Consumer Behaviour and Utility Analysis
What the exam tests
Consumer theory explains choice under a budget constraint. CB2 tests marginal utility, indifference curves, the equi-marginal condition, income and substitution effects, and consumer surplus.
Core rules
- Total utility rises while marginal utility is positive; TU is maximised where MU = 0. Diminishing marginal utility means MU falls as consumption rises.
- The budget line is PxX + PyY = M, with slope -Px/Py. It shifts out with income and rotates with a price change.
- Indifference curves are downward sloping, convex and cannot cross. The marginal rate of substitution, MRS = MUx/MUy, diminishes along a curve.
- Optimal choice: MRS = Px/Py, equivalently MUx/Px = MUy/Py. Every currency unit gives the same marginal utility per unit spent.
- A price fall has a substitution effect (always increases quantity of the cheaper good) and an income effect (normal good: reinforces; inferior: may offset; Giffen: outweighs).
- Consumer surplus is willingness to pay minus price, the area under the demand curve above the price.
Worked example
A consumer has income 30, Px = 3 and Py = 2. At current consumption MUx = 18 and MUy = 10. MUx/Px = 6 and MUy/Py = 5, so the last currency unit spent on X yields more utility. The consumer should buy more X and less Y. As X rises, MUx falls; as Y falls, MUy rises, until the ratios are equal. Only then is utility maximised subject to the budget.
Traps
- Maximising total utility where marginal utility is highest rather than where MU = 0.
- Confusing MRS with the price ratio; at the optimum they are equal, but MRS is a preference concept.
- Forgetting that a price change rotates the budget line, not shifts it parallel.
- Treating consumer surplus as total utility; it is the excess over price paid.