1. The document discusses concepts related to consumer choice theory including utility, total utility, marginal utility, budget constraints, indifference curves, and how consumer choices are impacted by changes in income and prices. 2. It provides illustrations of budget constraints, indifference curves, and how consumers optimize their choices of goods at the point where the highest indifference curve is tangent to the budget constraint. 3. It also explains how increases in income shift the budget constraint outward, allowing consumers to consume more goods, and how decreases in price rotate the budget constraint outward and impact substitution between goods.

1. 2121The Theory of
Consumer Choice

2. Utility, Total Utility and Marginal Utility
• In economics, the satisfaction or pleasure consumers
derive from the consumption of goods is called “utility”.
• Total utility is the total utility a consumer derives from the
consumption of all units of a good over a given
consumption period.
• Marginal utility is the utility a consumer derives from the last
unit of a good she or he consumes during a given
consumption period.
• Total utility = Sum of marginal utilities
• The Law of Diminishing Marginal Utility
Over a given consumption period, as more and more of a
good is consumed by a consumer, beyond a certain point,
the marginal utility of additional units begins to fall.

3. Total Utility
0
50
100
150
200
1 2 3 4 5 6 7 8 9 10 11
Marginal Utility
-20
-10
0
10
20
30
40
50
1 2 3 4 5 6 7 8 9 10 11
Q ($) TU ($) MU
0 0
1 40 40
2 85 45
3 120 35
4 140 20
5 150 10
6 157 7
7 160 3
8 160 0
9 155 -5
10 145 -10
145
How much ice cream does Jill
buy in a month?
Total and Marginal Utility for Ice Cream

4. BUDGET CONSTRAINT: What a consumer can afford
• The budget constraint depicts the limit on the
consumption “bundles” that a consumer can
afford.
• People consume less than they desire because their
spending is constrained by their income.
• Budget constraint shows various combinations of
goods the consumer can afford given his or her
income and the prices of the two goods.
• If a consumer wants to spend $ 1,000 on Pepsi and
pizza, where price of Pepsi is $ 2 and Pizza is $10,
then probable combinations would be:

5. Probable combinations of Pepsi and Pizza
under Budget Constraint

6. Figure 1 The Consumer’s Budget Constraint
Quantity
of Pepsi
0
Consumer’s
budget constraint
500
B
250
50
C
100
A
Cannot be E
E
Quantity of Pizza

7. • Illustration of Figure 1 (Consumer’s Budget Constraint)
• For example, if the consumer buys no pizzas, he can afford 500
pints of Pepsi (point B). If he buys no Pepsi, he can afford 100
pizzas (point A).
• Alternately, the consumer can buy 50 pizzas and 250 pints of
Pepsi (point C).
• But the consumer cannot go out of the inner boundary of budget
line (point E).
• Any point on the budget line indicates the consumer’s
combination or tradeoff between two goods
• The slope of the budget line equals the relative price of the two
goods, that is, the ratio of price of one good compared to the
price of the other.
• It measures the rate at which a consumer trade a good for other

8. PREFERENCES: What a consumer wants
• A consumer’s preference among consumption bundles
may be illustrated with indifference curves.
• An indifference curve is a curve that shows consumption
bundles that give the consumer the same level of
satisfaction

9. Figure 2 The Consumer’s Preferences
Quantity
of Pepsi
0
Indifference
curve,I1
I2
C
B
A
D
Quantity of Pizza

10. Representing Preferences with Indifference Curves
• The Consumer’s Preferences
• The consumer is indifferent, or equally happy, with the
combinations shown at points A, B, and C because
they are all on the same curve.
• The Marginal Rate of Substitution
• The slope at any point on an indifference curve is the
marginal rate of substitution.
• It is the rate at which a consumer is willing to trade one good
for another.
• It is the amount of one good that a consumer requires as
compensation to give up one unit of the other good.

11. Figure 2 The Consumer’s Preferences
Quantity
of Pepsi
0
Indifference
curve,I1
I2
1
MRS
C
B
A
D
Quantity of Pizza
MRS = MU (Piz) / MU (Pep)
= Change in Pepsi/Change in Pizza

12. Four Properties of Indifference Curves
• Property 1: Higher indifference curves are
preferred to lower ones.
• Consumers usually prefer more of something to get.
• Higher indifference curves represent larger quantities of goods
than do lower indifference curves.
• Property 2: Indifference curves are downward
sloping.
• A consumer is willing to give up one good only if he or she gets
more of the other good in order to remain equally happy.
• If the quantity of one good is reduced, the quantity of the other
good must increase.
• For this reason, most indifference curves slope downward.

13. Copyright©2004 South-Western
Figure 2 The Consumer’s Preferences
Quantity
of Pepsi
0
Indifference
curve,I1
I2
C
B
A
D
Quantity of Pizza

14. • Property 3: Indifference curves do not cross.
• Points A and B should make the consumer equally happy.
• Points B and C should make the consumer equally happy.
• This implies that A and C would make the consumer equally
happy.
• But C has more of both goods compared to A.
• Property 4: Indifference curves are bowed inward.
• People are more willing to trade away goods that they have in
abundance and less willing to trade away goods of which they
have little.
• These differences in a consumer’s marginal substitution rates
cause his or her indifference curve to bow inward.
Four Properties of Indifference Curves

15. Figure 3 The Impossibility of Intersecting Indifference
Curves
Quantity
of Pepsi
0
C
A
B
Quantity of Pizza

16. Figure 4 Bowed Indifference Curves
Quantity
of Pepsi
0
Indifference
curve
8
3
A
3
7
B
1
MRS = 6
1
MRS = 1
4
6
14
2
Quantity of Pizza

17. OPTIMIZATION: What the consumer chooses
• Consumers want to get the combination of goods on
the highest possible indifference curve.
• However, the consumer must also end up on or below
his budget constraint.
The Consumer’s Optimal Choices
• Combining the indifference curve and the
budget constraint determines the consumer’s
optimal choice.

18. Figure 6 The Consumer’s Optimum
Quantity
of Pepsi
0
Budget constraint
I1
I2
I3
Optimum
A
B
MRS =
MUPiz /MUPep= PPiz /PPep
Quantity of Pizza

19. The Consumer’s Optimal Choice
• Consumer optimum occurs at the point where
the highest indifference curve and the budget
constraint are tangent.
• The consumer chooses consumption of the two
goods so that the marginal rate of substitution
equals the relative price.
• For Two-Good Rule
MUPep $PPep
--------- = ----------
MUPiz $PPiz

20. How Changes in Income Affect the
Consumer’s Choices
• An increase in income shifts the budget constraint
outward.
• The consumer is able to choose a better combination of
goods on a higher indifference curve.
• Normal versus Inferior Goods
• If a consumer buys more of a good when his or her income
rises, the good is called a normal good (+)
• If a consumer buys less of a good when his or her income
rises, the good is called an inferior good (-).

21. Figure 7 An Increase in Income
Quantity
of Pizza
Quantity
of Pepsi
0
New budget constraint
I1
I2
2. . . . raising pizza consumption . . .
3. . . . and
Pepsi
consumption.
Initial
budget
constraint
1. An increase in income shifts the
budget constraint outward . . .
Initial
optimum
New optimum

22. Figure 8 An Inferior Good
Quantity
of Pepsi
0
Initial
budget
constraint
New budget constraint
I1
I2
1. When an increase in income shifts the
budget constraint outward . . .3. . . . but
Pepsi
consumption
falls, making
Pepsi an
inferior good.
2. . . . pizza consumption rises, making pizza a normal good . . .
Initial
optimum
New optimum
Quantity of Pizza

23. How Changes in Prices Affect Consumer’s
Choices
• A fall in the price of any good rotates the
budget constraint outward and changes the
slope of the budget constraint.
• Substitute the cheaper goods if price of one
goods increase relative to another

24. Figure 9 A Change in Price
Quantity
of Pepsi
0
1,000 D
500 B
100
A
I1
I2
Initial optimum
New budget constraint
Initial
budget
constraint
1. A fall in the price of Pepsi rotates
the budget constraint outward . . .
3. . . . and
raising Pepsi
consumption.
2. . . . reducing pizza consumption . . .
New optimum
Quantity of Pizza

25. Summary
• A consumer’s budget constraint shows the possible
combinations of different goods he can buy given his income
and the prices of the goods.
• The slope of the budget constraint equals the relative price of
the goods.
• The consumer’s indifference curves represent his preferences.
• Points on higher indifference curves are preferred to points on
lower indifference curves.
• The slope of an indifference curve at any point is the
consumer’s marginal rate of substitution.
• A consumer optimizes by choosing the point on his budget
constraint that lies on the highest indifference curve.

26. Summary
• When the price of a good falls, the impact on the
consumer’s choices can be broken down into an income
effect and a substitution effect.
The two effects of a price change:
• Income effect:
Normal good (+)
Inferior goods (-)
• Substitution effect
Happens as Price of Pepsi decreases, Pizza became
comparatively expensive
Consumer buy less Pizza and substituting it with Pepsi until
the optimizing condition is restored (-)