Consumer Theory - Model Setup

Model Setup

Further information: Indifference curve and Budget constraint

Economists' modern solution to the problem of mapping consumer choices is indifference curve analysis. For an individual, 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 his budget constraint. Every point on I3 is outside his budget constraint so the best that he can do is the single point on I2 that is tangent to his budget constraint. He will purchase X* of good X and Y* of good Y.

Indifference curve analysis begins with the utility function. The utility function is treated as an index of utility. All that is necessary is that the utility index change as more preferred bundles are consumed. Indifference curves are typically numbered with the number increasing as more preferred bundles are consumed. However, it is not necessary that numbers be used - any indexing system would suffice - colors for example. The advantage of numbers is that their use makes the math simpler. Numbers used to index indifference curves have no cardinal significance. For example if three indifference curves are labeled 1, 4, and 16 respectively that means nothing more than the bundles "on" indifference curve 4 are more preferred than the bundles "on" indifference curve I. The fact that the index number is a multiple of another is of no significance. For example, the bundles of good on 4 does not mean that they are four times more satisfying than those on 1. As noted they merely mean they are more satisfying.

Income effect and price effect deal with how the change in price of a commodity changes the consumption of the good. The theory of consumer choice examines the trade-offs and decisions people make in their role as consumers as prices and their income changes.