Consumers behave as if they are maximising their utility, and there are two aspects affecting their behavior, which is their preference of consumption and their budget constraint.
To model consumer preferences easily, there are three assumptions:
- Completeness – There exist a complete set of preferences over all goods. There can never be indifference between preferences of two different goods.
- Transitivity – If a consumer thinks that A > B, and B > C, then A > C.
- Non-satiation – Consumer will always want more. Never say no to more.
Properties of Indifference Curves / Preference Maps
Combinations of goods on a curve are indifferent to the consumer. For example, consuming 3 A 1 B and consuming 1 A 3 B are equivalent. The following are the four key properties of such curves:
- Consumers always prefer higher curves (due to assumption 3)
- Curves are always downward sloping (due to assumption 3)
- Curves cannot cross (due to assumption 2 and 3)
- Every combination / bundle of goods is on one of the curves (due to assumption 1)
Marginal Rate of Substitution (MRS) is the rate at which consumer is willing to trade off good A with good B. The key concept is that MRS is diminishing, meaning that as the consumer trades off A for B, and has less of A in possession, he is less willing to trade A for B, and he will demand to trade a smaller quantity of good A for an even greater quantity of good B.
This is due to a diminishing marginal utility. With a large quantity of good A, the last unit of good A do not yield as much utility and therefore is willingly traded off for other substitutes.
Therefore, the MRS is also the ratio between the marginal utility of good A and the marginal utility of good B at the point on the curve.
The utility function is a mathematical representation of preferences. Utility is a concept with no absolute meaning (a value of utility cannot be translated to a degree of happiness). It is however used to compare the relative enjoyment / benefit between two consumption choices (a higher utility option is always preferred).
Diminishing Marginal Utility means that the additional consumption of the same good will yield less additional utility for each of the next unit (marginal utility). This is because marginal utility is a negative function of quantity. This makes sense as consumers are definitely not willing to pay increasingly more for the next additional unit of good to be consumed, unless the consumer is addicted, and in this case the good is some kind of drug, but this is extraordinary behaviour and does not apply to the general case.
To model budget constraint easily, there is an assumption: the income of a consumer is the entire budget, with absolutely no savings. This will simplify consumer behaviour.
The budget constraint line shows the consumption possibilities given a budget constraint.
The slope of the line is the Marginal Rate of Transformation (MRT). It is the price ratio of the two goods. It also shows the opportunity cost of the goods, which means the value of the foregone alternatives.
When there is a price change, for example when the price of one good increases, now the opportunity set has been restricted as there are less consumption possibility. Slope of the budget constraint line will change accordingly.
However if budget changes instead, for example when budget shrinks, as there is no change in prices (the only factor that affects the slope), there will only be a shift in the line, even though the opportunity set has also decreased.
Utility with Budget Constraint
The tangent of the indifference curve and the budget constraint is the best point that offers the most utility, given the available budget and available prices. It is also the point where the slopes of both the curve and the line is the same.
This means that:
- MRS = MRT
And since MRS is concerned with the rate of marginal benefit gained and MRT is concerned with the rate of marginal cost incurred, this translates to an optimisation where given a budget, the maximum utility is achieved, or where:
- Benefits = Costs (you get what you pay for)
This is also the point that gives the most value-for-dollar for both goods. Meaning the last dollar spent on both good A and B at this point derives the same degree of enjoyment for both goods, and there can be no trading between A and B that derive more utility.
For consumers with special preferences, the indifference curve may be a line, meaning the slope is flat. For example, the consumer will always give up the same quantity of good A to get more of good B. This consumer is a hardcore fan of good A, and it is therefore possible that the optimal point of utility maximisation lies at the corner, where he spent all his budget on good A and none on good B.
Applications in the Real World
Even though the examples had been simplified, people typically do mental accounting when making decisions, therefore to some extent the concept certainly models consumer behaviour.
If a government wants to change affect consumption levels, it can for example raise taxes on a good to discourage consumption. This is similar to increasing the price of the good, resulting in consumption on a different point of the budget line and indifference curve.
The government can also try to change the perception of the good in the minds of consumers, effectively changing consumer preference. This concept is called Nudge, and is studied in behavioural economics.
Relation to Consumer Demand Curve
As the price of a good changes, the budget constraint line will be tangent to the preference curve at different points. Mapping all these possibilities on a separate chart of Price vs Quantity will yield a Consumer Demand Curve.
Similarly, as the income changes, so does the budget constraint line. Again taking the new tangent points between budget constraint and the preference curve will construct a new demand curve. We will see the demand curve shifting due to the income effect.
(Reference: MIT OCW Principles of Microeconomics)