CH04 PPT 8th Ed Class JG

Microeconomics
Eighth Edition, Global Edition
Chapter 4
Consumer Choice
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved

Topics
4.1 Preferences
4.2 Utility
4.3 Budget constraint
4.4 Constrained consumer choice
4.5 Behavioural economics and consumer choice.

Premises of consumer behaviour
• Individual tastes or preferences determine the
amount of pleasure people derive from the goods and
services they consume.
• Consumers face constraints or limits on their
choices.
• Consumers maximise their well-being or pleasure
from consumption, subject to the constraints they
face.

Properties of consumer preferences
(1 of 3)
• Completeness - when facing a choice between any

two bundles of goods, a consumer can always rank
them.
• That is, one and only one of the following relationships
is true:
▪ The consumer prefers the first bundle to the
second,
▪ prefers the second to the first, or
▪ is indifferent between them.

(2 of 3)
• Transitivity - a consumer’s preferences over bundles

is consistent, in the sense that, if the consumer
weakly prefers Bundle a to Bundle b (likes a at least
as much as b) and weakly prefers Bundle b to Bundle
c, then the consumer also weakly prefers Bundle a to
Bundle c.

(3 of 3)
• Non-satiation (‘more is better’) - all else being

the same, more of a commodity is better than less
of it.
– Good - a commodity for which more is preferred to
less, at least at some levels of consumption.
– Bad - something for which less is preferred to more,
such as pollution.

Preference maps
• Indifference curve - the set of all bundles of goods
that a consumer views as being equally desirable.
• Indifference map - a complete set of indifference
curves that summarize a consumer’s tastes or
preferences.

Just by the way - what is a burrito?
A burrito is a type of
Mexican and Tex-Mex
food, consisting of a
tortilla, wrapped or
folded into a cylindrical
shape to completely
enclose the filling.

Figure 4.1 Bundles of Pizzas and
Burritos Lisa might consume (1 of 2)
(a) (b)
Lisa prefers any bundle
Which of these in area A over e
two bundles would
B , Burritos per semester

c A c
25 be preferred by 25
Lisa?
f
20 20
Lisa prefers bundle fe
over bundle e,
d, since fe e
15 15
e has more of both
a a
d goods: Pizza and
10 10 I1
Burritos
5
B
15 25 30 15 25 30
Z , Pizzas per semester Z , Pizzas per semester
If Lisa
Lisa prefers
is indifferent
bundle ebetween
to we can draw an indifference
any bundle
bundles e, a,inand …..
areac B curve over those three points

Figure 4.1 Bundles of Pizzas and
Burritos Lisa might consume (2 of 2)
(a) (c)
c A c

25 25
f f
20 20
e I2
15 15
e
a a
d d
10 10 I1
5
B I0
15 25 30 15 25 30
Z , Pizzas per semester Z , Pizzas per semester
If Lisa is indifferent between we can draw an indifference

bundles e, a, and c ….. curve over those three points
Properties of indifference curves
1. Bundles on indifference curves farther from the
origin are preferred to those on indifference curves
closer to the origin.
2. An indifference curve goes through every possible
bundle.
3. Indifference curves cannot cross.
4. Indifference curves slope downward.

Figure 4.2 Impossible indifference curves

Fig 4.2 Impossible indifference curves (a)
• Lisa is indifferent between e
and a, and also between e

and b…
– so by transitivity she should
also be indifferent between a
and b…
e – but this is impossible, since b
b must be preferred to a given it
a I1 has more of both goods.
I0
Z , Pizzas per semester

Fig 4.2 Impossible indifference curves (b)
• Lisa is indifferent between

b and a since both points
are on the same
b
indifference curve…
– But this contradicts the
“more is better”
assumption. Can you tell a
why?
I
– Yes, b has more of both
and hence it should be
preferred over a.

Fig 4.2 Impossible indifference curves (c)
• Consumer is indifferent
between b and a since

both points are in the
same indifference
curve…
b
– But this contradicts the
a “more is better”
assumption since b has
I more of both and hence
it should be preferred
over a.

MCQ blitz
The principle that “more is better” results in indifference
curves:
A. sloping down.
B. not intersecting.
C. reflecting bundles that are preferred the further
they are from the origin.
D. All of the above.
E. None of the above.

Willingness to substitute between goods
• Marginal rate of substitution (MRS) - the
maximum amount of one good a consumer will
sacrifice to obtain one more unit of another good.
• Lisa’s marginal rate of substitution of burritos for
pizza is
B
MRS =
Z
MRS is the slope of the indifference curve.

Figure 4.3(a) Marginal Rate of Substitution
Indifference Curve Convex to the Origin
a From bundle a to bundle b, Lisa is willing

8 to give up 3 Burritos in exchange for 1
more Pizza…
–3
b From bundle b to bundle c, Lisa is willing to give up 2
5
1 Burritos in exchange for 1 more Pizza…
-2
c From bundle c to bundle d, Lisa is willing to give up 1
3
1
-1 d Burrito in exchange for 1 more Pizza…
2
1
I
0 3 4 5 6

Curvature of indifference curves
• Casual observation suggests that most people’s
indifference curves are convex to the origin.
• Diminishing marginal rate of substitution: The
marginal rate of substitution approaches zero as we
move down and to the right along an indifference
curve.
• Why?

MCQ blitz
Convexity of indifference curves implies that consumers
are willing to:
A. give up more “y” to get an extra unit of “x” the more
“x” already they have.
B. give up more “y” to get an extra unit of “x” the less “x”
they have.
C. settle for less of both “x” and “y”.
D. acquire more “x” only if they do not have to give up
any “y”.
E. None of the above.

Consumers with different preferences
(from Frank, R.H. Microeconomics and behaviour, 8th ed.)
Relatively speaking, Tex is a potato-lover and Mohan a rice-lover. Can

you see this difference in preferences from their IC curves? For any
given bundle, Tex’s MRS of potatoes for rice is smaller than Mohan’s.

Diminishing Marginal Rate of Substitution
• The marginal rate of substitution approaches zero
as we move down and to the right along an
indifference curve.
• Discussion: Could you imagine a pair of goods

that does not exhibit this property?

Figure 4.3(b) Marginal Rate of Substitution
Indifference curve concave to the origin (rare)
(b) Indifference Curve Concave to the Origin • From bundle a to

bundle b, Lisa is willing
to give up 2 Pizzas for

1 Burrito.
a
7
–2 – Nevertheless, from b to
b c she is willing to give
5
1 up 3 Pizzas for 1
Burrito.
–3
c
2 – This is very unlikely
1
(Could you think why?)
I
0 3 4 5 6

Curvature of indifference curves (cont.)
• Casual observation suggests that most people’s
indifference curves are convex to the origin.
• Special cases:
– Perfect substitutes - goods that a consumer
is completely indifferent as to which to
consume.
– Perfect complements - goods that a
consumer is interested in consuming only in
fixed proportions (i.e. together).

Figure 4.4(a) Perfect Substitutes
• Bill views Coke and Pepsi as
perfect substitutes: what do
Coke, Cans per week
4 you think his indifference

curves would look like?
3
– Straight, parallel lines
with an MRS (slope) of
2
−1.
1 – Bill is willing to exchange
I1 I2 I3 I4
one can of Coke for one
can of Pepsi.
0 1 2 3 4
Pepsi, Cans per week

Figure 4.4(b) Perfect Complements
▪ If Maureen has only one
piece of pie, she gets as
Ice cream, Scoops perweek
much pleasure from that

piece and one scoop of
e c
3 I3 ice cream, a,
b  as from that piece and
d
2 I2 two scoops, d,
a  or from that piece and
1 I1 three scoops, e.
0 1 2 3
Pie, Slices per week

Figure 4.4(c) Imperfect Substitutes
• The standard-shaped,
convex indifference curve
in the panel lies between

these two extreme
examples.
• Convex indifference
curves show that a
consumer views two
I goods as imperfect
substitutes.

Application: Indifference curves between
food and clothing

Problems: Constructing indifference curves
1. Don is altruistic. Show the possible shape of his
indifference curves between charity and all other
goods.
2. Miguel considers tickets to the opera and to
football games to be perfect substitutes. He’s
always willing to exchange one opera ticket for
one football game ticket. Show his preference
map.
3. If Joe views two candy bars and one piece of
cake as perfect substitutes, what is his marginal
rate of substitution between candy bars and
cake?
Problems: Constructing indifference curves
Football
All Don’s IC map game Miguel’s IC map
Other tickets
2
goods
1 2 Opera tickets
Charity
4
Joe’s IC map
Candy
bars
2 Candybars 2
MRS = = − = −2
Cake 1
1 2 Pieces of cake
Utility
• Utility - a set of numerical values that reflect the
relative rankings of various bundles of goods.
• Utility function - the relationship between utility
measures and every possible bundle of goods:
– For our pizza & burrito example, U(Z, B)
– E.g. Lisa’s U might be: U ( Z , B ) = BZ
– So we could work out a numerical value for U if

we know how much Z & B she has

Example with Lisa’s utility (cont.)
So if Lisa had to choose between these two bundles:

Deal 1: [9B & 16Z]
OR
Deal 2: [13B & 13Z] ??
We could say which she’d prefer:
U ( Z , B ) = BZ
so for Deal 1: U = √9x16 = 12
& for Deal 2: U = √13x13 = 13
So Lisa would get more utility from Deal 2 ☺
Ordinal Preferences
• If we only know a consumer’s relative ranking of
bundles, the measure of pleasure is ordinal.
– Tells us the relative ranking of two things, but not ‘by
how much’ one is better than another.
• A cardinal measure is one by which absolute
comparisons between ranks may be made. Money is
an example of a cardinal measure.
• Here, we use utility (utils) as a cardinal measure.

Utility and indifference curves
• An indifference curve consists of all those bundles
that correspond to a particular level of utility.
• If Lisa’s utility function is U(Z, B), then an
indifference curve is given by
U = U ( Z, B )

Figure 4.5(a) The relationship between the
utility function and indifference curves

Figure 4.5(b) The relationship between the
utility function and indifference curves

Marginal Utility
• Marginal utility - the extra utility that a consumer
gets from consuming the last unit of a good.
– the slope of the utility function as we hold the
quantity of the other good constant.
• Marginal utility of good Z is:
U
MUZ =
Z

Figure 4.6 Utility and Marginal Utility
• As Lisa consumes more pizza,
holding her consumption of
burritos constant at 10, her
total utility, U, increases…
– and her marginal utility of
pizza, MUZ, decreases
(though it remains
positive).
• Marginal utility is the slope of
the utility function as we hold
the quantity of the other good
constant.

Utility and Marginal Rate of Substitution
• The MRS is the negative of the ratio of the marginal
utility of another pizza to the marginal utility of
another burrito.
• Formally, B MU Z
MRS = =−
Z MU B
• Since utility is constant along a given IC,
MU Z Z = MU B B
• i.e. moving down a given IC, utility lost from having
fewer burritos is compensated exactly by utility
gained from having extra pizzas.
To see why MRS is the negative of the ratio of
the marginal utilities:
Moving from a to b, Lisa is
giving up 3 burritos and
getting 1 more pizza.

8
a Her total utility from
eating B & Z stays the
–3
same from a to b.
(Why?)
b
So the ‘lost’ U from
5
1 - ∆B.MUB = ∆Z.MUZ
fewer burritos must
exactly equal the
3
‘gained’ U from Rearrange:
2 more pizza ∆B / ∆Z = - MUZ / MUB
I
0 3 4 5 6

Budget Constraint (1 of 5)
• Budget line (or budget constraint) - the bundles
of goods that can be bought if the entire budget is
spent on those goods at given prices.
• Opportunity set - all the bundles a consumer can
buy, including all the bundles inside the budget
constraint and on the budget constraint.

• If Lisa spends all her budget, Y, on pizza and
burritos, then
pBB + pZ Z = Y
– where pB B is the amount she spends on burritos and
pZ Z is the amount she spends on pizzas.
• This equation is her budget constraint.

– It shows that her expenditures on burritos and pizza
use up her entire budget.

• How many burritos can Lisa buy?
– To answer, solve budget constraint for B (quantity of
burritos):
PB B + PZ Z = Y
PB B = Y − PZ Z
Y PZ
B= − Z
PB PB

From previous slide we have: Y PZ
B= − Z
PB PB
Lisa can buy more burritos with a higher income, a lower
price of burritos or pizza, or if she buys fewer pizzas.
If pZ = $1, pB = $2, and Y = $50, then:

$50 $1 1
B= - Z = 25 - Z
$2 $2 2
Some bundles Lisa can afford:

Figure 4.7 Budget Constraint
Amount of Burritos  From previous slide we have
consumed if all income that if:
is allocated for Burritos. pZ = $1, pB = $2, and Y = $50,

a then the budget constraint, L1,
25 = Y /pB
is:
b
20 $50 − ($1 Z )
B= = 25 − 0.5Z
L1 $2
c Amount of Pizza
10 consumed if all income
Opportunity set is allocated for Pizza.
d
0 10 30 50 = Y / pZ

Slope of the Budget Constraint
• We have seen that the budget constraint for Lisa
is given by the following equation:
Y PZ
B= - Z
PB PB
Slope =  B/ Z = MRT

– The slope of the budget line is also called the
marginal rate of transformation (MRT).

Solved Problem 4.2
• Suppose that a government rations water by
setting a quota on how much a consumer can
purchase.
• If a consumer can afford to buy 12 thousand litres
a month but the government restricts purchases to
no more than 10 thousand litres a month, how
does the consumer’s opportunity set change?

Solved Problem 4.2: Answer

Fig 4.8(a) Changes in the budget constraint:
price of pizza doubles
Slope = -$1/$2 = -0.5
B= Y - PZ = $1
$2
Z
PB PB
25 If the price of pizza
doubles, (increases from
L 1 (p Z = $1) $1 to $2) the slope of the
budget line increases
Loss
L2 (pZ = $2) This area represents
the bundles she can no
longer afford
0 25 50
Slope = -$2/$2 = -1

Fig 4.8(b) Changes in the budget constraint:
income doubles
PZ
B = $100
$50 - Z
PB PB
B, Burritos per semester
If Lisa’s income increases

50 by $50 the budget line
L 3 (Y = $100)
shifts to the right (with the
same slope!)
25
This area represents the
Gain
new consumption
L 1 (Y = $50) bundles she can now
afford!!!
0 50 100

Solved Problem 4.3
Is Lisa better off if her income doubles or if the prices of
both the goods she buys fall by half?
Answer: Her budget line and her opportunity set are
the same with either change.

Problems for class discussion
Thando consumes cans of anchovies (A) and boxes
of biscuits (B). Her indifference curves show
diminishing MRS. Where A = 10 and B = 7, her
MRS between cans of anchovies and boxes of
biscuits is –2 (= MUB / MUA).
If offered a bundle with 6 cans of anchovies and 9
boxes of biscuits, would she find it more, less or
equally as desirable as her current bundle? Why?

Problems for class discussion
Ayanda consumes choc bars and oranges. He is
given 2 choc bars and 10 oranges. He can buy or
sell choc bars for R5 each, or oranges for R2 each.
If he has no other source of income, draw his
budget constraint and write the equation. What is
the most he can spend on these goods?

Constrained Consumer Choice
• Given information on Lisa’s preferences and how
much she can spend, we can determine her optimal
bundle.
• Her optimal bundle is the bundle out of all the bundles
that she can afford that gives her the most pleasure.

Fig 4.9 Consumer maximization, interior
solution (1 of 2) • Would Lisa be able to consume any bundle along
▪I▪(i.e.
3 Would
Bundle Lisa
bundle f)? e isbe called
ableato
consumer’s
–consume
No! Lisa does any optimum.
bundle
not have along
enough income
3
to
1 afford any bundle along I
I ? If Lisa is consuming this
 Yes; she could
bundle, she afford
has no bundles
d, c, and a.
25
incentive to change
 Nevertheless, there are other
her
20
c f behaviour
affordable by substituting
bundles that should
beone good for
preferred andanother.
affordable.
B e  For instance bundle e
10
I3
d I2
A a
I1
0 10 30 50

Fig 4.9 Consumer maximization, interior
solution (2 of 2)
▪ The budget constraint and the indifference curve
have the same slope at point e where they touch.
Therefore, at point e:
MUZ PZ
MRS = − =− = MRT
25 MUB PB
Slope of I2
e Slope of BL
I2
0 50

Consumer maximization, interior solution
cont.
i.e. rate at which consumer will trade off one good

for the other = rate at which the two are traded in
the market
Rearrange:
MUZ = MUB
pZ pB
In equilibrium / at optimal bundle / to max U,

consume goods such that the last $ spent on
each brings as much U.
Additional Problem 4.?
• Nate’s utility function over jelly and peanut butter is U
= JN. Nate’s marginal utility from jelly is MUJ = N,
and his marginal utility from peanut butter is MUN = J.
• The price of a jar of jelly is $5. The price of a jar of
peanut butter is $10. Nate has a budget of $100 to
allocate to these two items.
• If Nate maximizes his utility, how much of each good
does he consume?

Problem 4.?: Answer guideline
1. Derive Nate’s budget line by setting his expenditure
equal to his budget.
2. Find the relationship between N and J.
3. Substitute this utility-maximizing condition into the
budget equation to determine J and N.
4. Substitute the solution for J into the budget line to
solve for N.

Fig 4.10 Consumer maximization, corner
solution For another student, Rethabile:
• at all bundles, Rethabile’s MRS is lower than
the MRT,
• that is, her ICs are flatter than the BL.
B, Burritos per semester
• Rethabile does best to consume only burritos

and no pizzas
• Her optimal bundle is e (0 pizzas, 25 burritos).
• Her optimal bundle is a corner solution.
• Why is bundle y not optimal?
e
25
I3
x
I2
y
Budget line
I1
50
Solved Problem 4.4
• The concentration of the active ingredient, sodium
hypochlorite, in Clorox is twice that of the generic
brand.
• Consequently, Chris views one cup of Clorox to be
a perfect substitute for two cups of the generic.
• If Clorox costs $3 gallon, the generic costs $1, and
Chris allocates Y = $6 per year, what bundle does
Chris buy? If the price of Clorox falls to $2, how
does Chris’s behaviour change?

Solved Problem 4.4

Food Stamps (1 of 2)
• The U.S. Food Stamp Plan started in 1939.
• Renamed to Supplemental Nutrition Assistance
Program (SNAP) in 2008.
• 44 million people receive food stamps at a cost of
$67 billion in early 2016.
• The average benefits were $125 per person per
month or $4.12 per day (U.S. Department of
Agriculture).

Food Stamps (2 of 2)
• Would a switch to a comparable cash subsidy
instead of food stamps increase the well-being of
people who receive food assistance?
• Would recipients spend less on food and more on
other goods?

Social grants in SA
• Grants paid in cash,
unlike USA food
stamps
• 45.5% of SA
households received
at least one form of
social grant in 2015
http://www.statssa.gov.za

Some findings re SA social grant
• Aguero, Carter & Woolard (2006): The impact of
unconditional cash transfers on nutrition: The South African
Child Support Grant
• Unconditional, targeted transfers have significantly
improved child nutrition (height-for-age) – so grants are
being spent on food.
• Not the case in other countries. (Most SA recipients are
women / mothers…?)
• ‘Human capital’? Studies link wages to adult height – the
present value of increased future earnings may be 60% -
130% more than the cost of early life CSG support!

Fig 4.12 Food Stamps Versus Cash

Fig 4.12 adapted: Impacts of cash grant in SA?
All other goods per month Budget line with cash

Y + 100
C
Y
A Original
budget line
0 Y Y + 100
Food per month
Behavioural Economics
• Economists try to better predict economic decision
making by adding insights from psychology and
empirical research on human cognition and
emotional biases to the rational economic model.

Test of Transitivity
• Adults tend to make transitive choices.
• Children are less likely to make transitive choices.

Endowment Effect
• People place a higher value on a good if they own it
than they do if they are considering buying it.
• Consumer choice theory assumes a consumer’s
endowment does not affect the indifference curve
map.
• Research has shown that experience significantly
reduces the endowment effect.

Salience and Bounded Rationality (1 of 2)
• People are more likely to consider information if it
is presented in a way that grabs their attention or
if it takes relatively little thought or calculation to
understand.
– for example, tax salience is awareness of a tax.

Salience and Bounded Rationality (2 of 2)
• When a store’s posted prices exclude the sales
tax, consumers are much less likely to react to a
change in the price.
• Tax is not salient and some consumers ignore
taxes.
• Bounded rationality - people have a limited
capacity to anticipate, solve complex problems, or
enumerate all options.

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Microeconomics

Eighth Edition, Global Edition

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved

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• Completeness - when facing a choice between any

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• Transitivity - a consumer’s preferences over bundles

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• Non-satiation (‘more is better’) - all else being

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Copyright © 2018 Pearson Education, Ltd. All Rights Reserved

B , Burritos per semester

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B , Burritos per semester

If Lisa is indifferent between we can draw an indifference

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and a, and also between e

Z , Pizzas per semester

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B , Burritos per semester

Z , Pizzas per semester

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between b and a since

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a From bundle a to bundle b, Lisa is willing

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Relatively speaking, Tex is a potato-lover and Mohan a rice-lover. Can

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• Discussion: Could you imagine a pair of goods

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(b) Indifference Curve Concave to the Origin • From bundle a to

to give up 2 Pizzas for

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4 you think his indifference

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much pleasure from that

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in the panel lies between

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– So we could work out a numerical value for U if

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So if Lisa had to choose between these two bundles:

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getting 1 more pizza.

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• This equation is her budget constraint.

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If pZ = $1, pB = $2, and Y = $50, then: