Microeconomics: Lecture 4

Consumer Behavior (Part II)

Consumer Theory: Roadmap

Building blocks Preferences and Axioms of Rationality (Part I) Today: (Part II) Representation of Rational Preferences: Utility Affordable Bundles: Budget Set Third Part: A model of Consumer Choice: Utility Maximization: Derivation of Individual Demand Last Part Derivation of Market Demand Two Levels of Rationality: In Preferences and in Choices

Consumer Theory: Part II

Representation of Rational
Preferences: Utility

Affordable Bundles: Budget Set

Introducing Utility
Utility function Formula that assigns a level of utility to individual market
baskets

If the utility function is

A market basket with 8 units of food and 3 units of clothing gives a utility of

Utility Representation
Utility rankings are ordinal in nature: they record the
relative desirability of commodity bundles

This means that if U represents my preferences and

U(icecream)=100 and U(cake)=10, then someone can deduce that I prefer ice cream to cake but NOT that I like ice cream 10 times more than I like cake.

This representation is unique only up to an ORDERpreserving transformation and it does not have any meaning of intensity.

Utility

Utility is affected by the consumption of physical commodities psychological attitudes general cultural environment
Economists generally devote attention to quantifiable options while holding constant the other things that affect utility or ceteris paribus assumption

Utility

Because utility measures are not unique, it makes no sense to consider how much more utility is gained from A than from B
It is also impossible to compare utilities between people

Utility - Example
Market Basket Food Clothing Utility

Utility - Example

Baskets for each level of utility can be plotted to get an indifference curve

To find the indifference curve for a utility of 14, we can

change the combinations of food and clothing that give us a utility of 14

Utility - Example

Utility and the MRS

Suppose an individuals preferences for hamburgers (Y) and soft drinks (X) can be represented by

Solving for Y, we get

Solving for MRS =

Utility and the MRS

Note that as X rises, MRS falls

Marginal Utility
Suppose that an individual has a utility function
of the form

We can define the marginal utility of good X1 by The marginal utility is the extra utility obtained
from slightly more X1 (all else constant)

Marginal Utility

The total differential of U is

The extra utility obtainable from slightly more X1, X2,, Xn is the sum of the additional utility provided by each of these increments

Deriving the MRS

Suppose we change X and Y but keep utility constant (dU = 0)

Rearranging, we get:

MRS is the ratio of the marginal utility of X to the marginal utility of Y

Marginal Utility and the MRS

Again, we will use the utility function

The marginal utility of a soft drink is

The marginal utility of a hamburger is

Examples of Utility Functions

Cobb-Douglas Utility
where and are positive constants

The relative sizes of and indicate the

relative importance of the goods

Examples of Utility Functions

Perfect Substitutes
Quantity of Y The indifference curves will be linear. The MRS will be constant along the indifference curve.

U3 U1 U2 Quantity of X

 Perfect Complements
Quantity of Y

Examples of Utility Functions

The indifference curves will be L-shaped. Only by choosing more of the two goods together can utility be increased.
U3 U2 U1 Quantity of X

Affordable bundles: budget set

Bundle: a combination of goods What does it mean for a bundle to be

affordable?

It costs less than the amount of money the

consumer has to spend.

Affordable bundles belong in the budget

set

The Budget Line

Different choices of food and clothing can be calculated that use all income These choices can be graphed as the budget line

Example: Assume income of $80/week, PF = $1 and PC = $2

The budget line then can be written:

Assumption: All income is allocated to food (F) and/or clothing (C)

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The Budget Line

Clothing

(I/PC) = 40 30

A B
10 D 20 E

20 10

G
0
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20

40

60

80 = (I/PF)

Food
22

The Budget Line - Changes

The Effects of Changes in Income

An increase in income causes the budget
line to shift outward, parallel to the original line (holding prices constant)

Can buy more of both goods with more

income

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The Budget Line Changes

Clothing (units per week)

80 60 40 20
0
L3 (I = $40)
4/22/2014

An increase in income shifts the budget line outward

A decrease in income shifts the budget line inward

L1 (I = $80) L2 (I = $160)

40

80

120

160

Food

(units per week)

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The Budget Line Changes: Price change

Clothing (units per week) A decrease in the price of food to $.50 changes the slope of the budget line and rotates it outward

40

L3
(PF = 2)
4/22/2014

L1
(PF = 1)
80

L2
120 160

An increase in the price of food to $2.00 changes the slope of the budget line and rotates it inward

(PF = 1/2)
Food
(units per week) 25

40

The Budget Line

The slope indicates the rate at which the two goods can be substituted without changing the amount of money spent
We can rearrange the budget line equation to make this more clear

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budget set (1)

Assume that an individual has I dollars

to allocate between good x and good y
Quantity of y
I py

pxx + pyy I
If all income is spent on y, this is the amount of y that can be purchased

The individual can afford to choose only combinations of x and y in the shaded triangle

If all income is spent on x, this is the amount of x that can be purchased

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I px

Quantity of x
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Summary
Rational Preferences can be represented by utility functions A few simple functional forms can capture important
differences in individuals preferences for two (or more) goods

Cobb-Douglas function linear function (perfect substitutes) fixed proportions function (perfect complements) The Budget Set contains all affordable bundles for a
consumer

Required Reading

Pindyck and Rubinfeld,

Microeconomics, 8th edition, Chapter 3, pp. 78-86.