Lecture 7

Dr Soumyatanu Mukherjee
Topics We Aim To Cover

• Optimal Choice and Demand

• Revealed Preference
 Recap: Demand Curve with an Interior Solution
𝑈(𝑥, 𝑦) = 𝑥𝑦

– 𝑀𝑈𝑥 = 𝑦 and 𝑀𝑈𝑦 = 𝑥

– The prices of x and y are 𝑝𝑥 and 𝑝𝑦, respectively & income = $120

• We Have:

1. 𝑝𝑥𝑥 + 𝑝𝑦 𝑦 = 120

2. 𝑀𝑈𝑦(= 𝑥)/𝑝𝑦 = 𝑀𝑈𝑥(= 𝑦)/𝑝𝑥

• Substituting the second condition into the budget constraint, we then have:

3. 𝑝𝑥𝑥 + 𝑝𝑦 (𝑝𝑥/𝑝𝑦)𝑥 = 120 or…𝑥 = 120/2𝑝𝑥

• Let’s two consumption points on D1, when 𝑃𝑥1 =$15 and 𝑃𝑥2 =$10. Denote them as point A and point B
respectively.

• When income increases to $200, how the demand for food in (1) changes?
Demand Curves for Food at Different Income Levels
• The quantity of food demanded, 𝑥, depends on the price of food, 𝑃𝑥 , and on the level of income,
𝐼. The equation representing the demand for food is 𝑥 = 𝐼/(2𝑃𝑥 ).
• When income is $120, the demand curve is D1 in the graph. Thus, if the price of food is $15, the
consumer buys 4 units of food (point A). If the price of food drops to $10, she buys 6 units of food
(point B).
• If income rises to $200, the demand curve shifts to the right, to D2. In this case, if the price of
food is $10, the consumer buys 10 units of food (point C).

TIP: An alternative way to think about why demand curves slope

downward is to focus on opportunity costs.
• When the price of food decreases, an individual doesn’t have
to give up as many units of clothing to buy one more food.
• So consuming food becomes more attractive.
• Conversely, when the price of food increases, consuming food
becomes a less attractive use of resources, and the consumer
buys less.
A consumer purchases two goods, food and clothing.
He has the utility function

𝑈(𝑥, 𝑦) = 𝑥𝑦 + 10𝑥,

where 𝑥 denotes the amount of food consumed and 𝑦

• Use this equation to fill in the following table
the amount of clothing.
to show how much clothing he will purchase at
The marginal utilities are 𝑀𝑈𝑥 = 𝑦 + 10 and 𝑀𝑈𝑦 = 𝑥.
each price of clothing (these are points on his
The consumer’s income is $100, and the price of food demand curve):
is $1. The price of clothing is 𝑃𝑦 .

• Show that the equation for the consumer’s demand

curve for clothing is

100 − 10𝑃𝑦
𝑦= , 0 < 𝑃𝑦 < 10.
2𝑃𝑦

𝑦 = 0, 𝑃𝑦 ≥ 10.
Problem to solve
Miss Muffet always likes to have things “just so.” In fact, the only way
she will consume her curds and whey is in the ratio of 2 units of
whey per unit of curds. She has an income of $20. Whey costs $.75
per unit. Curds cost $1 per unit.
• How many units of curds and whey will Miss Muffet demand in
this situation?
• Write down Miss Muffet’s demand function for whey as a function
of the prices of curds and whey and of her income, where 𝑝𝑐 is the
price of curds, 𝑝𝑤 is the price of whey, and 𝑚 is her income.
Recap: Isolating SE & IE – Normal Good
Inferior Good – SE & IE
Summary
Giffen Good

Food is Giffen Good

• Given an initial level of income and prices for
two goods (housing and clothing), the consumer
faces budget line 𝐵𝐿1 and chooses basket 𝐴.
• Suppose prices and income change so that the
budget line becomes 𝐵𝐿2 , and he chooses
basket 𝐵.
• What do the consumer’s choices reveal about
his preferences?
 Revealed Preference
• First, the consumer chooses basket 𝐴 when he could afford

any other basket on or inside 𝐵𝐿1 , such as basket 𝐵.

• Therefore, 𝐴 is at least as preferred as 𝐵 (𝐴 ≽ 𝐵).

• But he has revealed even more about how he ranks 𝐴 and 𝐵.

• Consider basket 𝐶. Since the consumer chooses 𝐴 when he

can afford 𝐶, we know that 𝐴 ≽ 𝐶.

• Given that 𝐶 lies to the northeast of 𝐵, 𝐶 must be strongly

preferred to 𝐵 (𝐶 ≻ 𝐵).

• Then, by transitivity, 𝐴 must be strongly preferred to 𝐵 (if

𝐴 ≽ 𝐶 and 𝐶 ≻ 𝐵, then 𝐴 ≻ 𝐵).

Revealed Preference
• Consider a case in which a utility-maximizing consumer buys only two goods.

• Suppose that when the prices of the goods are initially (𝑃𝑥 , 𝑃𝑦 ), the consumer chooses basket 1, containing
(𝑥1 , 𝑦1 ). At a second set of prices (𝑃෩𝑥 , 𝑃
෪𝑦 ), he chooses basket 2, containing (𝑥2 , 𝑦2 ).

• At the initial prices, basket 1 will cost the consumer 𝑃𝑥 𝑥1 + 𝑃𝑦 𝑦1 . Let’s suppose that basket 2 is also
affordable at the initial prices, so that
𝑃𝑥 𝑥1 + 𝑃𝑦 𝑦1 ≥ 𝑃𝑥 𝑥2 + 𝑃𝑦 𝑦2

• We say that (𝑥1 , 𝑦1 ) is directly revealed preferred to (𝑥2 , 𝑦2 ) at the set of prices (𝑃𝑥 , 𝑃𝑦 ).

• At (𝑃෩𝑥 , 𝑃
෪ ෩ ෪
𝑦 ), basket 2 will cost the consumer 𝑃𝑥 𝑥2 + 𝑃𝑦 𝑦2 .

• If the consumer is now choosing basket 1 as the optimal/maximal consumption bundle, then
𝑃෩𝑥 𝑥2 + 𝑃
෪ ෩ ෪
𝑦 𝑦2 ≤ 𝑃𝑥 𝑥1 + 𝑃𝑦 𝑦1

• In other words, if the consumer is now choosing bundle 1 as the optimal consumption bundle, then it must
be the case that (𝑥2 , 𝑦2 ) cannot be directly revealed preferred to (𝑥1 , 𝑦1 ).
Which Is Not Consistent With Utility-Maximising Behaviour?
For you to solve
• A consumer has an income of $24 per week and buys two goods in
quantities measured by 𝑥 and 𝑦. Initially he faces prices (𝑃𝑥 , 𝑃𝑦 ) = ($4, $2)
and chooses basket 𝐴 containing (𝑥1 , 𝑦1 ) = (5,2). Later the prices change
to (𝑃𝑥 , 𝑃𝑦 ) = ($3, $3). He then chooses basket 𝐵, containing (𝑥2 , 𝑦2 ) =
(2,6). Show that he cannot be choosing baskets that maximize his utility in
both cases.
• When prices are (4, 6), Goldie chooses the bundle (6, 6), and when prices
are (6, 3), she chooses the bundle (10, 0). Is Goldie’s behaviour consistent
with optimising choices?