Chapter 3: Theory of Consumer Behaviour & Rational Choice
The basic model of Consumer Behavior focuses on 2 important factors influencing consumer
First is the consumers’ preferences(willingness), or tastes over various combination of goods.
Second is the ability of consumers to acquire goods as determined by income and prices of the
The theory follows directly from the theory of constrained maximization.
How do individual consumers form their demands for products?
We assume that our consumer is rational and wishes to maximize his/her well being which is a
function of the goods he/she consumes.
However, the amount of goods she can consume will be constrained by her income, given the
prices of goods, their tastes and preferences for goods and given their income.
We’ll develop the concepts of utility functions, indifference curves and budget lines and
from this we’ll derive the consumer demand curve for a good.
We show how the consumer’s demand shifts when income changes.
The derivation of consumer’s demand curve is based on a model of Indifference Curves &
Utility Function : Utility is the benefit or satisfaction consumers obtain from goods & services
A Utility Function is an equation that shows an individual’s perception of the level of utility
that would be attained from consuming each conceivable bundle or combination of goods
& services. U=f(X,Y).
It represents the preference ranking of the consumer regarding the goods a consumer is
Consumers are willing to make tradeoffs or substitute among different goods.
This willingness to substitute is determined by the form of that person’s utility function. A
fundamental tool for analyzing consumer behavior is an Indifference Curve. It is a locus of
points representing different combos of good & services each of which provides an
individual with the same level of utility. It shows the preferences of the consumer.
Properties of Indifference Curves
a)All combos of goods X & Y along the indifference curve I yield the consumer the same level
b)An IC is downward sloping
c)ICs are convex The convexity of ICs implies a diminishing marginal rate of substitution .
Marginal Rate of Substitution. (MRS) The MRS measures the number of units of Y that must
be given up per unit of X added so as to maintain a constant level of utility.
The MRS diminishes as we go down to the right along an Indifference Curve(IC). ICs generally
reflect a declining MRS.
We therefore assume that ICs are convex to the origin, which implies that the consumer’s MRS
declines as we move down any one of these curves.
Marginal Utility Interpretation of MRS MRS can be interpreted as the ratio of the MU of X
divided by the MU of Y.
Thus MRS = -dY/dX = MUx/MUy.
Marginal Rate of Substitution(MRS) is discussed in this chapter to explain and understand what
the slope of the indifference curve shows or represents.
1 d)Indifference Maps-ICs cannot intersect. An indifference map is made up of 2 or more ICs.
An IC lying above and to the right of another represents a higher level of utility.
Also note that price and income has nothing to do with preferences.
Preferences is a theoretical concept about how people can rank bundles of goods.
The Budget Line - Consumer’s Budget Constraint Recall from ch 2 that
demand functions indicate what consumers are both willing & able to do.
Because Indifference Curves are derived from the preference patterns of consumers, they show
what consumers are willing to do.
Consumers are however constrained as to what they are able to do—what bundles of goods they
can purchase is constrained by the market determined prices of the goods & by their incomes.
This is analysed by discussing the budget line .
A Budget Line is the locus of all combos or bundles of goods that can be purchased at
given prices if the entire money income is spent.
Whether a particular indifference curve is attainable by a consumer depends on money income of
the consumer and on commodity prices. The Budget Line reflects the ability of the consumer.
Suppose our consumer’s income is $600/week
1)Suppose the price of clothing is $60 and price of a pound of food is $3.
2)Then if she spent all her income she can buy 200 pounds of food and zero clothing per week or
10 pieces of clothing and zero of food per week.
3)Otherwise if she wished, buy some food and some clothing.
4)Each such combination can be represented by a point on the line as shown in Figure 3-4. in the
This is called a budget line.
A consumer’s budget line shows the market baskets that he or she can purchase, given the
consumer’s income and prevailing market prices.
To obtain the equation for the consumer’s budget line, note that:
YPf + XPc = I Equation.3.1
3Y+ 60X = 600
where Y is the amount she buys of food, X is the amount she buys of clothing, Pf is price of food, Pc
is price of clothing and I is her income.
Solving equation (3.1) for Y, we obtain:
Y = I - PcX
3Y=600-60X Or Y=200-20X
which is the equation for her budget line.