Consumer Theory: Kazi Zayana Arif BSS (Economics), MSS (Economics) University of Dhaka

Consumer Theory
Kazi Zayana Arif

BSS (Economics), MSS (Economics)
University of Dhaka
Choice and Preference
A consumer has to take an umpteen number of decisions
everyday regarding the allocation of his scarce resources. He
has to make choices.
A consumer makes choice based on his preferences. If
offered with two options, consumer chooses the option that
best suits his taste!
? ?
Utility
Utility is the satisfaction or usefulness a consumers can
derive from the consumption of a good or service. If burger
has higher utility than sandwich, it implies he prefers burger
over sandwich. A rational consumer maximizes his utility,
that is, he chooses the bundle of consumption that he
prefers the most.
Total Utility
Total utility is the sum of the satisfaction that a person can
receive from the consumption of all units of a specific
product or service.
Marginal Utility
“Marginal” means “additional” or “extra”. Marginal utility is
the additional utility a consumer derives from the
consumption of an additional unit of a commodity.
The Law of Diminishing Marginal Utility
The Law of Diminishing Marginal Utility states that, as the
amount of a good consumed increases, the marginal utility
derived from each additional unit tends to decline.
Suppose, a consumer who is very hungry, buys 6 slices of
pizza. As he is very hungry, the first slice of the pizza gives
him great satisfaction or utility. The second slice gives a bit
lower satisfaction as he is not as hungry as before, The
utility falls further with consumption of the 3rd, 4th and 5th
slices. The consumer cannot even consume the 6th slice, as
he is already full, he ends up getting negative utility.
As the person consumes more slices, his total utility
increases. But as he consumes more and more his total utility
increases at a slower rate, which implies that marginal utility
is falling as he is consuming more.
Numerical Example Here in this table we can see in
1. 2. Total 3.Margina column 2, total utility increases
Quantity Utility l Utility as consumption grows. Column
(In Units) 3 shows the marginal utility,
0 0 0 that is the additional utility
gained when an extra unit of
1 5 5
the good is consumed. Thus
2 9 4 when he consumes the 2nd unit,
3 12 3 MU= 9-5=4, for the 3rd unit,
4 14 2 MU= 12-9=3. The fact that MU
5 15 1 falls with the increased
6 15 0 consumption illustrated the law
of diminishing marginal utility.
Total Utility
15
14
12 Marginal Utility
0 1 2 3 4 5 6 0 1 2 3 4 5 6
Quantity (in units) Quantity (in units)
Figure 1 Figure 2
Figure- Law of Diminishing Marginal Utility
The Law of Diminishing Marginal Utility
In Figure 1, the blocks add up to the total utility derived at
each level of consumption. The curve shows that as the
consumption level rises, total utility increases but at a
decreasing rate. The purple blocks show the additional
utility derived from each additional unit consumed. The
declining steps of the marginal utility implies that, total
utility increasing at a diminishing rate, resulting in a
concave shaped Total Utility curve.
In Figure 2, each of the purple blocks of marginal utility is of

the same size as the corresponding grey blocks in Figure 1.
The law of diminishing marginal utility implies a downward
sloping Marginal Utility curve.
Limitations of the Law of Diminishing Marginal
Utility
❑Various units of a good might not be homogeneous.
❑Drunkards and misers
❑Might not apply at the initial stage
❑Measurement of utility is subjective
❑Rare collection
❑Hobbies
❑Change in the taste of consumer
❑Consumption of certain goods are not continuous
❑Might not apply at the initial stage
The Indifference Curve
A consumer, when offered with two bundles, he chooses
the bundle that best suits his taste. If the two bundles suit
his taste equally and make him equally happy, we can say
that he is indifferent between the two bundles.
The indifference curve is the graphical representation of

preference. An indifference curve is a curve that shows
various consumption bundles that give the consumer the
same level of satisfaction. Each point on the indifference
curve shows different combinations of two goods towards
which the consumer is indifferent.
The Indifference Curve
Here we can see two indifference
curves. This curve shows different
combinations of Pepsi and pizza
Quantity of Pepsi which make the consumer equally
satisfied. The consumer is
indifferent among combinations
A A,B and C, as all of this
D combinations are on the same
B curve. If the consumption of Pepsi
I’
C falls (say, from point A to B), the
I
consumption of pizza must
Quantity of Pizza
increase to keep the consumer
equally happy. If the consumption
Figure 3- Indifference Curve of Pepsi falls further (from point B
to C), the consumption of pizza
must increase yet again.
Four Properties of The Indifference Curve
❖ Higher Indifference curves are preferred to lower ones
as a consumer prefers more consumption to less and
higher indifference curves reflect greater quantities. In
figure 3, I’ is preferred to I.
❖ Indifference curves are downward sloping. As in most
cases, consumer likes both goods, if the quantity of one
good is reduced, the other needs to increase to keep the
consumer equally happy.
❖ Indifference curves do not cross. Let us see, what
happens if they cross each other in figure 4. Here, as
point A and B are on the same indifference curve, the 2
points make consumer equally happy.
As point B and C are on the same indifference curve, these 2
point make him equally happy. These conclusions imply that
point A and C make him equally happy, although point C has
more of both goods and is on a higher indifference curve.
This contradicts our assumption that consumer prefers more
of both goods and prefer to be on higher Indifference curve.
Quantity of
Pepsi
C
A
Quantity of Pizza
Figure-4
❖ Indifference curves are bowed inward. The Marginal
Rate of Substitution (MRS) is the rate at which a consumer
is willing to trade one good for another. MRS is the slope
of the indifference curve. Here in our example , MRS
measures the amount of Pepsi required to compensate the
consumer for a one unit reduction in pizza consumption.
MRS at each point depends on how the amount of a good
the consumer is already consuming. People are more
willing to trade away a good that he already have in
abundance and less willing to trade away a good that they
have little.
In figure 5, at point A, consumer has a lot of Pepsi, very little
pizza. So he is more hungry than thirsty. To induce him to
give up 1 unit of pizza, he has to be given 6 bottles of Pepsi.
So, MRS is 6 bottles per pizza. But at point B, he has little
Pepsi and lots of pizza. So he will be willing to give up 1 pizza
to get 1 bottle of Pepsi. MRS at point B is 1 bottle per pizza.
The bowed shape of the indifference curve reflects
consumer’s greater willingness to give up a good that he
already have in abundance. Quantity of Pepsi
14
6
8 A
1
Figure-5
4 B
3 1
1 I
2 3 6 7 Quantity of Pizza
Budget Constraint
In economics, a budget constraint represents all the
combinations of goods and services that a consumer may
purchase given current prices within his or her given income.
Suppose a consumer has a fixed monthly income of $1000
and he spends all his income on Pepsi and pizza. Price per
pizza is $10 and price of Pepsi per bottle is $2. If the
consumer spends all his money on pizza, he will be able to
buy 100 units of pizza but won’t have any Pepsi. If he decides
to spend all his income on Pepsi, he will be able to buy 500
bottles of Pepsi, but won’t have any pizza. There are many
other combinations of pizza and Pepsi that the consumer can
afford for his given income of $1000.
Budget Constraint Quantity of Pepsi
500 A
Here, the budget constraint
shows the different
consumption bundles that
the consumer can afford. At 250 C
point A, he buys 500 bottles

of Pepsi, and no pizza. At
point B, he buys 100 pizzas, B
50 100
but no Pepsi. At point C, Quantity of Pizza
consumer spends an equal
amount on pizza and Pepsi, Figure 6- Budget Constraint
to buy 50 pizzas and 250
bottles of Pepsi.
Budget Constraint
Any point on the budget line, that are between point A and
B are affordable to him.
The slope of the budget constraint shows the rate at which
consumer can trade on good for the other. Slope between
two points is calculated as the change in the vertical
distance divided by the change in the horizontal distance.
From point A to B,
Vertical Distance= 500
Horizontal axis= 100
So, slope= 5 bottles per pizza
The slope of 5 implies a trade off of 1 pizza for 5 bottles of
Pepsi.
The Consumer’s Optimal Choice
Now we put “consumer’s preference (what he is willing to
buy)” and “consumer’s budget constraint (what he can
afford)” together and see what he decides to buy.
Consumer would like to be
on the highest indifference Quantity of Pepsi
curve and get the best
possible combination of Optimum
Pepsi and pizza but he must
A
be on or below the budget B
constraint. So the highest
indifference curve he can I’’
I’
reach is I’ which barely I
touches the budget
constraint. Quantity of Pizza
o B is affordable, but on a lower IC, providing less
satisfaction.
o A is preferred but not affordable as its above the budget
line.
o The optimum is at the point where IC barely touches the
Budget line, it shows the best combination of Pepsi and
pizza available to the consumer. At this point,
Slope of Indifference curve= Slope of budget constraint

That is, MRS= Relative price
MRS is the rate at which consumer is willing to trade one
good for the other. Relative price is the rate at which market
is willing to trade one good for the other. At optimum,
consumer’s valuation of the two goods equals the market’s
valuation.
How Change in Income Affect the Consumer’s Choice
As income rises, consumer can afford more of both goods, so
budget line shifts outward, the shift is parallel as relative
price, which is the slope of budget line, remains same.
Figure 7 (a) Figure 7 (b)
Quantity of Pepsi Quantity of Pepsi
New
Optimum Initial
Optimum
New
Initial Optimum
Optimum
Quantity of Pizza Quantity of Pizza

If both goods are normal (in figure 7(a)), consumer at new
optimum will consume more of both goods and move to a
higher IC. If we assume that Pepsi is an inferior good (in figure
7(b)), the consumption of Pepsi falls with the increase in
income, as consumer moves to a higher IC.
How Change in Prices Affect the Consumer’s Choice
If the price of Pepsi falls from $2 to $1 per bottle, consumer
can buy more Pepsi with the given income. If consumer
spends all his income on pizza he still can buy 100 units as
before, point B remains same. But if he spends all his income
on Pepsi, he now can buy 1000 bottles of Pepsi rather than
only 500. So, the point A will move to point D.
The slope of the budget Quantity of Pepsi
line is the relative price of 1000

the two goods. As, the
price of Pepsi now has New Optimum
fallen from $2 to $1, a

500
consumer now can trade a
pizza for 10 bottles of Initial Optimum
Pepsi, rather than 5. As a
result, the budget line is
100
now steeper than before. Quantity of Pizza
Figure 8
Income and Substitution Effects
The change in price of a good has two effects on
consumption-
Income Effect- The change in consumption of a good due
to a change in the purchasing power of a consumer as price
of a good changes. A fall in the price of Pepsi, increases the
purchasing power of consumer. If pizza and Pepsi both are
normal goods, he will spread this improvement in
purchasing power over both goods. Income effect tends to
make him buy more of both pizza and Pepsi.
Substitution Effect- The change in consumption of a good
due to the change in the relative price of a good compared
to the other good. A fall in the price of Pepsi makes the
consumption of Pepsi less expensive relative to the
consumption of pizza. This substitution effect makes the
consumer buy more Pepsi and less pizza.
As the two effects work at the same time, and both effects
tend to increase the consumption of Pepsi, its consumption
rises. But its ambiguous if the consumption of pizza falls or
rises, as the income and substitution effect works on
opposite direction when it comes to pizza.
Derivation of the Demand Curve
Figure 9(a) shows as the price of Pepsi falls from $2 to $1,
budget line shifts outward and purchase of Pepsi rises from
250 to 750 bottles. Figure 9(b) shows the resulting demand
curve. Price of Pepsi
Quantity of Pepsi
500
New Optimum
75
0 A
$2
B
Initial $1
25 Optimum
0
250 750
Quantity of Pizza Quantity of
Pepsi
Figure 9(a)- The Figure 9(b)- The Demand
Consumer’s Optimum Curve for Pepsi
THANK YOU!

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Consumer Theory

Kazi Zayana Arif

In Figure 2, each of the purple blocks of marginal utility is of

The indifference curve is the graphical representation of

point A, he buys 500 bottles

Slope of Indifference curve= Slope of budget constraint

Quantity of Pepsi Quantity of Pepsi

Quantity of Pizza Quantity of Pizza

line is the relative price of 1000

fallen from $2 to $1, a

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