Theory of Consumer

1. Utility (Total Utility and Marginal

Utility
2. Derivation of Indifference curves –
the 3D Utility Diagram
3. Indifference curves and Budget
line – the Consumer Equilibrium
4. Applications
Cases

2
 Cases
Ride 10 get one free「搭十送一」車票集

3
 Health Care Voucher

Consumption
voucher scheme

4
 1. Utility
The objective of learning Consumer Theory
• In the previous weeks, you have learnt how to use demand
and supply to explain changes in the market (Qualitative
analysis). And you have also learnt how to use elasticity of
demand and supply to conduct quantitative analysis.
• In this week, we are going to have a deeper look at demand.
We are going to learn how people make choice given their
tastes, income and the prices of goods and services available
to them.
 1. Utility
• Utility is the enjoyment or satisfaction people
receive from consuming goods and services.
• The utility function of one good (X) can be
shown as:
U = f(X)

*Utility is a difficult concept to measure, because there is no way of knowing exactly

how much enjoyment a consumer receives from consuming a product. And it is not
possible to compare utility across consumers. However, to make the model of
consumer behavior become easier, let’s assume that utility is something directly
measurable. Later, when we learn indifference curve, you will find that we can
ignore this assumption.
 Total Utility
• Total Utility shows the relationship between
utility and the amount of X consumed. By the
assumption that more is better than less, total
utility is increasing.
U=f(X)
However, as you can see the
sloping is decreasing, total utility is
increasing at a decreasing rate.
Why?

X
 Marginal Utility
• MU shows how total utility change as X increases
by a very small amount. Or, MU is the slope of TU
curve.
MU = dU/dX
dU/dX
Law of diminishing
marginal utility states that
when a consumer keeps
increasing the
consumption of a certain
good or service, the
marginal utility receives
from one more unit of
consumption diminishes.
X
Total Utility and Marginal Utility
U=f(X)

dU/dX X

X
Exercise

The supply of wheat decreases, so that the quantity of wheat

consumed decreases. Thus
A) both the marginal utility and the total utility from wheat
increase.
B) the marginal utility from wheat increases and the total
utility decreases.
C) the marginal utility from wheat decreases and the total
utility increases.
D) both the marginal utility and the total utility from wheat
decrease.
2. Derivation of Indifference curves
– the 3D Utility Diagram
• If we consider two goods, the utility function
is changed into:
U = f(X,Y)
• We can derive total utility function of X and Y
from U = f(X,Y). However, when we derive the
total utility function of X, we must hold the
quantity of Y consumed fixed, vice versa.
 Total Utility for Two Goods

Ux Y=2 Uy X=2
Y=1
X=1
Y=0
X=0

X Y
 Total Utility of X given Y
U = f(X,Y)
Ux when Y = 3
Ux when Y = 2

Ux when Y = 1

Ux when Y = 0

Y X

3
2
1
0
 Total Utility of Y given X
U = f(X,Y)

Uy when X = 3

Uy when X = 2

Uy when X = 1

Uy when X = 0

Y X

3
2
1
0
 3D Utility Hill
U = f(X,Y)

Y X

3
2
1
0
 Derivation of IC curves
IC = Any combination of
U = f(X,Y) X and Y will give the
same level of utility

Y X
3
3
2
2
1 1
0
 3. Indifference curves and Budget
line
Indifference Curve - A curve that Good Y
defines the combinations of 2 or
III.
more goods that give a consumer
the same level of satisfaction. II.
I.
Slope of IC curve - Marginal Rate
of Substitution
The rate at which a consumer is
willing to substitute one good for
another and maintain the same
satisfaction level.
Good X
 Properties of IC
1. Completeness
2. More is Better
3. Diminishing Marginal Rate of Substitution
4. Transitivity

19
 1. Complete Preferences
• Completeness Property
Good Y
– Consumer is capable of
expressing preferences (or III.
indifference) between all
II.
possible bundles. (“I don’t
know” is NOT an option!) I.
– If the only bundles available to A B
a consumer are A, B, and C,
then the consumer
– is indifferent between C
A and C
– will prefer B to A.
– will prefer B to C.
Good X
 2. More Is Better!
• More Is Better Property
– Bundles that have at least
as much of every good and Good Y
more of some good are
preferred to other bundles. III.

– Bundle B is preferred to II.

A since B contains at I.
least as much of good Y A B
and strictly more of 100

good X.
– Bundle B is also
C
33.33

preferred to C since B
contains at least as 1 3
Good X
much of good X and
strictly more of good Y.
 3. Diminishing MRS
• Marginal Rate of Substitution Good Y
– The amount of good Y the
consumer is willing to give up to III.
maintain the same satisfaction
level decreases as more of good X II.
is acquired. I.
• To go from consumption bundle A to A
B the consumer must give up 50 units 100
of Y to get one additional unit of X.
• To go from consumption bundle B to B
C the consumer must give up 16.67 50
C
units of Y to get one additional unit 33.33 D
of X. 25
• To go from consumption bundle C to
D the consumer must give up only
8.33 units of Y to get one additional 1 2 3 4 Good X
unit of X.
 Explanation for Diminishing MRS
• Mathematic proof: MRS = MUX/MUY
U = f(X, Y)
• dU = MUXdX + MUYdY
• Set dU = 0 (X and Y change but utility remains
constant, so dU=0),
-MUXdX = MUYdY
-MUX/MUY = dY/dX
 4. Consistent Bundle Orderings
• Transitivity Property Good Y
– For the three bundles A, B, and C, III.
the transitivity property implies
that if C  B and B  A, then C  II.
A. I.
– Transitive preferences along with 100 A
the more-is-better property imply C
75
that B
50
• indifference curves will not
intersect.
• the consumer will not get
caught in a perpetual cycle of
indecision. 1 5 7
Good X
 Impossible indifference curves
Noodles Noodles
Crossing Upward
sloping

Pizza Pizza
What’s wrong with the above indifference curves?

25
1. Joe prefers a three pack of soda to a six-pack. What properties
does this preference violate?
a. Completeness
b. Transitivity
c. More is better
d. Diminishing MRS
2. A situation where a consumer says he does not know his
preference ordering for bundles X and Y would violate the
property of:
a. More is be better
b. Completeness
c. Substitutability
d. Complementarity
3. The marginal rate of substitution (MRS) determines the rate
at which a consumer is willing to substitute between two
goods in order to achieve
a. A higher level of satisfaction
b. A lower level of satisfaction
c. The same level of satisfaction
d. None of the statements associated with this question are
correct
4. In the above figure, which curve is an indifference curve for
someone who views frozen pizzas and milk as perfect
complement?
A) Indifference curve F
B) Indifference curve G
C) Indifference curve H
D) Indifference curve I
5. A convex indifference curve diagram has movies on the
vertical axis and sodas on the horizontal. As the consumption of
sodas increases and movies decreases (moving southeast along
an indifference curve) the marginal rate of substitution of sodas
A) rises.
B) falls.
C) does not change.
D) probably changes, but more information is needed to
determine if it rises or falls.
 The Budget Constraint
• Budget Line
– The bundles of goods that exhaust a Y
consumer income.
• PxX + PyY = M. Budget Line
Y = M/PY – (PX/PY)X
• Market Rate of Substitution M/PY

– The slope of the budget line

• -Px / Py
• Relative Price of good X
• The amount of good Y the
consumer needs to pay for 1 M/PX
X
unit of X in the market.
 Changes in the Budget Line
Y
M1/PY
• Changes in Income
– Increases lead to a parallel,
M0/PY
outward shift in the budget
line (M1 > M0).
– Decreases lead to a parallel, M2/PY
downward shift (M2 < M0).
• Changes in Price X
– A decreases in the price of Y
M2/PX M0/PX M1/PX

good X rotates the budget New Budget Line for

line counter-clockwise (PX0 > M0/PY a price decrease.
PX1).
– An increases rotates the
budget line clockwise (not
shown).

M0/PX0 M0/PX1
X
1. Suppose a consumer with an income of $100 who is faced with PX = 1 and PY =
1/2. What is the market rate of substitution between good X (horizontal axis) and
good Y (vertical axis)?
a. -0.50
b. -1.0
c. -2.0
d. -4.0
2. The difference between a price decrease and an increase in income is that
a. A price decrease does not affect the consumption of other goods while an
increase in income does
b. An increase in income does not affect the slope of the budget line while a
decrease in price does change the slope
c. A price decrease decreases real income while an increase in income increases
real income
d. A price decrease leaves real income unchanged while an increase in income
increases real income
3. What is the maximum amount of good Y that can be purchased if X and Y are the
only two goods available for purchase and PX = $5, PY = $10, X = 20, and M = 500?
a. 40
b. 25
c. 50
d. 75
 Consumer Equilibrium
• The equilibrium
consumption bundle Y Consumer
is the affordable Equilibrium
bundle that yields the M/PY

highest level of
satisfaction.
• Consumer equilibrium
occurs at a point where III.

MRS = PX / PY. II.

I.

M/PX
X
 Income Changes and Consumer
Equilibrium
• Normal Goods
– Good X is a normal good if an increase
(decrease) in income leads to an increase
(decrease) in its consumption.
• Inferior Goods
– Good X is an inferior good if an increase
(decrease) in income leads to a decrease
(increase) in its consumption.

33
 Normal Goods
Y
An increase in
income increases
the consumption of M1/Y

normal goods.
(M0 < M1).

B
Y1
M0/Y
II
A
Y0
I
X0 M0/X X1 M1/X X
0

34
 Inferior Goods
Y
An increase in
income decreases
the consumption of M1/Y

Inferior goods (X). B

(M0 < M1). II

M0/Y

A
Y0
I
X0 M0/X M1/X X
0

35
 Price Changes
Potato chip
(Y)

M/PY1

B
Y2

Y1 A II

I
0 X1 M/PX1 X2 M/PX2
Beer (X)

36
 Market Demand Curve
Y

• An individual’s
demand curve is
derived from each II

new equilibrium point I

found on the $ X0 X1 X

indifference curve as
the price of good X is P0
varied. P1 D

X0 X1 X
 Exercise

Mitchell's money income is $150, the price of X is $2, and the price
of Y is $2. Given these prices and income, Mitchell buys 50 units of
X and 25 units of Y. Call this combination of X and Y bundle J. At
bundle J Mitchell's MRS is 2. Given these prices and income, what
is Mitchell's equilibrium consumption of X?
A) X < 50
B) X = 50
C) X > 50
D) None of the statements associated with this question are
correct

38
 4. Applications
• Free photocopying quote
• Buy one get one free
• Cash Coupon (Voucher) or Cash?
• Ride 10 get 1 free
1. Free photocopying quote

M1/PY

0 M1/PX X

40
 2. Buy one get one free

M1/PY

0 M1/PX X

41
3. Cash coupon (voucher) or Cash
Y

M1/PY

0 M1/PX X

42
 Real Life Application
• MTR, in 2011, launched a ``Ride $100 Get 1 Free'' promotion in
which passengers got one free ride for spending at least HK$100
within a week. Passengers have complained of restrictions on the
concessions.
Question 1:
• Use budget line and indifference curve analysis, illustrate the effect
of promotion scheme from MTR on the long-distance passengers
and short distance passengers. Which type of passengers will
favour the scheme? Please use separate diagrams to illustrate short
distance and long-distance passenger’s choice.
• For simplicity, assume that the weekly expenditure (income) on
MTR transportation is $100 for both types of passengers and the
fare for short distance is $5 (one way) and for long distance is $10
(one way). Passengers will only use MTR to commute to work from
Monday to Friday.
• Based on Question 1,

• In 2012, MTR launched Ride 10 get one free scheme. Will your
answer in Question 1 change? Please use budget line and
indifference curve analysis to illustrate.