Unit 5: Introduction to Consumer Choice
As you know, consumers are driven by their unique preferences when they seek to maximize their satisfaction (utility) while considering their limited budgets. Despite the subjectivity of preferences, choices are also influenced by income and prices. This Unit introduces the economic theories behind consumer decision-making. We build upon the budget constraint concept from Unit 1 and demonstrate how economic theory helps predict consumption responses to price and income changes.
Completing this unit should take you approximately 3 hours.
Upon successful completion of this unit, you will be able to:
- explain consumer preferences using concepts related to utility, including total utility and marginal utility;
- analyze a household’s budget line and describe how it changes when prices or incomes change;
- use indifference curves to explain the principle of diminishing marginal rate of substitution; and
- derive a demand curve from an indifference map by analyzing the quantity of the good consumed at different prices.
5.1: The Rational Consumer, Consumer Preferences, and Consumer Choice
Are consumers rational? How do economists explain and measure consumer preferences and choices?
In 1986, Adam Wagstaff argued that hospitals face the dilemma of not having enough resources to provide life-saving treatments to all patients. However, the technology was/is available to do so. Instead, society allocates resources to other priorities such as infrastructure, sports, education, and defense.
Wagstaff explained that while individuals may value their health, they do not prioritize it above all else, as evidenced by behaviors like overeating, smoking, and drinking alcohol. The allocation of resources to non-health-related areas indicates that health is not the overriding value for society. (Wagstaff A. The Demand For Health: Some New Empirical Evidence. Journal of Health Economics, 1986)
In this section, we explore the rationality of consumer choices by introducing the concepts of total and marginal utility and exploring consumer preferences. Terms like rationality, choices, and marginal utility may seem intimidating, but at the heart of it all, we are simply exploring the question: What do people desire in life?
Read this introductory text to understand how we organize the main concepts included in this unit.
Watch this video to explore the concepts of total utility and marginal utility. Make sure you understand that while total utility increases with consumption, marginal utility diminishes. The additional amount of happiness (marginal utility) consumers obtain from one more unit decreases with each additional unit.
Read this text on consumption choices. The budget line is built considering the constraint imposed by a limited budget and the utility and the marginal utility derived from the consumption of two goods. Remember, we introduced the concept and graph of the budget line in Unit 1.
Watch this video on equalizing marginal utility per dollar spent for two products to review the rule on maximizing utility. Remember, this method determines what products people prefer to spend their income on, given a budget.
Watch this video on depicting the budget line in a graph. Remember that the budget line for a consumer shows different combinations for purchasing two goods, given a fixed budget.
Read the first two sections of this text on how income, prices, and preferences influence consumer choices. Make sure you grasp that changes in product prices prompt consumers to adjust their consumption of related goods, not just the affected product.
We have analyzed how prices, budget constraints, and consumer preferences interact to shape household decisions.
Before we move on to the next section, try to solve the following to ensure you are prepared for the next section.
5.2: Indifference Curves
Suppose a consumer has a limited monthly budget and wants to maximize their satisfaction (utility) by deciding how much to spend on video games and streaming video subscriptions. Indifference curves can help illustrate their preferences and choices based on what you have already studied in section 5.1.
Watch this video on how to build and interpret indifference curves. Make sure you understand the math and microeconomics behind the slope of the indifference curve.
Now, we can apply the indifference curve analysis to the types of goods and services identified in Unit 2, such as complements, substitutes, normal, and inferior goods. Review the section on the slope of the indifference curve in the previous video to better grasp the various shapes of indifference curves presented here.
Watch this video to review indifference curves and obtain consumer equilibrium. This equilibrium shows the optimal consumer choice and is mathematically determined by the tangency condition between the budget line and the indifference curve.
5.3: Building the Demand Curve from an Indifference Curve Map
Consumer choice and equilibrium analysis may appear dense and abstract initially. You might wonder if such a framework is necessary for analyzing consumer choices. In reality, economists employ this framework to address various issues, including taxation on energy-dense foods, evaluating health-related quality of life, and assessing risk levels in financial decisions, among others.
When we introduced the law of demand and the demand curve in Unit 2, we did not delve into the full details. Now, you are prepared to understand that the demand curve can be derived by adjusting the prices of the products considered in the indifference curve-budget line framework presented in the preceding section.
Watch this video on how to draw the demand curve from working with the marginal utility per dollar.
If you are deeply involved in the analytical framework of consumer choice and do not mind mathematics and diagrams, it might be beneficial to watch this demonstration of the derivation of different demand curves from the consumer's equilibrium. While not required for this course, it may help you review the concepts and relationships introduced in this unit.
Unit 5 Assessment
- Receive a grade
Take this assessment to see how well you understood this unit.
- This assessment does not count towards your grade. It is just for practice!
- You will see the correct answers when you submit your answers. Use this to help you study for the final exam!
- You can take this assessment as many times as you want, whenever you want.