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¾ Indifference curves
¾ Budget constrains
¾ Utility maximization
5-6
The Consumer’s
Optimization Problem
We assume all individual consumption
decisions are made with the goal of
maximizing total satisfaction from
consuming various goods and services
~ Subject to the constraint that spending on
goods exactly equals the individual’s money
income
5-7
The Consumer’s
Optimization Problem
The basic model of consumer theory seeks to
explain how consumers make their purchasing
decisions when they are completely informed
about all thing that matter:
~ Range of products available
~ Prices of all products
~ Capacity of products to satisfy
~ Their incomes
5-8
Suppose that B is considered the most
desirable bundle, and C and A are
viewed as providing equal but lesser
Properties of consumer preferences amounts of satisfaction than B
four assumptions form the basis for the theory of consumer choice.
A B C
5-10
Properties of consumer preferences
5-11
Utility
Benefits consumers obtain from goods &
services they consume is utility.
~ Utility is an abstract measure of the satisfaction or
happiness that a consumer receives from a bundle of
goods. Economists say that a consumer prefers one
bundle of goods to another if one provides more utility
than the other.
~ Utility is a measuring unit to satisfaction, like dollar,
kilometre, kilogram.
5-12
Example: Utility & Use value
5-13
Example: Utility
Some people prefer
travelling by air to train
To these people, utility of
go travel by air > travel
by train.
5-15
2. Indifference Curves
5-16
A B C
5-17
Now suppose that other bundles, designated as E,F,G
and H, are also considered equivalent to A and C.
This bundles are plotted on a graph
Cans of
deodorant
The points can be joined to form an
A indifference curve that represents all
bundles of goods that provide an
C individual with equal levels of
E satisfaction
F
G
H
Bottle of
mouthwash 5-18
Indifference Curves
Indifference curve is a set of points
representing different bundles of goods &
services, each of which yields the same
level of total utility
5-19
Indifference Curves
(1) Indifference curves are downward-sloping
2
Quantity of
good X
5-20
Indifference Curves
(2) Indifference curves
are convex
consumers will be willing to
give up successively fewer
units of one good in order to
get additional units of
another good assures that
indifference curves will have
the convex shape.
5-21
Two Extreme Examples of Indifference Curves:
Perfect substitutes
Suppose that someone offered you bundles of
nickels and dimes. How would you rank the
different bundles?
Two Extreme Examples of Indifference
Curves: Perfect complements
Suppose that someone offered you bundles of shoes.
Some of the shoes fit your left foot, others your right foot.
How would you rank these different bundles?
Marginal Rate of Substitution
MRS measures the number of units of Y
that must be given up per unit of X added
so as to keep utility constant
The consumer is indifferent between
combination A (10X and 60Y) and B (20X
and 40Y).
Thus the rate at which the consumer is willing
to substitute is :
∆ 60 40
2
∆ 10 20
5-25
Marginal Rate of Substitution
A
600
Quantity of good Y
C (360,320)
320
I
T’
B
0 360 800
Quantity of good X
Quantity of Y
greater the level of IV
utility associated with
the curve III
9 Combinations of goods
on higher indifference II
curves are preferred to
combinations on lower I
curves
Quantity of X 5-27
Indifference Map
Indifference curves do not intersect
The bundle denotes by 4 has
Quantity of more of both goods than 5
good X
4 is preferred to 5
Because 3 and 5 are on the same
4
5 indifference curve
5-29
A marginal utility interpretation
of MRS
For points on a given indifference curve, all
combinations of goods yield the same level of utility, so
∆U is 0 for all changes in X and Y that would keep the
consumer on the same indifference curve. So, it follows
that:
∆U = (MUX*∆X)+ (MUY*∆Y) = 0
∆
Therefor, solving for ∆Y/ ∆X: ∆
∆
We have known:
∆
ΔY MU X
MRS = − =
ΔX MUY 5-30
3. The consumer’s budget
constraint
what the consumer can afford
Actual purchases are strongly influenced by income
and prices.
5-31
People consume less than they desire because
their spending is constrained. While the
indifference curve only describes the
consumer’s preference. So after discussing
indifference curve, we need to consider the
budget constraint.
5-32
To keep things simple, we examine the
decision facing a consumer who buys
only two goods: pizza and Pepsi.
Income constraints
• Suppose the consumer has an income of $1,000 per
month and he spends his entire income on pizza and
Pepsi.
The price of a pizza is $10
The price of a pint of Pepsi is $2
5-33
Find the combination of pizza and pepsi
that the consumer can buy.
5-34
Consumer’s Budget Line
A budget line shows all possible bundles
of goods that can be purchased at given
prices if the entire income is spent
M = PX X + PY Y
or
M PX
Y= − X (In the form of a
straight line)
PY PY
5-35
Consumer’s Budget
The term M/PY Gives the amount of Y the
consumer can buy if no X is purchased.
M
PY
•A Line AB shows all combination of X and Y that
can be purchased with the income (M) and
given prices of goods (Px and Py).
M PX
Quantity of Y
Y= − X
PY PY Is the slope of the budget line
and indicates how much Y
must be given up for an
additional unit of X
R
120
A A
Quantity of Y
Quantity of Y
100 100
F
80
Z B N C B D
160 200 240 125 200 250
Quantity of X Quantity of X
5-39
Point X
Which point is the Lies on the budget constraint, indicating that
utility maximized it is an affordable bundle.
point? But X is not the bundle that will maximize the
individual’s utility.
Quantity
of pizzas Point Y
Lies at the tangency between the budget
constraint and the indifference curve.
●Z That is, point Y is the only point on the
curve that touches the budget
constraint.
Y Point Z
● A point such as Z on any higher
indifference curve is above
the budget constraint and
hence is not affordable.
X
●
Quantity
of burgers
Utility Maximization subject to a
limited income
Given the individual’s tastes, preference, and
income, and the price of the two goods, there is
no other point that will provide the same level of
utility or satisfaction as point Y.
Quantity
of pepsi
X
●
Quantity
of pizza
Utility Maximization subject to a
limited income
Utility maximization subject to a limited
income occurs at the combination of
goods for which the indifference curve is
just tangent to the budget line
ΔY PX
− = MRS =
ΔX PY
5-42
Constrained Utility Maximization
(Figure 5.8)
50
45 •A
Quantity of pizzas
40 •B •D
R E IV
30 •
III
20
15 •C II
T
10 I
0 10 20 30 40 50 60 70 80 90 100
Quantity of burgers
5-43
Explain: a consumer maximizes utility when MRS XY =−
PX
PY
PX Here, x is burger
Suppose at point C: | MRS XY |< Y is pizza
PY
∧
∆ In the market, 1 burger can be
= 4/8 1/2 exchanged for 1/2 pizza.
∆
PX Here, x is burger
Suppose at point B: | MRS XY |> Y is pizza
PY
∨
∆ In the market, 1 burger can be
= 4/8 1/2 exchanged for 1/2 pizza.
∆
MU X MUY
=
PX PY
5-47
Quantity
of pepsi
●Z
the slope of the two lines is I/Py
equal at point Y ●
Y
X
●
Quantity
According to indifference curve, of pizza
I/Px
the slope of point Y is: MRSxy=△y/ △x
MRSxy=△y/ △x=MUx/MUy
So, MUx/MUy=Px/Py MUx/Px=MUy/Py
Utility Maximization, N Goods
The utility maximization principle is
easily extended to cover any number of
goods
ΔX i Pj
− = MRS =
ΔX j Pi
MU1 MU 2 MU 3 MU N
= = = ... =
P1 P2 P3 PN
5-49
Example: finding the optimal
bundle of hot dogs and cokes
(P180)
5-50
5. Individual demand and
market demand curves
5-51
Individual Consumer Demand
An individual’s demand curve for a
specific commodity relates utility-
maximizing quantities purchased to
market prices
~ Income & prices held constant
~ Slope of demand curve illustrates law of
demand—quantity demanded varies
inversely with price
5-52
Deriving a Demand Curve
(Figure 5.9)
100
Quantity of Y Px=$10
Px=$8
Px=$5
0
50 65 90 100 125 200
Quantity of X
Price of X ($)
10
Demand for X
0
50 65 90
Quantity of X 5-53
Market Demand & Marginal Benefit
List of prices & quantities consumers are
willing & able to purchase at each price, all
else constant
Derived by horizontally summing demand
curves for all individuals in market
Because prices along market demand
measure the economic value of each unit of
the good, it can be interpreted as the
marginal benefit curve for a good
5-54
Derivation of Market Demand
(Table 5.1)
Quantity demanded
Market
Price Consumer 1 Consumer 2 Consumer 3
demand
$6 3 0 0 3
5 5 1 0 6
4 8 3 1 12
3 10 5 4 19
2 12 7 6 25
1 13 10 8 31
5-55
Derivation of Market Demand
Figure (5.10)
5-56
6. Corner Solution
5-57
Corner Solution
In many cases consumers spend their
entire budget and choose to purchase
none of some specific good
5-58
Corner Solution: X* = 0
Figure (5.11)
This figure shows a corner solution in
which the consumer spends her entire
budget on good Y and buys none of
good X.
In general, a corner solution, in which the
consumer purchases none of some good
X, result when …… for all
goods I, j, etc.
The consumer spends all of her income,
yet the marginal utility per dollar spent on
X is less than the marginal utility per
dollar spent on any other good that is
purchased. This is usually what we mean
when we say we “cannot afford”
something.
A corner solution exists when the utility
maximizing bundle lies at one of the
endpoints of the budget line and the
consumer chooses to consume zero units
of a good
5-60
Corner Solution
For goods X and Y, a corner solution, in which
the consumer purchases none of good X, results
when
MU X MUY
<
PX PY
In general, a corner solution, in which the
consumer purchases none of good X, results
when
MU X MU i MU j
< = ... =
PX Pi Pj 5-61
Summary
Basic premise for analyzing consumer behavior
~ Individuals make consumption decisions with the goal of
maximizing their total satisfaction from consuming various
goods and services, subject to the constraint that their spending
on goods exactly equals their incomes
The benefit consumers obtain from the goods and
services they consume is called utility
~ The utility function shows an individual's perception of the level
of utility from consuming each conceivable bundle of goods
~ Marginal utility is the addition to total utility attributable to adding
one unit of a good, holding constant the amounts of all other
goods consumed
~ The marginal rate of substitution (MRS) shows the rate at which
one good can be substituted for another while keeping utility
5-62
constant
Summary
An indifference curve is a set of points representing
different bundles of goods and services, each of which
yields the same level of total utility
The consumer’s budget line shows the set of all
consumption bundles that can be purchased at given
prices and income if the entire income is spent
A consumer maximizes utility subject to a limited
income at the combination of goods for which the
indifference curve is just tangent to the budget line
~ At this combination, the MRS is equal to the price ratio
5-63
Summary
An individual consumer’s demand curve relates utility-
maximizing quantities to market prices, holding
constant income and prices of all other goods
~ The slope of the demand curve illustrates the law of demand:
quantity demanded varies inversely with price
Market demand is derived by horizontally summing the
demand curves for all individuals in the market
When a consumer spends the entire budget and
chooses to purchase none of a specific good, this
outcome is called a corner solution
5-64