Theory of Consumer Behavior

Group Number 05
Team Members

Overview
Introduction
Basic Assumption of Consumer Theory
The Utility Function
Indifference Curve
Marginal Rate of Substitution
Indifference Map
A Marginal Utility Interpretation of MRS
The Consumer Budget Constraint
Utility Maximization
Marginal Utility Interpretation of Consumer
Optimization
Individual Consumer and Market Demand Curves
Substitution and Income Effects
Summery

Two Important Properties of Demand
Curves
1. The level of utility that can be attained changes
as we move along the curve.
2. At every point on the demand curve, the
consumer is maximizing utility by satisfying the
condition that the MRS of food for clothing
equals the ratio of the prices of food and
clothing.



Substitution Effect
Substitution Effect
The substitution effect is the change in an items
consumption associated with a change in the price of
the item, with the level of utility held constant.
When the price of an item declines, the substitution
effect always (like the Old Faithful!) leads to an
increase in the quantity of the item demanded.
Income Effect
Income Effect
The income effect is the change in an items
consumption brought about by the increase in
purchasing power, with the price of the item
held constant.
When a persons income increases, the
quantity demanded for the product may
increase or decrease.
Income and Substitution
Effects
Income Effect
Even with inferior goods, the income effect is
rarely large enough to outweigh the
substitution effect.
Income and Substitution
Effects: Normal Good
Y
O
X
R
F
1
S
C
1
A
U
1
The income effect, EF
2
,
( from D to B) keeps relative
prices constant but
increases purchasing power.
Income Effect
C
2
F
2
T
U
2
B
When the price of Y falls,
consumption increases by F
1
F
2

as the consumer moves from A
to B.
E
Total Effect
Substitution
Effect
D
The substitution effect,F
1
E,
(from point A to D), changes the
relative prices but keeps real income
(satisfaction) constant.
Food (units
per month)
O
R
Clothing
(units per
month)
F
1
S F
2
T
A
U
1
E
Substitution
Effect
D
Total Effect
Since food is an
inferior good, the
income effect is
negative. However,
the substitution effect
is larger than the
income effect.
B
Income Effect
U
2
Income and Substitution
Effects: Inferior Good
Giffen Good
A Special Case of Inferior Good:
The income effect may theoretically be large
enough (to dominate over and reverse the
substitution effect) to cause the demand curve for
a good to slope upward.
This rarely occurs and is of little practical interest.