Consumer Choice:
Indifference Theory
Gilbert Kachamba
gilbertkachamba@[Link]
0999 195 129
Introduction
• In this section we look more closely at the
determinants of consumer demand. In particular,
we discuss the concept of utility and use it to gain
insights into how consumers allocate their
spending.
• We show how indifference curves can be used to
describe consumers’ tastes and then introduce a
budget line to describe the consumption
possibilities open to a consumer who has a given
income.
Learning Outcomes
• In particular, you will learn that:
• Consumers will maximize their overall satisfaction when the
marginal utility per pound spent is equal for all products
purchased.
• A theory of demand can be built by focusing on bundles of
goods between which the consumer is indifferent.
• Indifference curves show combinations of goods that give
the same level of satisfaction.
• A budget constraint shows what the consumer could buy
with a given income.
• A consumer optimizes by moving to the highest indifference
curve that is available with a given budget constraint.
Learning Outcomes
• In particular, you will learn that (cont’d):
• The response to a price change can be decomposed
into an income and a substitution effect.
• For a good to have a negatively sloped demand curve it
is necessary (but not sufficient) that it be an inferior
good.
• The basic assumption here is that consumers
are motivated to make themselves as well off
as they can, or as economists like to put it: to
maximize their satisfaction, or utility.
• All units of the same product are identical but
the satisfaction that a consumer gets from
each unit of a product in not the same.
• This suggests that the satisfaction that people
get from consuming a unit of any product
varies according to how many of this product
they have already.
• Economists and philosophers thinking about
consumer choice and satisfaction in the
nineteenth century developed the concept of
utility and were hence sometimes called
utilitarians.
• But the big breakthrough for economics came
in the 1870s with what is known as the
marginal revolution, which gave birth to
neoclassical economics.
Marginal and total utility
• The satisfaction a consumer receives from
consuming that product is called utility.
• Total utility refers to the total satisfaction
derived from all the units of that product
consumed.
• Marginal utility refers to the change in
satisfaction resulting from consuming one
unit more or one unit less of that product.
Diminishing marginal utility
• A basic assumption of utility theory, which is
sometimes called the law of diminishing
marginal utility, is as follows:
The marginal utility generated by additional
units of any product diminishes as an
individual consumes more of it, holding
constant the consumption of all other
products.
Maximizing utility
• We can now ask: what does diminishing
marginal utility imply for the way a consumer
who has a given income will allocate spending
in order to maximize total utility?
• How should a consumer allocate his or her
income in order to get the greatest possible
satisfaction, or total utility, from that
spending?
• If all products had the same price, the answer
would be easy.
• A consumer should simply allocate spending
so that the marginal utility of all products was
the same.
• If the marginal utility of all products were not
equal then total utility could be increased by a
different spending pattern.
For example!
• If one product had a higher marginal utility
than the others, then expenditure should be
reallocated so as to buy more of this product,
and less of all others that have lower marginal
utilities.
• By buying more, its marginal utility would fall.
This continues until the consumer's utility
equates to his/her expenditure and utility is
maximized.
• How does this work if products have different
prices?
• Again, the same principles apply but now the
best a consumer can do is to rearrange
spending until the last unit of satisfaction per
pound spent on each product is the same.
Note!
To maximize utility consumers allocate
spending between products so that equal
utility is derived from the last unit of money
spent on each.
Conditions for maximising utility
• The conditions for maximizing utility can be
stated more generally.
• Denote the marginal utility of the last unit of
product X by MUX and its price by pX.
• Let MUY and pY refer, respectively, to the
marginal utility of a second product, Y, and its
price.
• The marginal utility per pound spent on X will
be MUX/pX.
• The condition required for any consumer to
maximize utility is that the following
relationship should hold, for all pairs of
products:
Note!
• This is the fundamental equation of utility
theory.
• Each consumer demands each good up to the
point at which the marginal utility per pound
spent on it is the same as the marginal utility
of a pound spent on each other good.
• When this condition is met, the consumer
cannot shift a pound of spending from one
product to another and increase total utility.
Consumers choose quantities not
prices
• If we rearrange the terms in previous equation
we can gain additional insight into consumer
behaviour:
• The right-hand side of this equation states the
relative price of the two goods.
• It is determined by the market and is beyond
the control of individual consumers, who react
to these market prices but are powerless to
change them.
• The left-hand side of the equation states the
relative contribution of the two goods to add
to satisfaction if a little more or a little less of
either of them were consumed, a choice that
is available.
Note!
• If the two sides of eqn (5.2) are not equal, the
consumer can increase total satisfaction by
changing the spending pattern.
• Assume, for example, that the price of a unit
of X is twice the price of a unit of Y (pX/pY = 2),
while the marginal utility of a unit of X is three
times that of a unit of Y (MUX/MUY = 3).
• Reducing purchases of Y by two units frees
enough purchasing power to buy a unit of X.
• Since one extra unit of X bought yields 1.5
times the satisfaction of two units of Y
forgone, the switch is worth making.
• What about a further switch of X for Y?
• As the consumer buys more X and less Y, the
marginal utility of X falls and the marginal
utility of Y rises.
• In this example the consumer will go on
rearranging purchases—reducing Y
consumption and increasing X consumption—
until the marginal utility of X is only twice that
of Y.
• At this point, total satisfaction cannot be
further increased by rearranging purchases
between the two products.
Note!
• It shows that an equilibrium position reached
when decision-takers have made the best
adjustment they can to the external forces
that constrain their choices.
• When they enter the market, all consumers
face the same set of market prices.
• When they are fully adjusted to these prices,
each one of them will have identical ratios of
their marginal utilities for each pair of goods.
• A rich consumer may consume more of each
product than a poor consumer and get more
total utility from them.
• However, the rich and the poor consumer (and
every other consumer who is maximizing
utility) will adjust their relative purchases of
each product so that the relative marginal
utilities are the same for all.
• Thus, if the price of X is twice the price of Y,
each consumer will purchase X and Y to the
point at which his or her marginal utility of X is
twice the marginal utility of Y.
• Consumers with different tastes will, however,
derive different marginal utilities from their
consumption of the various commodities.
• So they will consume differing relative
quantities of products
Note!
• But all will have declining marginal utilities for
each commodity and hence, when they have
maximized their utility, the ratios of their
marginal utilities will be the same for all of
them.
Total and Marginal Utility Schedules
Number of films Total utility Marginal utility
attended per month
0 0.00
1 15.00 15.00
2 25.00 10.00
3 31.00 6.00
4 35.00 4.00
5 37.50 2.50
6 39.00 1.5
7 40.25 1.25
8 41.30 1.05
9 42.20 0.90
10 43.00 0.80
Total and Marginal Utility Schedules
As consumption increases, total utility rises but marginal
utility falls.
The marginal utilities are the changes in utility when
consumption is altered by one unit.
For example, the marginal utility of 10m, shown in the
entry in the last column, arises because with attendances
at the second film total utility increase from 15 to 25 a
difference of 10.
The data in this table are plotted in the following figure.
Total and Marginal Utility Curves
50
Utility [K]
20
Utility [K]
40
30 15
20 10
10 5
0 2 4 6 8 10 0 2 4 6 8 10
Quantity of films [attendance per month]
[i]. Increasing total utility [ii]. Diminishing marginal utility
Consumer’s Surplus for an Individual
3.00
Price of milk [K per glass]
2.00
1.00 Market price
0.30
1 2 3 4 5 6 7 8 9 10
Glasses of milk consumed per week
Consumer’s Surplus for an Individual
Consumer’s surplus is the sum of the extra valuations
placed on each unit above the market price paid for
each.
This figure is based on the data in the [Link].
Green pays the red area for the 8 glasses of milk she
consumes per week when the market price is K0.30 a
glass.
The total value she places on these 8 glasses of milk is
the entire shaded area (red and green).
Hence her consumer’s surplus is the green area.
Consumers’ Surplus for the Market
Price
0 Quantity
Price
Consumers’ Surplus for the Market
Market price
p0
0 Quantity q0
Consumers’ Surplus for the Market
The area under the demand curve shows the total
valuation that consumers place on all units consumed.
For example, the total value that consumers place on q0
units is the entire area shaded red and green under the
demand curve up to q0.
At a market price of p0 the amount paid for q0 units is
the red area.
Hence consumers surplus is the green area under the
demand curve and above p0.
MARGINAL UTILITY
The Utility Theory of Demand
• Marginal utility theory distinguishes between the total utility
that each consumer gets from the consumption of all units of
some product and the marginal utility each consumer obtains
from the consumption of one more unit of the product.
– The basic assumption in utility theory is that the utility the consumer
derives from the consumption of successive units of a product
diminishes as the consumption of that product increases.
– Each consumer reaches a utility-maximizing equilibrium when the utility
he or she derives from the last K1 spent on each product is equal.
MARGINAL UTILITY
• Another way of putting this is that the marginal utilities
derived from the last unit of each product consumed will
be proportional to their prices.
• Demand curves have negative slopes because when the
price of product X falls, each consumer restores
equilibrium by increasing his or her purchases of X.
• The increase must be enough to lower the marginal utility
of X until its ratio to the new lower price of X is the same
as it was before the price fell.
• This restores the equality of the ratio to what it is for all
other products.
MARGINAL UTILITY
Consumers’ Surplus
• Consumers’ surplus is the difference between [1] the value
consumers place on their total consumption of some
product and [2] the actual amount paid for it.
• The first value is measured by the maximum they would
pay for the amount consumed rather than go without it
completely.
• The second is measured by market price times quantity.
MARGINAL UTILITY
• It is important to distinguish between total and marginal
values because choices concerning a bit more and a bit less
can not be predicted from knowledge of total values.
• The paradox of value involves confusion between total and
marginal values.
• Elasticity of demand is related to the marginal value that
consumers place on having a bit more or a bit less of some
product; it bears no necessary relationship to the total value
that consumers place on all of the units consumed of that
product.
Bundles Conferring Equal Satisfaction
Bundle Clothing Food
A 30 5
B 18 10
C 13 15
D 10 20
E 8 25
F 7 30
Bundles Conferring Equal Satisfaction
35
a
30
Quantity of clothing per
25
g
week
20 b
15
c
d
10 e
f
h
T
5
5 10 15 20 25 30 35
Quantity of food
Bundles Conferring Equal Satisfaction
None of the bundles in the table are obviously superior to any
of the others in the sense of having more of both commodities.
Since each of the bundles shown in the table give the consumer
equal satisfaction, he is indifferent between them.
The data in this table are plotted in the corresponding figure.
An Indifference Map
Quantity of food per week
I5
I4
I3
I1 I2
0 Quantity of food per week
An Indifference Map
A set of indifference curves is called an indifference map.
The further the curve from the origin, the higher the
level of satisfaction it represents.
Moving along the arrow is moving to ever-higher utility
levels.
Shapes of Indifference Curves
Perfect Substitutes Perfect Complements A good that gives zero
utility
Left hand gloves
Vegetables
I2
I2
I2 I1
I1
I1
0 0 0
[i]. Packs of green pins [ii]. Right hand gloves [iii]. Meat
Shapes of Indifference Curves
A good that confers a negative utility A good that is
An absolute necessity after some level of consumption not consumed
I2 I1
a
All other goods
All other goods
All other goods
I2
I1 0 I2
w f0 0 b I1
0
[iv]. Water [v]. Food [vi]. Good X
The Equilibrium of a Consumer
35
Quantity of clothing per week
30
25
20
15
10
5 10 15 20 25 30 35
Quantity of food per week
The Equilibrium of a Consumer
Quantity of clothing per week
30
a b
25
c
20
E
15
10 I5
d
I4
5 e
I3
f I2
I1
5 10 15 20 25 30 35
Quantity of food per week
The Equilibrium of a Consumer
Paul has an income of K150 a week and faces prices of K5 a
unit for clothing and K6 a unit for food.
A bundle of clothing and food indicated by point a is
attainable.
But by moving along the budget line to points such as b and c,
higher indifference curves can be reached.
At E, where the indifference curve I4 is tangent to the budget
line, Paul cannot reach a higher curve by moving along the
budget line.
If he did alter his consumption bundle by moving, for
example, from E to d, he would move to the lower
indifference curve I3 and thus to a lower level of satisfaction.
An Income-consumption Line
Income-consumption line
Quantity of clothing per week
E3
E2
E1
I3
I2
I1
0 Quantity of food per week
An Income-consumption Line
This line shows how a consumer’s purchases react to
changes in income with relative prices held constant.
Increases in income shift the budget line out parallel to
itself, moving the equilibrium from E1 to E2 to E3.
The blue income-consumption line joins all these points of
equilibrium.
The Price-consumption Line
a
Price-consumption
line
Quantity of clothing per week
E1
E2 E3
I3
I2
I1
b c d
Quantity of food per week
The Price-consumption Line
This line shows how a consumer’s purchases react to a
change in one price, with money income and other
prices held constant.
Decreases in the price of food (with money income and
the price of clothing constant) pivot the budget line from
ab to ac to ad.
The equilibrium position moves from E1, to E2 to E3.
The black price-consumption line joins all such
equilibrium points.
Derivation of an Individual’s Demand Curve
Value of all other goods
Price-consumption line
[K per month]
E2
E1
E0
I2
I0 I1
0 60 120 220 267 400 800
[i] Petrol [litres per month]
Price of petrol [K per month]
0.75 x
y
0.50 Demand curve
0.25 z
0 60 120 220
Derivation of an Individual’s Demand Curve
The points on a price-consumption line provide the
information needed to draw a demand curve.
In part (i) Phillip has an income of K200 per month and
alternatively faces prices of K0.75, K0.50, and, K0.25 per litre
of petrol, choosing positions E0, E1, and E2.
The information for the number of litres he demands at each
price is then plotted in part (ii) to yield his demand curve.
The three points x, y, and z in (ii) correspond to the three
equilibrium positions E0, E1 and E2 in part (i).
The Income and Substitution Effects
Value of all other goods [K per week]
a1
E0
E1
Substi I1
tution
effect
0 q0 q1 b q j1 Quantity of petrol [litres per week]
2
Income and Substitution
• The income effect is the change in
the consumption of goods by
consumers based on their income
(purchasing power). The substitution
effect happens when consumers
replace cheaper items with more
expensive ones due to price changes
or when their financial conditions
improve, and vice-versa.