Chapter 3: Consumer Theory

Consumer theory addresses the question: “How does a consumer maximize their satisfaction (utility) given a certain budget?“

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1. Utility and Marginal Utility

(1) Utility

Subjective satisfaction a consumer derives from consuming goods.

• Marginal Utility (MU): The additional utility gained from consuming one more unit of a good.
• Law of Diminishing Marginal Utility: As the consumption of a good increases, the satisfaction derived from each additional unit (MU) tends to decrease.

(2) Utility Maximization Condition (Equimarginal Principle)

$\frac{MU_x}{P_x} = \frac{MU_y}{P_y}$ In other words, total utility is maximized when the marginal utility per dollar spent is equal across all goods.

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2. Indifference Curve

A curve connecting combinations of two goods that provide the consumer with the same level of satisfaction.

(1) Properties

1. It is downward-sloping. (To get more of one good, you must give up some of another)
2. Curves further from the origin represent higher levels of utility.
3. Curves do not intersect.
4. It is convex to the origin. (Due to the Law of Diminishing Marginal Rate of Substitution)

(2) Marginal Rate of Substitution (MRS)

$MRS_{xy} = \frac{MU_x}{MU_y}$ The amount of good Y a consumer is willing to give up to obtain one additional unit of good X while maintaining the same utility level.

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3. Budget Line

A line representing combinations of two goods that a consumer can purchase with a given income. $P_x \cdot X + P_y \cdot Y = I$ (where I is Income)

• Change in Income: The budget line shifts parallelly.
• Change in Price: The slope of the budget line changes.

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4. Consumer Equilibrium and Derivation of Demand

(1) Consumer Equilibrium

Occurs where the indifference curve is tangent to the budget line. Condition: $MRS_{xy} = \frac{P_x}{P_y}$

(2) Income and Substitution Effects

A change in price causes a change in quantity demanded due to two effects:

1. Substitution Effect: Moving toward the relatively cheaper good (always in the opposite direction of price).
2. Income Effect: The change in quantity demanded due to the change in real income.

Giffen Good: A specific type of inferior good where demand increases as price rises. This happens when the income effect outweighs the substitution effect.

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Key Checklist

• Why is the indifference curve convex to the origin? (Answer: Diminishing MRS)
• How does the budget line move when income increases?
• Which economic principle describes the act of looking for ‘value for money’? (Answer: Equimarginal Principle)
• For a normal good, are the income effect and substitution effect in the same or opposite direction when price falls?