4. CONSUMER THEORY
Consumer theory is the study of how people decide to spend their money based on
their individual preferences and budget constraints.
A branch of microeconomics, consumer theory shows how individuals make choices,
subject to how much income they have available to spend and the prices of goods
Building a better understanding of individuals’ tastes and incomes is important
because these factors impact the shape of the overall economy.
Consumer theory is not flawless, though, as it based on a number of assumptions
about human behavior.
6. Understanding Consumer Theory
Individuals have the freedom to choose between different
bundles of goods and services. Consumer theory seeks to
predict their purchasing patterns by making the following
three basic assumptions about human behavior
Utility maximization: Individuals are said to make calculated
decisions when shopping, purchasing products that bring
them the greatest benefit, otherwise known as maximum
utility in economic terms
Nonsatiation: People are seldom satisfied with one trip to
the shops and always want to consume more
Decreasing marginal utility: Consumers lose satisfaction in a
product the more they consume it.
7. INPUTS REQUIRED IN CONSUMER
Working through examples and/or cases, consumer
theory usually requires the following inputs :-
A full set of consumption options
How much utility a consumer derives from each bundle
in the set of options
A set of prices assigned to each bundle
Any initial bundle the consumer currently holds
8. Introducing the Budget Constraint : what
the consumer can afford
Budget constraints represent the plausible combinations of
products and services a buyer can purchase with the
available capital on hand.
The concept of budget constraints in the field of economics
revolves around the idea that a given consumer is limited in
consumption relative to the amount of capital they possess.
As a result, consumers analyze the optimal way in which to
leverage their purchasing power to maximize their utility
and minimize opportunity costs.
People consume less than they desire because their
spending is constrained , or limited by their income.
10. Consumer budget
Any point on the budget
constraint line Indicates the
consumer’s combination or
trade off between two goods.
If a consumer buys no pizza he
can afford 500 points of pepsi (
Point B) . If he buys no pepsi he
can afford 100 Pizzas. ( Point A).
11. Indifference Curves
Indifference curves underline the way in which a given
consumer interprets the value of each good relative to
one another, demonstrating how much of ‘good x is
equivalent in utility to a certain quantity of ‘good y (and
Any point along the indifference curve will represent
indifference to the consumer, or simply put equivalent
preference for one combination of goods or the other.
In the figure it is clear that the budget curve has been
included in conjunction with the indifference curves,
which allows insight as to the ideal actual quantity of
each good is optimal for this specific consumer.
14. Indifference curve has a negative slope:
An indifference curve slopes
downward from left to right, ie, it
has a negative slope. A negative
slope implies that the two goods
are substitutes for one another.
Therefore, if the quantity of one
commodity decreases, the quantity
of the other commodity must
increase if the consumer has to
stay at the same level of
In the above figure, when the consumer
moves from point A to B, the quantity of Y
decreases from Y1 to Y2. At the same time,
the quantity of X increases from X1 to X2
keeping the level of satisfaction the same.
The same thing happens as the consumer
moves from point B to C. But the decrease in
Y i.e. Y2Y3 is less than Y1Y2 and the increase
in X, ie. X2X3 is equal to X1X2.
15. Indifference Curve is Convex to the origin:
Indifference curves for normal goods are
convex to the origin. This implies that the two
goods are imperfect substitutes for one
another and the marginal rate of substitution
between the two goods decreases as a
consumer moves along an indifference curve.
Diminishing marginal rate of substitution
means that as the quantity of X is increased
by an equal amount then that of Y diminishes
by a smaller amount.
16. Indifference curves neither Intersect nor
become tangent to one another:
If two indifference curves
intersect or are tangent to
each other, it means that
an indifference curve
indicates two different
levels of satisfaction.
If two indifference curves
intersect, it violates
consistency or transitivity
17. Higher indifference curve represents a
higher level of satisfaction than the lower
A higher indifference curve
represents a higher level of
satisfaction than the lower one.
The reason is that an upper
indifference curve contains a larger
quantity of one or both goods than
the lower one.
18. Indifference curves are not necessarily
Another important property of the
indifference curve is that Indifference curves
are not necessarily parallel. Though
indifference curves are falling, negatively
sloped to the right, yet the rate of fall will not
be the same for all indifference curves.
In other words, the diminishing marginal rate
of substitution between the goods is not the
same in the case of all indifference
schedules. Therefore, it is not necessary to
be parallel between two indifference curves.
19. OPTIMIZATION: what the consumer
Consumer wants to get the combination of goods on the
Highest possible indifference Curve.
However, the consumer also end up on or below its budget
Combining the indifference Curve and budget constraints
determine the consumer’s optimal choices.
Consumer optimum occurs at the point where the highest
indifference Curve and the Budget Constraint are tangent.
The consumer chooses Consumption of the two goods So that
the marhinal rate of substitution equals the relative price.
21. How changes in income affects the
The income effect in microeconomics is the change in
demand for a good or service caused by a change in a
consumer’s purchasing power resulting from a change
in real income.
This change can be the result of a rise in wages etc., or
because existing income is freed up by a decrease or
increase in the price of a good that money is being
For normal economic goods, when real consumer
income rises, consumers will demand a greater
quantity of goods for purchase.
22. How change in price affects the Consumer
When the price of a good rises, households will typically demand less of
that good—but whether they will demand a much lower quantity or only
a slightly lower quantity will depend on personal preferences.
Also, a higher price for one good can lead to more or less demand of
the other good.
If the price is too high, the supply will be greater than demand, and
producers will be stuck with the excess.
Conversely, as the price of a good goes down, consumers demand more
of it and less supply enters the market.