ECON101 Study Guide

Unit 5: Introduction to Consumer Choice

5a. Explain consumer preferences using concepts related to utility, including total utility and marginal utility

What is marginal utility?
How do consumers choose between two goods?
Why is marginal utility diminishing?
What does the law of diminishing marginal utility indicate?

The theory of consumer choice seeks to understand how consumers allocate their limited income to maximize their utility. Consumers' choices are affected by preferences, budget restrictions, and the prices of goods and services. As individuals seek to maximize their utility, it is essential to remember that marginal utility (the benefit per unit of a good or service) diminishes while total utility increases with consumption.

To review, see:

5b. Analyze a household's budget line and describe how it changes when prices or incomes change

What is a consumer's budget line?
How does the budget line limit consumer choices?
How does a price change affect the budget line?
How does an income change affect the budget line?

We explored the concept of the budget line and the relevant diagram in Unit 1. Here, we review the budget line in the context of consumer choice theory and analyze the effect of price changes and income changes on the budget line.

Review this monthly budget line below for a consumer who buys pizzas and books. If books are $15 per unit and pizzas are $10 per unit, how much income does the consumer have? Recall that we assume the consumer maximizes their utility by spending their entire income (that is, without saving).

What would happen if the price of pizzas goes up? We can apply the Law of Demand from Unit 2. The decrease in the quantity demanded that results is represented by an inward rotation of the budget line. We can use the same process to analyze the impact of a change in income. What is the impact of an increase in income on the budget line?

To review, see:

5c. Use indifference curves to explain the principle of diminishing marginal rate of substitution

What is an indifference map and an indifference curve?
What is the marginal rate of substitution?
Why does the marginal rate of substitution decrease as we move downward in an indifference curve?
How is the optimal consumer choice obtained using an indifference map and the budget line?

Let's analyze the same consumer from the previous section who spent their entire budget on books and pizzas. We are familiar with their budget line, but we want to review the satisfaction they obtain from consuming a given combination of pizzas and books and the rate at which they are willing to exchange books for pizzas. This information is contained in the indifference map and in each indifference curve.

What has to happen for the consumer to be able to move from Indifference Curve 1 to Indifference Curve 2? Does the consumer prefer to consume five books and two pizzas or four books and four pizzas? Why is the marginal rate of substitution (MRS) – the rate that the consumer is willing to give up one good in exchange for an additional unit of another good while keeping their level of satisfaction or utility constant – diminishing?

Imagine you only have two books. Wouldn't you demand a larger number of pizzas to give up one book than if you had, let's say, ten books? This is what the MRS measures and why it decreases along a given indifference curve.

To find the optimal consumer choice, we look for the equilibrium between the highest possible indifference curve and the budget line. Make sure you spend some time reviewing why A is the optimal consumer choice and what it means. Due to the abstract nature of this section, make sure that you review all the resources thoroughly.

To review, see:

5d. Derive a demand curve from an indifference map by analyzing the quantity of the good consumed at different prices

What is a demand curve in the framework of optimal consumer choices?
How is the demand curve connected to the budget line and the indifference curves?
Why does a decrease in price result in an increase in the quantity demanded?

The demand curve, which we introduced in Unit 2 as a simple relationship between price and quantity, is formally derived from the optimal consumer choice (consumer equilibrium) you recently reviewed.

Consumer equilibrium displays the optimal combination of goods and services a consumer can afford to buy given their preferences (illustrated by indifference curves) in terms of the prices of goods and their income (illustrated by the budget line). In turn, the demand curve presents the connection between prices and the quantity demanded of goods and services. It is obvious, therefore, that there is a connection between consumer equilibrium and the demand curve.

To establish this link, we only need to change the price of the good measured on the x-axis within the consumer equilibrium framework. Changing the price rotates the budget line, leading to a new quantity demanded. This is precisely what the demand curve illustrates – it represents the connection between the market price and the quantity demanded of a good or service. In this sense, each consumer equilibrium point at different prices (tangency between an indifference curve and a budget line) is a point of the demand curve.

To review, see:

Unit 5 Vocabulary

Be sure you understand these terms as you study for the final exam. Try to think of the reason why each term is included.

budget line
demand curve
indifference curve
indifference map
marginal rate of substitution (MRS)
marginal utility
optimal consumer choice
theory of consumer choice