Chapter IV Consumer Choice and Utility Maximization PDF

# Chapter IV Consumer Choice and Utility Maximization ## Learning Objectives After reading and studying this chapter, you should be able to: - Describe a consumer - Define goods and services - Differentiate consumer taste and consumer preference - Illustrate Maslow's Hierarchy of Needs - Expla...

# Chapter IV Consumer Choice and Utility Maximization ## Learning Objectives After reading and studying this chapter, you should be able to: - Describe a consumer - Define goods and services - Differentiate consumer taste and consumer preference - Illustrate Maslow's Hierarchy of Needs - Explain the Economics of Satisfaction - Define consumer surplus - Define marginal rate of substitution (MRS) - Explain budget line - Explain the importance of utility We, as consumers, are unique in many ways. We have different needs, wants, and demands. We differ in likes and dislikes, standards, reactions, lifestyles, traditions, etc. However, our behavior as a consumer is hard to identify and measure. From an economic stand point, our objective as consumers is to maximize our satisfaction given our limited budget (or income). With this in mind, economics seeks to explain why consumers behave differently and in a particular manner. In this chapter, you will learn how we, as consumers, behave in order to maximize our satisfaction on the goods and services that we consume given our limited income. ## Consumer - Before we proceed with our discussion of consumer behavior, let us first define who is a consumer. - Simply defined, a consumer is one who demands and consumes goods and services. - Without consumption (mainly by households), there is no need for production made by firms. - The consumer is the king in a capitalist or free-market economy. - Producers, for their own interests, have to satisfy the needs and wants of consumers in order to earn profits. - In this perspective, all of us are consumers because as we live our daily lives, we demand goods and services the moment we wake up in the morning until we retire to our bed at night. - As consumers, our power is to determine or even dictate what are to be produced since we are the ultimate purchasers of goods and services. This is referred to as consumer sovereignty. - In general terms, if we, as consumers, demand more of a good or service, then more of it will be supplied or vice versa. - The producers simply obey the wishes and desires as well as the needs and wants of consumers. - This therefore implies that producers are 'passive agents' in the price system because they simply respond to what we want. - However, in certain kinds of market (notably oligopoly and monopoly), producers are so powerful vis-à-vis consumers that it is they who effectively determine the range of choice open to us consumers. - Nevertheless, our freedom to satisfy our human wants is not completely unlimited. - For the good of society and the individual consumers, the government restricts consumer sovereignty. - For example, the government prohibits the use of dangerous drugs and substances and regulates the use of products that are health hazards like alcoholic beverages and cigarettes. - It also regulates products that are destructive to the environment like the use of leaded gasoline. ## Consumer Behavior - Consumer behavior involves the use and disposal of products as well as the study of how they are purchased. - By definition, consumer behavior is the study of individuals or groups, and the process consumers use to select, secure, use, and dispose of products and services, to satisfy needs. - This talks about how these individuals or groups, as consumers, deal with what to buy, where they buy goods and services, how they buy and how much they buy them, when they buy and the reason or why they buy. - The theory of consumer behavior, as developed by the economist Alfred Marshall, is based on the assumption that an individual, as a rational buyer, has the perfect information about the market, and is fully aware of his needs and can determine full satisfaction. - This theory asserts that the consumer as a rational person spends his or her income on goods and services that yield or would give, the highest level of satisfaction. - It is important to study the consumers and how they behave to help firms sustain and improve their operation and production. - The ability to understand the consumers would allow them to produce better goods and services that can help create better economic conditions for consumers as well. ## Goods and Services - Before we go any further, it is also important to clarify first what goods and services are. - Goods refer to anything that provides satisfaction to the needs, wants, and desires of the consumer. - They can be any tangible economic products (like cars, books, clothes, mowbil phones, iPods, etc.) that contribute directly (final goods) or indirectly (intermediate goods) to the satisfaction of human needs and wants. - Services, on the other hand, are any intangible economic activities (such as hairdressing, catering, insurance, banking, telecommunications, etc.), that likewise contribute directly or indirectly to the satisfaction of human wants. - Tangible goods can be classified according to, but not limited to, the following: ### Consumer Goods - These are the goods that yield satisfaction directly to any consumer. - These goods are primarily sold for consumption, and not to be used for further processing or as an input or raw material needed in producing another good. - Usually, these are the goods that are easily accessible to consumers (for example, soft drinks, bread, crackers, cellular phone loads, clothes, etc.). ### Essential or Necessity Goods vs. Luxury Goods - In the previous chapter, we have defined necessity goods and luxury goods in the context of elasticity - As we study consumer behavior, it's important to reiterate what these goods are. - Essential or necessity goods are goods that satisfy the basic needs of man. - In other words, these are goods that are necessary in our daily existence as human beings. - These are also goods that we cannot live without such as food, water, shelter, clothing, electricity, medicine, etc. - Conversely, luxury goods are those which human beings may do without, but which are used to contribute to their comfort and well-being. - Examples of luxury goods are private jet, yacht, luxury cars, perfumes, jewelry, etc. ### Economic and Free Good - An economic good is that which is both useful and scarce. - It has value attached to it and a price has to be paid for its use. - If a good is so abundant that there is enough of it to satisfy everyone's needs without anybody paying for it, that good is free. - Water from our faucet is an economic good, because we are not utilizing it for free, we have to pay its distributor. - The air that we breathe and the sunlight coming from the sun are examples of free goods. ## Tastes and Preferences - Consumers have various tastes and preferences. - Generally, tastes and preferences are determined by age, income, education, gender, occupation, customs and traditions as well as culture. - Preferences are the choices made by us consumers as to which products or services to consume. - The strength of our preferences will determine which products to buy given our limited disposable income and thus the demand of products as well as which product to buy. - We as consumers also express preferences as to which particular brand of a product to purchase. - Even in the choice of food, clothing and shelter, for instance, we differ in our choices and preferences. - Some prefer bread than rice, others like fish and vegetables than meat. - In fact, we can generalize that no two consumers have exactly the same likes and dislikes. - Some individuals have simple taste and few preferences; others are sophisticated and extravagant. - Before we leave this discussion, it is also important to understand what brand is. - Simply defined, a brand is the name, term, or symbol given to a product by a supplier in order to distinguish his or her offering from that of similar products supplied by competitors. - Brand names are used as a focal point of product differentiation between suppliers. - Examples of brand names include Coca Cola for the soft drink products; Guess, Levi's, and Lacoste for RTW products, etc. - Now, can you identify other brands that you usually buy or consume? ## Maslow's Hierarchy of Needs - Maslow's hierarchy of needs identifies the basic priorities of every consumer. - Maslow saw human needs in the form of a hierarchy, ascending from the lowest to the highest. - He concluded that when one set of needs is satisfied, this kind of need ceases. - The basic human needs placed by Maslow in an ascending order of importance (like a pyramid) are: - Physiological needs - Security, or safety needs - Social needs - Esteem needs - Self-actualization needs ### Physiological Needs - These are the basic needs for sustaining human life itself, such as food, water, warmth, shelter, sex, and sleep. - According to Maslow, until these needs are satisfied to the degree necessary to maintain life, other higher order needs will not stimulate people. ### Safety Needs - These are the needs to be free of physical danger and the fear of losing one's work, property, food, or shelter. ### Social Needs - These needs cover the value of the sense of belongingness, love, care, acceptance, and understanding of family, relatives and friends, and to be accepted by others. ### Esteem Needs - These needs explain the importance of self-esteem, recognition, status of an individual and the general acceptance of the society to an individual. - This kind of need produces such satisfaction as power, prestige, status, and self-confidence. ### Self-Actualization Needs - These needs explain the worth of a person's self-development, growth and realization and achievement. - According to Maslow, this is the highest need in the hierarchy. It is the desire to become what is capable of becoming-to maximize one's potential and to accomplish something. ## The Economics of Satisfaction - You may be wondering by now how economics can explain the behavior of consumers in order to attain maximum level of satisfaction on the goods and services that they generally consume. - In this section, we will try to explain how consumers attain maximum satisfaction level on the many goods and services available to them for consumption. - However, we have to remember at this point that satisfaction is a relative term. - This is because we differ in the way we are satisfied as well as the degree of our satisfaction. - As we have said earlier, no two consumers have the same likes and dislikes. - This section will discuss to you some of the theories that economists have devised to explain how consumers are able to attain maximum level of satisfaction when consuming a particular good or service. ### The Utility Theory - Utility, in economics, refers to the satisfaction or pleasure that an individual or consumer gets from the consumption of a good or service that he or she purchases. - For purposes of economic analysis, utility is also measured by how much a consumer is willing to pay for particular goods or services. - **Table 4.1** presents a hypothetical demand schedule for siopao. - You will notice in the table that the amount of money that you are willing to buy for an additional unit of siopao declines. - What is the reason for this? - As you may have experienced the more siopao you eat, the more you become satiated so that you are not willing to spend more for the next siopao that you wish to consume. - In other words, the satisfaction or utility that you derive in the consumption of an additional siopao declines as you consume more and more of it. **Table 4.1 Hypothetical Demand Schedule for Siopao** | Price (P) | Quantity Demanded (Q) | |---|---| | 15.00 | 1 | | 12.75 | 2 | | 10.50 | 3 | | 8.25 | 4 | *The table shows that as you continue to buy siopao, your willingness to pay for it continuously declines because your satisfaction from the good declines as you consume more of it.* - The hypothetical example that we have illustrated is what the utility theory is all about. - It simply tries to explain how our satisfaction or utility as consumers decline when we try to consume more and more of the same good at a particular point in time. - Two important concepts need to be explained before we fully understand the utility theory. - These are the marginal utility and total utility concepts. - **Marginal utility** is defined as the additional satisfaction that an individual derives from consuming an extra unit of a good or service. - Marginal means 'additional' or 'extra'. - In economics, we use marginal analysis in the examination of the effects of adding one extra unit to, or taking away one unit from, some economic variable. - For this purpose, we are interested in the incremental or additional utility derived from an additional consumption of a commodity. - Thus, the **marginal utility** of a commodity is the increase in total utility or satisfaction derived from the consumption of an additional or extra unit of such commodity; it is the loss of utility or satisfaction if one unit less is consumed. - In other words, it is the change in the total utility that results from a one-unit increase in the quantity of a good consumed. - **Total utility**, on the other hand, is the total satisfaction that a consumer derives from the consumption of a given quantity of a good or service in a particular time period. - We can also say that total utility is the total benefit that a person gets from the consumption of a good or services. - Total utility depends on the quantity of the good consumed-more consumption generally gives more total utility. - Hence, our total utility usually increases as we consume more and more of a good or service, but generally the increase is at a slower or declining rate. - This implies that each extra unit consumed adds less and less marginal utility than the previous units consumed as we become satiated with the good or service we are consuming. - **Let us illustrate this using the hypothetical utility schedule presented in Table 4.2.** - Assume that at the end of our class, you are too hungry so that you went directly to the cafeteria. In the cafeteria, you bought and consumed one siopao for your merienda. - In this case, your total and marginal utilities are 40 utils. - Assume further that you consumed another siopao because you are too hungry after the class. - Your total utility now increases to 90 utils so that marginal utility increases by 50 utils. - Let us now assume that you have consumed five siopao. - Take note in that table that your total utility for the fifth unit is 350 utils. - However what is more important is the marginal utility. - As we can observe, marginal utility has declined to only 80 utils. - Why is this so? - This is because of the **Law of Diminishing Marginal Utility**. - This **Law states that as a consumer gets more satisfaction in the long run, he or she experiences a decline in his satisfaction for goods and services.** - This means that consumption of more successive units of the same good increases total utility, but at a decreasing rate because marginal utility diminishes. - In other words, as we consume more and more of a good or service, we begin to like it less and less, and as we consume increasing amounts of a good or service, we derive diminishing utility, or satisfaction, from each additional unit consumed. **Table 4.2 Hypothetical Utility Schedule for Siopao** | Unit Purchased | Total Utility | Marginal Utility | |---|---|---| | 1 | 40 | 40 | | 2 | 90 | 50 | | 3 | 170 | 80 | | 4 | 270 | 100 | | 5 | 350 | 80 | *The table shows the various units purchased, the total utility for each unit purchased, and the corresponding marginal utility. The derivation of marginal utility is shown below.* ### Mathematical Derivation of Marginal Utility - How do we derive marginal utility? - Marginal utility is simply the change in total utility divided by the change in quantity. Thus, *MU = ΔTU / ΔQ* - Expanding our equation, we can solve for marginal utility using the following equation: *where* MU = (TU2 - TU1) / (Q2 - Q1) - TU2 = the new total utility - TU1 = the original utility - Q2 = the new quantity consumed - Q1 = the original quantity consumed - Applying the formula, we can derive the marginal utility for the total utility presented in **Table 4.2.** - Thus, if we want to determine the marginal utility from the consumption of two pieces of siopao to three pieces, we can simply apply the formula presented above. *MU = (170 - 90) / (3 - 2)* *MU = 80* - You may try the other combination of quantity and total utility and solve for the marginal utility. ### Graphical Illustration of TU and MU - We have already discussed the concepts behind total utility and marginal utility. - Now, we are ready to analyze total utility and marginal utility in graphical form. - **Figures 4.1 and 4.2** are graphical presentations of the total and marginal utility concepts we have discussed earlier. - As we have noted in our previous discussions, when we consume more and more of a good or service, our total utility increases but at a decreasing or declining rate. - This concept is illustrated in **Figure 4.1**. - As you may have observed, our total utility curve is concave from the origin. - We can see from the curve, as indicated by the dashed lines, that the initial consumption of 1 unit of Q going to 2 units of Q has a larger angle than the next consumption (from 2 units to 3 units). - We can therefore imply that the consumption from i unit of Q to 2 units of Q has a total utility of 10 utils or an incremental increase of 5 utils, while for the next consumption it only increased to 11 utils, or only an additional 1 util. **Figure 4.1: Total Utility Curve**  on the y-axis and quantity (Q) on the x-axis. The curve begins low on the Y-axis and increases but at a decelerating rate, eventually leveling off to form a slightly concave shape. ) - The marginal utility curve illustrated in Figure 4.2 is a convex curve. - This is because marginal utility starts at high level but as consumption of the same good increases, marginal utility declines - We can see from the curve that the marginal utility is at very high in the initial stage of consumption. - However, the marginal utility declines as we consume more and more of the same good at a succeeding interval. **Figure 4.2: Marginal Utility Curve**  on the Y-axis and quantity (Q) on the X-axis. The curve begins high on the Y-axis and rapidly slopes down to form a slightly convex shape.) **Maximizing Total Utility** - Until when do we stop consuming the same good? - As consumers, we have our own unique way of maximizing our utility or satisfaction. - We are given the opportunity to maximize our satisfaction by continuously consuming more units of a certain good until our satisfaction falls down zero. - Thus, we can say that we have already reached the peak of our satisfaction is our marginal utility is already zero. - Beyond this point (negative MU), we have already exceeded our satisfaction of that we stop consuming the same good. ## Consumer Surplus - We have already encountered the term surplus in our discussion of price-quantity equilibrium in the previous chapter. - We have to remember that the term surplus is used in economics for several related quantities. - For this section, our interest is to understand what consumer surplus is. - **In general, consumer surplus is a measure of the welfare we gain from the consumption of goods and services, or a measure of the benefits that we derive from the exchange of goods.** - In specific term, **consumer surplus is the difference between the total amount that we are willing and able to pay for a good or service and the total amount that we actually pay for that good or service.** - **Let us illustrate this concept through an example.** - Suppose you are interested in buying a new pair of maong pants. - So you went to the mall to look for the pants that you wanted so much. - Your budget for the pants is P3,000.00. - When you went to the boutique, you found out that the pants you liked most cost only P2,500.00. - Immediately, you bought the pants. - What is now your consumer surplus? - **Take note in our example that you are willing to pay for the pants at P3,000.00. However, when you bought the pants your actual expense was only P2,500.00, therefore you have a consumer surplus of P500.00.** - Why? - Because consumer surplus is simply the difference between what you pay (for the pants and all other goods or services that you buy) and what you would have been willing to pay for them. - **We can also illustrate our example of the consumer surplus using a graph. Since the consumer surplus is the difference between what you pay and the price you would have been willing to pay, then the consumer surplus in Figure 4.3 is the area between P2,500.00 (the actual price) and P3,000.00 (the price that you are willing to pay for the pants).** **Figure 4.3 Consumer Surplus**  on the Y-axis and quantity (Q) on the X-axis. The graph shows a downward sloping line representing the demand curve. The Y-axis is labeled from 2,500 to 3,000. The area between P2,500 and P3,000 is shaded and labeled as consumer surplus.) - **Could you think of other examples based on your own experience how you are able to apply the concept of consumer surplus?** ## The Indifference Curve - Another important concept used in explaining consumer behavior is the indifference curve. - **An indifference curve is a line that shows combinations of goods among which a consumer is indifferent.** - To clearly understand the concept of indifference curve, **Table 4.3** presents a hypothetical combination of two goods, meat and fish, each with corresponding prices that will give equal satisfaction to the consumer. - Hence, **Consumer A** for instance can choose any combination of meat and fish, such as combination A wherein he can consume 5 kilos of meat priced at P500.00 and a kilo of fish priced at P100.00. - Or, he can choose combination C wherein he can consume 3 kilos of meat priced at P300.00 and 3 kilos of fish also priced at P300.00. - In any of the combinations of meat and fish, **Consumer A** will get the same satisfaction, thus he will be indifferent to any of the combinations given. - This is because each combination will give him equal satisfaction given his limited budget of P600.00. - **We can also illustrate the indifference curve in a graph.** - In fact, in microeconomic theory, the indifference curve is a graph showing different combination of bundles of goods, each measured as to quantity, between which a consumer is indifferent. - That is, at each point on the curve, the consumer has no preference for one bundle over another. **Table 4.3 Hypothetical Table for Consumption of Meat and Fish** | Combination | Meat (kg) | Price of Meat (P) | Fish (kg) | Price of Fish (P) | |---|---|---|---|---| | A | 5 | 500 | 1 | 100 | | B | 4 | 400 | 2 | 200 | | C | 3 | 300 | 3 | 300 | | D | 2 | 200 | 4 | 400 | | E | 1 | 100 | 5 | 500 | *The table shows the various combinations of kilos of meat and fish consumed with corresponding prices that eventually yields equal satisfaction to consumer. Regardless of the combinations chosen, all of them shall provide an equal amount of satisfaction to the consumer.* **Figure 4.4: Indifference Curve**  - As we can observe in **Figure 4.4** consumer A consumes four hamburgers and two pizzas at point a. - However, he is indifferent to all the points on his indifference curve. - Moreover, he prefers any point above his indifferent (say at point b) and to any point on it and does not prefer any point on the indifference curve to any point below it (say at point c). - We can therefore say the consumer A is just as happy as consuming four hamburgers and two pizzas as to consume the combination of hamburger and pizza at any other point along the same indifference curve. - Consumer A also indicates that he prefers all the combinations of hamburger and pizza above the indifference curve to those on the original indifference curve. - These combinations contain more hamburgers and pizzas or more of both. - The concept of the marginal rate of substitution is the key to ‘readingʼ a preference map. - The marginal rate of substitution is the rate at which a person will give up good y (the good measured on the y-axis; in our example in **Figure 4.4**, it pertains to the pizzas) to get more of good x (the good measures on the x-axis; in our example above, it refers to hamburgers) and at the same time remain indifferent (remain on the same indifference curve). - The MRS is measured by the magnitude of the slope of an indifference curve. **Figure 4.5: Indifference Curve Map**  ### Indifference Curve Map - The Indifference curve map shows indifference curves in the same diagram. - Looking at **Figure 4.5,** as the curve moves further to the right, the level of utility becomes higher. - The shape of the indifference curve is not a straight line but convex and indifference curves will never cross. - This is due to the concept of the diminishing marginal rate of substitution between the two goods. ### Marginal Rate of Substitution (MRS) - The marginal rate of substitution is the slope of the curve and measures the rate at which the consumer will be willing to give up one good for the other while maintaining the same level of utility. - Thus, the marginal rate of substitution reflects the ratio of marginal utilities between the two goods. - The marginal rate of substitution is the amount of one good (i.e., burger) that has to be given up if the consumer is to obtain one extra unit of the other good (pizza). *The marginal rate of substitution (MRS) = change in good X / change in good Y* - If the indifference curve is steep, the MRS is high. - This implies that the person is willing to give up a large quantity of good y, for example, pizza, to get a small quantity of good x, for instance, hamburger, while remaining indifferent. - But if the indifference curve is flat, the marginal rate of substitution is low. - In other words, the person is willing to give up only a small quantity of good y pizza to get a large amount of good x hamburger to remain indifferent. - **Take note however that as consumer A moves down along his indifference curve, his MRS diminishes.** - Diminishing MRS is the key assumption of consumer theory. - Diminishing MRS is the general tendency for the MRS to diminish as the consumer moves along an indifference curve, increasing consumption of the good measured on the x-axis and decreasing consumption of the good measured on the y-axis. - The shape of a person's indifference curve incorporates the principle of the diminishing MRS because the curves are bowed toward the origin. - The reason behind the diminishing of the marginal rate of substitution is due to the principle of diminishing marginal utility. - The relationship between marginal utility and the marginal rate of substitution is often summarized with the following equation; *MRS = Mu / Mu* ## Budget Line - A budget or consumption-possibility line shows the various combinations of two products that can be purchased by the consumer with his or her fixed budget, given the prices of the products. - In other words, a consumer, given his or her fixed budget, must spend wisely and efficiently in order to maximize his or her satisfaction. - In a household budget, for example, a line item budget may include such things as mortgage, electric, telephone, groceries, car payment, and other items that are monthly household expenditures. - A budget line also helps businesses, entrepreneurs, and heads of households to track and monitor available funds, revenues, and expenses by type. - To firmly understand, the graph below shows the hypothetical table sample for budget line. **Table 4.4 Hypothetical Table for Budget Line** | Units - A (Beans in kg) | Price A | Units - B (Onions in kg) | Price B | Budget | |---|---|---|---|---| | 5 | P 125 | 1 | P 25 | P 150 | | 4 | 100 | 2 | 50 | 150 | | 3 | 75 | 3 | 75 | 150 | | 2 | 50 | 4 | 100 | 150 | | 1 | 25 | 5 | 125 | 150 | *The table shows the budget given for various combinations of the consumption of beans and onions with corresponding prices. Given the various combinations, each combination equals the budget of P150.00, which will eventually provide equal satisfaction to the consumer.* - **Table 4.4 shows the budget given by consumer A for the various combinations of his consumption of beans and onions. For instance, if he consumes 5 kilograms of beans and 1 kilogram of onions, his budget for beans and onions will be P125.00 and P25.00, respectively given his budget of P150.00.** - However, if he will consume 4 kilograms of beans, he will need to consume two kilograms of onions in order for him at achieve similar satisfaction. - If this is the case, his budget for this new combination of beans and onions will be P100.00 and P50.00 respectively if he will use his entire budget of P150.00. - Observe that if consumer A consumes more of a good (for instance, onions) he must give up the consumption of other goods (for example, beans) in order for him to achieve the same amount of satisfaction given his limited budget. - Thus, in our example, the more he consumes onions, the more that he gives up the consumption of beans given his limited budget of P150.00. - **We can also illustrate our example using the budget line as illustrated in Figure 4.6.** **Figure 4.6: Budget Line**  given the prices (125, 25), (100, 50), (75, 75), (50, 100) and (25, 125).) - The budget line in **Figure 4.6** has been derived from the data presented in **Table 4.5**. - Thus, the figure shows the budget line for the consumption of two commodities beans and onions. - Along the budget line, there are various possible combinations in the consumption of beans and onions given the limited budget of P150.00. - However, as the consumer moves from one point in the budget line (for example, at point a) to another point in the same budget line (for instance at point b), he must give up one good (such as beans) in order to consume more of the other good (like onions) if he will maintain the same level of satisfaction given his limited budget. ## Purpose of a Budget - The purpose of budget is to not spend more than what you have. - It tracks the incoming and outgoing monies. - Individuals, households, businesses, and even government use budgets so that they have at least a small amount of money left (savings) at the end of the month for a movie with the kids or dividends for the investors. - *As a consumer, are you really rational when you consume goods and services given your limited budget? Can you cite an example based on your experience how you applied the concept of the budget line we have just discussed?* ## Budget Constraint - The budget constraint indicates the combinations of the two goods that can be purchased given the consumer's income and prices of the two goods. - The intercept points of the budget constraint are computed by dividing the income by the price of the good. - For example, if the consumer has 100 pesos to spend and the price of burger is 20 pesos and pizza is 10 pesos, we can compute that the consumer can buy five burgers (P100/20=5) or 10 pizzas (P100/10=10). - Any combination of the two goods that is on or beneath the budget constraint becomes affordable, while those to the outside (farther from the origin) now become unaffordable. ## Change in Consumer Income - If the income of the consumer increases, the consumer has the ability to buy more or higher combination of goods. - This will cause the budget line to shift to the right. - Conversely, if there is a decrease in income, budget line will shift to the left (**Figure 4.7**). **Figure 4.7: Budget Line Shift**  - *If consumer income increases (decreases), then there would be a corresponding parallel shift to the right (left) to represent a fall in the potential combinations of the two goods that can be purchased. In our example, when income increases from P1,000 to P2,000, the consumer budget constraint shifts up from point a to point b.* - A rational consumer with the intent of maximizing utility would prefer to be on the highest possible indifference curve given their budget constraint. - Looking at **Figure 4.8**, the maximizing utility occurs at the point where the indifference curve touches or tangent to the budget line. - The optimum consumption point is Pt. C on the 2nd indifference curve. **Figure 4.8: maximizing utility given budget constraint**  ## Income and Substitution Effect - Indifference curves and budget constraints can be helpful in order for us to understand the income and substitution effects more clearly. - Indifference analysis can be used to analyze how a consumer would change the combination of two goods for a given a change in their income or the price of the good. ### Illustration - Let's say that a consumer has an income of P100.00 and the price of the apple is P5.00 and the price of orange is P10.00. - Given the prices of these goods, the consumer can