Chapter Summary

Our task in this chapter was to set forth the basic model of rational consumer choice. In all its variants, this model retains certain common features; in particular, it takes consumers' preferences as given and assumes they will try to satisfy them in the most efficient way.

The first step in solving the budgeting problem is to identify the set of bundles of goods that the consumer is able to buy. In the standard case, the consumer is assumed to have an income level given in advance and to face fixed prices. Prices and income together define the consumer's budget constraint, which, in the simple two-good case, is a downward-sloping line whose slope, in absolute value, is the ratio of the two prices. It is the set of all possible bundles that the consumer might purchase if he spends his entire income.

The second step in solving the consumer budgeting problem is to summarize the consumer's preferences. Here, we begin with a preference ordering by which the consumer is able to rank all possible bundles of goods. This ranking scheme is assumed to be complete and transitive and to exhibit the more-is-better or nonsatiation property. Preference orderings that satisfy these restrictions give rise to indifference maps, or collections of indifference curves, each of which represents combinations of bundles among which the consumer is indifferent. Preference orderings are also assumed to exhibit a diminishing marginal rate of substitution, which means that, along any indifference curve, the more of a good a consumer has, the more he must be given to induce him to part with a unit of some other good. The diminishing MRS property is what accounts for the characteristic convex shape of indifference curves.

The budget constraint tells us what combinations of goods the consumer can afford to buy. To summarize the consumer's preferences over various bundles, we may use either an indifference map or a utility function (see the chapter appendix). In the indifference-curve framework, the best affordable bundle occurs at a point of tangency between an indifference curve and the budget constraint. At that point, the marginal rate of substitution is exactly equal to the rate at which the goods can be exchanged for one another at market prices.

The appendix to this chapter develops the utility function approach to the consumer budgeting problem. Topics covered include cardinal versus ordinal utility, algebraic construction of indifference curves, the use of calculus to maximize utility, and the characteristics of certain special utility functions.