ECON1268

Price Theory
Lecture 3 – Consumer Choice
 Topics for today's lecture . . .
1. The budget constraint

2. Optimal choice

3. Corner solutions

4. Transfers and vouchers

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The budget constraint

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 Another way of thinking about wealth

It is common to think about an individual's wealth in terms of the

monetary value of her/his assets.

On the other hand, we recognise that an individual's welfare (utility)

is derived from her/his consumption of goods and services
(amongst other things).

It will be useful to describe a consumer's wealth in terms of the

consumption possibilities that her/his wealth creates.
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The cost of a consumption basket
 Suppose that:
• The price of food (good x)
is per meal.
• The price of clothing (good
y) is per item.

Basket A, containing meals

and items of clothing, costs,

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The cost of a consumption basket 2

𝑃 𝑥 𝑥 𝐴 +𝑃 𝑦 𝑦 𝐴 =20×14+100×5=$780
 

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 Definition: Budget constraint
The set of baskets that a consumer can purchase given
her/his income and the prevailing prices.

The budget constraint describes the alternative consumption

possibilities that are available to a consumer.

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Affordable consumption baskets
 Suppose that the consumer’s
income is
• If the consumer spends all of
her/his income on food then,
meals
• If the consumer spends all of
her/his income on clothing
then,
items
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The budget line
 Theequation of the budget
constraint is,

The set of baskets that are only

just affordable is called the
budget line.

Baskets that lie below the

budget line (such as A) are
affordable.
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The budget line 2
Baskets that lie above the
budget line (such as B, which
costs $1400) are unaffordable.

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The trade-offs along the budget line
 The slope of the budget line is
the negative of the ratio of
prices,

The ratio is the number of units

of clothing (good y ) that must be
given up in order to obtain an
additional unit of
food (good x).
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 Quiz 1
Each week Sarah spends a total of $100 on coffee and cake. The price of coffee is
$4 per cup, and the price of cake is $12 per slice. If Sarah purchases 7 slices of
cake, how many cups of coffee does she purchase?

(a) 1.

(b) 4.

(c) 16.

(d) 25.
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 Quiz 2
Each week Sarah spends a total of $100 on coffee and cake.
The price of coffee is $4 per cup, and the price of cake is $12
per slice. If Sarah wants to increase by 1 the number of slices
of cake she purchases, without altering the total amount she
spends on coffee and cake, how many cups of coffee must
she give up?

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 Quiz 2 2
(a) 1/3.

(b) 1.

(c) 3.

(d) 12.

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A fall in income
 Suppose that the consumer's
income falls from $1000 to $500.
meals

items

The slope of the budget line

does not change.

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A fall in income 2
The shaded area represents the
consumption possibilities lost
when the consumer's income
falls.

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An increase in the price of food
 Suppose that the price of food
increases from $20 to $40 per
meal.
meals
The y -intercept does not
change.

The budget line is steeper

(

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An increase in the price of food 2
The consumer has fewer
available consumption baskets.

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Exercise: Inflation
 Suppose that per meal,
per item, and
1. On a graph, illustrate how the
consumer's budget set
changes if the prices of food
and clothing both increase by
10%.
2. What happens to the budget
set if the consumer's income
also increases by 10%.
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Optimal Choice

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Constrained optimisation
A consumer's objective is
to achieve the highest
possible level of utility
(reach the highest available
indifference curve).

The budget constraint limits

the set of baskets from
which the consumer may
choose. 21
Constrained optimisation 2
The optimal choice is the
basket that maximises
her/his utility, within her/his
budget constraint.

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The optimal consumption basket lies on the budget line

Take any basket A that lies

below the budget line.

The more is better

assumption implies that any
basket above and to the
right of A delivers a higher
level of utility.

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The optimal consumption basket lies on the budget line
2

Therefore, A cannot be
optimal as there must exist
a basket B on the budget
line that is preferred to A.

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At the optimum, the indifference curve does not cross
the budget line

Take any basket A lying on the

budget line, at a point at which an
indifference crosses the budget
line.

There must exist a basket B, on

the same indifference curve as A,
that lies below the budget line.

Therefore, A cannot be optimal as

the basket C is preferred over B,
and the consumer is indifferent
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between B and A.
At the optimum, the indifference curve is tangent to the
budget line

The optimum must lie on an

indifference curve that touches,
but does not cross, the budget
line.

Diminishing marginal rate of

substitution implies that we can
find the optimal basket A where
the indifference curve is tangent
to the budget line.

At most one consumption basket

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can satisfy these conditions.
Two conditions for an interior optimum

•  The optimal consumption basket lies on the budget line,

therefore,

• At the optimum the slope of the indifference curve is equal

to the slope of the budget line, therefore,

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Two conditions for an interior optimum 2

•  

Note: These conditions are predicated on the more is better

assumption holding for both goods, and on a diminishing
marginal rate of substitution.

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 Bang for your buck
•An  alternative way of stating the tangency condition is,

In words, at an interior optimum the marginal utility per dollar

must be equal for all goods.

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 Bang for your buck 2
• The bang for your buck condition must hold for every pair
of goods an individual consumes, regardless of the number
of goods in her/his consumption basket.

Intuitively, if the marginal utility per dollar is higher for good x

than for good y , the consumer can increase her/his utility by
reducing spending on y , and increasing spending on x.
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 Quiz 3
•The
  utility Sarah derives from coffee (good x) and cake (good
y ), is given by the function . The corresponding marginal
utilities are,

and

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 Quiz 3 2
If
• the
  price of coffee is per cup, the price of cake is per slice, and Sarah's
income is , what is Sarah's optimal consumption basket?

(a) x = 12 cups, y = 4 slices.

(b) x = 5 cups, y = 5 slices.

(c) x = 15 cups, y = 5 slices.

(d) x = 5 cups, y = 15 slices.

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 Quiz 4
•The
  utility Sarah derives from coffee (good x) and cake (good
y ), is given by the function . The corresponding marginal
utilities are,

and

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 Quiz 4 2
If
• the
  price of coffee is per cup, the price of cake is per slice, and Sarah's
income is , what is Sarah's optimal consumption basket?

(a) x = 5 cups, y = 10 slices.

(b) x = 10 cups, y = 5 slices.

(c) x = 4 cups, y = 12 slices.

(d) x = 12 cups, y = 4 slices

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Exercise: Perfect complements
 Suppose left shoes (good
x), and right shoes (good
y ), are perfect
complements with,

Moreover, , and the

consumer’s income is

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Exercise: Perfect complements 2
1. What is the optimal
consumption basket?

2. What is the consumer's

utility at the optimum?

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Corner solutions

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When the tangency condition fails
It is possible that no basket
on the budget line satisfies
the tangency condition.

The highest indifference

curve this consumer can
reach is U3, by choosing
basket A.

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When the tangency condition fails 2
This is called a corner
solution because it lies at a
corner of the budget set.

A corner solution is only a

possibility if indifference
curves intersect one or both
axes.

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Bang for your buck in a corner solution

 At basket A the marginal

utility per dollar is greater
for good x than good y ,

Note: This inequality is

reversed for a corner
solution on the y -axis.

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Bang for your buck in a corner solution 2

The consumer would like to

exchange good x for good y,
but cannot as she/he cannot
consume fewer than zero
units of good y .

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 Discussion: Corner solutions
How many different products do you think are sold in your
local supermarket?

How many of these products have you, yourself, purchased?

How does marginal utility per dollar (bang for your buck)
help explain your behaviour?

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Corner solutions and perfect substitutes

 The perfect substitutes

utility function is where and
are
positive constants.

The corresponding marginal

utilities are and .

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Corner solutions and perfect substitutes 2

 An optimising consumer will

exclusively purchase good x
if,

The optimum is basket A in

the figure.

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Corner solutions and perfect substitutes 3

 An optimising consumer will

exclusively purchase good y
if,

The optimum is basket A in

the figure.

Every basket on the budget

line is optimal if,
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Corner solutions and perfect substitutes 4

 
This is the only case in
which perfect substitutes
has an interior solution.

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 Quiz 5
•Jeff's
  preferences over pizza (good x), and hotdogs (good y ),
are represented by the perfect substitutes utility function . The
corresponding marginal utilities are and

If the price of pizza is per slice, the price of hotdogs is each,

and Jeff's income is $60, then Jeff's optimal

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 Quiz 5 2
consumption basket contains,

(a) 30 slices of pizza, and no hotdogs.

(b) No slices of pizza, and 20 hotdogs.

(c) No slices of pizza, and 30 hotdogs.

(d) 30 slices of pizza, and 20 hotdogs.

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 Quiz 6
•Jeff's
  preferences over pizza (good x), and hotdogs (good y ),
are represented by the perfect substitutes utility function . The
corresponding marginal utilities are and

If the price of hotdog is , the highest price that Jeff is willing to

pay for a slice of pizza is,

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 Quiz 6 2
(a) Px = $2:50.

(b) Px = $5.

(c) Px = $7:50.

(d) Px = $10.

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Transfers and vouchers

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 Transfers and vouchers 2
Suppose that, as a part of its commitment to renewable
energy, the Government wants to increase the number of
solar panels installed on household rooftops.

The government is considering two policies:

• Transfer $20,000 to each household.

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 Transfers and vouchers 3
• Provide each household with a voucher redeemable for
$20,000 of solar panels. (A voucher cannot be redeemed
for any other good.)

Which policy best implements the Government's objective?

Which policy is best for households?

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 Definition: Composite good
A good that represents a consumer's collective expenditures
on every good except the product under consideration.

By aggregating all but one good into a single composite

good representing ‘everything else’, we can reduce the
economy to two dimensions.

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 Joey's household
•Joey
  has preferences over solar panels (good x) and the
composite good (good y) represented by the utility function

Joey's marginal utilities are and .

Joey's household income is

The price of solar panels is per panel.

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The budget constraint with a composite good

 We will follow the

convention that when y is
the composite good.

It follows that the vertical

axis represents both the
quantity of good y , and total
expenditure on the
composite good.
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The budget constraint with a composite good 2

 With and , the horizontal

intercept of Joey's budget
line is 30 solar panels.

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Joey's optimum with a $20,000 transfer

 Absent a transfer or
voucher, Joey's
optimum (basket A)
contains
solar panels, and units of
the
composite good. (You
should check this.)

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Joey's optimum with a $20,000 transfer 2

 A transfer
of $20,000
increases Joey's available
income to $50,000.

Joey's optimum with the

transfer (basket B) contains
solar panels, and units of
the composite good. (You
should check this.)
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The budget constraint with a $20,000 voucher

If Joey spends all his

income on the composite
good, he can still purchase
20 solar panels with the
voucher.

If he spends all his income

on solar panels, he can
purchase 50.
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The budget constraint with a $20,000 voucher 2

The voucher shifts Joey's

budget line to the right by
the number of panels that
can be purchased with the
voucher.

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Joey's optimum with a $20,000 voucher

The budget line with the

voucher is the same as with
the transfer, except for a
‘kink’ at the level of Joey's
income.

Joey's optimum with a

transfer remains feasible
with a voucher.
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Joey's optimum with a $20,000 voucher 2

Therefore, the transfer and

voucher have identical
effects on Joey's behaviour
and welfare.

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Exercise: Vouchers and corner solutions (part 1)

•Cynthia
  has preferences represented by the utility function .
Her corresponding marginal utilities are and . Cynthia's
income is , and the price of solar panels is per panel.

1. Show that, absent a transfer or voucher, Cynthia's optimal

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Exercise: Vouchers and corner solutions (part 1) 2

consumption basket contains x = 0 solar panels.

2. Show that a transfer of $20,000 does not affect of the

number of solar panels Cynthia purchases. How does the
transfer alter Cynthia's behaviour?

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Exercise: Vouchers and corner solutions (part 2)

•Cynthia
  has preferences represented by the utility function .
Her corresponding marginal utilities are and . Cynthia's
income is , and the price of solar panels is per panel.

3. Show that a voucher of $20,000, redeemable for solar

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Exercise: Vouchers and corner solutions (part 2) 2

•panels,
  will cause Cynthia to purchase exactly solar panels.
Illustrate this optimum on a graph.

3. Does Cynthia prefer a transfer or a voucher?

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Transfers versus vouchers
If the Government's
objective is a level of
consumption (as opposed to
maximising consumer
welfare), then vouchers
perform at least as well as
transfers.

However, transfers provide

consumers with at least as
much utility as vouchers. 68
 Discussion: Voucher schemes
What are some examples of government schemes that
behave like vouchers?

For each of these schemes, why do you think that the

government prefers vouchers over transfers?

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Questions?

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 Key concepts from today's lecture
You can use these concepts (as search terms) to conduct
further research into the topics covered in today's lecture:

• Budget constraint

• Ratio of prices

• Consumption possibilities

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 Key concepts from today's lecture 2
• Optimal choice

• Tangency condition

• Marginal utility per dollar

• Corner solution

• Composite good
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 Key concepts from today's lecture 3
• Transfers

• Vouchers

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