Chapter 5

Consumer Demand Theory

 Contents
• Total and Marginal Utility
• Consumer Equilibrium
• Indifference Curves: Definition
• The Marginal Rate of Substitution
• The Characteristics of Indifference Curves
• The Budget Constraint Line and Consumer Equilibrium
• Exchange
• The Income-Consumption Curve and the Engel Curve
• The Price-Consumption Curve and the Consumer’s
Demand Curve
• Separation of the Substitution and Income Effect
 Glossary
The Household Budget Line: A household’s budget line describes the limits to a
household’s consumption choices.
Utility means satisfaction. Utility is the property of a commodity that satisfies
a want or need of a consumer.
Total utility (TU): TU is the overall satisfaction that an individual receives from
consuming a specified quantity of a commodity per unit of time.
Marginal utility (MU): MU is the change in the total utility per unit change in
the quantity of a commodity consumed per unit of time.
Saturation point: Saturation point is the point where the TU received by an
individual from consuming a commodity is maximum and the marginal
utility is zero.
Principle of diminishing marginal utility: It is a concept that states that as an
individual consumes more units of a commodity per unit of time, the TU
received increases, but the extra or MU decreases.
(Continued)
 Glossary
Marginal rate of substitution (MRSxy): MRSxy is the amount of
commodity Y that a consumer is willing to give up in order to gain
one additional unit of commodity X ( and still remains on the same
level of satisfaction).
Budget constraint line: This line shows all the different combinations
that a consumer can purchase, subject to a given money income
and the prices of the two commodities.
Consumer equilibrium: Is the point where a consumer maximizes the
TU or satisfaction, subject to given income and price constraints.
Consumer’s demand curve: This curve shows the amount of a
commodity the consumer would purchase at various prices, other
things constant.
Income consumption curve: This curve is the locus of the points of
consumer equilibrium resulting when only the consumer’s income
is varied. (Continued)
 Glossary
Engel Curve: This curve shows the amount of a
commodity that the consumer would purchase per unit
of time at various levels of income.
Indifference curve: Indifference curve shows the various
combinations of two commodities which yield equal
utility or satisfaction to the consumer.
Income effect: It is the increase in the quantity purchased
of a commodity with a given money income when the
commodity price falls.
Substitution effect: The increase in the quantity
purchased of a commodity when its price falls (as a
result of consumer of other similar commodities).
 The Household’s Budget
Consumption Possibilities
A household’s consumption possibilities are
constrained by its income and the prices of the
goods and services it buys.
A household has a given amount of income to
spend and cannot influence the prices of the
goods and services it buys.
A household’s budget line describes the limits to a
household’s consumption choices.
 The Household’s Budget

Figure shows a budget

line for movies and
soda.
The household can afford all
the points on or below the
budget line.

The household cannot afford

the points beyond the budget
line.
 The Household’s Budget
Relative Price
A relative price is the price of one good divided by
the price of another good.
The price of a movie is $6 and the price of soda is
$3 a six-pack.
So the relative price of a movie is $6 per movie
divided by $3 per six-pack, which equals 2 six-
packs per movie.
 The Household’s Budget
A Price Change
A change in the price
of the good on the x-
axis changes the
affordable quantity of
that good and
changes the slope of
the budget line.
Figure shows the rotation of
a budget line after a change
in the relative price of
movies.
 The Household’s Budget
Real Income
A household’s real income is the household’s
income expressed as the quantity of goods that
the household can afford to buy.
Expressed in terms of soda, Lisa’s real income is 10
six-packs—the maximum quantity of six-packs
that she can buy.
Lisa’s real income equals her money income
($30) divided by the price of a six-pack ($3).
 The Household’s Budget
A Change in Income
A change in the income
brings a parallel shift of
the budget line.
The slope of the budget line
doesn’t change because the
relative price doesn’t change.

Figure shows how the budget

line shifts when income
changes.
 Total and Marginal Utility
An individual demands a particular commodity because
of the satisfaction or utility received from consuming it. Up
to a point, the more units of a commodity the individual
consumes per unit of time, the greater the total utility
received. Although TU increases, the extra or marginal
utility received from consuming each additional unit of the
commodity usually decreases.
At some level of consumption, the TU received by the
individual from consuming the commodity will reach a
maximum and the marginal utility will be zero. This is
saturation point. Additional units of the commodity cause
TU to fall and MU to become negative.
(Example on next slide)
 Table: 1
TU & MU
Example:
QX TUX MUX
0 0 …
1 10 10
2 18 8
3 24 6
4 28 4
5 30 2
6 30 0 (Saturation point)
7 28 -2
 Preferences and Utility
Table provides an
example of total utility
schedule.
Figure shows a total
utility curve.

Total utility increases with

the consumption of a good.
 Preferences and Utility
Figure illustrates
diminishing marginal
utility.

Utility is analogous to
temperature.
Both are abstract concepts
and both are measured in
arbitrary units.
 Consumer Equilibrium
The objective of a rational consumer is to maximize the
TU or satisfaction derived from spending personal
income. This objective is reached and consumer is said
to be in equilibrium when he/she is able to spend
personal income in such a way that the utility or
satisfaction of the last Rupee spent on various
commodities is the same. This can be expressed
mathematically by:
Mux/Px= Muy/Py=…..
Subject to the constraint that:
PxQx + PyQy +…..= M ( M is the individual’s income)
(See example on the next slide)
The objective of a rational consumer is to maximize the TU or
satisfaction derived from spending personal income.
This objective is reached and the consumer is said to be in
equilibrium when two conditions are met viz:
(1) he is able to spend personal income in such a way that the
utility or satisfaction of the last rupee spent (MUs) on various
commodities is the same:
MUX / PX = MUY / PY =..…..and
(2) Subject to the constraint that:
PXQX + PYQY +……= M (the individual income)
Supposing individual’s income is Rs. 12
Price of good X (PX) is Rs. 2 and price of good Y (Py) is Rs. 1.
 Table: 2
Consumer Equilibrium
Q 1 2 3 4 5 6 7 8
MUX 16 14 ⓬ 10 8 6 4 2
MUY 11 10 9 8 7 ❻ 5 4
Spending schedule:
1st and 2nd rupees on 1st and 2nd units of Y (TU = 21 units)
3rd and 4th rupees on 3rd and 4th units of Y (TU = 17 units)
5th and 6th rupees on 1st unit of X (TU = 16 units)
7th and 8th rupees on 2nd unit of X (TU = 14 units)
9th and 10th rupees on 5th and 6th units of Y(TU = 13 units)
11th and 12th rupees on 3rd unit of X (TU = 12 units)
The overall utility received by the individual is (16+14+12)
from MUX and (11+10+9+8+7+6) from MUY= 93 utils.
Both conditions of maximizing utility are fulfilled.
(1) MUX/PX = MUY/PY
or
12/Rs.2 = 6/Rs.1
or 6 = 6 and
(2) PXQX + PYQY = M or (Rs.2*3) + (Rs. 1*6) = Rs.12

The same two general conditions would have to hold for the
individual to be in equilibrium if having purchased more
than two commodities.
 Table: 3
Consumer Equilibrium (Problem)
Determine consumer equilibrium from the
following data:
Q 1 2 3 4 5 6 7 8
MUx 20 18 16 14 12 10 8 6
MUy 14 13 12 11 10 9 8 7
Consumer Constraints:
 Total income: Rs.16
 Price of X = Rs.2
 Price of Y = Rs.1
 Indifference Curves
A consumer’s tastes and equilibrium can also be
shown by indifference curves.
An indifference curve shows various combinations
of commodity X and commodity Y which yield
equal utility or satisfaction to the consumer.
A higher indifference curve shows a greater amount
of satisfaction and a lower one, less satisfaction.
Thus, indifference curves show an ordinal rather
than a cardinal measure of utility.
Ordinal measure of utility: ranking that
indicates whether a consumer prefers one
basket to another, but does not contain
quantitative information about the intensity
of that preference.
Cardinal measure of utility: a quantitative
measure of intensity of a preference for one
basket over another.
 Characteristics of indifference curves

Indifference curves exhibit three basic

characteristics:
1.They are negatively sloped,
2.They are convex to the origin, and
3.They cannot intersect
 Problem: What do indifference curves show?

Answer: Indifference curves are a graphic picture of

a consumer’s tastes and preferences. The
consumer is indifferent among all the different
combinations of X and Y on the same indifference
curve but prefers points on a higher indifference
curve to points on a lower one. Thus indifference
curves show an ordinal rather than a cardinal
measure of utility. Even though we have chosen
to represent a consumer’s tastes by sketching
only 3 or 4 indifference curves here, the field of
indifference curves is dense (i.e. there are an
infinite number of them). (Continued)….
• All the indifference curves of a consumer give
us the consumer’s indifference map. Different
consumers have different indifference maps.
When the tastes of a consumer change, that
person’s indifference map also changes.
Indifference curves are negatively sloped, they
are convex to the origin and do not cross.
Indifference curves need not be and are not
usually parallel to one another.
 Marginal Rate of Substitution
The marginal rate of substitution of X for Y
(MRSXY) refers to the amount of Y that a
consumer is willing to give up in order to gain
one additional unit of X (and still remains on
the same indifference curve).
As the consumer moves down an indifference
curve, the MRSXY diminishes (See Table.4)
 Table: 4
Marginal Rate of Substitution
Indifference curve I Indifference curve II Indifference curve III
QX QY MRSXY QX QY MRSXY QX QY MRSXY
1 10 … 3 10 … 5 12 …
2 5 5 4 7 3 6 9 3
3 3 2 5 5 2 7 7 2
4 2.3 0.7 6 4.2 0.8 8 6.2 0.8
5 1.7 0.6 7 3.5 0.7 9 5.5 0.7
6 1.2 0.5 8 3.2 0.3 10 5.2 0.3
7 0.8 0.4 9 3 0.2 11 5 0.2
8 0.5 0.3 10 2.9 0.1 12 4.9 0.1
9 0.3 0.2
10 0.2 0.1
All points on the same indifference curve yields the same satisfaction to the
Consumer.
 Budget Constraint Line
The budget constraint line shows all the different combinations of the
two commodities that a consumer can purchase, given his or her
money income and the prices of the two commodities.

Qx
10

0 10 Qy
 The Budget Constraint Line and
Consumer Equilibrium
The budget constraint line shows all the different combinations of the two
commodities that a consumer can purchase, given his or her money
income and the prices of the two commodities.
QY

10 N

E
5 (III)
R (II)
0 5 10 (I) QX
 Consumer Equilibrium
A consumer is in equilibrium when, given personal income and
price constraints, maximizes the total utility or satisfaction
from his or her expenditures. In other words, a consumer is
in equilibrium when, given his or her budget line, the
person reaches the highest possible indifference curve.

Equilibrium occurs where the budget line is tangent to the

indifference curve. Point E is the equilibrium point on curve
II.

The consumer would like to reach indifference curve III, but

cannot because of limited income and price constraint.
• In a two individual (A and B), two commodity
(X and Y) world, there is basis for mutually
advantageous exchange as long as the MRSXY
for individual A differs from the MRSXY for
individual B.
 7. The Income- Consumption Curve and the
Engel Curve
By changing the consumer’s money income while keeping
constant personal tastes and the prices of X and Y, we
can derive the consumer’s income-consumption curve
and Engel curve.

The income-consumption curve is the locus of points of

consumer equilibrium resulting when only the
consumer’s income is varied.

The Engel curve shows the amount of a commodity that

the consumer would purchase per unit of time at
various levels of total income.
 Income-Consumption Curve and the Engel Curve

QY Income-Consumption Curve

Assumption:
PX=PY=Rs.1 III
II
0 I QX
M Engel Curve

Income

0 QX
 Problem (a) With what is consumer demand theory
concerned? (b) why do we study consumer demand
theory?
Answer: (a) consumer demand theory is concerned with
the individual’s demand curve for a commodity i.e.
how it is derived and the reason for its location and
shape. There are two approaches to the study of
consumer demand theory: the classical utility
approach and the more recent indifference curve
approach.

(b) We study consumer demand theory in order to learn

more about the market demand curve for a commodity
which is obtained by the horizontal summation of all
individuals’ demand curves for the commodity.
 Problem: what does a utility function reflect?

• Answer: a utility function refers to a particular

individual and reflects the tastes of this
individual. Different individuals usually have
different tastes and thus have different utility
functions also, when the tastes of an
individual change, the utility function also
change (shifts).
 Problem: why is water, which is essential to life, so
cheap while diamonds, which are not essential to life,
so expensive?
Answer: since water is essential to life, the TU
received from water exceeds the TU received
from diamonds. However, the price we are willing
to pay for each unit of commodity depends not
on the TU but on the MU. That is, since we
consume so much water, the MU of the last unit
of water consumed is very low. Therefore we are
willing to pay only a very low price for this last
unit of water consumed. Since all the units of
water consumed are identical, we pay the same
low price on all the other units of water
consumed. (continued)….
On the other hand, since we purchase so few
diamonds, the MU of the last diamond
purchased is very high. Therefore, we are
willing to pay a high price for this last diamond
and for all the other diamonds purchased.
Also, all diamonds are not identical. Each
piece of a diamond possesses its unique
characteristic and quality. That is why we pay
higher price for diamond and lower price for
water. This is called “water-diamond paradox”.
 We get total utility from
consumption, but the more
we consume of something the
smaller is the marginal utility
from it.
For water, the price is low,
total utility is large, and
marginal utility is small.

For diamonds, the price is high, total

utility is small, and marginal utility is
high.
But marginal utility per dollar is the
same for water and diamonds.
 Value and Consumer Surplus
The supply of water is
perfectly elastic, so the
quantity of water consumed is
large and the consumer
surplus from water is large.

In contrast, the supply of diamonds

in perfectly inelastic, so the price is
high and the consumer surplus from
diamonds is small.