Applied Microeconomics
Chapter 3. The consumer
Marcelo Moreno
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Batchelor’s Degree in Tourism
King Juan Carlos University (Vicálvaro)
3.1. Demand and utility theory
Definition
The demand and utility theory studies the way in which income will be
distributed by an individual who will act with economic rationality
among the different consumption possibilities available to him, that is,
assuming that he will seek to maximize his total utility.
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3.1. Demand and utility theory
In order to study consumer behavior, it is necessary to take into account
the two main characteristics related to the utility that the consumption of
a good reports to individuals, which are:
The total utility is a increasing function.
The marginal utility is a decreasing function.
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3.1. Demand and utility theory
The more we consume, the more ”pleasure” we experience; our welfare
increments. However, the ”pleasure” or utility that one additional unit of a
good provides is less and less.
Equimarginal principle
In order to maximize their utility and taking into account the price of
different goods, consumers will act in accordance with the equimarginal
principle.
MUA MUB MUn
= = ··· =
PA PB Pn
where A, B, · · · , n are goods or services and MUn is the marginal utility of
the n good or service.
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3.1. Demand and utility theory
The theory of consumer behavior begins with three basic assumptions
about people’s preferences:
1 Completeness. It is known if an individual prefers the good A over B
(A > B), B over A (B > A) or it is indifferent (A = B).
2 Transitivity. If an individual prefers A > B, and B > C , necessarily
A > C.
3 Insatiability. More is better than less, and the more the better
(except with bad things).
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3.1. Demand and utility theory
Indifference curve
An indifference curve is the set of all combinations of goods between
which the consumer is indifferent, since they provide the same level of
utility.
The consumer is indifferent to being
at point B, A or D.
The consumer is indifferent between
whatever points lie along the curve.
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3.1. Demand and utility theory
Marginal rate of substitution
(MRS)
Is the absolute value of the slope of
an indifference curve. It tells us the
amount of the good represented on
the Y axis that a consumer is willing
to give up to obtain an additional
unit of the good represented on the
X axis.
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3.1. Demand and utility theory
We could plot multiple indifference curves that describes a person’s
preferences, this is known as an indifference map:
The further from the origin the curve is, the more utility it provides.
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3.1. Demand and utility theory
The slope of indifference curves is negative, otherwise the insatiability
assumption is unfulfilled.
Indifference curves cannot intersect each other, otherwise the
transitivity assumption is unfulfilled.
In this case, A = D, B = A but
D < B (D ̸= B). Transitivity
assumption is not fulfilled
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3.1. Demand and utility theory
Sometimes some of the assumptions of individual preferences are not met:
Perfectly substitute goods (marginal rate of substitution is constant).
Perfect complementary goods (must be consumed together in fixed
proportions).
Totally indifferent goods.
The evil (brings dis-utility to the individual).
Satiable goods.
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3.1. Demand and utility theory
Perfectly substitute goods, e.g.: CocaCola (x) and Pepsi (y).
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3.1. Demand and utility theory
Perfectly complementary goods, e.g.: right foot shoe (x) and left foot shoe
(y).
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3.1. Demand and utility theory
Totally indifferent goods, e.g.: indifferent good, canceled concert tickets
(x); and normal good, money (y).
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3.1. Demand and utility theory
The evil, e.g.: the good, money (x); and the evil, punches in the face (y).
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3.1. Demand and utility theory
Satiable goods, e.g.: normal good, money (x); and satiable good, alcohol
(y).
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3.2. Budget constraint
Definition
The budget constraint shows all possible combinations of goods that
can be purchased by spending all disposable income.
If we call income I , Px the price of one of the goods represented on the
axes, and Py the price of the other, the budget constraint is expressed as:
I = Px · x + Py · y
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3.2. Budget constraint
Graphically, when the amount of
good x consumed is equal to zero
(x = 0), solving for the previous
equality we have y = I /Py , which is
the point of intersection with the
ordinate axis. If the quantity of good
y consumed is zero (y = 0), we have
that x = I /Px , which is the point of
intersection with the abscissa axis.
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3.2. Budget constraint
Because variations in the individual’s income level, the budget
restriction will shift; outwards if there are increases, inwards if they are
decreases.
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3.2. Budget constraint
However, if there are variations in prices, the point of intersection with
the axis on which the good whose price remains constant is represented
will not move, pivoting the budget constraint on it.
(example of an increase/decrease in the price of food)
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3.3. Consumer equilibrium
We jointly consider the tastes and preferences of the consumer
(expressed in the indifference curves) with their possibilities (manifested
by the budget constraint).
Since we assume that consumers are economically rational, they will seek
to maximize their utility (they will choose indifference curve furthest
from the origin), given their limitations, that is, without exceeding their
budget constraint.
This will be reached (general case) at the point where an indifference
curve is tangent -not intersecting- with the budget constraint.
In this point, the marginal rate of substitution: MRS = Px /Py
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3.3. Consumer equilibrium
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3.4. Demand curve
If we change the price of a good and
look at what happens to the
consumer’s equilibrium, we can
deduce a consumer demand function
for that good.
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3.4. Demand curve
In the same way that we have studied how the quantity demanded varies
when there are changes in the price of a good, we can do so in the face of
possible variations in income.
In this representation which is known as the Engel curve, we can
distinguish between:
Normal goods: when faced with an increase in income, the quantity
demanded of said good is greater.
Inferior goods: when faced with an increase in income, the quantity
demanded of said good is less.
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3.4. Demand curve
Examples of Engel curves:
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3.5. Income and substitution effect
When the price of a good changes, the consumer will decide to demand a
different quantity. Inside this change in the quantity demanded we could
distinguish between:
Substitution effect (SE): the change in quantity demanded
attributed to the relative price of substitute goods.
Income effect (IE): the change in quantity demanded attributed to
the income limitations.
The sum of the two effects is known as the total effect (TE).
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3.5. Income and substitution effect
The Hicks method to distinguish between substitution effect and income
effect:
Hicks method
To measure the substitution effect it considers that the consumer have the
same level of utility as before using a virtual budget constraint (that is
parallel to the end one). Income effect is deduced from:
TE = SE + IE → IE = TE − SE
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3.5. Income and substitution effect
Hicks method procedure:
1 Create a virtual budget constraint that has the same slope as the end
one, but is tangent to the initial indifference curve.
2 The difference between the two tangent points that are in the initial
indifference curve is the substitution effect (SE).
3 We can deduce that the income effect (IE) is the part of the total
effect (TE) that is not substitution effect (SE).
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3.5. Income and substitution effect
E.g.: Income and substitution effect when the price of the good x
decreases using Hicks (virtual budget constraint is the dashed line).
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References
Pyndick, R. S., & Rubinfeld, D. L. (2013). Chapter 3: Consumer
Behavior. Microeconomics (pp. 67-105), 8th ed., Pearson, Essex.
Pyndick, R. S., & Rubinfeld, D. L. (2013). Chapter 4: Individual and
Market Demand. Microeconomics (pp. 106-147), 8th ed., Pearson,
Essex.
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