of any
goods to less
II. CONSUMER PREFERENCE
1)
Preferences are complete
A consumer can always rank preferences
Preferences are complete if the consumer can
rank any two baskets of goods
Example
a) A is preferred to B: A 
b) B is preferred to A: B  A
c) A consumer is indifferent between A and B:
A≈B
II. CONSUMER PREFERENCE
1. Preferences are complete
- “I would rather go to a movie with Bobby than go
skiing with Mark.” (valid)
-“I prefer a computer with a good video card and
large screen to a computer with a good sound
card and good speakers.” (valid)
- “I hate everyone equally!” (valid)
-“I can’t decide whether Ruth or Victoria is
smarter!” (invalid)
II. CONSUMER PREFERENCE
2. Preferences are transitive
Choices are consistent:
If
a) A is preferred to B: A  B
b) B is preferred to C: B  C
then
a) A is preferred to C: A  C
II. CONSUMER PREFERENCE
2) Choices are transitive
-“I would rather see the movie Star Wars than
Tears and Feelings. I prefer seeing Oceans 13 to
Star Wars. Therefore, I prefer Oceans 13 to Tears
and Feelings.” (valid)
-“Ruth is smarter than Victoria and Susan is more
intelligent than Ruth. Victoria is brainier than
Susan, however.” (invalid)
II. CONSUMER PREFERENCE
3. More is better (Monotonic)
A consumer always prefers having more of a good
If a basket with more of at least one good and no less
of any good is preferred to the original basket
Examples:
-“I prefer seven hot dogs to 3.”
-“It’s better to have loved and lost than never to
have loved at all!”
-“2 heads are better than 1.”
III. INDIFFERENCE CURVES
 Indifference
curve: shows consumption bundles
that give the consumer the same level of
satisfaction
 Indifference curves represent all combinations of
market baskets that the person is indifferent to,
reflecting the consumer’s preferences and choice
◦ A person will be equally satisfied with either
choice
 Consumer preferences can be represented
graphically using indifference curves
III. INDIFFERENCE CURVES
 3 dimensional graphs are difficult to graph and
understand
 In
practice, consumer preference is graphed
using 2 goods on the X and Y axis and
indifference curves
 Each
indifference curve plots all the goods
combinations that yield the same utility; that a
person is indifferent between
III. INDIFFERENCE CURVES
Indifference Curves: An Example
Market Basket
Units of Food
A
20
Units of
Clothing
30
B
10
50
D
40
20
E
30
40
G
10
20
H
10
40
III. INDIFFERENCE CURVES
Example
 Graph the points with one good on the x-axis
and one good on the y-axis
 Plotting
the points we can make some
immediate observations about preferences
◦ More is better
III. INDIFFERENCE CURVES
An example
Clothing
50
B
40
Preferences
area
H
30
The consumer prefers
A to all combinations
in the yellow box, while
all those in the pink
box is preferred to A.
E
A
20
D
G
10
Preferences
area is less
10
20
30
40
Food
III. INDIFFERENCE CURVES
An example
 Points such as B & D have more of one good but less
of another compared to A
◦ Need more information about consumer ranking
 Consumers may decide they are indifferent between B,
A, and D
◦ We can then connect those points with an
indifference curve
III. INDIFFERENCE CURVES
An example
•Indifferent between
B, A, & D
•E is preferred to
U1
•U1 is preferred to H
&G
B
50
Clothing
H
E
40
A
30
D
20
U1
G
10
10
20
30
40
Food
III. INDIFFERENCE CURVES
 Any market basket lying northeast of an
indifference curve is preferred to any market
basket that lies on the indifference curve.
 Points on the curve are preferred to points
southwest of the curve
B
50
Clothing
H
E
40
A
30
20
10
D
G
U1
III. INDIFFERENCE CURVES
 Indifference curves slope downward to the
right.
◦ If it sloped upward, it would violate the
assumption that more is preferred to less.
 Some points that had more of both goods
would be indifferent to a basket with less of
both goods
If the quantity of
fish is reduced,
the quantity of mangos
must be increased to
keep Hurley equally
happy.
III. INDIFFERENCE CURVES
 To describe preferences for all combinations of
goods/services, we have a set of indifference
curves – an indifference map
◦ Each indifference curve in the map shows the
market baskets among which the person is
indifferent.
III. INDIFFERENCE CURVES
Indifference Map
Market basket A
is preferred to B.
Market basket B is
preferred to D.
Clothing
D
B
A
U3
Higher
indifference
curves are
preferred to
lower ones.
U2
U1
Food
III. INDIFFERENCE CURVES
Indifference map
 Indifference maps give more information about
the shapes of indifference curves
◦ Indifference curves can not cross
 Violates the assumption that more is better
◦ Why? What if we assume they can cross?
III. INDIFFERENCE CURVES
•B is preferred to D
Indifference maps
Clothing
U2
•A is indifferent to B & D
•B must be indifferent to D
but that can’t be if B is
preferred to D
U1
Indifference curves
cannot cross.
A
B
U2
D
U1
Food
III. INDIFFERENCE CURVES
Indifference curves
 The shapes of indifference curves describe
how a consumer is willing to substitute one
good for another
◦ A to B, give up 6 clothing to get 1 food
◦ D to E, give up 2 clothing to get 1 food
 The more clothing and less food a person has,
the more clothing they will give up to get more
food
III. INDIFFERENCE CURVES
Indifference curves
Clothing
A
16
14
12
Observation: The amount
of clothing given up for
1 unit of food decreases
from 6 to 1
-6
10
B
1
8
-4
D
6
1
E
-2
4
1
G
-1
1
2
1
2
3
4
5
Food
III. INDIFFERENCE CURVES
Indifference curves
 We measure how a person trades one good for
another using the marginal rate of substitution
(MRS)
◦ It quantifies the amount of one good a
consumer will give up to obtain more of
another good.
◦ is measured by the slope of the indifference
curve.
III. INDIFFERENCE CURVES
Marginal rate of substitution
Clothing
A
16
MRS = − C
MRS = 6
14
12
-6
10
B
1
8
MRS = 2
-4
D
6
1
E
-2
4
1
G
-1
2
1
1
2
3
4
5
Food
F
III. INDIFFERENCE CURVES
Indifference Curves: An Example
Market Basket
A
B
D
E
G
H
Units of Food
x
20
10
40
30
10
10
Units of
Clothing y
30
50
20
40
20
40
MB G (X=10 and Y= 20 move to MB A X=20 and Y= 30)
GA= 20-30/10-20=1=-1) MRS of FC
III. INDIFFERENCE CURVES
Marginal rate of substitution
 Indifference curves are convex
◦ As more of one good is consumed, a
consumer would prefer to give up fewer units
of a second good to get additional units of the
first one.
 Consumers generally prefer a balanced market
basket
III. INDIFFERENCE CURVES
Marginal rate of substitution
 The MRS decreases as we move down the
indifference curve
◦ Along an indifference curve there is a
diminishing marginal rate of substitution.
◦ The MRS went from 6 to 4 to 1
III. INDIFFERENCE CURVES
Marginal rate of substitution
 Indifference curves with different shapes imply
a different willingness to substitute
 Two polar cases are of interest
◦ Perfect substitutes
◦ Perfect complements
III. INDIFFERENCE CURVES
Marginal rate of substitution
One extreme case: perfect substitutes
Perfect substitutes: two goods with straightline indifference curves, constant MRS
Example: nickels & dimes
Consumer is always willing to trade
two nickels for one dime.
III. INDIFFERENCE CURVES
Marginal rate of substitution
Another extreme case: perfect complements
Perfect complements: two goods with right-angle
indifference curves
Example: Left shoes, right shoes
{7 left shoes, 5 right shoes}
is just as good as
{5 left shoes, 5 right shoes}
III. INDIFFERENCE CURVES
Less extreme cases: close substitutes and close
complements
Quantity
of Pepsi
Quantity
Indifference curves for
of hot dog buns
close substitutes are not
very bowed
Quantity of Coke
Indifference curves for
close complements
are very bowed
Quantity
of hot dogs
IV. BUDGET CONSTRAINT
 Preferences do not explain all of consumer
behavior.
 Budget constraints also limit individuals’ ability
to consume in light of the prices they must pay
for various goods and services.
IV. BUDGET CONSTRAINT
 The budget line
◦ Indicates all combinations of two commodities
for which total money spent equals total
income.
◦ We assume only 2 goods are consumed, so
we do not consider savings
IV. BUDGET CONSTRAINT
1.Budget constraint: the limit on the consumption
bundles that a consumer can afford
 Budget line is a graphical representation of all
possible combinations of two goods which can be
purchased with given income and prices
IV. BUDGET CONSTRAINT
Budget line is I = P1 X1 +P2 X 2
∗
∗
I=1000
𝑃1 = 2
𝑃2 =10
1000=2X1+10X2 (1)
X1= 100-1/5X2 (2)
X2=500-5X1 (3)
IV. BUDGET CONSTRAINT
The budget line
 As
consumption moves along a budget line
from the intercept, the consumer spends less on
one item and more on the other.
 The slope of the line measures the relative cost
of food and clothing.
 The slope is the negative of the ratio of the
prices of the two goods.
IV. BUDGET CONSTRAINT
The budget line
 The slope indicates the rate at which the two
goods can be substituted without changing the
amount of money spent.
 We can rearrange the budget line equation to
make this more clear
IV. BUDGET CONSTRAINT
 The budget line
◦ The vertical intercept (I/PC), illustrates the
maximum amount of C that can be purchased
with income I.
◦ The horizontal intercept (I/PF), illustrates the
maximum amount of F that can be purchased
with income I.
IV. BUDGET CONSTRAINT
 As we know, income and prices can change
 As
incomes and prices change, there are
changes in budget lines
 We can show the effects of these changes on
budget lines and consumer choices
IV. BUDGET CONSTRAINT
Budget line - change
 The effects of changes in income
◦ An increase in income causes the budget line
to shift outward, parallel to the original line
(holding prices constant).
◦ Can buy more of both goods with more
income
◦ A decrease in income causes the budget line
to shift inward, parallel to the original line
(holding prices constant).
◦ Can buy less of both goods with less income
IV. BUDGET CONSTRAINT
The budget line - changes
Clothing
(units
per week)
A increase in
income shifts
the budget line
outward
80
60
A decrease in
income shifts
the budget line
inward
40
20
L3
(I =
$40)
0
40
L1
L2
(I = $160)
(I = $80)
80
120
160
Food
(units per week)
IV. BUDGET CONSTRAINT
Budget line - change
 The effects of changes in Price
◦ If the price of one good increases, the budget
line shifts inward, pivoting from the other
good’s intercept.
◦ If price of food increases and you buy only
food (x-intercept), then can’t buy as much
food. The point shifts in
◦ If buy only clothing (y-intercept), can buy the
same amount. No change
IV. BUDGET CONSTRAINT
Budget line - change
 The effects of changes in Price
◦ If the price of one good decreases, the budget
line shifts outward, pivoting from the other
good’s intercept.
◦ If price of food decreases and you buy only
food (x-intercept), then can buy more food.
The point shifts out.
◦ If buy only clothing (y-intercept), can buy the
same amount. No change
IV. BUDGET CONSTRAINT
The budget line - changes
Clothing
(units
per week)
A decrease in the
price of food to
$.50 changes
the slope of the
budget line and
rotates it outward.
An increase in the
price of food to
$2.00 changes
the slope of the
budget line and
rotates it inward.
40
L3
L2
L1
(PF = 1/2)
(PF = 1)
(PF = 2)
Food
40
80
120
160
(units per week)
IV. BUDGET CONSTRAINT
Budget line - change
 The effects of changes in Price
◦ If the two goods increase in price, but the
ratio of the two prices is unchanged, the slope
will not change.
◦ However, the budget line will shift inward to a
point parallel to the original budget line
◦ If the two goods decrease in price, but the
ratio of the two prices is unchanged, the slope
will not change.
◦ However, the budget line will shift outward to
a point parallel to the original budget line
V. CONSUMER’S OPTIMAL CHOICE
 Consumers
choose a combination of goods
that will maximize their satisfaction, given the
limited budget available to them.
The maximizing market basket must satisfy two
conditions:
1.
It must be located on the budget line.
◦ They spend all their income – more is better
2.
It must give the consumer the most preferred
combination of goods and services.
V. CONSUMER’S OPTIMAL CHOICE
 Graphically, we can see different indifference
curves of a consumer choosing between
clothing and food
 Remember
that U3 > U2 > U1 for our
indifference curves
 Consumer wants to choose the highest utility
within their budget
V. CONSUMER’S OPTIMAL CHOICE
Clothing
(units per
week)
A, B, C on budget line
D highest utility but not
affordable
C highest affordable utility
Consumer chooses C
40
A
30
D
20
C
U3
U1
B
0
20
40
80
Food (units per week)
V. CONSUMER’S OPTIMAL CHOICE
 Consumer will choose the highest indifference
curve on the budget line
 In
the previous graph, point C is where the
indifference curve is just tangent to the budget
line

The slope of the budget line equals the slope
of the indifference curve at this point
V. CONSUMER’S OPTIMAL CHOICE
At the optimum,
slope of the
indifference curve
equals
slope of the
budget constraint:
Quantity
of Mangos
MRS = PF/PM
marginal value
of fish
(in terms of
mangos)
Consumer
optimization is
another example of
“thinking at the
margin.”
1200
A
600
price of fish
(in terms of
mangos)
150
300
Quantity
of Fish
V. CONSUMER’S OPTIMAL CHOICE
The Effects of an Increase in Income
Quantity
of Mangos
An increase in
income shifts the
budget constraint
outward.
B
A
If both goods are
“normal,” Hurley
buys more of each.
Quantity
of Fish
V. CONSUMER’S OPTIMAL CHOICE
The Effects of a Price Change
Initially,
Quantity
of Mangos
PF = $4
PM = $1
1200
initial optimum
new optimum
PF falls to $2
budget constraint
rotates outward,
Hurley buys
more fish and
fewer mangos.
600
500
150
300
600
350
Quantity
of Fish
V. CONSUMER’S OPTIMAL CHOICE
The Income and Substitution Effects
A fall in the price of fish has two effects on Hurley’s
optimal consumption of both goods.
◦ Income effect
A fall in PF boosts the purchasing power of Hurley’s
income, allows him to buy more mangos and more
fish.
◦ Substitution effect
A fall in PF makes mangos more expensive relative
to fish, causes Hurley to buy fewer mangos & more
fish.
V. CONSUMER’S OPTIMAL CHOICE
 Recall, the slope of an indifference curve
is:
C
MRS = −
F
Further, the slope of the budget line is:
PF
Slope = −
PC
V. CONSUMER’S OPTIMAL CHOICE
 Therefore, it can be said at the
consumer’s optimal consumption point,
PF
MRS =
PC
V. CONSUMER’S OPTIMAL CHOICE
 It can be said that satisfaction is maximized when
the marginal rate of substitution (of F and C) is
equal to the ratio of the prices (of F and C).
 Note this is ONLY true at the optimal consumption
point
 Optimal consumption point is where marginal
benefits equal marginal costs
 MB (marginal benefits) = MRS = benefit
associated with consumption of 1 more unit of food
 MC = cost of an additional unit of food
◦ 1 unit food = ½ unit clothing
◦ PF/PC
V. CONSUMER’S OPTIMAL CHOICE
 If MRS ≠ PF/PC then individuals can reallocate
the basket to increase utility
 If MRS > PF/PC
◦ Will increase food and decrease clothing
until MRS = PF/PC
 If MRS < PF/PC
◦ Will increase clothing and decrease food until
MRS = PF/PC
Thank You !