Unit 4: The Consumer
In this unit we focus on the individual consumer and the characteristics that compel them (to choose) to spend income on goods and services. The consumer experiences utility – a measure of satisfaction – with every purchase they make, and economists measure this utility to determine a consumer's optimal rate of consumption. The theory of demand is derived from the theory of consumer behavior presented in this unit. We can explain an individual's demand function by two approaches that help illustrate personal preferences: utility analysis and indifference analysis. We explore these concepts more fully in this unit.
Completing this unit should take you approximately 12 hours.
Upon successful completion of this unit, you will be able to:
- identify and describe the basic tenets of consumer theory through two alternate approaches: the utility analysis and the indifference analysis; and
- correlate the derivation of the theory of demand to the theory of consumer behavior.
4.1: The Rational Consumer
Read Chapter 6 for information on consumer choice, including utility, consumer equilibrium, consumer equilibrium demand, consumer surplus, budget constraint, and consumer equilibrium and indifference curves.
Read the Chapter 7 Introduction and Sections 7.1 and 7.2. Attempt the "Try It" problems at the end of each section. Take a moment to read through the stated learning outcomes for this chapter of the text, which you can find at the beginning of each section. These outcomes should be your goals as you read through the chapter.
This is an optional lecture and not a requirement of the course. If you would like to, listen to this guest lecture in which the speaker talks about her ground-breaking research on how people make choices and explains attitudes towards their decisions.
Watch this video about marginal utility.
Watch this video about the budget line.
Watch this video about deriving the demand curve from tweaking marginal utility per dollar.
To use this simulation, you must download and install the Mathematica Viewer. Although this software is free, it is a sizable download. This activity is therefore optional.
This simulation presents an excellent illustration of how indifference curves and budget lines interact to produce optimal consumption (highest combined utility) of goods, given a set budget.
Our first task is to avoid letting the title of the simulation and the mathematical expressions fluster us! Once you have downloaded the software to your desktop, open the simulation and read the instructions.
A Lagrangian is an optimal point. Consumer optimization is all about finding the optimal point on the highest indifference curve (the red curve convex to the origin). An indifference curve shows different quantities of much of each of two goods (X1 and X2) a person can consume and end up with equivalent utility. You will work with an example of a college student who is trying to optimize his utility derived from eating pizza and drinking beer in the following quiz.
A vital constraint to consider in optimizing utility is budget. The slope of the budget line is controlled by the relative prices of both products. In the simulation, change the sliders that control the relative price of each good (X1 and X2) and note how the budget line changes. The cheaper either product is the more of that product can be bought, but that does not necessarily mean utility will respond proportionately. The income slider moves the budget line inward or outward; with more income we can buy proportionately more of both products. Notice how the budget line changes shape or moves up or down different indifference curves are tangent to the budget line. The indifference curve doesn't move, but we rather encounter different curves to which the budget line becomes tangent.
The "preference strength" for X1determines the shape of the indifference curve and consequently where it becomes tangent to the budget line. Experiment with varying preferences and recall that preference is another way of stating tastes. As preferences change, higher or lower indifferences curves intersect the budget line.
Start your exploration by setting all sliders to the middle of their respective bars. Then, try the following:
- Examine the consequence of an overall price decline in both products. (Hint: Move both X sliders in turn, then at the same time.)
- Examine the consequences of an overall price increase in both products in turn and at the same time.
- Reset to the midpoints and explore income increases and decreases. How do these compare with price increases?
- Reset to the midpoints and explore how changing preferences affect quantities purchased.
- How could you represent luxuries and necessities with this demonstration?
Record your observations in your notes and consider sharing your conclusions on the discussion forum.
Take this quiz to check your understanding of total utility, marginal utility, and how consumers maximize behavior by getting the maximum utility per dollar.
- 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.
4.2: Consumer Preferences and Consumer Choice
Read this section to learn about indifference analysis. Attempt the "Try It" problems at the end of the section before checking your answers.
Watch this lecture for an explanation of consumer theory, and especially mathematical representations of consumer preferences.
Watch these two lectures for an explanation of labor analysis.
Watch this video about equalizing marginal utility per dollar spent.
Watch this video about the types of indifference curves.
Watch this video about first degree price discrimination.
To use this simulation, you must download and install the Mathematica Viewer. Although this software is free, it is a sizable download. This activity is therefore optional.
It is difficult to map indifference curves because preferences can change from moment to moment, but budget lines are real and tangible. This simulation shows how price changes and income changes affect a budget line. Of course, we are often making purchasing decisions based on more than two goods at a time, but modelling simpler considerations is the first step to modelling more complex decisions.
Once you have downloaded the software to your desktop, open the simulation and click the "reset parameters" box. The two goods in this model are labeled A and B. At the initial settings, the person to whom this budget line belongs can purchase a maximum of four units of good B at $6 per unit. Alternately, the this person could chose to buy only good A., purchasing 6 units at a price of $4 each. Notice that, in either case the total is $24; $24 is the budget this person has to spend on goods A and B. All points on the red line is a possible combination of goods with the $24 budget. For example, purchasing 2 units of good B at $6 each and 3 units of good A at $4 each fits within the budget.
Explore the simulation. Move the income slider to, say, $36. The dotted line that appears is the new budget line. Notice how this new budget line is parallel to the previous budget line at the lower income. Does that make sense? It ought to! The slope of the budget line is determined by the respective prices of goods A and B, not income!
Next, reset the parameters and examine what happens when goods A and B are different prices. Raise and lower both prices separately.
Now, lower both prices. Change the price of good A to $2.66 and the price of good B to $4. Doesn't the dotted line look like the previous budget line you had for $36? Why might this be? In effect, with general deflation we experience a general wage increase, as we will be able to buy more for the same total price. Yes, the lowering of prices is conceptually equivalent to an increase in income.
Try the opposite last. Reset the values, lower the budget line, and find a level of price for each good such that the budget line approximates the previous one. Take a few more moments to experiment with this simulation.
Watch this video about the optimal point on a budget line. The optimal consumer choice in the indifference curve analysis is determined by the tangency condition between the marginal rate of transformation (MRT) and the marginal rate of substitution (MRS).
Read this section about price elasticity.
Unit 4 Review
You may go through these lecture notes if you wish to review topics covered in this unit in a more mathematical way.
Unit 4 Assessment
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.