Chapter Three

 Consumer preferences
 Utility Theory
 Constructing Indifference curves
 Properties of Indifference curves
Intuition of consumer theory
 How does a consumer choose the best
things that she can afford?
◦ What is the best
◦ Afford  budget constraint
◦ How to choose  constrained optimization
 3.1. Preference

 given any two consumption bundles (groups of goods)

available for purchase, how a consumer compares

the goods? Does he prefer one good to another, or
does he indifferent between the two groups.

 Given any two consumption bundles, the consumer

can either decide that one of consumption bundles is
strictly better than the other, or decide that he is
indifferent between the two bundles.

3
 Axioms of preferences
 Strict preference
Given any two consumption bundles(X1,X2) and (Y1,Y2),if
(X1,X2)>(Y1,Y2) or if he chooses (X1,X2) when (Y1,Y2) is
available the consumer definitely wants the X-bundle than
 Weak preference
Given any two consumption bundles(X1,X2) and (Y1,Y2),if
the consumer is indifferent between the two commodity
bundles or if (X1,X2) (Y1,Y2) the consumer would be equally
satisfied if he consumes (X1,X2) or (Y1,Y2).

4
 Completeness
◦ A > B, B > A, A ~ B for all bundles A, B
 Transitivity
◦ A > B and B > C => A > C
◦ Otherwise we won’t be able to tell which bundle
is the best
 Non-satiation:
◦ more is preferred to less. Goods are always
“good”
◦ Counter examples: bad (dislike), neutral goods
(indifferent)
The analysis of consumers’ behaviour is on the
basis of the following assumptions,
Assumptions
 A consumer is a rational.
 Consumer has a full knowledge of
◦ all the available commodity,
◦ their price and
◦ his income.
 The goal of the consumer is to maximize his
utility

6
Utility
What is utility?
• the term utility describe the satisfaction or enjoyment derived
from the consumption of a good or service
• Numerical score representing the satisfaction that a consumer
gets from a given basket of goods.
Is utility measurable?
 Economists are divided on the issue of measurability of utility
 For some utility can be quantitatively measured
 For others utility is rather ordinal in nature
 Accordingly, we have two approaches
◦ Cardinal utility approach
◦ Ordinal Utility approach
 3.2.1. Cardinal Utility Approach

 This school postulate that the utility can be

measured
 What is the measurement unit?
◦ Monetary unit
◦ By a subjective unit called util
Assumptions
 Rationality
 Cardinal Utility: The utility of each commodity is
measurable and the most convenient measurement
is money.
 Constant Marginal Utility of Money.
 The essential feature of a standard unit of
measurement is that it is consistent. 8
 Consumer Income is constant and all is spent on
the same product.

◦ That is, saving gives no positive utility to the

consumer.

 Diminishing Marginal Utility (DMU).

◦ The utility derived from each successive units

of a commodity diminishes. .

 Consumer is price taker: He cannot influence the

market price of goods and services.

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Total and Marginal Utility

Total Utility: refers to the total amount of satisfaction a

consumer gets from consuming or possessing some specific
quantities of a commodity at a particular time.

 if a consumer consumes 4 units of a commodity and derives U1,

U2, U3 and U4 from the successive units consumed,

 then TU = U1+U2+U3+U4.

 In case the number of commodities consumed is greater than

one, then

TU= TUx TUy + TUz + ……… TUn

10
Graphical representation of total utility

TU

15
14
TU
12
9
5

O 1 2 3 4 5 Quantity 11
Total and Marginal Utility
Units of Apples Total utility Marginal Utility
(TU) (MU)

0 0

1 5 5-0=5

2 9 9-5=4

3 12 12-9=3

4 14 14-12=2

5 15 15-14=1

One common property:

Diminishing marginal utility
Marginal Utility (MU)
• It can be defined the utility you get when you consume one
more unit of good X
 It is the change in the total utility resulting from unit
change in commodity consumed
 It is the slope of total utility,
 MU = TU/ Q
◦ TU = Change in Total Utility
◦ Q = Change in quantity consumed

13
Show MU in graph
Total
Utility U

Units of apples
(X)
compute MU, diminishing MU?

 U=5X
 U=5lnX
 U=X0.3
 U=100-X2
 U=X0.4Y0.6
Consumers Equilibrium: The General Case:(The law of
equi-marginal Utility)
A utility maximizing consumer consumes commodities in
order of their utilities.
 if the consumer consumes a bundle of n commodities i.e
X1, X2 X3…… Xn, he/she would be in equilibrium or
utility is maximized if and only if:

MU X 1 MU X 2 MU X n
  .........   MU m
PX1 PX 2 PX n
 Exercise: Consider a consumer having only
birr 7 in his pocket to buy bread and
banana
 If the Price of banana is birr 4/kg and
price of bread is birr one per unit
determine.
i. His marginal utility schedule for the two
commodities
ii. Determine his optimum consumption of these
two goods
iii. The total utility at optimum consumption
 Bread, Price=birr 1/unit Banana, Price=4birr/kg

Quantity of TU MU MU/P Quantity TU MU MU/P

0 0 0 0
1 6 1 12
2 11 2 20

3 14 3 26
4 13 4 29

5 13 5 32

6 11 6 31
Solutions
Bread , Price=birr 1/unit Banana, Price=4birr/kg

Quantity TU MU MU/P Quantity TU MU MU/P

0 0 - - 0 0 - -

1 6 6 6 1 12 12 3

2 11 5 5 2 20 8 2

3 14 3 3 3 26 6 1.5

4 13 1 1 4 29 3 0.75

5 13 0 0 5 32 2 .5

6 11 -2 -2 6 31 -1 -0.25
Exercise: Consider a consumer having only
birr 20 in his pocket to buy bread and
banana
If the Price of banana is birr 4/kg and
price of Orange is birr 2 per unit
determine.
i. Determine his optimum consumption of
these two goods
ii. The total utility at optimum
consumption
Limitation of the Cardinal approach
a) The assumption that utility is a cardinal
concept (utility is objectively measurable) is
doubtful.
◦ Utility is a subjective concept, which cannot be
measured objectively.
b) The assumption of constant marginal utility of
money is also unrealistic..

21
 3.2.1. Ordinal Utility Approach
 utility is not cordially measurable,
but it is an ordinal in magnitude.
 That is, the consumer may not know
the specific unit of utility derived
from different commodity.
 But he is able to rank or order
different basket of good in utility.
 The modern theory of consumer’s
behavior is on the basis of consumers
preference

22
 The ordinal utility approach is also on the
basis of the following assumptions:-
1. Rationality: The consumer is assumed to
be rational aiming at maximizing his
2. Consistence of Choice:
◦ If he preferred bundle A to B, he will not
choose bundle B over A another time.
◦ Thus, if A is preferred to B then B is not
preferred over A.
3. The consumer’s choice is transitive: For any
three bundle, A, B, and C,
◦ if A is preferred to B and B is preferred
to C the A is preferred to C.

23
Indifference curves
 Definition of Indifference Curve:
◦ the set of consumption bundles among which
the individual is indifferent. That is, the bundles
all provide the same level of utility.
 each indifference curve corresponds to a
specific utility level
 Indifference curves never cross each
other
Properties of indifference curves
for typical preferences
 Indifferent curves are downward sloping
◦ Violate non-satiation if upward sloping
 Indifference curves never cross
◦ Violate transitivity if they cross
 Indifference curves are convex
◦ Violate balance if they are concave or linear
Examples of indifference curves
 U(X,Y)=X * Y Y

point X Y U
1 1 1 1
2 2 2 4
3 3 3 9
4 4 4 16
5 1 4 4
6 4 1 4
7 2 3 6
X
8 3 2 6

Typical convex preference

Satisfy all four axioms of preference
Special indifference curves
 U(X,Y)=X + Y
Y
point X Y U
1 1 1 2
2 2 2 4
5
3 3 3 6
4 4 4 8 3 4
7
5 1 4 5
6 4 1 5 8
2
7 2 3 5
8 3 2 5 1 6 X
Perfect substitutes
MUx is a constant (not diminishing), so is MUY
  U(X,Y)=min(X, Y)
Y
point X Y U
1 1 1 1
2 2 2 2
3 3 3 3
4 4 4 4
5 1 4 1
6 4 1 1
7 2 3 2
8 3 2 2
X

Perfect complements
U is not always differentiable, MU is not well defined at the kinks
 Marginal rate of substitution (MRS)
 Definition:

Marginal Rate of Substitution (of X for Y)

Number of units of Y given up
MRS X ,Y 
Number of units of X gained
y
 MRS X
x
,Y

 MRS x,y= -dy/dx | same satisfaction (i.e. same U)

 How many units of Y would you like to give up to get one

more unit of X?
 Can be interpreted as marginal willingness to pay for X if Y is
numeraire (money left for other goods)
 Bundle A B C D
(Combination)
Orange (X) 1 3 5 7

Banana (Y) 23 15 9 6

Y 8
MRS X ,Y (between points A and B )   4
X 2
Marginal rate of substitution (MRS)
Y

Slope = - MRS at point A

X
Diminishing MRS
(MRS of X for Y diminishes with X)
A lot of Y
Y relative to
X

Not much
Y rel to X

X
Consistent with diminishing marginal utility
Mathematical derivation of MRS

◦ U=U(X,Y)

◦ Total differentiation:

◦ dU = MUx * dX + MUy * dY =0

◦

◦ -dY/dX = MUx / MUy = MRS (of X for Y)

MRS and ordinal utility
 Calculate MRS:
◦ U=XY
◦ U=lnX + lnY
◦ U=X+Y
◦ U=X+Y2
◦ U=(X+1)(Y+2)
◦ U=X2 Y2
Budget constraints
 Definition:
◦ The budget constraint presents the
combinations of goods that the consumer can
afford given her income and the price of
goods.
 Equation: Px * X + Py * Y = I
 Rearrange: Y = I/ Py + (- Px / Py ) * X

intercept slope
Graph budget constraint
Y

I/Py

Slope = - Px / Py

I/Px X
Px/Py = the rate at which Y is traded for X in the marketplace
Unlike MRS, the price ratio does not depend on consumer psyche
 What happens with income tax cut?
 Tax cut  more income
Y
• Does the intercept
on Y change?
• Does the intercept
I/Py on X change?
• Does the slope of
the budget line
change?

Slope = - Px / Py

I/Px X
 What happens if price of x goes up?

 Px increases
Y
• Does the intercept
on Y change?
• Does the intercept
I/Py on X change?
• Does the slope of
the budget line
change?

Slope = - Px / Py

I/Px X
 Optimum of the Consumer

 A consumer reach at optimum when he chooses

the quantity that maximizes his utility given his
income and market prices of commodities
 This occurs when an indifference curve is
tangent to the budget line
 At the point of tangency the slope of the
indifference curve (MRSxy) is equal to the slope
of the budget line

MRS X ,Y  PX / PY

39
 Graphical presentation
Y
MRS > Px/Py

I/Py
A
Slope = - Px / Py
C

B
MRS < Px/Py

I/Px X
Mathematical derivation
 Max U(X,Y) by choosing X and Y
 Subject to I = Px * X + Py * Y
 Define Lagrangian function
 L = U(X,Y) + λ (I – Px * X – Py * Y)
 λ is an additional variable, now need to
choose X, Y, λ
Mathematical derivation

Exercise: find the best choice when
 U (Food, Clothes) = ln (F) + ln (C)
 Price of food = $2
 Price of clothes =$1
 Income=100
 Consumer’s optimal choice
◦ Inner solution, corner solution
 Cobb-Douglas utility
 Price and consumer choice
 Income and consumer choice
 Normal, inferior and giffen goods
 Typically: Inner solution
Y
At the optimal choice:

MRS = Px/Py
I/Py
I=Px * X + Py * Y

I/Px X
 What if the equal marginal principle
cannot be satisfied?
 corner solution
Spend every penny:
Y I=Px * X + Py * Y
U
I/Py Check which corner gives
higher utility

I/Px X
 Example 1 of corner solution:
perfect substitutes
U=X+2Y
Y Px=10
U Py=10
100 Income=1000

100 X
 Example 2 of corner solution:
perfect complements
U
Y U=min(X,2Y)
Px=10
100 Py=10
Income=1000

100 X
Special example:
Cobb-Douglas Utility


Two
equations
Solve for
two
unknowns
(X and Y)

Demand only
depends on own
price, not price of
other goods

MRS only depends

on the ratio of X
and Y

Fixed share of
income for each
good
Graph consumer choice in response to:

 Price changes
 Income changes
Two goods:
food, clothing

Price of food drops

 Two goods:
food, clothing

Income increases

Note that income-

consumption curve is
not necessarily linear

Income Consumption Curve

(ICC) : is a locus of all
points that representing
various combinations of the
two commodities purchased
by the consumer at
different levels of his
income, all other things
remaining the same.
 Normal goods
◦ Consumers want to buy more quantity of
normal goods as their incomes increase.

 Inferior goods
◦ Consumers want to buy fewer quantity of
inferior goods as their incomes increase.

 Examples?
 the income –consumption curve when good
X is inferior
Y
ICC

Y3

Y1

X
X1 X3
Engel curve
Giffen goods
 Normal and inferior goods are defined by
how consumer choice changes in
response to income change
 Giffen goods depend on price change
◦ Typical goods have downward sloping demand
curve
◦ Giffen goods have upward sloping demand
curve: as price increases, consumers buy
more; as price decreases, consumers buy less.
 Food price falls
 Initial choice A  new choice B
 Imaginary D: same utility as A, but face new price
Decompose income and substitution effects in response to price change
Slusky Equation

Total effects Substitution Income

effects effects
What if X is an inferior good?
 income effect works against the substitution effect
What if X is a Giffen good?
 income effect works against and more than
cancels off the substitution effect