Consumer Choices

The purpose of the model of consumer behavior is to examine how preferences, income and the price of goods influence consumer choices. The assumed objective of the consumer is to maximize the utility level. Subject to the constraint that no more than the available income per period can be spent.

Max (X, Y) subject to Px X +Py Y= I

The market baskets that achieve this objective indicates the consumers most preferred weekly purchases of goods X and Y. Given the income and the prices of X and Y.

 

By moving along the budget line from B₅ to the B₃ and thus moving to a higher indifference curve U2 > U1 consumer can increase utility. Also consumer increases utility from moving from B₂ to B₃.

Market basket corresponding to the point inside the space below the budget line such as B₇ provides the consumer with lower levels of utility.

On the other hand Market basket corresponding to the point above the budget line such as B₈, provide more utility than B3 but are unaffordable.

In general the consumer is in the equilibrium when the highest possible level of utility has been obtained given the available income and the prices of goods X and Y.

This occurs when the indifference curve is just tangent to the budget line. Market basket B₃ Þ combination of X and Y that the consumer chooses where Qx* = 3 cassettes per week & Qy* = 4.

Thus the consumer equilibrium is a condition achieved when the consumer purchases the market basket which maximize utility subject to the budget constraint and it is achieved when consumption is adjusted such as MRS_xy = Px / Py for any two goods.

MRS - gives the maximum amount of Y the consumer is willing to forgo (give up) for an additional unit of X.

The ratio of prices Px / Py gives the amount of Y the consumer must forgo when an additional unit of X is purchased at current prices for this goods.

The equilibrium condition therefore implies that the consumer purchases X up to the point at which the maximum of Y s/he willing to give up for an additional unit of X equals the amount that must be given up for that last unit of X at current prices.
 

Income consumption curve.

Curve for a normal good.

Normal goods: are those whose consumption increases with income. The income consumption curve for such goods is positively sloped.

Income consumption curve is one that connects all of the equilibrium points on a consumer indifference map as income changes. Initially the consumer is in the equilibrium at the market basket corresponding to point E1 at which Qx units of good X are consumed per year. As an income increases the consumption of X per year increases shown by Q_x1=3 Q_x2=5 Q_x3=7 Q_x4=9

An increase in income from I₁ to I₂ shifts the budget line out parallel to itself. That results in a new equilibrium at E₂.

Inferior goods - are those whose consumption decreases with increase in income (e.g. Bus travel) The income consumption curve for inferior goods turn backward and become negatively sloped.

Income consumption curve for inferior goods

Increases in income result in decreased consumption of X when income is greater than I₂. That means that after a certain level has been reached further increase in income result in less rather than more consumption of the good.

Finally some goods are neither inferior nor normal for the consumer - Examples are salt toilet paper and toothpaste.

The income consumption curve for goods of that kind is vertical curve.
 

The consumption of a good is independent from income the consumer continues to consume Qx* units as income increases above its initial level I₁

Price consumption curves and the derivation of Individual Consumer demand curves.

Indifference curve analysis can be used to illustrate how the law of demand is consistent with the model behavior.

Price consumption curve - is a graph that connects points of consumer equilibrium as price changes. It shows the consumption of good changes in response to price change.

A demand curve can be derived from a price consumption curve by allowing price of good vary while income prices of other goods and preferences are held constant.

• The consumer income is fixed at I as indicated by the intercept of the various budget lines. As the price of X falls the consumer moves to a new equilibrium points.
   

• On the graph the consumer is initially in equilibrium at point E₁ A reduction in the price if X moves the consumer to a new equilibrium points as shown by E₂, E₃ and E₄.

The points on the X-axis shows the amount of X the consumer could buy if s/he would spend all of his/her income on that good (food) and these are indicated by F₁, F₂, F₃ and F₄. These points can be used to calculate the price of X at any point. May be calculated as I/F, where F is the amount of X that could be bought if the consumer spent all of his /her income on it. It follows from the budget constraint: Px X +Py Y= I
If consumer spent all income on good 1 =>  I = P₁F₁ +P₂* 0 =>  P₁ = I / F₁

At this price the consumer is in equilibrium at point E1.

P₁ corresponds to E₁ at which s/he consumes Q₁ units of good X

As a price of X falls, the budget line shifts outwards along the X -axis. When the intercept of x -axis is F₂ the price of X is equal to P₂ = I / F₂

P₂ is less than P₁ because F₂ greater than F₁ the new consumer equilibrium will be at point E₂ and the amount of X consumed increases to Q₂.

Thus the demand curve and the consumption curve are two different ways of showing how (other things being constant, ceterus paribus) The quantity of good demanded varies inversely with the price.