Managerial

Economics
MBAFT 6103

Today
Consumer Choice:
Utility and Budget Constraint

1. Motivation

Content

2. Consumer Preferences and the Concept of Utility

3. Marginal Utility and Marginal Rate of Substitution
4. Indifference Curves
5. Some Special Preferences
6. Budget Constraint
7. Consumer Choice
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Why do we care?

Because Managers need to understand their
consumer base
We need to have framework to understand:
Where does the demand curve come from?
How do individual consumers make decisions?

Examples

CNN Money reports, despite substantial fall in gas
price, consumer demand for driving in U.S. has not
picked up. the sharp drop in prices has not
resulted in demand recovery, as it has been offset
by shrinking home values, 401(k)s and cash in
pockets
If you are running an automobile company, you
need to understand what are some of the related
products your consumer cares about and the
consumer decision making process.

Example:
Inventory Management

You sell both video game consoles and video games.
You want effective inventory management (not too little and
too much)
Need to recognize the relationship that exists among
complementary products (example: when price of your game
consoles is reduced the demand for both game consoles and
video games will increase)
Need to recognize the relationship that exists among
substitute goods (example: when price of your game consoles
is reduced the demand for game consoles produced by your
rival will decrease.
You need to take both effects in account for effective
inventory management. Again, you need to understand the
consumers decision making process.
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Consumer Problem:
Two Components

Consumer Preference (signifies Willingness)
o Consumer Preferences tell us how the consumer
would rank (that is, compare the desirability of)
any two combinations of goods.
o These combinations of goods are referred to as
baskets or bundles.
Budget Constraint (signifies Ability) Set of baskets of
goods and services that consumers can afford.

Consumer Preference:
Key Properties

Completeness
Given the choice between any 2 bundles of goods a consumer either
Prefers bundle A to bundle B: A B.
Or prefers bundle B to bundle A: A B.
Or is indifferent between the two: A B.

Consumer Preference:
Key Properties

Transitivity
Preferences are transitive if a consumer who prefers basket A to basket B,
and basket B to basket C also prefers basket A to basket C, i.e. if A B,
and B C, then A C.

Monotonicity
Preferences are monotonic if a basket with more of at least one good
and no less of any good is preferred to the original basket.

Intransitivity and Age

Age Number of Subjects Intransitive
(%)
4
39
83
5
6
7
8
9
10
11
12
13
Adults

33
23
35
40
52
45
65
81
81
99

82
82
78
68
57
52
37
23
41
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Source: See Hirshleifer, Jack and D. Hirshleifer, Price Theory and Applications.

Concept of Utility

Ordinal Preference
o Tells us how consumers rank alternative baskets.
o Tells us that consumers prefer A to B, but do not
tell us how much more consumers like A than B.

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Concept of Utility

Cardinal Preference
o Quantitatively measures a consumers
preference for one basket over the other.
o Represented by utility function.
o Utility function assigns a number to each basket
so that more preferred baskets get a higher
number than less preferred baskets.
o Utility function, U, measures the level of
satisfaction that one receives from a basket, x: U
= U(x)
o Example: A consumer care about only one
good, x, and her utility is given by U(x) = x1/2

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Utility Function

Example:
Students take an exam. After the exam, the students
are ranked according to their performance. An
ordinal ranking lists the students in order of their
performance (i.e., Alka did best, Arvind did second
best, Ashwini did third best, and so on). A cardinal
ranking gives the mark of the exam, based on an
absolute marking standard (i.e., Alka got 80, Arvind
got 75, Ashwini got 70 and so on).

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Examples of Utility
Functions

Cobb Douglas: U(x,y) = Axy; A>0, 0<=<=1,
0<=<=1
Linear Utility: U(x,y) = Ax + By; A, B>0
Quasi Linear Utility: U(x,y)=Ax+Bln(y); A, B>0
Leontief Utility: U(x,y) = min[Ax, By] ; A, B>0
CES Utility: U(x,y) = [A1/sx(s-1)/s + B1/sy(s-1)/s ]s/(s-1); A, B>0
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Marginal Utility

A consumer cares about two goods, x and y and his
preference is given by a utility function, U(x,y). The marginal
utility of good, x, is the additional utility that the consumer
gets from consuming a little more of x when the
consumption of y in the consumers basket remain
constant.
U/x (y held constant) = MUx= partial derivative of U w.r.t x
The marginal utility of x is the slope of the utility function
with respect to x. The principle of diminishing marginal
utility states that the marginal utility falls as the consumer
consumes more of a good.
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Graphically
Marginal utility:
U
MU x =
X
Marginal utility is
represented by the
slope of the utility
curve.

U: utility

x: weekly consumption of Coca Cola

Marginal Utility: Example

Relative Income and Life Satisfaction Across
Nations(shows positive and diminishing/constant
marginal utility)

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Marginal Utility: some

properties

When MU x and MU y are both positive, the
indifference curve has a negative slope (implies
monotonicity)
Marginal utility (generally) diminishes or stays
constant when consumers have more and more of
that good.

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Indierence Curves:

We generally deal with consumer preference with
two goods x, y. But that means if we want to plot
utility function U(x,y), it will be a three dimensional
graph. We reduce that to a two dimensional graph
by drawing something called the Indifference
Curve.
We choose a value of utility that we want, U(x,y)=U
and the find out the all the possible combinations of
x and y that delivers U. To draw multiple indifference
curves we keep choosing different values of U each
time.
HW: Choose any utility function and draw at least three different
indifference curves by choosing three different values of utility.
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Analyzing Indierence Curves

Indifference Curve
o An indifference curve
plots all the baskets
that give a consumer
the same level of
satisfaction.
o One indifference
curve represents one
level of utility.
o Note: Indifference
curve not the same as
utility function

Good Y
III.
II.
I.

Good X

IC: Properties
The higher an indifference curve, the
higher the level of the utility it represents.

Preference direction

IC2
IC1
x

IC: Properties

Monotonicity: Consider a bundle A

Preferred to A

Less
preferred

IC1
x

IC: Properties

Can Indifference Curves Cross each other?

IC1

IC2
B

No, They can not!

Suppose ICs intersect.
We know B preferred to A.
But, by definition, B indifferent to C
and C indifferent to A
=> B indifferent to A by transitivity.
Contradiction.

Related Concept:
Marginal Rate of Substitution (MRS)
Marginal Rate of Substitution y
o The rate at which a
consumer is willing to
substitute one good for
another and maintain
the same satisfaction
level.
o When you increase
one unit of x, how
many units of y are
you willing to sacrifice?
Thats MRS of x for y, MRSx,y

IC
x

Marginal Rate of Substitution

MRSx,y= MUx/MUy
Example: U = Ax2+By2; MUx=2Ax; MUy=2By
(where: A and B positive numbers)
MRSx,y= MUx/MUy= 2Ax/2By= Ax/By
Marginal Rate of Substitution at any point is the
negative of the slope of the indifference curve at
that point.
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MRS:
Decreases with Increased Consumption
To go from consumption
bundle A to B the consumer
must give up 50 units of Y to
get one additional unit of X.

Good Y
III.
II.

To go from consumption
bundle B to C the consumer
must give up 16.67 units of Y
to get one additional unit of
X.
To go from consumption
bundle C to D the consumer
must give up only 8.33 units of
Y to get one additional unit of
X.

I.
A

100

50

33.33
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Good X

Diminishing MRS
The more of good x you have, the more you are
willing to give up to get a little of good y.
The indifference curves get flatter as we move
out along the horizontal axis and steeper as we
move up along the vertical axis
The marginal rate of substitution is in fact the
negative of the slope of the indifference curve:

MRS xy

y
=
x

Important Thing To Note

All the indifference curves we have drawn so far are
convex to the origin? Why?
Averages preferred to extremes! (generally)
Diminishing marginal rate of substitution implies the
indifference curves are convex to the origin (implies
averages preferred to extremes)

Average Preferred to Extremes

(.5A, .5B)

IC2

IC1
x

Are ICs always convex to the

origin?

NO
Not all preferences are well behaved (meaning,
some preferences violate the property of
diminishing MRS)
o Perfect substitutes
Blue pens and black pens
o Perfect complements
Left shoe and right shoe
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Special Preferences: Examples

y

Indifference curves for perfectly

substitutable goods:
Constant Marginal Rate of
Substitution

Constant Slope

IC1

IC2

IC3

Special Preference: Example

Example: For the
f o l l o w i n g
indifference curves,
the marginal rate
of substitution
between x and y is:
0?

Infinite?
undefined ?
Diminishing?
all of the above?

Next

Budget Constraint

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