Microeconomics (PGP-I)

Session 2

Joysankar Bhattacharya
 Session Two: Overview

1. Consumer Preferences and the Concept of Utility

3. The Utility Function

• Marginal Utility and Diminishing Marginal Utility

4. Indifference Curves

5. The Marginal Rate of Substitution

6. The Budget Constraint

7. Consumer Choice

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 Objective

• Our aim is to understand the consumer decision-

making process that generates demand functions
for goods and services

• It is important to know how changes in various

prices, changes in income distribution, and changes in
the ‘attribute mix’ of a product will affect demand
 Rationality assumption
• Every consumer has well-defined preferences over
goods and services, and given his/her constraints
(prices and incomes), (s)he chooses a commodity
bundle that maximizes his/her well-being
 Consumer Preferences

Consumer Preferences tell us how the consumer would

rank (that is, compare the desirability of) any two
combinations or allotments of goods, assuming these
allotments were available to the consumer.

These allotments of goods are referred to as baskets or

bundles. These baskets are assumed to be available for
consumption at a particular time, place and under particular
physical circumstances.

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 Consumer Preferences

Preferences are complete if the consumer can rank any

two baskets of goods (A preferred to B; B preferred to
A; or indifferent between A and B)

Preferences are transitive if a consumer who prefers

basket A to basket B, and basket B to basket C also
prefers basket A to basket C
AA B;
B;BB CC ==>> AA CC

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 Consumer Preferences

Preferences are monotonic if a

basket with more of at least one
good and no less of any good is
preferred to the original basket.

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 Types of Ranking

Students take an exam. After the exam, the students are ranked
according to their performance. An ordinal ranking lists the
students in order of their performance (i.e., A did best, B did
second best, C did third best, and so on). A cardinal ranking
gives the mark of the exam, based on an absolute marking
standard (i.e., A got 80, B got 75, C got 74 and so on).

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 The Utility Function

The three assumptions about preferences allow us to represent

preferences with a utility function.

Utility function

– a function that measures the (maximum) level of satisfaction

a consumer receives from any basket of goods and services.

– assigns a number to each basket so that more preferred

baskets get a higher number than less preferred baskets.

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 The Utility Function

• An ordinal concept: the precise magnitude of the number that

the function assigns has no significance.

• Utility not comparable across individuals.

• Any transformation of a utility function that preserves the

original ranking of bundles is an equally good representation of
preferences. e.g. U = vs. U = + 2 represent the same
preferences.

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 Marginal Utility

Marginal
Marginal Utility
  
Utility of
of aa good
goodYY

•• additional
additional utility
utility that
that the
the consumer
consumer gets
gets from
from
consuming
consuming aa little
little more
more of
ofY Y

•• i.e.
i.e. the
the rate
rate at
at which
which total
total utility
utility changes
changes as
as the
the
level
level ofof consumption
consumption ofof good
goodY Yrises
rises

•• MU
MUyy ==

•• slope
slope of
of the
the utility
utility function
function with
with respect
respect to
toY
Y
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 Diminishing Marginal Utility

The
The principle
principle of
of diminishing
diminishing marginal
marginal utility
utility
states
states that
that the
the marginal
marginal utility
utility falls
falls as
as the
the
consumer
consumer consumes
consumes more
more of
of aa good.
good.

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Diminishing Marginal
Utility

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 Marginal Utility

The
The marginal
  
marginal utility
utility of
of aa good,
good, X,X, isis the
the additional
additional
utility
utility that
that the
the consumer
consumer getsgets from
from consuming
consuming aa littlelittle
more
more of of X X when
when thethe consumption
consumption of of allall the
the other
other
goods
goods inin the
the consumer’s
consumer’s basket
basket remain
remain constant.
constant.

•• U(X,
U(X,Y)
Y) :: Utility
Utility Function
Function

•• (Y
(Yheld
heldconstant)
constant)
== MU
MUXX

•• (X
(Xheld
heldconstant)
constant)
== MU
MUYY
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 Marginal Utility

Example
Example of
of U(B)
U(B) and
and MU
MUBB

U(B) = 10B
U(B) = 10B – B– B22

MU
MUBB == 10
10 –– 2B
2B
B B2 U(B) MUB
1 1 9 8
2 4 16 6
4 16 24 2
6 36 24 -2
8 64 16 -6
10 100 0 -10 15
Marginal Utility

U(B) = 10B – B2

MUB = 10 – 2B

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 Marginal Utility

Example
Example of
of U(B)
U(B) and
and MU
MUBB

• The point at which he should stop

consuming hotdogs is the point at which
MUB = 0
• This gives B = 5.
• That is the point where Total Utility is flat.

• Beyond B=5, the utility is diminishing.

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 Indifference Curves

An Indifference Curve or Indifference Set: is the set

of all baskets for which the consumer is indifferent

- shows all combinations of consumption along which

an individual is indifferent

An Indifference Map : Illustrates a set of indifference

curves for a consumer

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 Indifference Curves

1)Indifferencecurves
1)Indifference curveshave
havenegative
negativeslope
slope(Monotonicity)
(Monotonicity)

2)Indifference
2)Indifferencecurves
curvesdo
donot
notcross
cross(Transitivity)
(Transitivity)

3)Each
3)Each basket
basket lies
lies on
on only
only one
one indifference
indifference curve
curve
(Completeness)
(Completeness)

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Indifference Curves

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Indifference Curves

Suppose
SupposethatthatBBpreferred
preferredtotoA.
A.
But
But… …bybydefinition
definitionof
ofIC,
IC,
BBindifferent
indifferenttotoCC
AAindifferent
indifferenttotoCC=>
=>BBindifferent
indifferent
totoCCby
bytransitivity.
transitivity.

And
Andthus
thusaacontradiction
contradiction!!!!

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Indifference Curves

U = xy2
.

x y xy2
8 4.24 143.8
4 6 144
3 6.93 144.07
1 12 144
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 Indifference Curves

Example:
Example: Utility
Utility
Indifference Curve for U = xy2 and
and the
the single
single
indifference
indifference curve.
14

12
curve.
10

y
6
U = 144
4

0
0 1 2 3 4 5 6 7 8 9
X

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 Indifference Curves
y
Example: Graphing Indifference
Curves

Preference direction

IC2

IC1
x 24