CONSUMER THEORY - microeconomics

Consumer theory relates preferences, indifference curves and budget constraints to consumer demand curves.

Indifference curves and budget constraints

Using indifference curves and an assumption of constant prices and a fixed income in a two good world will give the following diagram. The consumer can choose any point on or below the budget constraint line BC. This line is diagonal since it comes from the equation.

In other words, the amount spent on both goods together is less than or equal to the income of the consumer. The consumer will choose the indifference curve with the highest utility that is within the budget constraint. I3 has all the points outside of their budget constraint so the best that they can do is I2. This will result in them purchasing X* of good X and Y* of good Y.

Price effects

More usefully, this can now be used to predict the effect of various shifts in the constraint. The below graphic shows the effect of a price shift for good y. If the price of Y increases from where it is at BC2, the budget constraint will shift to BC1. Notice that since the price of X does not change, the consumer can still buy the same amount of X if they only choose to buy good X. On the other hand, if they choose to buy only good Y, they will be able to buy less of good Y since its price increased. This causes the amount of good Y bought to shift from Y2 to Y1, and the amount of good X bought to shift from X2 to X1. Opposite effect will happen if the price of Y decreases causing the shift from BC2 to BC3.

If this shifts are repeated with many different prices for good Y, a demand curve for good Y can be constructed. If the price for good Y is fixed and the price for good X is varied, a demand curve for good X can be constructed. The below diagram shows this for good y.

Income effect

Another important item that can change is the income of the consumer. As long as the prices remain constant, changing the income will...

Consumer theory relates preferences, indifference curves and budget constraints to consumer demand curves.

Indifference curves and budget constraints

Using indifference curves and an assumption of constant prices and a fixed income in a two good world will give the following diagram. The consumer can choose any point on or below the budget constraint line BC. This line is diagonal since it comes from the equation.

In other words, the amount spent on both goods together is less than or equal to the income of the consumer. The consumer will choose the indifference curve with the highest utility that is within the budget constraint. I3 has all the points outside of their budget constraint so the best that they can do is I2. This will result in them purchasing X* of good X and Y* of good Y.

Price effects

More usefully, this can now be used to predict the effect of various shifts in the constraint. The below graphic shows the effect of a price shift for good y. If the price of Y increases from where it is at BC2, the budget constraint will shift to BC1. Notice that since the price of X does not change, the consumer can still buy the same amount of X if they only choose to buy good X. On the other hand, if they choose to buy only good Y, they will be able to buy less of good Y since its price increased. This causes the amount of good Y bought to shift from Y2 to Y1, and the amount of good X bought to shift from X2 to X1. Opposite effect will happen if the price of Y decreases causing the shift from BC2 to BC3.

If this shifts are repeated with many different prices for good Y, a demand curve for good Y can be constructed. If the price for good Y is fixed and the price for good X is varied, a demand curve for good X can be constructed. The below diagram shows this for good y.

Income effect

Another important item that can change is the income of the consumer. As long as the prices remain constant, changing the income will...