Given the budget constraint, the theory of demand assumes a consumer seeks to reach the maximum possible level of utility.
The budget line shows the maximum affordable quantity of one good for each given quantity of the other good. The position of the budget line is determined by income and
prices alone. Its slope reflects only relative prices.
Because the consumer prefers more to less, he or she will always select a point on the budget line. The consumer has a problem of choice. Along the budget line, more of one good can be obtained only by sacrificing some of the other good.
Consumer tastes can be represented by a map of non-intersecting indifference curves. Along each indifference curve, utility is constant. Higher indifference curves are preferred to lower indifference curves. Since the consumer prefers more to less, indifference curves must slope downwards. To preserve a given level of utility, increases in the quantity of one good must be offset by reductions in the quantity of the other good.
Indifference curves exhibit a diminishing marginal rate of substitution. Their slope is flatter as we move along them to the right. To maintain given utility, consumers sacrifice ever smaller amounts of one good to get successive unit increases in the amount of the other good.
Utility-maximizing consumers choose the consumption bundle at which the highest reachable indifference curve is tangent to the budget line. At this point the market trade-off between goods, the slope of the budget line, just matches the utility trade-off between goods, the slope of the indifference curve.
At constant prices, an increase in income leads to a parallel outward shift in the budget line. If goods are normal, the quantity demanded will increase.
A change in the price of one good rotates the budget line around the point at which none of that good is purchased. Such a price change has an income effect and a substitution effect. The income effect of a price increase is to reduce the quantity demanded for all normal goods. The substitution effect, induced by relative price movements alone, leads consumers to substitute away from the good whose relative price has increased.
In a two-good world, goods must be substitutes. The substitution effect is unambiguous. With many goods, the pure substitution effect of a price increase also reduces demand for goods that are complementary to the good whose price has risen.
A rise in the price of a normal good must lower its quantity demanded. For inferior goods, the income effect operates in the opposite direction but rarely seems to dominate the
substitution effect. Demand curves slope downwards.
The market demand curve is the horizontal sum of individual demand curves, at each price adding together the individual quantities demanded.
Consumers prefer to receive transfers in cash rather than in kind, if the two transfers have the same monetary value. A transfer in kind may restrict the choices a consumer can make.
