2E Demand Side Tool Kit How Does a Consumer Decide What to Buy
A Theory of Optimal Consumption
A Theory of Optimal Consumption
1. Consumption Bundles: These represent the combination of products Ronny decides to purchase at the supermarket, which he
collects in his cart before paying.
2. Preferences / Utility: This refers to how Ronny, or any economic agent, enjoys different combinations of products. Utility
measures the satisfaction or happiness derived from consumption bundles.
3. Budget Line: This concept represents the constraints Ronny faces due to his limited income. It determines the range of
consumption bundles Ronny can afford.
4. Indifference Curves (Lines of equal preferences): These are lines that represent consumption bundles providing Ronny with
the same level of utility or happiness. They help in understanding Ronny’s preferences.
5. Rationality/optimal consumption: The theory assumes that Ronny is a rational agent who aims to maximize his utility. He will
choose the consumption bundle that offers the highest satisfaction within his budget constraints. A rational agent, Ronny, will
always consume a consumption bundle that optimises her preferences given her income and the prices of the goods that are
available.
Consumption Bundles
Consumption bundles
A Consumption bundle is a combination of different goods and services that a consumer can purchase with their income. For
example, if a consumer has a choice between apples and bananas, a bundle could be:
3 apples and 2 bananas
1 apple and 4 bananas
2 apples and 3 bananas
Utility and Preferences
Consumers have preferences for different bundles. Utility is a measure of the satisfaction a consumer gets from a bundle.
Consumers aim to choose the bundle that gives them the highest utility.
Budget Constraint
Consumers have a limited income, which creates a budget constraint.
The budget constraint shows all the possible bundles a consumer can afford given their income and the prices of goods.
Horizontal line on Indifference curve
Optimal Consumption Bundle
The optimal consumption bundle is the one that maximizes a consumer's utility while staying within their budget.
This occurs where the consumer's highest indifference curve (representing equal levels of utility) is tangent to the budget
constraint.
Tastes and utility
Define the notions of preferences (or tastes) and the notion of utility
Preferences/utility
Consumption bundle. Represents what a consumer would like to consume. A bundle contains different quantities of various
goods. (e.g. simple bundle films and meals. 4 films 5 meals).
Consumers have tastes, or preferences, about the goods they consume.
Consumers obtain utility from consuming goods.
Therefore utility is the final objective of consumption. It represents what a consumer achieves by consuming a particular
consumption bundle.
Taste and utility help consumer decide between different Consumption bundle
3 Key assumptions:
Completeness The consumer can always rank alternative bundles of goods according to the satisfaction or utility they
provide. It is unnecessary to quantify this utility,' for example to say that one bundle yields twice as much utility as another
bundle. We only require that the consumer can decide that one bundle is better than, worse than or exactly as good as
another. This assumption rules out the possibility that a consumer facing different bundles cannot decide which one she
prefers.
Transitivity We assume that the ranking of possible bundles is internally consistent: if bundle a is preferred to bundle b and
bundle b is preferred to bundle c, then bundle a must be preferred to bundle c.
Consumers prefer more to less. If bundle b offers more films but as many meals as bundle c, we assume bundle b is
preferred. The same applies if bundle b offers more meals but as many films as bundle c. What about things, such as
pollution, which are not goods but 'bads'? Consumers do not prefer more pollution to less. We get round this problem by
redefining commodities so that our assumption is satisfied. We analyse clean water rather than polluted water. More clean
water is better than less.
Describe the concept of diminishing marginal utility
The Marginal rate of substitution (MRS) tells us how many films the consumer is willing to exchange for an additional meal without
changing total utility.
Diminishing marginal rate of substitution tastes exhibit this when, to hold utility constant, diminishing quantities of one good must
be sacrificed to get successive equal increases in the quantity of the other good.
Representing tastes as indifference curves
Represent preferences (tastes) as indifference curves
Lines of equal preferences—indifference curves
Indifference curve shows all the consumption bundles yielding a particular level of utility.
Indifference curves are a graphical representation of the tastes of a consumer.
Characteristics of indifference Curves:
Downward Sloping: To maintain the same level of utility, an increase in one good must be offset by a decrease in the other.
Convex to the Origin: Reflects the principle of diminishing marginal rate of substitution (MRS), meaning consumers are
willing to give up fewer units of one good to get additional units of another as they have more of it.
Non-Intersecting: Indifference curves cannot cross because it would violate the transitivity of preferences.
Slope of budget line = Slope of Indifference curve
We can represent the tastes of any consumer by drawing the complete map of her indifference curves.
An indifference curve is defined as the curve representing all the combinations of consumption bundles that provide the same
level of utility for a consumer.
Therefore a consumer is indifferent between consuming any of the bundles that lie on a given indifference curve.
An indifference curve is a downward-sloping curve connecting all the bundles that our consumer considers as equally desirable in
terms of the utility they provide.
Indifference curves further away from the origin (higher indifference curves) are associated with higher levels of utility because the
consumer prefers more to less.
As per assumption of completeness of tastes, there is an indifference curve passing through every possible bundle faced by
our consumer. (theoretical)
Indifference curves cannot cross. It will violate 2 assumptions:
1. More preferred to less
2. Transitivity
Start at bundle a.
Bundles in the preferred region (like bundle c) are preferred to a and therefore they provide a higher utility to our consumer.
Therefore those bundles in Preferred region cannot be on the same indifference curve as bundle a.
Bundles that are on the Dominated region (like bundle b) are worse than bundle a and therefore they provide lower utility to our
consumer.
Those bundles in Dominated region cannot be on the same indifference curve as bundle a.
The only possible bundles that can provide the same utility to our consumer as bundle a are bundles that lie on the north-west
and south-east regions compared with a. Therefore consumer is indifferent between bundles a, d and e
Since the consumer can face many different bundles, we can have many different indifference curves on the same graph to
represent the tastes of our consumer. U1, U2, U3
As consumer prefer more to less then U1 < U2 < U3 and points E < A=B=C < D
Because a consumer prefers more to less, indifference curves must slope downwards.
The slope of a typical indifference curve gets steadily flatter as we move to the right. This reflects a Diminishing marginal rate of
substitution.
The budget constraint
Budget line
Derive a budget line
Budget constraint the different bundles that the consumer can afford.
A consumer's income and the market prices of goods define her budget constraint.
The budget constraint introduces the problem of scarcity into our analysis.
The budget constraint shows the maximum affordable quantity of one good given the quantity of the other good being purchased.
To adjust quantity of one good in bundle consumer will face trade-off as some quantity ofther good have to be given up.
Budget constraint Graph
Points A-F lie on a budget line and can be aquired
Point G lies outside of budget and can not be afforded
Point K can be aquired with excess resource to spare
The slope of the budget line shows how many A must be sacrificed to get another B. Thus it represents the Opportunity cost of A
in terms of B.
The slope of the budget line depends only on the ratio of the prices of the two goods.
The slope of a line is the change in the vertical distance divided by the corresponding change in the horizontal distance.
Slope of budget line =
−P x
Py
Budget Constrain Calculation
Describe and calculate the concept of marginal rate of substitution (MRS) (the slope of the indifference curve), understand
diminishing, and calculate the marginal rate of substitution (MRS)
Utility maximization and choice
Rationality/optimal consumption
Explain how indifference curves and budget constraints explain consumer choice.
We put Indifference curve and Budget constraint concepts together in order to see how the consumer chooses among different
bundles.
We assume that the consumer is rational, implying that she chooses the affordable bundle that maximizes utility.
Chosen bundle the point at which an indifference curve just touches the budget line.
Our glutton should pick a point with more meals and fewer films than the point our film buff selects.
1. Show how to use indifference curves to find the bundle the consumer chooses.
2. Confirm that our model of consumer choice captures the different behaviour of the glutton and the film buff.
Budget line AF.
Points are at U3 are unfordible as they above Budget constraint (budget line)
Points on U1, B and E are attainable, but not prefered as more prefered to less
As U1 < U2
Utility Maximising point is C
It lies on U2 (U1 < U2 < U3, but U3 is unafordible)
Wherever the budget line crosses an indifference curve, a move along the budget line in the smart direction will increase utility. B
and E < C
Tastes will alter how Indifference curve will look
Calculations
slope of budget line = −
Q1:
Q2:
Q3:
Q4:
Q5:
price of good x
price of good y