Rational Choice Theory: Consumer Behaviour

Dr. Divya Gupta

Economics I

Dr. Divya Gupta Rational Choice Theory: Consumer Behaviour Economics I 1 / 32

References

Neva Goodwin: Chapters 8 and 9

Mankiw: Chapters 21

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Consumer’s Optimal Choice
So far, our discussion on the free market mechanism has taken a consumer’s
‘demand curve’ and a producer’s ‘supply curve’ as given.
In this module, we focus on Consumer’s decisions that lead us to
de-construct the ‘demand curve’.
That is, what motivations and actions lie behind each point on the demand
curve.
The final decision, which we call as a consumer’s optimal ‘choice’, is based
on two factors:
Stated preferences
Resource constraints
Therefore, Consumer Choice Theory explains how a consumer, with
pre-determined well-defined preferences, decides to allocate constrained
resources such as time and money towards the consumption of a basket of
goods and services, with an objective of maximising their self-interests,
measured by satisfaction.
In simple words:
Preferences + Resource Constraints = Optimal Choice
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Preferences

Preferences of a consumer tells us how much of each good would the

consumer want/desire to consume and in what combination.
Therefore, the first step in building a model of consumer behaviour,
we need to analyse what these preferences are and how they would
behave.

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Concepts and Definitions
Before we develop, mathematically and graphically, preferences, let’s lay down a
few concepts and definitions, assuming a ‘two-commodity world’:
Consumption Bundle: Shows different quantities of commodities
consumed by the consumer.
Example: In a two-commodity world with commodities X and Y, some
possible consumption bundles are: say, A(5, 10); B(10, 5); C(7, 7) and D(20,
20).
Where, bundle A contains 5 units of commodity X and 10 units of
commodity Y; and so on.
Preference relations: A consumer displays preferences over/across various
commodities and consumption bundles, which can be expressed as follows:
‘≻’ denotes ‘preferred over’. Therefore, if A ≻ B, we say, bundle A is
‘preferred over’ B.
‘∼’ denotes ‘indifference’. Therefore, if A ∼ B, we say, consumer is
‘indifferent’ between bundles A and B.
‘≽’ denotes ‘at least as good as’. If A ≽ B, bundle A is ‘at least as
good as’ bundle B; hence, ruling out the possibility of B ≻ A.
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Concepts and Definitions (contd.)

Goods: The two commodities are assumed to be ‘goods’, that is

those commodities which give positive utility and not ‘bads’ - which
give negative utility (example: pollution).
This assumption is important because our axioms of preferences and
indifference curves are defined for goods.
Difference between Desire and Choice: Choices are final set of
real actions (and not merely mental determinations). Therefore,
choices are limited and are in fact constrained by a consumer’s access
to limited resources. Desires, on the other hand, are unlimited and
are not constrained by access to resources like time and money.

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Axioms of Preferences

1 Completeness
If there are two consumption bundles A and B, which have (x1 , y1 ) and
(x2 , y2 ) of each of the two goods, X and Y, respectively, then, the
consumer must have: either A ≻ B or B ≻ A or A ∼ B
That is, the consumer is never in an ‘indecisive’ state and will be able
to develop some kind of preference ordering between the two bundles.
2 Transitivity
If there are three consumption bundles A, B and C which have (x1 , y1 ),
(x2 , y2 ) and (x3 , y3 ) of each of the two goods, X and Y,
respectively,then: if A ≻ B and B ≻ C then A ≻ C .
Similarly, for all the other preference relations denoted by ∼ and ≽,
this must hold true.
This axiom is important to make sure that a consumer’s preferences
are consistent.

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Axioms of Preferences (contd.)
3 Reflexivity
A consumption bundle A with (x1 , y1 ) of each of the two goods X and
Y, is at least as good as itself. That is: A ≽ A.
This axiom also makes sure that consumer’s preferences are consistent.
4 More is Better
If there are two consumption bundles A and B, which have (x1 , y1 ) and
(x2 , y2 ) of each of the two goods, X and Y, respectively, such that
either A has more of both the goods or strictly more of one of the two
goods then, A ≻ B.
A consumer will always prefer to consume more of both the
commodities - because these are goods and goods give positive utilities,
hence, increasing their consumption will increase consumer’s utilities.
These four axioms together make sure that decisions taken by the
consumers are ‘rational decisions’.
Hence, if any of these are violated, the consumer will be said to be
‘irrational’.
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Measuring preferences: Utility Functions

The term ‘utility’ was first coined by ‘Jeremy Bentham’, to define it

as “By utility is meant that property in any object whereby it tends to
produce benefit, advantage, pleasure, good or happiness or to prevent
the happening of mischief, pain, evil, or unhappiness to the party
whose interest is considered”.
One of the ways to represent these preferences/utilities is with the
help of utility functions.
Utility Functions are mathematical rules/functions that assign values
to an individual’s utilities over a basket of goods and services.
For example: U(X , Y ) = xy
The above is an example of a utility function whereby, if a consumer
consumes a bundle A(3, 8), their utility will be measured as:
U(A) = xy = 3x8 = 24.

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Measuring preferences: Indifference Curves
An Indifference Curve (IC) is the locus/collection of all those
consumption bundles that give the consumer exactly same level of
satisfaction or utility; or makes the consumer equally happy.
In the figure given below, on the first indifference curve, I1 , points A
and B reflect the same level of satisfaction for different combination
of two goods as they are both on the same IC.
That is, at I1 , U(A) = U(B), which implies that for the consumer:
A ∼ B, hence, the term ‘indifference’ curve.

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Slope of Indifference Curve: Marginal Rate of Substitution
(MRS)
Mathematically, the slope of any curve is measured as the change in
y-axis, with respect to a unit change in the x-axis.
In case of indifference curves, since the two-axes take the quantities
of the two commodities, the slope reflects the change in consumption
of one commodity - good Y, with respect to consumption of an
additional unit of the second commodity - good X.
∆Y
That is, slope of an IC = ∆X .
Adding an economic intuition and meaning to it, slope of an IC is
called as ‘Marginal Rate of Substitution (MRS)’.
Thus, MRS is defined as the rate at which the consumer is willing to
trade off one good for the other; or the number of units of good Y
that a consumer is willing to sacrifice/give up, in order to consume to
one extra unit of good X.
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Properties of Indifference Curves
1 Downward Sloping
ICs are downward sloping, i.e., they have a negative slope, or
MRS < 0, always.
This is because since for consumers we must have “More is Better” (recall
axiom 4), which implies that if the quantity of one good increases, the
quantity of the other must fall to keep the consumer at the same level of
happiness/ satisfaction.
2 Higher ICs are preferred
Higher ICs represent higher levels of utilities/satisfaction; hence, higher ICs
are preferred to lower ones. This is so because people typically prefer to
consume more of a good than less of it.
This can be reflected in ICs with higher ICs, farther from the origin, depicting
higher satisfaction than a lower IC, one that is nearer to the origin. See the
figure of an indifference map, as given below:

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Properties of Indifference Curves (contd.)
3 Two ICs cannot intersect each other
Let’s consider a fallacy that suppose two ICs can indeed intersect each
other (see figure below).
Now, based on this, we must have C ≻ A, as it has more of both the
goods, thus U(C ) > U(A)......(1).
Further, the consumer must have A ∼ B, because these bundles are on
the same IC, thus, U(A) = U(B)......(2).
Similarly, consumer must be indifferent between bundles C and B, as
they too are on the same IC, thus, U(C ) = U(B)......(3).
Now, using the axiom of transitivity, based on eqns (1) and (2), since
C ≻ A and A ∼ B; consumer must have C ≻ B.
However, as per eqn (3), we see that C ∼ B. This is contradictory and
hence the two ICs cannot intersect each other.

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Properties of Indifference Curves (contd.)
4 ICs are convex
ICs are bowed inwards, or convex to the origin.
The bowed shape of the IC reflects consumers’ greater willingness to
give up a good that they already have in large quantity.
As shown in the figure on slide 15, at point A0 , the consumer has a lot
of Pepsi and only a little Pizza. She is very hungry but probably not
very thirsty.
Thus, to consume one extra unit of pizza, she would be willing to give
up 6 units of pepsi, to move to point A.
The marginal rate of substitution is, thus, 6 liters of pepsi per pizza.
By contrast, at point B0 , the consumer has little Pepsi and a lot of
pizza, and hence, could be very thirsty but probably not very hungry.
At this point, to consume one extra unit of pizza, she would be willing
to give up only 1 litre of Pepsi and no more, to move to point B.
Or conversely, in order to move from point B to B0 , the consumer is
willing to give up one pizza so that she gets to consume one more litre
of pepsi.
The marginal rate of substitution is, thus, 1 litre of pepsi per pizza.
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Properties of Indifference Curves (contd.)
This phenomenon is called as the property of “Diminishing Marginal Rate
of Substitution”.
That is, the MRS does not stay constant, rather declines as we move along
the IC.
Mathematically, any curve which is not a straight line will have a
non-constant slope.
Therefore, since ICs are convex, their slope, i.e. MRS, does not remain
constant, but declines.

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DMRS and Diminishing Marginal Utility
As discussed previously, we saw that ICs are convex because the MRS is
declining.
Further we discussed that the MRS declines because “the consumer is
willing to give-up lesser of what they have in lesser quantity and willing to
give-up more of what they have in abundance” - WHY?
This is because of the ‘law of diminishing marginal utility (DMU)’.
Marginal Utility - the change in a consumer’s total utility/satisfaction owing
to consumption of one additional unit of any good, represented as MUx -
marginal utility of good X; and MUy - marginal utility of good Y.
The law of DMU, thus, states that as the consumption of a good increases,
its marginal utility decreases, i.e. the additions to total satisfaction become
smaller and smaller.
Example: On eating the first chocolate, suppose, a consumer’s total
satisfaction was 10.
Now when the consumer eats second chocolate, the total satisfaction
increases to 15, implying MUx = 5.
Now, on eating the third chocolate, the total satisfaction does increase,
but to 18, i.e., now, MUx = 18 − 15 = 3.
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DMRS and DMU (contd.)

Hence, we can see that the MUx declines from 5 to 3 and so on.
Please note that the total satisfaction on eating chocolates continues to
increase, that is, chocolate is still a ‘good’ and provides ‘positive total
utility’.
It is just its additional/marginal utility that declines.
Thus, DMU contributes to DMRS - how?
Along an IC - with the same level of utility, as consumption of good X
increases, then as per the law of DMU, the increase in utility from increased
consumption of X becomes smaller and smaller; hence, the number of units
of good Y to be sacrificed becomes smaller and smaller, to keep the utility
at the same level.
MUx
Based on this, we can prove that: MRS = MUy .

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Extreme Cases of ICs: Perfect Substitutes
Two goods are said to be perfect substitutes to each other, if they can be
consumed in place of each other to satisfy a given want.
Examples: Rs.50 currency note and Rs.100 currency note; blue pencil and red
pencil; etc.
In case of perfect substitutes, the consumer only cares about the total quantities
of the two goods they consume, rather than, specific quantities of each good.
Example: If a consumer wants Rs 500, it does not matter whether they have 10
notes of Rs 50 each, or 5 notes of Rs 100 each; or 6 notes of Rs 50 each along
with 2 notes of Rs 100 each.
Thus the two types of currency notes are perfectly substitutes, with an MRS of 2
(2 units of Rs50 notes for 1 unit of Rs100 note).
Since the MRS for perfect substitutes remains constant, the ICs for such two
goods are straight lines, as shown in figure below:

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Extreme Cases of ICs: Perfect Complements

Two goods are said to be perfect complements which are consumed together
(in a certain proportion) to satisfy a given want.
These goods cannot be separately consumed. Hence, they satisfy a given
want only when consumed as a combination.
Examples: Car and oil, tea and sugar, left shoe and right shoe, etc.
In case of such goods, the consumer cares only about the total number of
combinations of consumption possible.
For example, in case of left shoe and right shoe, the consumer cares for the
number of total pairs of shoes; in case of tea and sugar, the consumer cares
for the total number of sweetened cups of tea they can have etc.
In other words, the consumer would judge a bundle based on the minimum
number of pairs they could assemble from the two commodities.

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Extreme Cases of ICs: Perfect Complements (contd.)
The ICs for two goods which are perfect complements are, thus, are L-shaped, as
shown in the figure below:

At I1 , the number of pairs of shoes that a consumer can use are 5.

At bundle, the consumer has 5 right shoes and 5 left shoes, hence can have 5
complete pairs of shoes.
At bundle B, the consumer has 7 right shoes, but only 5 left shoes, still making
only 5 complete pairs.
Likewise, at bundle C, although the consumer has 7 left shoes, there are only 5
right shoes, thus, making 5 complete pairs.
Hence, the consumer is indifferent between bundles A, B and C - and they all lie
on the same IC - I1 .
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Budget Constraint
We continue with the simplified assumption of a two-commodity world.
The only constraint that we discuss in this model is that of income, i.e. the
income constraint - also called as ‘budget constraint’.
Note that this assumption can be very easily relaxed without affecting the
conclusions of the model.
Example: Time as a constraint will limit number of hours in a day to 24
hours.
Application: Participation in labour market decisions can be easily
understood using this model, which takes time as a constraint, instead of
income as a constraint.
Budget constraint: shows the various bundles or various combinations of
the two goods that the consumer can buy (afford) for a given income and
given prices of the two commodities, as show in the figure below:

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Budget Constraint (contd.)

A budget constraint is, thus, given by: PX X + PY Y = I .

Based on this budget line equation, if the income is 1000, price of good X, i.e.
pizza is 10, and that of good Y, i.e. pepsi is 2, then we can find out various
bundles which the consumer can afford - which will all lie on the budget line, i.e.
satisfy the equation.
As shown in the graph above, bundles A, B, C, D and E - all are affordable as they
are lying on the budget line.
At A (100, 0), the consumer is buying 100 units of Pizza, which is priced at 10,
therefore, rendering expenditure of 1000 on it. This leaves nothing to be spent on
Pepsi. Hence, consumption of pepsi is 0.
Likewise, at B(0, 500), the consumer spends all of their income on consumption of
Pepsi, leaving nothing for Pizza.
All other bundles - C, D, E have some units of both goods.
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Budget Constraint (contd.)
Based on the budget line seen previously, we can note two vital features:
Downward sloping: A budget line is always downward sloping. This is
because, if you increase the consumption of one commodity, say good X,
then the income left to be spent on good Y will be lesser and hence, your
consumption of Y must reduce. This is due to the fact that income is fixed.
Constant slope - PPyx : Another noticeable feature of a budget line is that it
is a ‘straight’ line - implying having a constant slope.
The slope of a budget line shows the market rate at which consumer
can trade one good for the other (in this example, pepsi for pizza).
It is equal to the relative prices of two goods – the price of one good
P
compared to the price of the other, i.e. slope of a budget line = PX
Y
In the example, since Price of Pizza (i.e. PX = 10) is 5 times that of
Pepsi (i.e. PY = 2), therefore, slope of budget constraint = 10 2 = 5.
The budget line shows this trade-off, that is, in order to consume one
extra unit of Pizza the consumer has to give up 5 units of Pepsi, at the
market allowed rate of exchange.
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Budget Constraint (contd.)

As indicated in the figure above, the two points at which the budget line intersects
the two axes are called the corresponding intercepts.
The horizontal intercept lies on the x-axis, and vertical intercept on the y-axis.
Horizontal Intercept: = PIX . It denotes the maximum possible consumption of
good X, at its given price, PX , and income, I , i.e. when the consumer spends all
their income on good X.
Likewise, Vertical Intercept: = PIY . It denotes the maximum possible consumption
of good Y, at its given prices, PY and income, I , i.e. i.e. when the consumer
spends all their income on good Y.
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Budget Constraint and Change in Income
As seen previously, the budget line is defined by: PX X + PY Y = I .
Thus, if there is any change in PX and/or PY and/or I , the budget line will change.
We first consider the effect of change in income (I ), assuming that there are no
changes in the two prices PX and PY .
If income increases from I to I1 , the budget line shifts outwards parallelly from AB
to A1 B1 (see figure below).
If the income decreases from I to I2 , the budget line shifts inwards parallelly from
AB to A2 B2 (see figure below).
The shifts in the budget line are parallel because the slope doesn’t change (Why? ).
The new budget lines will have the new intercept values as: A1 = PI1X , B1 = PI1Y ;
I2 I2
and A2 = PX
, B2 = PY
, respectively.

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Budget Constraint and Changes in Prices
First, we consider changes in price of good X, assuming that there is no change in
I and PY (see figure 1.)
If price of good X decreases from PX to PX 1 , budget line rotates/pivots outwards
from AB to A1 B, because the horizontal intercept changes to A1 = P I and the
X1
slope changes (why? ).
If price increases from PX to PX 2 , the budget line rotates inwards from AB to A2 B,
because horizontal intercept changes to A2 = P I
X2
Likewise for changes in price of good Y (assuming no changes in I and PX ) (see
figure 2):
If price decreases from PY to PY 1 , budget line rotates outwards from AB to AB1 ,
because vertical intercept changes to B1 = P I
Y1
When price increases from PY to PY 2 , budget line rotates inwards from AB to AB2 ,
because the vertical intercept changes to B2 = P I .
Y2

Figure 1: Changes in PX Figure 2: Changes in PY

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Consumer Equilibrium: Optimal Choice

As stated previously, Rational

Preferences + Budget Constraint
= Optimal Rational Choice.
Graphically, when we combine a
consumer’s preferences (ICs) with
their budget constraint, we find
consumer equilibrium or consumer’s
optimal choice, at the point where All other bundles in this preference
the two are tangential (see the given map are sub-optimal bundles
figure). because:
As is shown in the figure, bundle E is Bundle A: cannot be afforded.
Bundle B: can be afforded but
the optimal bundle chosen by income is not exhausted.
consumer, at which: Bundles C and D: can be afforded
The budget line is tangent to IC2 . and income is exhausted, but are
sort of extreme bundles, and are
Hence, slope of budget line = on lower IC. Hence, consumer can
slope of IC (why? ). do better (increase utility) by
PX MUX moving towards bundle E.
Hence, PY
= MRS(= MUY
).
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Effect of Income Change on Optimal Choice
Suppose income of consumer increases, with no changes in prices of two goods
(see figure below).
Due to this income change, the budget line shifts outwards (why? - recall previous
discussions).
With the new expanded budget set, if the consumer continues to consume the
initial optimal bundle E1 , it becomes sub-optimal - as the consumer can now do
much better by increasing consumption of both goods.
Also, as per the new budget line, at E1 , the new increased income is not exhausted.
Thus, the new optimal bundle chosen by the consumer will be E2 , where
consumption of both goods X (pizza) and Y (pepsi) are increasing, hence, making
them normal goods.
At E2 , the consumer’s utility is maximised by IC2 , which is the highest possible IC
for the new budget line.

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Effect of Price Change on Optimal Choice

Suppose now the price of good Y (pepsi) decreases, with no change in the
income of consumer, and the price of good X (pizza), see figure on slide 30.
Due to this price change, the budget line rotates outwards towards vertical
axis, from AB to AD (why? - recall previous discussions).
With the new expanded budget set, if the consumer continues to consume
the initial optimal bundle E1 , it becomes sub-optimal - as the consumer can
now do much better.
Also, as per the new budget line, at E1 , the income is not exhausted.
Thus, the new optimal bundle chosen by the consumer will be E2 , where
consumption of both goods X (pizza) is decreasing and that of good Y
(pepsi) is increasing.
At E2 , the consumer’s utility is maximised by IC2 , which is the highest
possible IC for the new budget line AD.

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Effect of Price Change on Optimal Choice (contd.)

Note that it is possible to imagine a scenario, where at E2 , the consumption of

both goods X and Y will increase.
This is possible because even though there is no change in consumer’s income per
se, however, a decrease in price leads to an increase in ‘real income’ or purchasing
power, which the consumer can allocate towards more consumption of both the
goods.
On similar lines, the optimal decision of the consumer may change due to ‘increase
in price of good Y’, or ‘increase/decrease in price of good X’, or ‘simultaneous
change in the price of two goods X and Y’, or ‘simultaneous change in the income
and price of one or both goods’.
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Deriving the Demand Curve

Recall the starting point of this Based on the optimal bundles, under
discussion - we are trying to the three prices, as indicated by E1 ,
de-construct the demand curve, E2 and E3 , the quantity demanded of
which was assumed to be given. good X is, thus, X1 , X2 and X3 ,
Rational Choice Theory (or Utility respectively.
Theory) helps explain the
decision-making process that lie
behind each point on the demand
curve.
What is a demand curve? - it is the
locus/combination of optimal
decisions of the consumer, when
price of a good changes.
As shown in the figure, as price of
good X decreases from P1 to P2 and
further to P3 , the budget line of the
consumer rotates outwards from AB1
to AB2 and AB3 , respectively.
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 ALL THE BEST!

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