Lesson 1: Consumer behavior.

1. Preferences and utility.

Nowadays, economists understand that ranking our preferences is the best we can do. In other
words, modern microeconomics has change from a cardinal appoach (1, 2, 3...) to a ordinal
approach (1º ,2º ,3º...) to classify our preferences.
Preferences.
We call the objectives of the consumer choice consumption bundles (x1, x2), where x1 denotes the
amount of one good and x2 the amount of the other good. We will suppose that given any two
consumption bundles: (x1, x2) and (y1, y2), the consumer can rank them as:
– The consumer strictly prefers X to Y : (x1, x2) ≻ (y1, y2).
– The consumer is indifferent between X and Y : (x1, x2) ∼ (y1, y2).
– The consumer weakly prefers X to Y : (x1, x2) ≻∼ (y1, y2).
These relations are not independent concepts, the relations are themselves related:
– If (x1, x2) ≻∼ (y1, y2) and (y1, y2) ≻ (x1, x2), then (x1, x2) ∼ (y1, y2).
– Similarly, if (x1, x2) ≻∼ (y1, y2) and we know that it is not the case that (x1, x2) ∼ (y1, y2),
then (x1, x2) ≻ (y1, y2).
Economists usually make some assumptions about the “consistency” of consumers’ preferences.
They are called axioms:
– Complete: we assume that any two bundles can be compared and the consumer is always
able to make a choice between any two given bundles.
– Reflexive: we assume that any bundle is at least as good as itself: (x1, x2) ≻∼ (x1, x2). It is
any bundle is at least as good as an identical bundle.
– Transitive: If (x1, x2) ≻∼ (y1, y2) and (y1, y2) ≻∼ (z1, z2), then (x1, x2) ≻∼ (z1, z2). It is not
a statement of pure logic but a hypothesis about people’s choice behavior. However, if
preferences were not transitive there could be a set of bundles for which there is no best
choice (for example grains of sugar). Then, we could not rank preferences. For this reason,
the Consumer Choice Theory assumes that preferences are transitive.
There are two ways of working with preferences:
– Indifference curves: they are a grafical representation of consumer's preferences.
– Utility function: they are an analitical representation of consumer's preferences.
Indifference curves.
The indifference curve through a consumption bundle consists of all bundles of goods that leave the
consumer indifferent to the given bundle. Any comsumption bundle in the same line must be
indifferent. Indifference curves can take very peculiar shapes indeed. But, if preferences are
transitive, indifference curves representing distinct levels of preferences cannot cross.

The shape of the indifferent curves depends on the relation between the two goods:
– Perfect substitutes: two goods are perfect substitutes if the consumer is willing to substitute
one good for the other at a constant rate (constant rate of sustitution). If we want to pass
from one point to another in this indifference curve, we have to sacrify an oportunity cost.
Then, the indifference curves of perfect substitutes are straight lines with a constant negative
slope.
– Perfect complements: they are goods that are always consumed together in fixed
proportions. Then the indifference curves of perfect complements are L-shaped, with the
vertex of the L occurring in the fixed proportions.
– A bad and a good commodity: a bad is a commodity that the consumer does not like, and a
good a commodity that he likes. The line can be curve and must be in the area where it is
indifferent, so, it must be an increasing function.
– A neutral and a good/bad commodity: a good is neutral if the consumer doesn’t care about it
one way or the other. Then the indifference curves of a bad and a good are straight lines.
Whether the lines are vertical or horizontal depends on which axes we use to represent the
neutral good.
– Satiation: in this case, there is some overall best bundle for the consumer, and the closer he
is to that best bundle, the better off he is in terms of his own preferences. The part that is
near

– Well-behaved preferences: these are the preferences that describe "preferences in general",
the widest class of preferences. And, in general, the consumer will surely tell us that: more is
better, an averages are preferred to extremes. These two regularities are the two additional
axioms that Wellbehaved preferences satisfy:
– Strong monotonicity: we assume that more is better, that is, that we are talking about
goods. So if: y1 > x1 and y2 ≥ x2 or y1 ≥ x1 and y2 > x2, then, Y ≻ X. Note that Strong
monotonicity implies that:
– We cannot talk about bads, neither neutrals.
– The indifference curves have a negative slope.
– Strict convexity: we assume that averages are preferred to extremes. Given any two
bundles X and Y such that (x1, x2) ∼ (y1, y2), a preference relationship satisfies strict
convexity when, for any t ∈ (0,1), we have: (t x1 +(1− t)y1,t x2 +(1− t)y2) ≻ (x1, x2).
 Basically this show that we prefer everything that is between the extremes x1 and x2.
Note that Strict convexity implies that:
– Indifference curves cannot contain straight lines.
– The set of bundles weakly preferred to X is a convex set: if you take any two points
in the set and draw the line segment connecting these two points, the line segment
lies entirely in the set.

Utility function.
To early philosophers and economists, utility was cardinal. They consider people were able to
assign meaningful utility numbers to their consumption. The cardinal approach raises some
problems because satisfaction, as pain or happiness are difficult to measure. Because of these
conceptual problems, economists have abandoned this approach. Modern economics consider
therefore utility as an ordinal representation of preferences, because ranking our preferences is the
best we can do.
A utility function, u(·), is a way of assigning a number to every possible consumption bundle such
that more-preferred bundles get assigned larger numbers than less-preferred bundles. It is therefore
a numeric representation of an individual’s ranking of preferences. A utility function assigns to
every possible consumption bundle a number, such that (x1, x2) ≻ (y1, y2) ⇔ u(x1, x2) > u(y1, y2).
Similarly, if (x1, x2) ∼ (y1, y2) ⇔ u(x1, x2) = u(y1, y2). This kind of utility is referred to as ordinal
utility. This means that the magnitude of the utility function is only important in so far as it ranks
the different consumption bundles.
A positive monotonic transformation consists on adding to the utility function a number,
multipliying the utility function by a number or raising it to an odd power. So, since only the
ranking of the bundles matters, there can be no unique way to assign utilities to bundles of goods.
This means that any positive monotonic transformation of a utility function that represents some
particular preferences is also a utility function that represents those same preferences. Because a
positive monotonic transformation preserves the order of the numbers.
There are some examples of the most common utility functions:
– Quasilinear preferences: u(x1, x2) = v(x1)+ x2. Indifference curves are special: they are
vertical translates of one another. Their advantages are: It is easy to work with, and it is
useful to represent the consumption of a very particular good (x1) and a general good (x2).
 – Cobb-Douglas indifference curves look just like the nice convex monotonic indifference
curves that we referred to as well-behaved indifference curves. Of course, a monotonic
transformation of the Cobb-Douglas utility function will represent exactly the same
preferences. In an indifferent curve, the value of my utility function is constant. Any change
in U moves from a indifferent curve to another.

Marginal Rate of Sustitution and Marginal Utility.

The Marginal Rate of Substitution (MRS) is the slope (in absolute value) of an indifference curve at
a particular point. It measure the rate at which a consumer is willing to substitute one good for the
other in order to keep utility constant. We use the absolute value because it is always negative.
When the increment is smaller, we obtein the derivative by a tangent line.

The MRS measures the rate at which the consumer is just on the margin of trading or not trading. At
any rate of exchange other than the MRS, the consumer would want to trade. But if the rate of
exchange equals the MRS, the consumer wants to stay put. MRS is decreasing. That is, the rate at
which a consumer is willing to substitute one good for the other is high when the consumer has a lot
of the good he is giving up, and small when he has little of it. That is, the more you have of one
good, the more willing you are to give some of it up in exchange for the other good. This is a result
of the convexity. The marginal utility is the rate of change in utility (∆u) associated with a small
change in the amount of one good:
2. Budget constaint.
Let us define the following variables:
– Consumption bundle: (x1, x2).
– Prices of the two goods: (p1,p2).
– Amount of money the consumer has to spend (income): m.
The budget constraint or budget set represents the set of affordable consumption bundles at prices
(p1,p2) and income m: p1x1 + p2x2 ≤ m,
where p1x1 is the amount of money spent on good 1 and p2x2 is the spent on good 2. The butget
line is the set of bundles that cost exactly m: p1x1 + p2x2 = m.

The slope of the budget line measures the rate at which the market is willing to substitute one good
for the other. That is, p1/p2 tells us how much units of good 2 the consumer has to sell if he wants
to buy one unit of good 1. It is call the rate of exchange.
Comparative statics.
– Changes in income:
• ∆m > 0: an increase in income will increase the vertical intercept and not affect the slope
of the line. Thus, it will result in a parallel shift outward of the budget line.
– Changes in prices:
• ∆p1 > 0: an increases in p1 does not change the vertical intercept, but it makes the
budget line steeper, since p1/p2 becomes larger. The budget line shifts inward, becoming
steeper.
• ∆p2 > 0: an increases in p2 decreases the vertical intercept, making the budget line
flatter, since the horizontal intercept m/p1 does not change. Thus, the budget line shifts
inward, becoming flatter.
• p ′ 1 = kp1 , p ′ 2 = kp2, with k > 1, m constant: it results in a decrease of the vertical
intercept (↓ m/p2 ), but the slope does not change. Thus, there is a parallel shift inwards
in the budget line.
• ∆p2 > ∆p1 > 0: it results in a decrease in the (absolute value of the) slope of the budget
line (↓ p1/p2 ), and a decrease in the vertical intercept (↓ m/p2 ) Thus, the budget lines
shifts inwards, becoming flatter.
– Simultaneous change in income and prices:
• If p ′ 1 = kp1, p ′ 2 = kp2 , m′ = km, with k > 0 ⇒ the budget lines does not change.
• If ∆p1 > 0, ∆p2 > 0 and ∆m < 0 ⇒ the budget line shifts inwards.
• If p ′ 1 = k1p1, p ′ 2 = k2p2, m constant, with k1,k2 > 1.
➢ If k1 > k2 ⇒ the budget line becomes steeper.
➢ If k2 > k1 ⇒ the budget line becomes flatter.
3. Consumer demand.
We will put together the budget set and the theory of preferences in order to examine the optimal
choice of consumers. People choose the best things they can afford. We have drawn the budget set
and several of the consumer’s indifference curves. Our objective is to find the bundle in the budget
set that is on the highest indifference curve. Since preferences are well-behaved, so that more is
preferred to less. (x1* , x2* ) is the optimal choice for the consumer, at this choice, the indifference
curve is tangent to the budget line. At the consumer optimal choice:
– At this point, the slope of the two curves is the same: p1/p2 = MU1/MU2
– It is in the budget line: p1x1 + p2x2 = m (It doesn´t matter that yuo spend all your money
because we don´t consider saving).

Taking into account that the slope of the indifference curve is −MRS and the slope of the budget
constraint is − p1/p2 , we have: MRS = (x1* , x2*) = p1/p2 .
That is, at the optimal choice (x1* , x2*), the MRS (rate at which the consumer is willing to
substitute a small amount of good 2 for good 1) equals the rate of exchange p1/p2 (rate at which the
market is willing to substitute a small amount of good 2 for good 1).

Consumer demand.
People choose the best things they can afford. Mathematically:
– max (x1,x2) u(x1, x2)
s.t. p1x1 + p2x2 ≤ m.
Also we hace two conditions:
– MRS = p1/p2.
– P1x1 + p2x2 = m.
This is the consumer’s maximization problem. And its solution is the consumer’s demand functions
for goods 1 and 2. The result is the consumer’s demand functions for goods 1 and 2: x1* (p1,p2,m)
x2* (p1,p2,m) where they are the functions that relate the optimal choice of goods 1 and 2. The
consumer’s optimal choice refers to the quantities of goods 1 and 2 that the consumer demands for
some given prices and income. If we substitude p1, p2 and m for the values, we get the consumer´s
optimal consumtion bundle. If the function that we are going to maximinizes is a cobb-douglas
utility, it has a convenient property: The consumer always spends a fixed fraction of his income on
each good. The size of the fraction is determined by the exponent in the Cobb-Douglas function.