Lecture 6

Dr Soumyatanu Mukherjee
How Do Consumers Optimize Their Purchasing Decisions?—1

• Imagine that you go to a pizzeria, where you can eat

slices of pizza and drink cans of Pepsi.
• How much of each good will you buy to maximize
your utility?
Deciding What to Buy

A simple rule to maximize utility:

• Allocate income by choosing goods that give you the
most utility per dollar spent.
• You want the biggest bang for your buck.

MU X MU Y
Which is larger?
Price X Price Y

• If the MUX/PX > MUY/PY, you . . .

Pizza and Pepsi Optimum—1
Pizza and Pepsi Optimum—2
How Do Consumers Optimize Their Purchasing Decisions?—2

At the consumer optimum, two conditions are satisfied:

• All income is spent.
• For the last unit purchased:

MU Pizza MU Pepsi
=
Price Pizza Price Pepsi

We can explain by contradiction why this rule is correct

 A consumer’s Optimum Consumption Bundle

M/Ppepsi The bundle A is the optimum choice of

the consumer. One maximizes
satisfaction subject to the budget
Pepsi constraint. At the optimum, the slope of
the budget line is equal to the slope of
A the indifference curve. That is the
marginal rate of substitution of food for
Pizza clothing is equal to the opportunity cost
of purchasing food.
M/Ppizza
Budget Constraint with Food Stamps
Food Stamp Subsidy
50

40 unaffordable
combinations
30
x2

20
feasible
10 combinations

0
0 20 40 60 80
x1

Cash equivalent budget constraint is different.

Max U s.t. Food Stamp Constraint
if x1  x , x2 = m / p2
if x1  x , x 2 = m/p 2 − p1 / p 2 (x1 − x )

Excel’s Solver can be used to find the optimal solution.

The constraint can be entered in a

single cell with an IF statement:

=IF(x1_<x1bar,m/p2_-x2_,m/p2_-(p1_/p2_)*(x1_-x1bar)-x2_)
 Inframarginal versus Distorted

Inframarginal Distorted
80 80

60 60
x2

x2
40 40
U = 248451.99
U = 165634.66
U = 1225 U = 82817.33
20 U = 816.67 20
U = 408.33

0 0
0 20 40 60 80 0 20 40 60 80
x1 x1
Kinky budget constraint - revisited
 Inframarginal and Distorted with Cash
Equivalent
Inframarginal with Cash Distorted with Cash
80 80

60 60

x2
x2

40 40 U = 303579
U = 202386
U = 1225 U = 101193
20 U = 817 20
U = 408
0 0
0 20 40 60 80 0 20 40 60 80
x1 x1

For Distorted consumers, food stamps create a deadweight loss when compared to cash
Class Activity: Think-Pair-Share: Optimizing Consumption Decisions—1

Consider Marinda, who has a $27 fast-food budget per month. She can
purchase sub sandwiches (S), burgers (B), or tacos (T). The price of a
sub sandwich is PS = $5, the price of a burger is PB = $4, and the price
of a taco is PT = $2. Use the table below to find Marinda’s optimal
consumption bundle.

# MU(S) MU MU(B) MU MU(T)

MU Subs # Burgers # Tacos
Subs P(S) Burgers P(B) Tacos T
0 --- 0 --- 0 ---
1 50 1 36 1 20
2 45 2 32 2 16
3 40 3 28 3 12
4 35 4 24 4 8
Class Activity: Think-Pair-Share: Optimizing Consumption Decisions—2

Income = $27 fast food, PS = $5, PB = $4, PT = $2. Use

the table below to find Marinda’s optimal consumption
bundle.
# MU(S) MU MU(B) MU(T)
MU Subs # Burgers # Tacos MU Tacos
Subs P(S) Burgers P(B) T

0 --- --- 0 --- 0 ---

1 50 10 1 36 9 1 20 10

2 45 9 2 32 8 2 16 8

3 40 8 3 28 7 3 12 6

4 35 7 4 24 6 4 8 4
 ∗ ∗
Decrease in Price of Food on (𝐹 , 𝐶 )
Pf Df(pf, pc0, M0)
M0/pc

A Pf0
B
Pf1

F0 M/pff0 F1 Food M0/pf1 F0 F1 Food

Individual household demand curve for food

Exercise – 1
• Helen’s preferences over CDs (C) in X-Axis and sandwiches (S) on the
Y-Axis are given by 𝑈(𝐶, 𝑆) = 𝐶𝑆 + 10(𝐶 + 𝑆), with 𝑀𝑈𝐶 = 𝑆 +
10 and 𝑀𝑈𝑆 = 𝐶 + 10. If the price of a CD is $9 and the price of a
sandwich is $3, and Helen can spend a combined total of $30 each
day on these goods, find Helen’s optimal consumption basket (Hint:
find 𝑀𝑈𝐶 /𝑃𝐶 and 𝑀𝑈𝑆 /𝑃𝑆 and compare at each of the two endpoints
of the budget line).
Exercise 2
• Consider a consumer with the utility function 𝑈 𝑥, 𝑦 = min 3𝑥, 5𝑦 .
The prices of the two goods are Px = $5 and Py = $10, and the
consumer’s income is $220. Determine the optimum consumption
basket and show the same on a graph involving the ICs and the
Budget line.
Exercise – 3
• Elmer’s utility function is 𝑈 𝑥, 𝑦 = min 𝑥, 𝑦 2 . 𝑃𝑥 = 1, 𝑃𝑦 = 2,
income = 8. What bundle 𝑥 ∗ , 𝑦 ∗ does Elmer choose in this
situation? (* denotes the optimal)