Chapter 3

Household as a consumer- Behind

the demand curve

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 The decision making process of
the consumer

Preference set Constraints

Optimal decision

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 Assumptions

• Completeness

• Transitivity

• Non satiation

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 Utility and Optimization
• Utility:
- reflects a rank ordering of preferences.
- is a magnitude indicating the direction of
preferences
• Optimization:
- Cardinal Approach and Ordinal Approach

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 Optimization
The Cardinal Approach
• Utility is cardinally measurable and the
objective is to maximize utility
• The Law of Diminishing Marginal Utility
• Optimization Rule 1:
When only one good is consumed and is
available for free, consume till
MUx = 0
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 Optimization

• Optimization Rule 2:
When only one good is consumed and is
available for a price:
Consume till MUx = Pricex
• Optimization Rule 3:When more than one
good is consumed and the goods’ prices are
different:
Consume till MUx/Px = MUy/Py = MUz/Pz

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Optimization- The Ordinal approach

• Rank ordering of preferences

• Combinations of goods

Two inputs required to arrive at optimal

combination:
1. Preference set
2. Opportunity set

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 Preference Set- Indifference
Curves
• Indifference Curve:
Combination of goods that yield the same level
of satisfaction.
• Properties of Indifference curves:
- Slope downward
- Convex to the origin
- Non intersecting

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 Shapes of Indifference curves

MRS decreasing MRS Constant=1 One fixed proportion

Normal substitutes perfect substitutes Complements

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 Opportunity Set

• Defined by Budget Constraint.

6x + 3y = 60
Given Px = 6 and Py = 3
Graphically,

Y
20 -Px/Py is the Slope

10 X
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 Consumer’s Equilibrium- The
Optimal Combination

y
e

x
At ‘e’ slope of the budget line is equal to the slope
of the Indifference curve.

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 Consumer’s Equilibrium

• Slope of the budget line: - Px/Py

• Slope of Indifference curve: MUx/MUy

• Equilibrium : MUx/MUy = Px/Py

or MUx/Px = MUy/Py

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 Changes in equilibrium when prices
change
• Relative price changes get reflected in changes in
slope of the budget line.

• New point of tangency between the indifference

curve and the new budget line

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 Changes in equilibrium

• Joining all these points of tangency gives the

Price Consumption Curve. (PCC)
Y
PCC

Price of X is falling.

X
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 Derivation of the demand curve

• Data contained in the PCC:

- Optimal level of consumption of X
- Optimal level of consumption of Y
- Prices of X and Y
• Demand curve for X requires –
- Price of X.
- Quantity consumed of X.

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 Demand Curve

• Every point on the PCC gives the price of X and

quantity demanded/consumed of X
Thus,
Px

Qx
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 Changes in equilibrium when
income changes
• Income changes show up as parallel shifts of the
budget line

• New points of tangency between indifference

curves and the new budget lines

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 Changes in equilibrium

• Joining all these points of tangency gives

the Income Consumption Curve (ICC)

ICC

X
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 Slope of the ICC

• If the goods are ‘Superior’, the ICC is

upward sloping

• If one of the goods is ‘Inferior’, the ICC

is downward sloping

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 Slope of the PCC

• If the goods are normal, PCC is upward

sloping

• If PCC is downward sloping, then one of them

is a Giffen Good

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 Giffen good

Income effect
• Price effect +
Substitution effect
• Substitution effect is inversely related to price.
• Income effect can be inversely related to
changes in income – Inferior Good
• Income effect can be positively related to
income-Superior good

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 Giffen Good

• If income effect is inverse and large enough to

offset the substitution effect, then it is a Giffen
Good

• The Demand curve for Giffen Good will have a

positive slope

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 Applications of Indifference curves

• Welfare effects of a Direct tax Vs Indirect

tax:
- Indirect tax changes slope of Budget line.
- Consumer shifts to a lower indiff curve.
- Direct tax (income tax) shifts the budget
line parallel inwards.
-Consumer shifts to lower indiff curve but..
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 Applications
• .. Higher than in the Indirect tax case

Why??

Indirect tax changes price structure.

So, imposes both substitution and income
effect

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 Applications

• Whereas direct tax imposes only income

effect.

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 Applications
• Another application: Work –leisure choice

• Two goods- Leisure and other goods

• Boils down to – Leisure and work

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 Applications
• Budget line: c = w(T- n)
T is max no: of work hours
n is no: of leisure hours
• Opportunity cost of leisure is ‘w’(wages)
• Therefore, c = wT – wn
• Slope of the Budget line is ‘w’.

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 Applications
• If w increases , leisure becomes costlier.
• If w decreases, leisure becomes cheaper.
• Substitution effect of a change in ‘w’ :
if ‘w’ increases, leisure becomes costly and
hence less leisure and more work.
• Income effect of a change in ‘w’:
if ‘w’ increases, preference for leisure increases
(since leisure is a superior good)

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 Applications
• If substitution effect is > income effect,
then,
‘w’ increase will lead to more work
• If income effect is > substitution effect,
then,
‘w’ increase will lead to more leisure.

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 Applications
• At higher levels of ‘w’, income effect
becomes > substitution effect.
So we have a backward bending Supply
curve such as: w

QL

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