Chapter 4

CONSUMER CHOICE
 Chapter Outline
4-2

1. Preferences.

2. Utility.

3. Budget Constraint.

4. Constrained Consumer Choice.

5. Behavioral Economics.
 Premises of Consumer
4-3
Behavior
The model of consumer behavior is
based on the following premises:
Individual preferences determine the

amount of pleasure people derive from

the goods and services they consume.
Consumers face constraints or limits

on their choices.
 Consumers maximize their well-being

or pleasure from consumption, subject to

the constraints they face.
 Five Properties of Consumer
Preferences
4-4

 Completeness - when facing a choice

between any two bundles of goods, a
consumer can rank them so that one and
only one of the following relationships is
true: The consumer prefers the first
bundle to the second, prefers the second
to the first, or is indifferent between
them.
 Five Properties of Consumer
Preferences
4-5

 Transitivity – a consumer’s preferences

over bundles is consistent in the sense
that, if the consumer weakly prefers
Bundle z to Bundle y (likes z at least as
much as y) and weakly prefers Bundle y
to Bundle x, the consumer also weakly
prefers Bundle z to Bundle x.
 Five Properties of Consumer
Preferences
4-6

 More Is Better - all else being the same,

more of a commodity is better than less of it
(always wanting more is known as
nonsatiation).
 Good - a commodity for which more is preferred
to less, at least at some levels of consumption
 Bad - something for which less is preferred to
more, such as pollution

Concentrate on goods
 Five Properties of Consumer
Preferences
4-7

 Continuity- if a consumer prefers

Bundle a to Bundle b, then the consumer
prefers Bundle c to b if c is very close to
a.
 The purpose of this assumption is to rule
out sudden preference reversals in
response to small changes in the
characteristics of a bundle
 Five Properties of Consumer
Preferences
4-8

 Strict Convexity- means that

consumers prefer averages to extremes,
i.e. more balanced baskets that have
some of each good.
 For example if Bundle a and Bundle b are
distinct bundles and the consumer prefers
both of these bundles to Bundle c, then the
consumer prefers a weighted average of a
and b, βa+(1-β)b, to Bundle c.
 Preference Maps
4-9

 To summarize information about a consumer’s

preferences is to create a graphical
representation- a map-of them

 Example: Each semester, Lisa, who lives for fast

food, decides how many pizzas and burritos to
eat.

 The various bundles of pizzas and burritos she

might consume are shown in panel (a) on the
next slide
 Bundles of Pizzas and Burritos Lisa Might
Consume
Which
Which of
of these
these Lisa prefers any
(a)
two
two bundles
bundles bundle in area A
(b)
would
would be over e

itos per semester

be
itos per semester

preferred
preferred by
by
c A c
25 25
Lisa?
Lisa?
f
20 20
Lisa prefers
bundle feover
over

B, Burr
B, Burr

e
15 15
e
a bundle e,d, since fe a
d
10 b
has more
10 of both b I1
goods: Pizza and
5 Burritos
B
15 25 30 15 25 30
,ZPizzas per semester ,ZPizzas per semester

If Lisa
Lisa prefers
is indifferent we can draw an
bundle e bundles
between to any e, a, indifferent curve over
4-10
bundle
and c …..
in area B those three points
 Indifference Curves
4-11

 Indifference curve - the set of all bundles

of goods that a consumer views as being
equally desirable.
 The figure shows indifference curves that are
continuous (have no gaps).
 It is downward sloping. To consume more food,
the consumer is willing to give up some units of
clothing consumption and still get the same
utility. In other words, if food consumption is
decreased, the consumer needs to obtain more
units of clothing to keep the same level of utility.
 Indifference Map
4-12

 Indifference map - a complete set of

indifference curves that summarize a
consumer’s tastes or preferences
 Properties of Indifference
4-13
Maps
1. Bundles on indifference curves farther
from the origin are preferred to those
on indifference curves closer to the
origin. (more is better)
2. There is an indifference curve through
every possible bundle.
3. Indifference curves cannot cross.
4. Indifference curves slope downward.
5. Indifference curves can not be thick.
 Bundles of Pizzas and Burritos Lisa
Might Consume
4-14

(a) (c)
itos per semester

itos per semester

c A c
25 25

f f
20 20

e I2
15 15
e
B, Burr

B, Burr
a a
d d
10 b 10 I1

5
B I0

15 25 30 15 25 30
,ZPizzas per semester ,ZPizzas per semester

we can draw an
indifferent curve over
those three points
 Fig 3.2 Impossible Indifference
4-15
Curves r per semester

 Lisa is indifferent
between e and a, and
also between e and
b…
so by transitivity she
itos


B, Bur

should also be
indifferent between a
e
b
and b…
 but this is impossible,
a I1
I0
since b must be
preferred to a given it
Indifference curves
has more of both
, ZPizzas per semester can not (cross:
goods. A given
More-is-better)
bundle cannot be on
 Impossible Indifference
4-16
Curves
 Lisa is indifferent

r per semester
between b and a
since both points
are in the same b
indifference
curve…

itos
B, Bur
 But this
contradicts the a
“more is better”
assumption. Can I
you tell why?
 Yes, b has more of
both and hence it
should be , ZPizzas per semester
preferred over a.
 Impossible Indifference Curves
4-17
 Problem
4-18

 Can indifference curves be thick?

 Answer:
 Draw an indifference curve that is at least
two bundles thick, and show that a
preference property is violated
 Solved Problem
4-19 r per semester

 Consumer is
indifferent between b
and a since both
points are in the same
itos

indifference curve…
B, Bur

b
a
 But this contradicts the
“more is better”
assumption since b has
I more of both and hence
it should be preferred
over a.
, ZPizzas per semester
 Utility
4-20

 Utility - a set of numerical values that reflect

the relative rankings of various bundles of
goods.
 A numerical score representing the satisfaction that a
consumer gets from a given market basket
 If buying 3 copies of Microeconomics makes you happier
than buying one shirt, then we say that the books give
you more utility than the shirt
 utility function - the relationship between
utility values and every possible bundle of
goods. U(q1, q2)
 It increases in both q1 and q2 (more is preferred to
less)
 Utility - Example
©2005 Pearson
Education, Inc.

Clothing Basket U = FC
C 25 =
15 2.5(10)
A 25 = 5(5)
B 25 =
C 10(2.5)
10

A U3 = 100
5
B U2 = 50
U1 = 25
Food
0 5 10 15
21
 Utility Function: Example
4-22

 Suppose that the utility Lisa gets from pizzas (q 1)

and burritos (q2 ) is
u  q1q 2
 This utility function gives us the relationship
between Lisa’s utility and one of her IC’s.
 An indifference curve would be those
combinations of q1 and q2 that give the same
level of utility. Each IC reflects a different level of
utility (indifference map?)
 Question: Can we determine whether Lisa would
be happier if she had Bundle x with 9 burritos and
16 pizzas or Bundle y with 13 of each?
 Utility function (in 3
dimensions)  Each panel measures Z along
one axis on the floor of the
4-23 diagram, and B along the other
axis on the floor. Utility is
measured on the vertical axis.
As Z, B, or both increase, she
has more utility: She is on a
higher point on the diagram.
 If we project all the points on
the curve I* that are at a given
height—a given level of utility
—on the utility surface onto
the floor of the diagram, we
obtain the indifference curve I.
 Along the indifference curve for
U = 2, we have the bundles:
(2,2) (1,4) (4,1), etc.
 Utility
©2005 Pearson
Education, Inc.

 Although we numerically rank baskets

and indifference curves, numbers are
ONLY for ranking
 The magnitude of utility difference does
not tell us anything i.e. by how much
one is preferred to another
 A utility of 4 is not necessarily twice as
good as a utility of 2

24
 Ordinal Preferences
4-25

 There are two types of rankings

 Ordinal ranking: An ordinal measure is one that
tells us the relative ranking of two things but does
not tell us how much more one rank is than
another
 Cardinal ranking: A cardinal measure is one by
which absolute comparisons between ranks may
be made
 If we know only consumers’ relative rankings of
bundles, our measure of pleasure is ordinal
rather than cardinal
 Utility measures are not unique
 Willingness to Substitute
©2005 Pearson
Education, Inc.
between goods: MRS
 Indifference curves are typically
downward sloping and convex (bowed
inward).
 Being convex would mean that as more of
one good is consumed, a consumer would
prefer to give up fewer units of a second
good to get additional units of the first one
(property of diminishing MRS)
 In other words, consumers generally
prefer a balanced market basket
26
 Willingness to Substitute
between goods: MRS
4-27

 Marginal Rate of Substitution- maximum

amount of one good that a consumer will
sacrifice (trade) to obtain one more unit of
another good Slope of the indifference curve

 Indifference curve is downward sloping,

hence a negative MRS

 We will use calculus to determine MRS at a

point on Lisa’s indifference curve (later in
slides)
 (a) MRS along an Indifference curve
4-28
Indifference Curve Convex to the Origin  The MRS from bundle
r per semester

From bundle a to a to bundle b is -3.

a bundle b, Lisa is  This is the same as the
8
willing to give up 3 slope of the
Burritos in exchange indifference curve
–3 between those two
for 1 more Pizza…
itos

points.
B, Bur

b
5 From bundle c
1
-2 to bundle d,
Lisa is willing to From b to c,

c
3 1  MRS = -2.
-1 d give up 1
2  This is the same as the
1 Burritos in
I slope of the
exchange for 1
0 3 4 5 6 more Pizza… indifference curve
between those two
, ZPizzas per semester
points.
 The indifference curve is convex
(bowed inward) only if MRS is
4-29
©2005 Pearson
Education, Inc.
diminishing
r per semester

Does diminishing MRS make sense?

For most cases, it does! At point a, the consumer
a has many units of burritos and few units of pizza
8 and therefore, it is reasonable to assume that s/he
may value pizza relatively more than burritos:
–3 s/he would give up a lot of burritos (3 units) to
itos

obtain 1 additional unit of pizza and still be able

B, Bur

b to keep the same level of utility.

5
1
However, at point c, s/he has few burritos and a
-2
lot of pizza. She’s only willing to give up a
c
3 1
small amount of burritos for an additional unit
-1 d of pizza, making the slope very flat. Therefore,
2 it is reasonable to assume that MRS diminishes
1
I as we move down the indifference curve.

0 3 4 5 6
, ZPizzas per semester

29
 (b) Marginal Rate of Substitution with
concave indifference curves
4-30
(b) Indif
erence
f Curve Concav
e to the O
rigin  From bundle a to
r per semester

bundle b, Lisa is
willing to give up
7
a 2 Pizzas for 1
Burrito.
–2
itos

b  Nevertheless, from
B, Bur

5
1 b to c she is
–3 willing to give up 3
Pizzas for 1 burrito.
c
2
1
 This is very
I unlikely
0 3 4 5 6  Could you think
,ZPizzas per semester why?
 (b) Marginal Rate of Substitution with
concave indifference curves
4-31

 When we have CONVEX preferences (as

in the normal case) The marginal rate of
substitution approaches zero as we
move down and to the right along an
indifference curve.

 Discussion: could you imagine a good

that does not exhibit this property?
 MRS And Marginal Utility
4-32

 Now lets show that MRS depends on how

much extra utility Lisa gets from a little
more of each good
 marginal utility - the extra utility that a
consumer gets from consuming the last
unit of a good.
 the slope of the utility function as we hold the
quantity of the other good constant.
 Lisa’s utility function is: (good 1 is pizzas
and good 2Uis burritos) U
U1  U2 
q1 q 2
 (a) Utility

Utility and

U, Utils
350 Utility function,U (10, Z)

Marginal Utility
250 U = 20
230 U
 As Lisa consumes Z = 1 MU Z 
Z
more pizza, holding
her consumption of
burritos constant at
10, her total utility,
U, increases…
 and her marginal 0 1 2 3 4 5 6 7 8 9 10
utility of pizza, MUZ, , ZPizzas per semester
decreases (though (b) Marginal Utility

utility of pizza
it remains positive). 130

 Marginal utility is
the slope of the
, Marginal

utility function as
we hold the
quantity of the
Z
MU

other good
constant. 20
MUZ

4-33 0 1 2 3 4 5 6 7 8 9 10
, ZPizzas per semester
 Marginal Utility
©2005 Pearson
Education, Inc.

 The principle of diminishing marginal

utility states that as more of a good is
consumed, the additional utility the
consumer gains will be smaller and
smaller
 Note that total utility will continue to
increase since consumer makes choices
that make them happier

34
 Marginal Utility and
©2005 Pearson
Education, Inc.
Indifference Curves

 As consumption moves along an

indifference curve:
 Additional utility derived from an increase
in the consumption one good, good X, must
balance the loss of utility from the decrease
in the consumption in the other good, good
Y.

35
 Marginal Utility and
©2005 Pearson
Education, Inc.
Consumer Choice
 It must be the case along an indifference
curve that

0  MUX(X)  MUY(Y)
No change in total utility along an indifference curve.
Trade off of one good to the other leaves the consumer
just as well off.

36
 Marginal Utility and
©2005 Pearson
Education, Inc.
Consumer Choice
 Rearranging:

 Y / X    MU X / MU Y
Since
 Y / X   MRS of X for Y
We can say
MRS   MUX/MUY
37
 Willingness to Substitute
4-38
between goods
Suppose more generally we have an indifference curve:

Then once we select a value for q1, then the point q2 is determined by the equation of the indifference curve, so we can write q2 as a function of q1, i.e. q2(q1)
(Example: U=FC; For utility=25, indifference curve is FC=25, or C=25/F)

Where U1 is MU of
good 1
 Marginal Rate of
4-39
Substitution
Graphical representation of the slope of an
IC

MRS at e = slope of indifference curve at e

= dB/dP
=dq2/dq1
 Solved Problem
4-40

Suppose that Jackie has what is known as

a Cobb-Douglas utility function:

where a is a positive constant, q1 is the

number of CDs she buys a year and q2 is
the number of movie DVDs she buys.
What is her MRS?
Answer:
 Problems: constructing indifference
curves
4-41

1. Don is altruistic. Show the possible shape

of his indifference curves between
charity and all other goods.
2. Miguel considers tickets to the Houston
Grand Opera and to Houston Astros
baseball games to be perfect substitutes.
Show his preference map.
3. If Joe views two candy bars and one
piece of cake as perfect substitutes, what
is his marginal rate of substitution
between candy bars and cake?
 Exercise:
©2005 Pearson
Education, Inc.

Suppose that utility function of a consumer is

give by U(F,C)= FC.
 Draw the indifference curve associated with a utility
level of 12 and the indifference curve associated with
the utility level of 24.
 Show that the indifference curves are convex. Use
indifference curve for utility level 12 as an example to
show this.
 Find the equation for the indifference curve for utility
level equal to 12 and find the MRS at (F,C) = (3,4).
 Find the MRS at point (F,C) = (2,3). You will have to
derive the equation for indifference curve that goes
through the point first, then find the MRS at that
point.

42
 Curvature of Indifference
4-43
Curves.
 Casual observation suggests that most
people’s indifference curves are convex.

 Exceptions:

 Perfect substitutes - goods that a consumer is

completely indifferent as to which to consume.
 Perfect complements - goods that a consumer
is interested in consuming only in fixed
proportions
 Perfect Substitutes
4-44

 Bill views Coke and

, Cans perweek

4 Pepsi as perfect
substitutes: can
you tell how his
3 indifference
curves would look
2 like?
Coke

 Straight, parallel lines

with an MRS (slope)
1 of −1.
I1 I2 I3 I4  Bill is willing to
exchange one can of
0 1 2 3 4 Coke for one can of
e
Ppsi, Cans per
week Pepsi.
 Perfect Complements
4-45

 If the consumer has only

week

one piece of pie, she gets

Ice cream, Scoops per

as much pleasure from it

e c and one scoop of ice
3 I3
cream, a,
d b 2
 as from it and two scoops,
2 I d,
 or as from it and three
a scoops, e.
1 I1

0 1 2 3
Pie
, Slices per
week
 EXERCISE
©2005 Pearson
Education, Inc.

 Suppose a Bill’s utility of consuming good-X

and good-Y is given by
U(X,Y) = min{X,2Y}
 Where, X is the amount of good-X and Y is the
amount of good-Y. The function “min” is a
function that chooses the smallest value in the
bracket. For example min{2,3} =2,
min(3,2}=2, min{100,3} =3.
 Draw an indifference curve representing Bill’s
preferences.

46
 Imperfect Substitutes
4-47

f
r per semester

 The standard-
shaped, convex
indifference curve
in panel lies
between these
two extreme
itos

examples.
B, Bur

 Convex
indifference
I curves show that a
consumer views
,ZPizzas per semester two goods as
imperfect
substitutes.
 Application: Indifference Curves Between
Food and Clothing
4-48

Research has
shown that at low
(subsistence) levels
of income (I1),
there is little
willingness to
substitute between
food and clothing.
 Consumer Preferences:
©2005 Pearson
Education, Inc.
An Application
 An analysis of consumer preferences
would help to determine where to spend
more on changes in car design:
performance or styling

 Some consumers will prefer better

styling and some will prefer better
performance in their car
49
 Consumer Preferences:
©2005 Pearson
Education, Inc.
An Application

Styling
These
consumers
place a greater
value on
performance
than styling

Performance
50
 Consumer Preferences:
©2005 Pearson
Education, Inc.
An Application

Styling
These consumers
place a greater
value on styling
than performance

Performance
51
 Budget Constraint
4-52

 budget line (or budget constraint) - the

bundles of goods that can be bought if
the entire budget is spent on those
goods at given prices.

 opportunity set - all the bundles a

consumer can buy, including all the
bundles inside the budget constraint and
on the budget constraint
 Budget Constraint
4-53

 If Lisa spends all her budget, Y, on pizza

and burritos, then
pBB + pZZ = Y

 where pBB is the amount she spends on burritos

and pZZ is the amount she spends on pizzas.

 This equation is her budget constraint.

 It shows that her expenditures on burritos and pizza
use up her entire budget.
 Budget Constraint (cont).
4-54

 From previous slide we have:

Y  PZ Z
B
PB
 If pZ = $1, pB = $2, and Y = $50, then:

$50  ($1 Z )
B  25  0.5Z
$2
 Budget Constraint
Amount of Burritos
consumed if all income
is allocated for
r per semester
 From previous slide we
have that if:pZ = $1, pB = $2,
and Y = $50, then the budget

Burritos. constraint, L1, is:

25 = Y/pB
a $50  ($1 Z )
B  25  0.5Z
b $2
20
L1
itos

Amount of Pizza
B, Bur

consumed if all income

c
10 is allocated for Pizza.
Opportunity set

d
0 10 30 50 = Y /pZ
, ZPizzas per semester

4-55
 Budget Constraint (cont).
4-56

 How many burritos can Lisa buy?

 To answer solve budget constraint for B
(quantity of burritos):

PB B  PZ Z  Y
PB B  Y  PZ Z
Y  PZ Z
B
PB
 Budget Constraints: Budget Line
©2005 Pearson
Education, Inc.

 Letting x and y be the goods on the x- and y-

axis respectively:
 The vertical intercept, I/P y, illustrates the maximum
amount of good y that can be purchased with income I
 The horizontal intercept, I/P x, illustrates the maximum
amount of x that can be purchased with income I
 The slope of the line measures the relative cost
of food and clothing; it’s the relative price of the
good on the x-axis.
 The slope is the negative of the ratio of the
prices of the two goods; it’s –Px/Py

57
 The Slope of the Budget Constraint
4-58

 We have seen that the budget constraint for Lisa

is given by the following equation:

Y PZ
B  Z
PB PB
Slope = B/Z = MRT
 The slope of the budget line is also called the marginal
rate of transformation (MRT)
 rate at which Lisa can trade burritos for pizza in the
marketplace
 Table: Allocations of a $50 Budget
Between Burritos and Pizza
4-59
 (a) Changes in the Budget Constraint: An
increase in the Price of Pizzas.
4-60
Y - PZ = $1
$2
B= Z
r per semester

Slope = -$1/$2 = -0.5

PB PB
25 If the price of Pizza
doubles, (increases
L1 (pZ= $1) from $1 to $2) the
itos

slope of the budget

B, Bur

line increases
Loss
This area represents
L (pZ = $2)
2
the bundles she can
no longer afford!!!
0 25 50
, ZPizzas per semester
Slope = -$2/$2 = -1
 (b) Changes in the Budget Constraint:
Increase in Income (Y)
4-61
$100
$50 PZ
B= P - Z
B PB
B, Burritos per semester

If Lisa’s income
50 increases by $50 the
L3 (Y =$100) budget line shifts to
the right (with the
same slope!)
25
This area represents
Gain
the new consumption
L1 (Y = $50) bundles she can now
afford!!!
0 50 100
, ZPizzas per semester
 Solved Problem
4-62

 A government rations water, setting a

quota on how much a consumer can
purchase. If a consumer can afford to
buy 12 thousand gallons a month but
the government restricts purchases to
no more than 10 thousand gallons a
month, how does the consumer’s
opportunity set change?
 Solved Problem
4-63
 Exercise
©2005 Pearson
Education, Inc.

 Connie allocates $200 of her monthly food budget

between two goods: meat and potatoes.
 Suppose meat costs $4 per pound and potatoes $2 per
pound. Derive the equation that describes Connie’s
budget constraint. Draw her budget line.
 Now, suppose that Connie’s supermarket is running a
special promotion: If she buys 20 pounds of potatoes (at
$2 per pound), she gets the next 10 pounds for free. All
potatoes in excess of the first 20 pounds (excluding
bonus potatoes) are still $2 per pound. This special offer
applies only to the first 20 pounds of potatoes she buys.
Draw her budget line.

64
 Consumer Choice
©2005 Pearson
Education, Inc.

 Given preferences and budget

constraints, how do consumers choose
what to buy?
 Consumers choose a combination of
goods that will maximize their
satisfaction, given the limited budget
available to them. This is referred to as
the “utility maximization” or “consumer
choice” problem

65
 Consumer Choice
©2005 Pearson
Education, Inc.

 The maximizing market basket must

satisfy two conditions:
1. It must be located on the budget line
 They spend all their income because
more is better
2. It must give the consumer the most
preferred combination of goods and
services

66
 Consumer Choice
©2005 Pearson
Education, Inc.

 Graphically, we can see different

indifference curves of a consumer
choosing between clothing and food
 Remember that U3 > U2 > U1 for our
indifference curves
 Consumer wants to choose highest
utility within their budget

67
 (a) Consumer Maximization: Interior Solution
 Would Lisa be able to
consume any bundle along  Bundle e is called a
I3 (i.e. bundle f)? consumer’s optimum.
r per semester

 No! Lisa does not have  If Lisa is consuming this

enough income to afford bundle, she has no
any bundle along I3 incentive to change her
behavior by substituting
one good for another.
itos
B, Bur

25
 Would Lisa be able to
c
consume any bundle along
f
20 I1?
 Yes; she could afford
B bundles d, c, and a.
e
10
I3
d I2
A a
I1
0 10 30 50
, ZPizzas per semester
4-68
 Consumer Choice
©2005 Pearson
Education, Inc.

 Consumer will choose highest

indifference curve on budget line
 In previous graph, point e is where the
indifference curve is just tangent to the
budget line
 Slope of the budget line equals the slope
of the indifference curve at this point

69
 Consumer Maximization: Interior
Solution
 The budget constraint and the indifference curve
r per semester

have the same slope at the point e where they

touch.
 Therefore, at point e:
MU1 P1
MRS      MRT
itos

MU 2 P2
B, Bur

25

Slope of I2
Slope of BL
e

I2

0 50
, ZPizzas per semester
4-70
 Consumer Choice
©2005 Pearson
Education, Inc.

 Recall, the slope of an indifference curve

is:
goodY
MRS 
goodX
Further, the slope of the budget line is:
Px
Slope  
Py
71
 Consumer Choice
©2005 Pearson
Education, Inc.

 Therefore, it can be said at

consumer’s optimal consumption
point,

PX
MRS  
PY

72
 Consumer Choice
©2005 Pearson
Education, Inc.

 It can be said that satisfaction is

maximized when marginal rate of
substitution (of X and Y) is equal to the
ratio of the prices (of X and Y)
 Note this is ONLY true at the optimal
consumption point
 EXCEPTIONS: Perfect substitutes and
perfect complements and (possibly)
quasilinear utility functions.

73
 Marginal Utility and
©2005 Pearson
Education, Inc.
Consumer Choice
 Rearranging, gives the equation for
utility maximization:

MU X / PX  MU Y / PY
 Total utility is maximized when the
budget is allocated so that the marginal
utility per dollar of expenditure is the
same for each good

74
 Consumer Choice
©2005 Pearson
Education, Inc.

 Optimal consumption point is where

marginal benefits equal marginal costs
 MB = MRS = benefit associated with
consumption of 1 more unit of X
 MC = cost of additional unit of X
 1 unit X = ½ unit Y
 PX/PY

75
 Consumer Choice
©2005 Pearson
Education, Inc.

Clothing,Y
(units per
week) Point B does not
maximize satisfaction
40 because the
-MRS = 10/10 = 1
is greater than the
B
30 price ratio = 1/2

-10C
20

+10F U1
0 20 40 80 76Food, X(units per week)
 Consumer Choice
©2005 Pearson
Education, Inc.

 If |MRS| ≠ PX/PY then individuals can

reallocate basket to increase utility
 If |MRS| > PX/PY
 Will increase good X and decrease good Y
until MRS = PX/PY
 If |MRS| < PX/PY
 Will increase Y and decrease X until |MRS|
= PX/PY

77
 Practice
4-78

 Sally consumes two goods, dinners (X) and DVDs (Y). Her
utility function is given by the expression U = 3XY. The current
market price for X is $10. Sally's current income is $500.
 Suppose Sally exhausts her income by consuming 20 dinners
and 60 DVDs. What is the price of a DVD? Write the budget
constraint equation. 
 Draw (accurately) a set of two indifference curves for Sally in
her consumption of dinners and DVDs. Put dinners on the
horizontal axis.
 What is the opportunity cost of dinners in terms of DVDs?
What is the opportunity cost of DVDs in terms of dinners?
 Determine the dinner and DVD combination which maximizes
Sally's utility, given her budget constraint. Show her optimum
point on a graph.
 Utility Maximation: Solution
4-79

 As long as we have an interior solution

(not corner), we will typically write two
equations as functions of good x and
good y:
1. MRS = - PX/PY

2. Budget Constraint: PXX + PY Y = Income

Then solve the two equations in two

unknowns
 Consumer Choice
©2005 Pearson
Education, Inc.

 A corner solution exists if a consumer

buys in extremes, and buys all of one
category of good and none of another
 MRS is not necessarily equal to PX/PY

80
 Figure 3.6 (b) Consumer
Maximization: Corner Solution
4-81 (Quasi-linear utility)
r per semester

|MRS|≤Px/Py
itos
B, Bur

e
25

I3

I2

Budget line
I1

50
, ZPizzas per semester
 A Corner Solution -
Example
 Suppose Jane Doe’s parents set up a trust
fund for her college education
 The money must be used only for education
 Original budget line, PQ, with a market
basket, A, of education and other goods
 Trust fund shifts out the budget line as long
as trust fund, PB, is spent on education
 Although a welcome gift, an unrestricted gift
might be better

82
 A Corner Solution - Example
©2005 Pearson
Education, Inc.

Other
Consumption
($) •Jane better off
on U2
•B is corner
solution
P
B •|MRS| ≠ PE/POG
U2
A

U1

Q Education ($)
83
 A Corner Solution - Example
©2005 Pearson
Education, Inc.

Other
Consumption
($) •If gift is
unrestricted,
C Jane can be at
point C on U3
U3 •Better off than
P
with restricted
B U2 gift
A

U1

Q Education ($)
84
 Food Stamps
4-85

 Nearly 11% of U.S. households worry

about having enough money to buy
food and 3.3% report that they suffer
from inadequate food (Sullivan and
Choi, 2002).

 Households that meet income, asset,

and employment eligibility
requirements receive coupons that can
be used to purchase food from retail
stores.
 Food Stamps (cont).
4-86

 The Food Stamps Program is one of the

nation’s largest social welfare programs
with expenditures of $33.1 billion for
nearly 29.1 million people in 2006.

 Would a switch to a comparable cash

subsidy increase the well-being of food
stamp recipients?
 Would the recipients spend less on food
and more on other goods?
 Food Stamps Versus Cash

All other goods per month

Budget line with cash
Y + 100
f

C e
Y I3
d I2

I1

B
Budget line with
ood
f stamps
A Original
b
udget line

0 100 Y Y + 100
4-87
o
Fod per month
 Problem 3.3
4-88

 Nigel, a Brit, and Bob, a Yank, have the

same tastes, and both are indifferent
between a sports utility vehicle (SUV) and a
luxury sedan. Each has a budget that will
allow him to buy and operate one vehicle
for a decade. For Nigel, the price of owning
and operating an SUV is greater than that
for the car. For Bob, an SUV is a relative
bargain because he benefits from lower
gas prices and can qualify for an SUV tax
break. Use an indifference curve–budget
line analysis to explain why Nigel buys and
operates a car while Bob chooses an SUV.
 Perfect Substitutes
4-89
 Practice: Perfect Substitutes
4-90

Jennifer’s parents give her $30 each month to spend on either blue
pens or black pens. Suppose that blue pens and black pens are perfect
substitutes for Jennifer, and that she is wiling to substitute the two
goods on a one-for-one basis. Determine Jennifer’s optimal
consumption bundle for each of the following cases. Draw a diagram
showing the budget constraint, the indifference curve, and the utility
maximizing bundles, clearly indicating each. Put blue pens on the
horizontal axis. (Draw a separate diagram for each part a, b, and c.)

a.Price of blue pens is $5, price of black pens is $6

b.Price of blue pens is $6, price of black pens is $5
c.Price of blue pens is $5, price of black pens is $5
 Practice: Perfect
4-91
Complements
Suppose a consumer’s utility of consuming good-X and good-Y is
given by
U(X,Y) = min{X,2Y}
Where, X is the amount of good-X and Y is the amount of good-Y.
The function “min” is a function that chooses the smallest value in
the bracket. For example min{2,3} =2, min{100,3} =3.

a)Draw the indifference curves associated with U=4, U=6 and show
that the good X and good Y are perfect complements for the
consumer, i.e., indifference curve is L shaped.

b) Solve the utility maximization problem such that:

U(X,Y) = min{X,2Y}
PX = $4, PY = $2, and income = $50
 Practice: Corner Solution
4-92

 Mary’s utility function is U = b + 10c – c2, where b is

the number of silver bells in her garden and c is the
number of cockle shells. She has 50 square feet in
her garden to allocate between silver bells and
cockle shells. Silver bells each take up 1 square foot
and cockle shells each take up 11 square feet. She
gets both kinds of seeds for free.

a. Draw the indifference curve for U=25

 
b. To maximize utility, how many silver bells and
cockle shells should she plant?
 Optimal Bundles on Convex Sections of
Indifference Curves
4-93
 Maximizing utility subject to a
constraint using calculus
4-94

 Lisa’s objective is to maximize her utility,

U(q1, q2), subject to (s.t.) her budget
constraint:

 Here the control variables are q1 and q2.

 Lisa has no control over the prices she
faces, p1 and p2, or her income, Y.
 Two methods of solving the problem. We’ll
focus on the substitution method only.
 Substitution
4-95

 First, we can substitute the budget constraint into

the utility function. Using algebra we can rewrite
the budget constraint as q1 = (Y-p2q2)/p1 and
substitute this expression for q1 in the utility
function

 Using standard maximization techniques we can

solve this problem. (i.e. take the first derivative of
the utility function with respect to q2 and set it
equal to zero)
 Substitution
4-96

 By rearranging terms in the above equation, we get

the same condition for an optimum that we obtained
using a graphical approach.

 When we combine the MRS=MRT condition with the

budget constraint we have two equations in two
unknowns , q1 and q2. So we can solve for the optimal
q1 and q2 as function of prices, p1 and p2, and income
 RECALL: Consumer Maximization
 Would Lisa be able to
consume any bundle along  Bundle e is called a
I3 (i.e. bundle f)? consumer’s optimum.
r per semester

 No! Lisa does not have  If Lisa is consuming this

enough income to afford bundle, she has no
any bundle along I3 incentive to change her
behavior by substituting
one good for another.
itos
B, Bur

25
 Would Lisa be able to
c
consume any bundle along
f
20 I1?
 Yes; she could afford
B bundles d, c, and a.
e
10
I3
d I2
A a
I1
0 10 30 50
, ZPizzas per semester
4-97
 Minimizing Expenditure
4-98

 We have shown how Lisa chooses quantities of goods so

as to maximize her utility subject to a budget constraint.
 There is a related or dual constrained maximization
problem where she finds the combination of goods that
achieve a particular level of utility for the least
expenditure.
 Earlier we showed that Lisa maximized her utility by
picking a bundle of q1 = 30 and q2 = 10 at the
indifference curve I2
 Now we see: How can Lisa make the lowest possible
expenditure to maintain her utility at a particular level
which corresponds to indifference curve I 2?
 Minimizing Expenditure
4-99

The figure shows three possible

budget lines corresponding to
budgets or expenditures E1, E2 and
E3.
E1 lies below I2.
E2 and E3 both cross I2. However the
BL with E2 is the least expensive way
for her to stay on I2.

The rule for minimizing expenditure while achieving a given level of utility is to
choose the lowest expenditure such that the budget line touches-is tangent to-the
relevant indifference curve
 Minimizing Expenditure
4-100

 Solving either of the two problems yields the same

optimal values.
 More useful to use the expenditure minimizing approach
 We can use calculus to solve the expenditure minimizing
problem

 The solution of this problem gives us the expenditure

function: the relationship showing the minimal
expenditures necessary to achieve a specific utility level
for a given set of prices.
 Practice
4-101

 Sally consumes two goods, dinners (X) and DVDs (Y).

Her utility function is given by the expression
U = 3XY. The current market price for dinners is $10
and DVDs is $5.
 Determine the dinner and DVD combination which
minimizes Sally's expenditures such that her utility is
maintained at 3750 utils. Show her optimum point on
a graph. (Partial quantities are possible.)
 Expenditure Minimization:
4-102
Solution
 As long as we have an interior solution (not
corner), we will typically write two equations
as functions of good x and good y:
1. MRS = - PX/PY

2. Equation of indifference curve pertaining to

given utility level

Then solve the two equations in two

unknowns
 Behavioral Economics
4-103

 behavioral economics - by adding

insights from psychology and empirical
research on human cognition and
emotional biases to the rational
economic model, economists try to
better predict economic decision making
 Framing
4-104

Imagine that the United States is preparing

for the outbreak of an unusual tropical
disease, which is expected to kill 600
people. Two alternative programs to
combat the disease have been proposed.
 Assume that the exact scientific estimates

of the consequences of the programs are

as follows
 Framing: Scenario I
4-105

 If Program A is adopted, 200 people

will be saved

 If Program B is adopted, there is a one-

third probability that 600 people will be
saved and a two-thirds probability that
no people will be saved
 Framing: Scenario II
4-106

 If Program A’ is adopted, 400 people

will die

 If Program B’ is adopted, there is a

one-third probability that nobody will
die and a two-thirds probability that
600 people will die
 Think fast!
4-107

 A bat and a ball cost $1.10 in

total.
 The bat costs $1 more than the

ball.
 How much does the ball cost?
 Heuristics or rules of thumb
4-108
can mislead
 Almost everyone reports an initial tendency to
answer “10 cents” because the sum
 $1.10 separates naturally into $1 and 10 cents,
and 10 cents is about the right magnitude.
 Frederick (2003) found that many intelligent
people yield to this immediate impulse: 50
percent (47/93) of agroup of Princeton students
and 56 percent (164/293) of students at the
University of Michigan gave the wrong answer.
 Another one:
4-109

 1 in 100 people in the world have a disease.

 We have a test for it.
 If someone has the disease, she has a 99%
chance of testing positive.
 If someone doesn’t have the disease, she has
a 99% chance of testing negative.
 Linda took the test, and tested positive.
 Assuming that Linda was drawn randomly
from the population, what is the probability
that she has the disease?
 Apply Bayes’ rule:
4-110

 If D = “has the disease” and N =

“doesn’t have the diseases”, T+ =“the
test is positive”, then:
 Hyperbolic Discounting
4-111

 Consider another thought experiment:

 Choose a ten minute break in 30 days or a

fifteen minute break in 31 days.
 Choose a ten minute break today or a fifteen
minute break tomorrow.

 Vast body of experimental evidence,

demonstrates that discount rates are higher (less
patient) in the short-run than in the long-run.
 Pick a consumption path
4-112
(ages 31 to 60).
1. You are deciding at age 30 and face no uncertainty
2. Consumption represents consumption flows (e.g.,
housing is calculated on a flow basis).
3. The path that you pick will be your actual consumption
path
4. Your household needs will not change over the lifecycle
(e.g., no kids)
5. You are guaranteed to survive until at least age 60.
6. All paths have the same net present value ($1,000,000)
assuming a 4% discount rate.
7. The inflation rate is 0%.
8. I let you choose among 11 paths.
 Choose a consumption path
4-113
 Intertemporal consumption
4-114

 Under reasonable interest rate

assumptions, subjects pick flat or rising
consumption profiles
 However, in reality:
4-115