CONSUMER THEORY

LECTURE ONE.

LECTURE OBJECTIVES

By the end of the lecture, the learner should:

State the budget constraint.

Determine the consumer preferences
Derive and determine the consumer equilibrium using indifference curves approach.
Demonstrate the consumer demand functions.

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In your elementary microeconomics, the basic principles of consumer behaviour were introduced
by laying a strong foundation on the theory of demand on which premise the consumer
behaviour is build upon. The consumer behaviour is introduced as a utility maximising
o purchase. A consumer is portrayed as an agent
who goes for the best that he/she can afford.

In level 200 series

first section, we will examine how to describe what a consumer can afford; the next section will
focus on the concept of how the consumer determines what is best. We will then be able to
undertake a detailed study of the implications of this simple mode of consumer behaviour.

The Budget Constraint

Suppose that there is some set of goods from which the consumer can choose. In real life there
are many goods to consume but we will consider two.

1 2 where X 1 , represents the number of units

the consumer chooses of good 1 and is the number of units of good to be chosen by the
consumer.

Let p1 and p2 represent the unit prices for the two goods respectively; and M to represent the
amount of money the consumer has to spend.

The budget constraint of the consumer can be written as:

Where P1 X1 is expenditure for good 1 and P1 X 1 is expenditure on good 2.

The budget constraint of the consumer requires that the amount of money spent on the two goods

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consumption bundles are those that do not cost any more than M. The set of affordable
consumption bundles at prices P1 P2 and income M is called the budget set of the consumer.

The set of bundles that cost exactly M is called the budget line.

et is
shown below:

The budget set consists of all bundles that are affordable at the given prices and income.

Re-arranging equations (2)

1
2 2
2 2

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 P1
This is an equation for a straight line with a vertical intercept of and a slope of
2 P2

The example tells how many units of good 2 the consumer needs to consume in order to just
satisfy the budget constraint, if she is consuming X 1 units of good 1.

The slope of the budget line measures the rate at which the market is willing to substitute good 1
for good 2.

X2 P1
X1 P2

The slope of the budget line is also said to be an opportunity cost of consuming good 1. In order
to consume more of good 1, one has to give up some consumption of good 2. Giving up the
opportunity to consume good 2 is the true economic cost of more of good 1 consumption, and
that cost is measured by the slope of the budget line.

Consumer Preferences

This section is devoted to clari

The objects of consumer choice are consumption bundles. This is a complete list of the goods
and services that are involved in the choice problem faced by a consumer.

Suppose there are two consumption bundles 1 2 and 1 2 . The consumer can rank them as
to their desirability. That is, the consumer can determine that one of the bundles is strictly better
than the other, or decide that she is indifferent between the two bundles.

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Assumptions about Preferences

1. Completeness: It is assumed that any two bundles can be compared. That is, given any
X bundle and any Y bundle, then or or both, in which
case the consumer is indifferent between the two bundles. This is to say that the
consumer can make a choice.
2. Reflexive: We assume that any bundle is at least as good as itself

3. Transitive: If and then we assume that consumer thinks

that X is at least as good as Y and that Y is at least as good as Z, then the consumer thinks
that X is at least as Z.

Indifference Curves

The whole theory of consumer choice can be formulated in terms of preferences that satisfy the
three axioms above. However, it is convenient to describe preferences graphically using
indifference curves.

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If 1 2 is a certain consumption bundle, the consumption bundle in the shaded region are

weakly preferred to 1 2 . It is called the weakly preferred set. The bundles on the boundary

of this set for which the consumer is just indifferent to from the indifference curve. It
consists of all bundles of goods that leave the consumer indifferent to the given bundle.

Shapes of Indifferent Curves

If no further assumptions about preferences are made, ICs can take very peculiar shapes.

1. Perfect Substitutes
Two goods are perfect substitutes if the consumer is willing to substitute one good for the
other at a constant rate. The simplest care of perfect substitutes occurs when the
consumer is willing to substitute the goods on a one to one basis. ICs for such a
consumer are all parallel straight lines.

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2. Perfect Complements
Perfect complements are goods that are always consumed together in fixed proportions,
e.g. shoes (left and right). The ICs are L shaped, with the vertex of the L occurring where
the number of one good equals the number of the other good.

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3. Bad Goods

are meat and pepper, the consumer loves meat but dislikes pepper. But suppose there is
some trade off possible between meat and pepper i.e. there would be some amount of
meat in samosa that could compensate the consumer for having to consume a given
amount of pepper, if more pepper is given in the samosa, more meat has to be given to
compensate for having to put up with the pepper. Thus this consumer will have
indifference curves that slope up and to the right.

4. Neutral Goods
A
Suppose in the above case the consumer is just neutral about pepper 2 . The IC would

be vertical lines as depicted below. The consumer only cares about the amount of X1 and

he/she has. The more of X1 the better but

adding more

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 X2

IC

0 X1

5. Imperfect Substitutes
If the rate at which one good is substituted for another is not constant, but diminishing,
then the two goods are imperfect substitutes. As more and more of one good is given up
successively larger units of the other good are consumed to compensate the consumer for
the loss. Such goods will have indifference curves that are rounded, i.e. the ICs are
strictly convex.

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The Marginal Rate of Substitution

The slope of the IC is known as the MRS. It measures the rate at which the consumer is just
willing to substitute one good for another.

Suppose that we take a little of good 1, X 1 away from the consumer. Then we give him X2,
an amount i.e. just sufficient to put him back on his/her IC, so that he is just as well off after this
substitution of for X 1 as he was before.

X2
The ratio is thought as being the rate at which the consumer is willing to substitute good 1
X1
for good 2 and is called the MRS.

The MRS measures an interesting measure of consumer behaviour. Suppose that the consumer
has well behaved preferences, i.e., preferences which are monotonic and convex, and currently
consuming some bundle 1 2 . The consumer is now offered a trade: to exchange good 1 for
E.

i.e. if the consumer gives up X 1 units of good 1, he can get 1 units of good 2 in exchange

X2
or conversely, if he gives up X 2 , units of good 2, he can get units of good 1.
E

X2
MRS E
X1
X2 E X1
X2
X1
E

Geometrically, we are offering the consumer an opportunity to move to any point along a line
with a slop E that passes through 1 2 as depicted.

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Moving up and to the left from X 1 to involves exchange of good 1 for good 2, and moving
down to the right involves exchanging good 2 for good 1. In either movement the exchange rate
is E. Since exchange always involves giving up one good in exchange for another, the exchange
rate E corresponds to slope at E.

The point of tangency between the budget line and the indifference curve is referred to as the
consumer equilibrium.

Behaviour of the Marginal Rate of Substitution

MRS is constant at

-1. The neutral case is characterized by the fact that the MRS is everywhere infinite. The
preference for perfect complements are characterised by the fact that the MRS is either 0 or
infinite and nothing in between.

The assumption of monotonicity implies that ICs must have a negative slope, so the MRS always
involves reducing the consumption of one good in order to get more of another for monotonic
preferences.

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The case of convex ICs exhibits yet another kind of behaviour for the MRS. For convex ICs, the
MRS decreases as more of X1 is consumed. Thus the IC exhibits a diminishing MRS. Convexity
of ICs implies that the more of a good consumed, the more willing is a consumer is to give some
of it up in exchange for the other goods. This seems very natural for a consumer and hence
convexity if ICs becomes both necessary and sufficient conditions for consumer equilibrium

UTILITY

The theory of consumer behaviour has been formulated with an objective of utility
maximization. Utility refers to the ability of/in a good to satisfy the consumer.

There are several approaches to the study of utility with one theory attaching significance to the
magnitude utility and is known as the cardinal utility theory. In this theory the size of the utility
difference between the bundles of goods is supposed to have some sort of significance.

Another theory formulates the consumer behaviour entirely in terms of consumer preferences
and utility is seen only as a way to describe preferences by ranking bundles according to utility
derived from each bundle. The proponents of this theory recognized that all that mattered about
utility as far as choice behaviour was concerned was whether one bundle had a higher utility than
matter (ranking was the only matter). Because of this
emphasis on ordering bundles of goods, this kind of utility is referred to as ordinal utility.

The Utility Function

A utility function is a way of assigning a number to every possible consumption bundle such that
more preferred bundles get assigned larger numbers than less preferred bundles.

A utility function is a way to label indifference curves. Since every bundle of an IC must have
the same utility, a utility function is a way to assign number to the different indifference curves
in a way that higher ICs get assigned larger numbers. As long as ICs containing more preferred
bundles get a larger label than indifference curves containing less preferred bundles, the labelling
will represent the different preferences.

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However, not all kinds of preferences can be represented by a utility function for example,
suppose a consumer had intransitive preferences so that A>B>C>A. Then a utility function for
these preferences would have to consist of numbers U(A), U(B) and U(C) such that
U(A)>U(B)>U(C)U(A), which is impossible.

Examples of Utility Functions

1. Perfect Substitutes goods

Preferences for perfect substitutes are represented by linear utility functions of the form.

Where , numbers that measure the value of goods 1 and 2 to the consumer. By

plotting all the points 1 2 such that equals a constant, yields a linear

indifference curve with a slope . For every different value of a constant, there is a

different IC, but having a similar slope of . Each represents utility functions which

are monotonic transformations to each other.

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2. Complementary Goods
These goods used together. The preferences for complementary goods take utility
functions of the form.

Where and are positive numbers that indicate the proportion in which the goods are

consumed, e.g. , then if then

Any monotonic transformation of this utility function will describe the same preferences
which are presented by L-shaped ICs.

3. Imperfect Substitutes
Perfect substitutes have an additive utility function which implies that a consumer will
yield some level of utility even by consuming only one of the goods.

However, many cases are such that some level of utility is only possible when a
combination of the goods is consumed, i.e. no amount of utility is achievable from
consuming zero amount of one good. Such goods are said to be imperfect substitutes and
their preferences take multiplicative form of utility functions.

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 U X1 X 2 X1 X 2

This kind of a function is referred to as a Cobb-douglas utility function. It yields a

convex monotonic indifference curve and are said to be well behaved.

It is the most useful preference in presenting algebraic examples of the economic ideas.
A monotonic transformation of the Cobb-Douglas utility function above will represent
exactly the same preferences as:

Marginal Utility and Marginal Rate of Substitution

Consider a consumer consuming bundle . The amount by which the total utility changes

when an extra unit of a good is consumed is the marginal utility with respect to the
good.

Suppose an extra unit of good 1 is consumed such that total utility changes from to

the MU of good 1 is written as:

1 1 2 1 2
1
1 1

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It measures the rate of change in utility associated with a small change in the amount of
good 1 1 . Therefore to calculate the change in utility associated with a small change in
consumption of good 1, we can multiply the change in consumption by the MU of the good.

Similarly,

U U X1, X 2 X2 U X1 X 2
MU 2
X2 X2

Recall that the MRS measures the slope of the IC at a given bundle of goods.

Consider now a change in the consumption of each good that keeps utility constant,
i.e., a change in consumption that moves us along the IC, then

Solving for the slope of the IC we have,

X2 MU 1
MRS
X1 MU 2

But since utility does not change along the indifference curve.

The slope is negative since to get more of one good, lesser units of the other good must be
X2 MU 1
consumed in order to keep the same level of utility. For example if 2
X1 MU 2

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Give up 2 units of good 2 to consume extra unit of good 1.

Consumer Equilibrium

This section concentrates with putting together the budget line and the theory of preference in
order to examine the optimal choice of consumers. We have noted that the economic model of
consumer choice is that consumers choose the best bundle they can afford, i.e. the consumers
choose the most preferred bundle from their budget set.

Suppose the budget set and the well behaved consumer preferences are drawn on the same
diagram as:

The bundle of goods that is associated with the highest indifference curve and is affordable is
* *
1 2 . Any bundle above this one is unaffordable, such a bundle that appears on a point of

equilibrium choice. The point of tangency is called the consumer equilibrium point. Since a
solution as is represented above is an interior solution, where the consumers optimal choice

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involves both goods. A situation where optimal consumption involves consuming 0 units of one
good and some units of another is called a boundary solution/optimum. For example:

X2

Budget line

X 1*

Boundary optimum: The optimum consumption involves consuming 0 units of good 2 and the
indifference curve is not tangent to the budget line.

The tangency condition is only a necessary condition to have as optimal choice but not a
sufficient condition. However, there is one important case where it is sufficient, the case of
convex preferences. In the case of convex preferences, any point that satisfies the tangency
condition must be an optimal point.

Generally there may be more than one optimal bundle that satisfies the MRS condition as show
below:

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In such a case, there are three tangencies but only two optimal points, so the tangency condition
is necessary but not sufficient. However, again convexity implies a restriction. If the
indifference curves are strictly convex, then there will be only one optimal choice in each budget
line.

Recall that the marginal rate of substitution is the rate of exchange at which the consumer is just
willing to stay put. On the other hand, the market is offering a rate of exchange to the consumer
P1
of (the slope of the budget line).
P2

If the consumer is at a consumption bundle where he/she is willing to stay put, it must be one
where the MRS is equal to this rate of exchange.

P1
MRS
P2

MU 1 MU 2
P1 P2

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Hence

MU 1 P1
MRS
MU 2 P2

Or simply

MU 1 P1
consumer equilibrium condition
MU 2 P2

The equilibrium point (optimal choice) has this characteristic that the slope of the IC (MRS) is

optimal choices for other preferences. Some examples include:

1. Perfect Substitutes
Recall that perfect substitutes have linear indifference curves, just similar to a budget line. If

2 1 , then the slope of the budget line is flatter than the slope of the indifference curves.
In such a case, the optimal bundle is where the consumer spends all income on good 1.

If 1 2 , then the consumer purchases only good 2. If 1 2 , there is a whole range of

optimal choices and any amounts of goods 1 and 2 that satisfies the budget constraint is
optimal.

The graph below illustrates an optimal choice with perfect substitutes which provide a
boundary solution.

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In summary

M
if P1 P2
P1
M
X1 any number between 0 and if P1 P2
P1
0 if P1 P2

2. Perfect Complements
In this case, the optimal choice must always lie on the diagonal, where the consumer is
purchasing equal amounts of both goods, no matter what prices are. The optimal choice
can be illustrated as:

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3. Concave preferences

The optimal choice is always going to be a boundary choice/solution such as bundle z.

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 The optimal choice is the boundary point z, not the interior tangency point X because Z
lies on a higher indifference curve.

The Consumer Demand Functions

ods as a function of
the prices and income faced by the consumer. The demand function are written as:

In elementary microeconomics, a clear distinction is made between the normal, inferior and
giffen goods.

When the consumer income changes, the optimal choice for the goods changes yielding an
income expansion path. The income consumption path is used to derive an Engel curve. On the
other hand, a change in price also changes the optimal choice of the consumer yielding a price
offer curve which is used to derive the demand curve.

In this level we give it a mathematical approach where we seek to determine the demand
functions for the optimal choice bundle of the consumer.

The consumer problem is stated as:

MaxU X 1 X 2 ........................................... i
st
P1 X 1 P2 X 2 M ...................................... ii

Introducing a langrangian multiplier and converting (1) and (2) into a composite function we
have:

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Obtaining the first order conditions,

1
1 1

2
2 2

1 1 2 2

Re- writing equations (4) and (5) and dividing them yields:

U
X1 P1
U P2
X2
MU X 1 P1
MU X 2 P2

This is a similar concept to what was earlier called the consumer equilibrium condition. It
corresponds to a point of tangency between an indifference curve and the budget line from the
graphical approach discussed in the previous sections.

Solving equations (iii), (iv) and (v) above simultaneously, we obtain the demand functions for
the optimal choice bundle. This is best demonstrated using a specific consumer preference and
in this case the Cobb-Douglas preference.

Suppose a utility function is specified as

U X1 X 2 X1 X 2

The consumer problem is stated as

MaxU X1 X 2
st
P1 X 1 P2 X 2 M

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L X1 X 2 P1 X 2 P2 X 2 M
L
X1 1X 2 P1 0....................... i
X1
L 1
X1 X 2 P2 0......................... ii
X2
L
P1 X 1 P2 X 2 M 0......................... iii

Re-writing and dividing equation 1 and 2 above we obtain

X1 1 X 2 P1
X1 X 2 1 P2
1 1 P1
X1 X2
P2
X2 P1
X1 P2

Such that

1
2 1
2

2 2
1
1

Equation (4) and (5) represent the income expansion paths or the income offer curve.

Substituting equation (4) and (5) into equation (3) one at a time we obtain.

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P1 X 1 P2 X 2 M
P1 X 1
P1 X 1 P2 M
P2

P1 X 1 P1 X 1 M

1 P1 X 1 M

P1 X 1 M

M
X1
1 P1

M
X 1*
P1

M
X 1* demand function for X 1
P1
M
X 2* demand funtion for X 2
P2

X 1* and X 2* are referred to as the Marshallian demand function that represents the optimal

choice bundle . They provide the solution to the consumer utility maximising problem.

Given the market prices and the income level for a consumer then the functions describe the
exact amount of both goods that the consumer would have to consume so as to maximise utility.

Revealed Preference

and the budget

constraints to determine his/her demand. However, in real life, preferences are not directly

preference theory shows how we can use information about the consumers demand to discover
information about his/her preferences.

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The theory adopts a maintained hypothesis that the consumers preferences are stable over the
time period for which his/her behaviour is observed-whether they may be or are known to be
strictly convex. Thus there will be a unique demanded bundle at each budget.

1 2 and

another arbitrary bundle 1 2 i.e. beneath the con

Bundle 1 2 is certainly an affordable purchase at the given budget. The consumer could have

bought it if he/she wanted to and even had money left over. Since is the optimal bundle
it must be better than anything else that the consumer could afford. Hence it must be better than

1 2 or any other bundle on or beneath the budget line.

Let 1 2 be the bundle purchased at prices 1 1 when the consumer has income M. Since

1 2 is affordable at these prices and income, then:

Since X1X2 is actually bought at the given budget, then

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Putting these two equations together

If the above inequality is satisfied and 1 2 is actually a different bundle from 1 2 , then

1 2 is said to be directly revealed preferred to 1 2 . This revealed preference is a relation

that holds between the bundle that is actually demanded at some budget and the bundles that
could have been demanded at that budget. The principle of revealed preference is therefore stated
as:-

Let 1 2 be the chosen bundle when prices are P1 P2 and let 1 2 be some other bundle
such that:

. Then if the consumer is choosing the most preferred bundle, he can

afford, we must have .

Suppose further that 1 2 is a demanded bundle at prices 1 2 and that 1 2 is itself revealed

preferred to some other bundle Z1 Z 2 . That is:

Then and . From the transitivity assumption, we can conclude

that .

This is illustrated:

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Revealed preference and transitivity assumption tell us that must be better than

for the consumer who made the illustrated choices. In this case 1 2 is said to be indirectly

revealed proffered to 1 2 . The chain of direct comparisons can be of any length such that if

indirectly revealed to Z.

If a bundle is either directly or indirectly revealed preferred to another bundle, we will say that
the first bundle is revealed preferred to the second.

From the figure below, since 1 2 is revealed preferred, either directly, to all of the bundles

below (shaded area) either budget lines, is in fact preferred to those bundles by the

consumer. That is, the true indifference curve through 1 2 , whatever it is, must lie above

the shaded region. It therefore also follows that, the true indifference curve through 1 2 must
lie above the flatter budget line.

The Weak Axiom of Revealed Preference

We have so far supposed that the consumer has preferences and that he/she is always choosing
the best bundle of goods affordable. If the consumer is not behaving this way, the estimates of
the indifference curves that we have constructed are meaningless.

Consider:

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According to the logic of revealed preference, the diagram allows us to conclude two things.

(i) is preferred to 1 2 and

(ii) 1 2 is preferred to 1 2

That is, the consumer has apparently chosen 1 2 when he/she could have chosen 1 2

indicating that 1 2 was preferred to 1 2 indicating that 1 2 was preferred to 1 2

but then he/she indicating the opposite. This situation is absurd and violates the weak Axiom of
Revealed Preference

Clearly this consumer cannot be a maximizing consumer. Either the consumer is not choosing
the best bundle he/she can afford or there is some other aspect of the choice problem that has

his/her economic environment have changed. If consumers are choosing the best bundles that
are affordable, but not chosen must be worse than what is chosen. Economists have therefore
formulated this simple point in a basic axiom of consumer theory referred to as the weak axiom
of revealed prefer is directly revealed preferred to 1 2

and the two bundles are not the same, then it cannot happen that 1 2 is directly revealed

preferred to 1 2 .

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In other words, if a bundle 1 2 is purchased at prices 1 2 and a different bundle 1 2 is

purchased at prices q1q 2 then if.

It must not be the case that

That is, if the Y bundle is affordable when the x-bundle is purchased, then when the Y-bundle is
purchased, the X bundle must not be affordable.

The consumer in (immediate diagram) has violated the WARP and therefore this consumer s
behaviour could not have been maximising behaviour. There is no set of indifference curves that
could make both bundles maximizing bundles.

On the other hand, a consumer who satisfies WARP is said to have a maximizing or optimal
behaviour and for such, it is possible to find indifference curves for which his/her behaviour is
optimal. One possible choice of indifference curves is illustrated below.

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The Strong Axiom of Revealed Preference

The weak axiom of revealed preference requires that if X is directly revealed preferred to Y, then
we should never observe Y being directly revealed to X. The strong axiom of revealed
preference requires that the same sort of condition hold for indirect revealed preference. The
strong Axiom of Revealed Preference. The strong Axiom of Revealed Preference (SARP) states
that:

If is revealed preferred to 1 2 either directly or indirectly and 1 2 is different from

1 2 is revealed preferred to 1 2 .

It is therefore clear that if the observed behaviour is optimizing behaviour, then it must satisfy
the strong axiom. For if the consumer is optimising and 1 2 is revealed preferred to, either

directly or indirectly, then it must be the case that 1 2 > 1 2 . Therefore, having 1 2

revealed preferred to 1 2 and 1 2 revealed preferred to 1 2 would imply that

> 1 2 and 1 2 > , which is a contradiction. We can conclude that either the
consumer must not be optimizing or some other aspect of the consumer s environment such as
tastes, other prices etc. must have changed.

While WARP is a necessary condition for optimizing behaviour, SARP is both necessary and
sufficient in the sense that, if the observed choices satisfy SARP, we can always find well
behaved preferences that could have generated the observed choices. It ensures both consistency
and transitivity of consumer preferences.

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