Theory of Consumer Behaviour

How a consumer chooses: utility, the budget line, indifference curves and the optimum, demand and what shifts it, normal and inferior goods, and price elasticity of demand.

Key ideas

• Marginal utility is the extra utility from one more unit; it falls as more is consumed, and total utility is greatest when marginal utility reaches zero.
• The budget line shows bundles costing exactly the whole income; a rise in income shifts it out in parallel, and a fall in one price pivots it out on that good’s axis.
• An indifference curve joins bundles of equal satisfaction; with monotonic preferences it slopes down and higher curves are better.
• At the optimum the budget line is tangent to the highest reachable indifference curve, so MRS equals the price ratio.
• Law of demand: other things equal, quantity demanded falls when price rises. A change in own price moves along the curve; income, tastes and related prices shift it.
• Demand for a normal good rises with income and for an inferior good falls; substitutes (tea, coffee) and complements (tea, sugar) affect each other’s demand.
• If demand is elastic, a fall in price raises spending; if inelastic, spending falls; if unitary, it stays the same.

Remember

Watch out

• Writing the budget-line slope as −p₂/p₁ instead of −p₁/p₂.
• Dividing the % change in price by the % change in quantity (quantity goes on top).
• Calling a change in the good’s own price a shift of the demand curve.
• Thinking a straight-line demand curve has the same elasticity everywhere.

Worked example