The UK’s European university
Economics for Accounting
ECON3007
Autumn Term
6. Consumer Demand II: Theory
Aims and reading
• Aim
• To discuss consumer’s optimal consumption
• To introduce the meaning of income and substitution
effects
• Reading
• Mulhearn & Vane Chapter 2; Sloman et.al. Chapters 5.5 & 6
2
Consumer’s optimal consumption
Income and substitution effects
3
Indifference curves
Francis Y. Edgeworth Vilfredo Pareto
(1845-1926) (1848-1923)
Indifference curves
Good 1
Marginal rate of substitution is the
quantity of a good a consumer must
A sacrifice to increase the quantity of
another good by one unit without
changing total utility (slope of the IC)
B
IC1
0 Good 2
Consumer’s optimal consumption
Any bundle within the budget
constraint is affordable, but
not all the budget is spent
Meals (C,D).
max H
x meal
E Any bundle beyond the
budget constraint you cannot
afford (H,G).
C G
Any bundle on the budget
constraint is affordable and
F ensures all the budget is
D
spent (E,F).
max
x cin. Cinema tickets
6
Consumer’s optimal consumption
Effect of a fall in income
Meals
max
xmeal
max
x cin. Cinema tickets
7
Consumer’s optimal consumption
Meals Increase in the price of cinema tickets
x max
meal
x cmina x. Cinema tickets
8
Consumer’s optimal consumption
• Finding the choice of the consumer requires
bringing in the two elements:
• The indifference curves, which show how agents rank
the different bundles
• The budget constraint, which shows which bundles are
affordable, and which are not
9
Consumer’s optimal consumption
Which is the best bundle ?
Meals
x max
Optimal bundle
meal A
C WHY?
D B
F
IC3
E IC2
IC1
max
x cin. Cinema tickets
10
Consumer’s optimal consumption
• The optimal bundle is on the tangency between
the budget constraint and the indifference curve
• At this point the ratio of prices (marginal rate of
transformation, MRT) is equal to the marginal
rate of substitution (MRS) between the two
goods or the ratio of marginal utilities
11
Consumer’s optimal consumption
• The slope of the budget line and the slope of the
IC coincide
MUa / Pa = MUb / Pb
MRS = MRT
• This means that the optimal bundle is on the
highest indifference curve achievable
• The one that gives the most satisfaction
12
Consumer’s optimal consumption
Income and substitution effects
13
Income and substitution effects
• Our model of consumer choice is based on the
interaction of affordable opportunities (the budget
line) and tastes (indifference curves)
• What is the effect of price changes in quantity
demanded?
• Economists break up the effect of a price
increase into two different effects:
• Change in the relative price of two goods
• Fall in the purchasing power of the given money income
14
Income and substitution effects
• Substitution effect is the change in the quantity
demanded of a good when price changes result in
consumers switching from relatively high-priced products
to relatively low-priced products
• Income effect is the change in the quantity demanded of
a good when price changes alter the purchasing power
15
What have we learnt?
• How the consumer maximises optimal consumption
• Meaning of income effect and substitution effects
16
