The Theory of Consumer Choice
This handout is designed to examine some of the factors that economics uses to understand the choices
made by individuals in allocating their resources (in particular, their incomes and their time) to particular
goods, services or activities. It is an opportunity to look beyond the ideas conveyed in the demand and
supply model, to look at the factors that lie behind the consumer’s demand for a commodity. We have here
a familiar starting point: the condition of scarcity. Individuals are presumed to make their choices to
make themselves as well off as possible in the face of the ever-present scarcity. Economics sees this as
individuals solving a constrained maximization problem.
In considering these concepts, we will develop a number of new ideas that will provide help in
understanding consumer behavior. In particular, we will learn about the economist’s conception of the idea
“Utility” and how this utility is a guiding factor in making the choices involved in everyday life. We will
also bring in, and make extensive use, of the concept of the Margin.
What Factors govern Consumer Choices?
In terms of the ideas we are examining, there are two simple factors. The first is the set of preferences or
tastes that the individual possesses. These, we presume, are unique to the individual and are internally
determined. The second factor is imposed on us by the outside world and it is the conditions of scarcity as
we experience them: these are the constraints. We will first examine the constraints we face and then will
consider the expression of preferences.
1. Constraints
What determines what a person can purchase and consume? There are two elements here: how much they
have—income—and how much they have to give up to obtain what they buy—prices. When we combine
these two, it forms what we call the Budget Constraint.
A budget constraint determines exactly how much a consumer can purchase of the available goods, and
displays the possible combinations of goods that the person is able to purchase. [You should note that this
is very similar to a Production Possibilities Frontier.] In other words, for a given set of prices how far does
your income go? To examine this, let us consider an example of an individual who has a decision to make
as to how to spend his income.
Our example focuses on Max, who has $150 to spend on entertainment each month. What should he spend
it on? We will consider only two alternatives (this is done to simplify our example and also make it
conducive to examination through a graphic approach). The two choices are: Concerts or Movies. Now,
we know that Concerts cost $30 each and movies are $10 each. Max’s choice, then it to determine which
combination of concerts and movies works best for him; in other words, which choice of concerts and
movies make him as well off as possible but are still within his budget.
We first begin by determining what combinations of concerts and movies are available or feasible to Max.
CONCERTS MOVIES
QUANTITY SPENT ON QUANTITY SPENT ON MOVIES
CONCERTS
A 0 0 15 150
B 1 30 12 120
C 2 60 9 90
D 3 90 6 60
E 4 120 3 30
F 5 150 0 0
We can also show this information in a diagram. This diagram shows the Budget Line facing Max. A
budget line depicts a number of things. It shows what Max can consume—in particular, it shows the
maximum amount of each good that he can choose and it also shows combinations that he cannot obtain,
because his income does not allow it. In addition, it shows the opportunity cost of choosing one good
relative to the other (how much of one good do you get when you give up a unit of the other—does this
sound familiar?) As we will see, this information is provided in terms of the relationship between the
prices. Below is the graphic representation of the budget line.
C o m b in a tio n s o f C o n c e r t a n d M o v ie s
Movies
20
15 A
B H
10
G C D
5
E F
0
0 2 4 6
Concerts
Note that points A-F are points on the budget line, which means that Max is spending all of the allotted
amount ($150) on entertainment. In contrast, point G is an interior point, meaning that he can still spend
more on either movies, on concerts or both. Point H is beyond his income, and is not feasible given his
current situation.
The slope of the budget line provides information about the trade off required by the market to get more of
one good—you give up (the ability to obtain) a certain amount of the other good. If Max gives up 15
movies, he can attend 5 concerts. In other words, there is a 3 to 1 trade off: for each concert he attends
Max has to forego going to 3 movies; alternatively, for each movie he sees, he gives up 1/3 of a concert.
This can also be easily seen by comparing the prices for the two goods: each movie costs $10 and each
concert $30. So the slope of the budget line is determined by the ratio of the two prices ($30/$10 or since it
implies a trade off -3); we call this the relative price ratio. You should note that this tradeoff is independent
of how much income the consumer (Max) has. (Again this is comparable to the production possibilities
frontier.)
Changes: You should expect that we would want to understand what happens, that is, how Max’s behavior
might change if the conditions that he faces changes. In the situation we examine, only two aspects can be
thought to change—either his income or the price of a good (concerts or movies). Let us consider income
first.
An income change is quite straightforward. If Max’s income rises, then his budget space (as shown by the
budget line) expands. Examine the figure below to see the alteration of the budget line when Max’s income
goes up by $60. We can also use this to see what types of goods we have. With respect to income, you
know that we can have either normal or inferior good. Note too, that it is only with respect to income that
we make this classification. Any other change, like that of a price, will not allow us to draw inferences
about the type of good we are considering.
If Max’s consumption starts at point A at the old income level ($150), and rises to the new level of $210
resulting in Max consuming at point B, then we can conclude that concerts are a normal good, while
Combinations of Concert and Movies
Movies
24
21
18
15
12
9 B
6 A
3
0
0 1 2 3 4 5 6 7 8
Concerts
movies would be an inferior good. While this comparison points out the two possible cases, it is not too
likely that movies would actually be an inferior good. It is more likely that both of the goods would be
normal, so that the consumption of both goods would rise with income.
We now can examine a price change. In the figure shown below, the price of movies is shown to have
fallen (from $10 to $5 each), and ceteris paribus (no other price or income changes). We can presume that,
by the law of demand, movie consumption would rise, but we have little more to say (at this point) about
the impact of such a change in price. This change has altered the relative price ratio, implying that movies
(in both absolute and relative terms) are now cheaper, while concerts are more expensive—in relative terms
(note: the price of concerts has not gone up but since more movies have to be foregone to go to a concert,
the relative price—its opportunity cost—has in fact gone up).
This effectively completes our discussion of the constraint side: the budget line that conveys information
about incomes and prices: it determines what can and cannot be purchased. Another way of expressing
this is that it conveys what the market determines that we have to do to consume a good. We now turn to
preferences, which provides information about what we desire to consume.
Combinations of Concert and Movies
30
25
20
15
10
5
0
0 1 2 3 4 5 6 7 8 9 10
Preferences
Our discussion of tastes and preferences begins by noting that all that we are attempting to do is to put
some structure on how we think about what determines what consumers choose to purchase—which is just
the set of factors that determine what they like and dislike, and the relationship between these likes.
Economists express this in terms of the concept of utility. In this context, utility is just the level of pleasure
or satisfaction that a consumer receives from the consumption of a good or service (or participating in some
activity). To this we add the concept of the margin, which allows us to talk about comparisons between
the consumption of different goods, in order to better understand the factors that affect the choices of which
and how much of a good a consumer chooses.
Taken together, we obtain the marginal utility. This is the change or increment in total utility an
individual obtains from consuming an additional unit of a good or service. Using our example, we would
be interested in understanding the marginal utility that Max receives from consuming an additional concert.
Sometimes when these ideas are discussed, examples provide a measure of utility in terms of actual
numbers. These examples usual count this using units generally called “utils.” We will make limited use
of these units, because we cannot really measure this in numerical units.
One concept that we will employ is called the (law of) diminishing marginal utility. This is an intuitive
concept, which implies that your utility derived from consuming additional units of a good declines as you
increase the quantity of the good. In other words, as the consumption of a good or service increases, the
marginal utility decreases. We can express this in symbols perhaps even more effectively. If we define
marginal utility as
MU U Q
Where U is Utility and Q is the quantity of the good. Diminishing marginal utility implies that MU
declines as Q increases. Note that MU goes down but is not negative.
Before proceeding, it is useful to note some the characteristics that we presume to be present in the
preferences of individual consumers. The central idea is that individuals display rationality. In this
context, we simply mean that the consumer behaves in a consistent manner. The person makes decisions in
pursuit of a goal—that is, to make themselves as well off as possible—and acts to achieve this goal. The
properties of this behavior are (1) that more is preferred to less; (2) that we have a specific form of
consistency in preferences called transitivity (i.e., that if A is preferred to B and B is preferred to C, the A
must be preferred to C); (3) comparability, which means that the individual can judge and choose between
different combinations of goods and services.
Given this rationality, an individual’s preferences are such that the consumer chooses the combination of
goods that make him or her as well off as possible (given the constraints that they face). In other words, the
person maximizes utility subject to their budget constraint. In particular, what this means is that the
individual wants to spend their budget in the most effective manner possible. The way that this is done is
to consider the increment to satisfaction as the amount of the good that is consumed changes, and to
compare that to other allocations of their budget. This is just comparing the marginal utility (MU)
associated with increases in one good, while reducing the consumption of some other good. To incorporate
the constraint directly into this implies that you consider the MU in terms of the dollars spent on each good.
Preferences and Constraints Together: Consumer Equilibrium
A consumer will have maximized his or her satisfaction—maximized utility—when the last dollar he or she
spends on one good gives that person the same additional satisfaction—MU—as the last dollar spent on the
other good. A simple way to express this is to look at the ratio
MU a Pa MU b Pb
To consider this, let us go back to the example with Max and look at his utility from the consumption of
concerts and movies. Consider the table below, which adds the marginal utility associated with changes in
the consumption of various quantities of the two goods.
Concerts Movies
QUANTITY MU MU/P QUANTITY MU MU/P
A 0 ---- ---- 15 50 5
B 1 1500 50 12 100 10
C 2 1200 40 9 150 15
D 3 600 20 6 200 20
E 4 390 13 3 350 35
F 5 300 10 0 ---- ----
The basic principle is that you choose to consume one good over the other—for the same expenditure—
whenever the marginal utility that you get from the first good is higher than the marginal utility for the
second. Max must choose between concerts and movies in such a way as to maximize his total utility. He
will do this when the ratio of the marginal utility to price ratios for each good are the same. In the table
above that will be when he consumes 3 concerts and 6 movies. No other combination of the two goods
gives him more total satisfaction than this bundle of the two goods. When Max (or anyone) reaches this
point, we say that it is a Consumer Equilibrium. We can also see why a person will (have to) respond if
something, like the price of one of the goods, or his or her income, changes. It throws the equilibrium out
of balance in some way. Preferences could also change, but it is nearly impossible to predict when or how
this may happen, so we assume that they do not change.
How do people respond to income changes (which would shift the budget line out for an increase or in for a
decrease)? We already know the answer to this—it depends upon the type of good that we have. Normal
goods will have a direct relationship to income; inferior goods will have an inverse relationship with
income.
What about price changes? We also know the answer to this from the Law of Demand. But exactly why
do people respond as they do? The response is actually a combination response, to the two components of
the price change. When prices change, two separate events occur. The first is that the ratio of prices has
been altered. For instance, suppose that the price of concerts falls. Now, in absolute terms, concerts are
cheaper. But they are also cheaper in relative terms, since the price of movies remains unchanged. By the
same token, since movie prices are still the same, movies are relatively more expensive (as measured in
terms of how many concerts are given up to go to a movie). We call this the Substitution Effect: people
substitute cheaper goods (concerts) for goods that are more expensive (movies)—noting that all of this is
due to the change in the price of concerts. This is consistent with the Law of Demand. [In a diagram this
would be the change in the slope of the budget line.]
There is a second effect: Since the price of concerts is lower, Max’s income goes further than it did before.
Note that his income is unchanged, only what he can buy with this income. We call this increase (or in
some cases, decrease) in purchasing power the Income Effect. The response follows from the type of good
that we have. For normal goods, this increase in purchasing power results in an increased demand for the
good; for inferior goods, the outcome is that the higher purchasing power leads to a reduction in the
demand for that good. [In a diagram, this would be the increase in available goods from the price change.]
The overall impact of a price change is the combination of the Substitution and Income Effects. For normal
goods, both work in the same direction. For inferior goods, the two effects work in opposite directions, but
we presume (and all the evidence implies that this is true) that the Substitution Effect is bigger than the
Income Effect for inferior goods. Therefore, the Law of Demand holds.
This allows us to consider what happens when the price of a good changes; for an individual the Law of
Demand works. We can then move to add up these effects for all individuals. So we can consider drawing
individual demand curves for individuals, and then add these together to get market demand curves.