Four key elements in consumer choice

• Consumer’s income
Chapter 4 • Prices of goods
Consumer Theory
• Consumer preferences

Le Thi Kim Dung, M.E

• The assumption that consumers maximize
utility

6.1

Possi Movies Soda

Budget constraint bi
lity Q Expend Six- Expend
• Ex: Lisa iture packs iture
(dollar (dollar
– Income: $30 a month s) s)
– She plans to buy only 2 goods: movies and a 0 0 10 30
soda, Pm = $6/ each , Ps = $3/ six-pack
b 1 6 8 24
• Income and prices together determine the
combinations of the goods that the consumer c 2 12 6 18
can afford. d 3 18 4 12
• The budget line separates the affordable from e 4 24 2 6
the unaffordable.
1.2
f 5 30 0 0 3

Budget constraint Preferences

• Utility: to describe preferences. The benefit or

satisfaction that a person gets from the
consumption of a good or service (G or S).
– Total Utility (TU): the total benefit that a person
gets from the consumption of G&S.
– Marginal Utility (MU): the change in total utility
that results from a one-unit increase in the
quantity of a good consumed.
MU = ΔTU / ΔQ

1.4 1.5

1
 Movies Soda
Movies Soda Qty TU MU Six- TU MU
Qty TU MU Six- TU MU per packs
mon per
per packs th month
mon per
6 196 21 6 225 19
th month
7 214 18 7 243 18
0 0 0 0
8 229 15 8 260 17
1 50 50 1 75 75 9 241 12 9 276 16
2 88 38 2 117 42 10 250 9 10 291 15
3 121 33 3 153 36 11 256 4 11 305 14
12 259 3 12 318 13
4 150 29 4 181 28
13 261 2 13 330 12
5 175 25 5 206 25 6
14 262 1 14 341 11 7

Maximizing Total Utility

• Consumer equilibrium: a situation in which:

– a consumer has allocated all his/ her available
income
– the prices of good and service are given
– Consumer maximizes his/ her TU.
• Two ways to find out consumer equilibrium:
1) TU: maximizing TU
2) MU: equalizing MU per dollar spent

1.8 1.9

Equalizing MU per Dollar Spent

Maximizing Total Utility
Movies TU from Soda Lisa maximizes total utility when she spends all
Qty TU movies TU Six- her income and consumes movies and soda
per and packs
soda
such that:
per
mo month • MUm = MUs (1)
nth
Pm Ps
a 0 0 291 291 10
Because of income restriction, we need to
b 1 50 310 260 8
satisfy the following equation:
c 2 88 313 225 6
Qm Pm + Qs Ps = I (2)
d 3 121 302 181 4
e 4 150 267 117 2
f 5 175 175 0 0 10 1.11

2
 Movies ($6 each) Soda ($3 per six-pack)

Qty MU MU/P Six-pack MU MU/P

a 0 10 15 5.00
b 1 50 8.33 8 17 5.67
c 2 38 6.33 6 19 6.33
d 3 33 5.50 4 28 9.33
e 4 29 4.83 2 42 14.00
f 5 25 4.17 0
12 1.13

Divisible and indivisible goods The budget line

• Divisible goods: can be bought in any

quantity desired.
• Ex: gasoline and electricity.
• When goods are divisible, the consumption
possibilities are not just points a through f,
but those points plus all the intermediate
points that form the line running from a to f:
a budget line

1.14 1.15

The budget equation Real income

Expenditure = Income • Real income: is the household’s income

expressed not as money but as a quantity of
Expenditure = Ps. Qs + Pm. Qm
goods the household can afford to buy.
Expenditure = Ps. Qs + Pm. Qm = Y • Ex: real income of Lisa in terms of soda is 10
Qs = Y/Ps – (Pm/Ps). Qm six-packs.

• If Ps = 3, Pm = 6, Y = 30
• Qs = 10 – 2Qm
1.16 1.17

3
 The budget equation:
Relative price
A change in price
• Relative price Pm/ Ps: relative price of a
movie in terms of soda. • A change in price: the higher the price of the
good measured on the horizontal axis, other
– Opportunity cost: Pm = $6, Ps = $3  Pm /
things remaining the same, the steeper is the
Ps = 2: that is, to see 1 more movie, Lisa
must give up two six-packs: So, her budget line.
opportunity cost of 2 six-packs is 1 movie.
– Slope of Lisa’s budget line: ΔS / ΔM = - (Pm
/ Ps)

1.18 1.19

The budget equation: The budget equation:

A change in price A change in income

• A change in income: slope of the budget line

does not change

1.20 1.21

The budget equation:

A change in income Modelling consumer preferences

• Assume the consumer

prefers more to less.
• Compared with point “a”:
– the consumer would
prefer to be to the
c north-east e.g. at “c”
a – but prefers “a” to such
points as “b” to the
b
south-west.

Quantity
of meals
1.22 6.23

4
 Modelling consumer preferences (2) Modelling consumer preferences (3)

• “a” is preferred to all • An indifference curve like

points in the dominated U2U2 shows all the
consumption bundles
region U2
Preferred that yield the same utility
region • but the consumer would to the consumer
d prefer any point in the
c – ICs slope downwards
preferred region to “a” (given our
a
• points like “d” and “e” assumptions)
b involve more of one good U2 – their slope gets
Dominated e steadily flatter to the
region and less of the other
compared with “a”. Quantity right
Quantity
of meals – ICs cannot intersect
of meals
6.24 6.25

Preferences and Indifference Curves Preferences and Indifference Curves

Preference
map: a
series of
indifference
curves.

1.26 1.27

Marginal Rate of Substitution (MRS) Marginal Rate of Substitution (MRS)

• Along an indifference curve, TU is the same

• From c to g: S decreases and M increases
– TU decreases since S decreases: TU = S. MUs
– TU increases since M increases: TU = M. MUm
• To be sure TU is unchanged:
– S. MUs + M. MUm = 0
– ⇨ S. MUs = - M. MUm
– ⇨ S / M = - (MUm / MUs ) = MRSms

1.29

5
 Marginal Rate of Substitution (MRS) Marginal Rate of Substitution (MRS)

The MRS: the rate at which a person will give up
y (the good measured on the y-axis) to get
more of good x (the good measured on the x-
axis) and at the same time remain indifferent
(remain on the same indifference curve).
Diminishing MRS is a general tendency for the
MRS to diminish as the consumer moves
along an IC, increases consumption of the
good measured on the x-axis and decreases
consumption of the good measured on the y-
axis.

1.30 1.31

Degree of Substitutability
(The shape of the ICs) The consumer’s choice
The point at which utility is maximized
is found by bringing together the ICs
and the budget line • The choice point is at C
• where the budget line is
U3
U at a tangent to an IC
U1 2
B • Points B and E are also
affordable
C • but give lower utility,
U3
E • being on a lower IC.
BL U1U2
The shape of the ICs reveals the degree of Quantity
substitutability between two goods. of meals
6.33

The consumer’s choice The consumer’s choice

• Best affordable point: • To maximize satisfaction, consumer should

– on the budget line choose the combination of X and Y to equalize
– on the highest attainable IC MU per dollar spent on each kind of goods:
– slope of the IC (- MUm / MUs) = slope of • Mum = MUs (1)
the budget line ( - Pm / Ps) • Pm Ps
• and Qm. Pm + Qs. Ps = I (2)

1.34 1.35

6
 Normal goods

U2
When both goods are
BL1

Films
U1
NORMAL, an increase
in income induces a new
BL0 choice point at C':
C' The quantity demanded
of each good
C
U2 increases
U1

Meals
1.36 6.37

An inferior good and a normal good An increase in the price of meals (1)
When “meals” is an inferior good The increase in price of meals shifts the
BL1 U2 the increase in income takes the
U1 budget line from BL0 to BL1
Films

consumer from C to C'.

Films

The quantity of meals falls

BL0 C' and the quantity of films
increases

U2
C
BL0
U1 BL1

Meals
Meals The increase in price reduces purchasing power.
6.38 6.39

An increase in the price of meals (2) Differentiation Formulas

U2 The consumer moves from

Films

U1 the original choice point C

to a new position at E.
C
U2
E
U1
BL1
BL0
Meals
Tracing out more of such points at different prices
enables us to identify the Demand curve.
6.40 1.41

7
Example 1: If y = u2 and u = 2x+1, find dy/dx
Example 2:
Solution: By the chain rule,
If y = 2u2 – 3u – 2 and u = x2 + 4, find dy/dx
Solution: By the chain rule,
dy dy du d 2 d
  (u ). (2 x  1)  ( 2u )( 2)  4u dy dy du d d
dx du dx du dx   ( 2u 2  3u  2). ( x 2  4)  (4u  3)( 2 x )
Replacing u by 2x + 1 gives dx du dx du dx

dy Replacing u by x2 + 4 gives
 4(2 x  1)  8 x  4 dy
dx
dx
   
 4( x 2  4)  3 ( 2 x )  4 x 2  13 ( 2 x )  8 x 3  26 x
1.43

Example 2 : If z = 3x3y3 – 9x2y + xy2 + 4y, find

Partial Derivatives ∂z/∂x, ∂z/∂y
Solution : To find ∂z/∂x we differen ate z with
Example 1: If f (x,y) = xy2 + x2y, find fx (x,y) and fy respect to x while treating y as a constant:
(x,y)
Solution: z
 3(3x 2 ) y 3  9(2 x ) y  1( y 2 )  0
x
To find fx (x,y), we treat y as a constant and = 9x2y3 – 18xy +y2
differentiate f with respect to x: To find ∂z/∂y we differen ate z with respect to y
fx (x,y) = (1)y2 + (2x)y = y2 + 2xy while treating x as a constant:
To find fy (x,y), we treat x as a constant and
z
differentiate f with respect to y:  3 x 3 ( 3 y 2 )  9 x 2 (1 )  x ( 2 y )  4 (1 )
y 3 2
fy (x,y) = (x)2y + x2 (1) = 2xy + x2 = 9x y - 9x2 + 2xy + 4
1.44 1.45