Consumer Behaviour and

Rational Choice
 Readings

 Robert Pindyck and Daniel Rubinfeld: Microeconomics (Eighth Edition),

Pearson India – Chapters 3 and 4

 Mansfield, Allen, Doherty and Weigelt: Managerial Economics: Theory,

Applications and Cases (Fifth Edition), W. W. Norton and Company –
Chapter 3

 Ahuja, H. L.: Modern Microeconomics (Theory and Applications), S. Chand

and Company Ltd.

 Thomas and Maurice: Managerial Economics: Concepts and Applications

(10th Edition), Tata McGraw-Hill.

2
Session Objectives

After studying this chapter, you should be able to:

• Define utility and explain how consumers choose goods and

services to maximize their utility.

• Use the concept of utility to explain how the law of demand results
from consumers adjusting their consumption choices to changes in
prices.

• Use the concept of indifference curve and budget constraint to

explain why the demand curve is downward sloping.

• Define consumer surplus and explain how and when the

government intervenes when the market fails.

3
 Can Amir Khan Get You to Drink Coca-Cola?

 When Coca-Cola hired Amir Khan to endorse its drink, it hopes to gain from
Amir’s celebrity icon.

 What do firm’s hope to gain from celebrity endorsements?

 The obvious answer is that firms expect celebrity advertising will increase
sales of their products.

 But why should consumers buy more of a product just because it is endorsed
by a celebrity?

 In these sessions, we shall examine how consumers make decisions about

which products to buy. Firms must understand consumer behaviour to
determine whether strategies such as using celebrities in their advertising are
likely to be effective.
4
An Example

 Mrs. A lives in Vasant Kunj, New Delhi. We will get to know about her
preferences and her responses to market incentives.

 She has a limited budget that she must allocate between food and
clothing.

• If her available budget increases, she can buy more of both goods.

• If the price of one good increases, she can buy less of that good.
 An Example

 Her utility maximizing combination of food and clothing is found where her
indifference curve is tangent to her budget constraint.

• If she receives a coupon, how will her budget constraint change?

• If she receives a quantity discount, how will her budget constraint

change?

• Why is she generally better off with a cash gift than a gift or gift card of
equal value?

• If the price of a good changes, how will her consumption bundle change?

• How is her demand curve derived?

 Why Study Theory of Consumer Behaviour?

The willingness of consumers to purchase a product or service is the

fundamental source of profit for any business

 No matter how efficiently production is accomplished, a firm cannot earn a profit

unless buyers believe they can benefit by consuming the firm’s product rather
than buying a rival’s product or even saving money for future consumption.

 Understanding consumer behaviour, then, is the first step in making profitable

pricing, advertising, product design, and production decisions.

 In earlier sessions, we saw that the model of demand and supply is a powerful
tool for analyzing how prices and quantities are determined. We also saw that
according to the law of demand, whenever the price of a good falls, the quantity
demanded increases. Here we will show how the economic model of consumer
behaviour leads to the law of demand.

7
 The Economic Model of Consumer Behaviour
in a Nutshell

 Imagine walking through a shopping mall trying to decide how to spend your
clothing budget.

 If you had an unlimited budget, your decision would be easy: Just buy as much
of everything as you want.

 Given that you had a limited budget, what do you do? Economists assume that
consumers act so as to make themselves as well off as possible.

 Therefore, you should choose among those combinations of clothes that you
can afford, the one combination that makes you as well off as possible.

 Stated more generally, the economic model of consumer behaviour predicts

that consumers will choose to buy the combination of goods and services that
makes them as well off as possible from among all the combinations that their
budgets allow them to buy.

8
 Concept of Utility
 Ultimately, how well off you are from consuming a particular combination of
goods and services depends upon your tastes, or preferences.

 If you buy Cadbury Temptation instead of a regular Dairy Milk, even though
Dairy Milk has a lower price, you must receive more enjoyment or satisfaction
from biting Temptation.

 Economists refer to the enjoyment or satisfaction people receive from

consuming goods and services as utility.

 Utility is defined as the want satisfying power of a commodity

 So we can say that the goal of a consumer is to spend available income so as

to maximize utility.

9
 The Utility
 Settling on a name for the benefits does not solve the problem of how to
measure these benefits from consumption

 Who would say how many units of satisfaction, or how much utility, they receive
from consuming an ice cream cone or pizza or from going to the movie.

 Two hundred years ago, economists had hoped it would be possible to measure
utility in units called ”utils.” These economists hoped it would be possible to say
that if Mr. A’s utility from eating Temptation is 10 utils and from Dairy Milk is 5
utils, then Mr. A receives exactly twice the satisfaction from eating a Temptation
than he does from Dairy Milk.

 This type of utility measurement is referred to as cardinal utility. However, this

type of detailed information is seldom available and even if available, is difficult
to measure. That is not a problem because nobody has to know how much more
desirable Temptation are to Dairy Milk in order to make a simple choice between
the two.

 Assumptions of Marshallian Cardinal Utility Analysis (from the Book- Principles of

Economics)
 The Cardinal Measurability of Utility.
 The hypothesis of independent utilities.


Constancy of the MU of Money.
Introspection Method.
10
 The Utility

 All that is necessary is to rank the products according to your order of preference.

 The consumer’s understanding of ordinal utility makes possible a rank ordering of

preferred goods and services.

 Ordinal Utility Analysis by two english economists, J. R. Hicks and R. G. D. Allen –

“A Re-consideration of the Theory of Value” / 1939 Book – “Value and Capital”

 If the consumer prefers a combination of 3 Temptations and 1 Coke over the

combination of 2 Temptations and 2 Coke, he will assign a higher number of the
first combination than second – but the numbers themselves have no meaning.
They only preserve the consumer’s order of preference.

11
 The Principle of Diminishing Marginal Utility

 To make the model of consumer behavior more concrete, let’s see how a
consumer makes decisions in a case involving just two products: Pizza and Coke

 To begin with, consider how the utility you receive from consuming a good
changes with the amount of good you consume.

 For example, suppose that you have just arrived at a new year party, where the
hosts are serving pizza, and you are hungry. In this situation, you are likely to
receive quite a lot of enjoyment, or utility, from consuming the first slice of
pizza. Suppose this satisfaction is measurable and is equal to 20.

 After eating the first slice, you decided to have a second slice. Because you are
no longer as hungry, the satisfaction you receive from eating the second slice of
pizza will be less than the satisfaction you received from eating the first slice.

 Consuming the second slice would increase your utility by only an additional 16,
which would raise your total utility from eating two slices to 36. If you continue
eating slices, each additional slice will give you less and less additional
satisfaction.
12
 The Principle of Diminishing Marginal Utility
Total and Marginal Utility from
Eating Pizza on New Year Party

The relationship between

consuming additional product
during a period of time and the
marginal utility received from
consuming each additional unit is
referred to as the law of
diminishing marginal utility

13
 The Budget Constraint
 The key challenge for consumers is to decide how to allocate their limited
incomes among all the products they wish to buy.

 Every consumer has to make trade-offs: If you have Rs.100 to spend on

entertainment for the month, then the more DVDs you buy, the fewer movies
you can see in the theatre.

 Economists refer to the limited amount of income you have available to spend
on goods and services as your budget constraint.

 The principle of diminishing marginal utility helps us to understand how

consumers can best spend their limited incomes on the products available to
them.

14
 The Rule of Equal Marginal Utility per Rupee Spent
 Suppose you attend a New Year party at a restaurant and you have Rs.10 to
spend on refreshments. Pizza is selling for Rs 2 per slice and Coke is selling for
Rs.1 per cup.

 If you do not have a budget constraint, you would buy 5 slices of pizza and 5
cups of coke, because that will give you a total utility of 107 (54 + 53), which is
the maximum utility you can achieve.

TOTAL
TOTAL MARGINAL UTILITY MARGINAL
NUMBER OF UTILITY UTILITY NUMBER OF FROM UTILITY
SLICES OF FROM EATING FROM THE CUPS OF DRINKING FROM THE
PIZZA PIZZA LAST SLICE COKE COKE LAST CUP
0 0 0 0
1 20 20 1 20 20
2 36 16 2 35 15
3 46 10 3 45 10
4 52 6 4 50 5
5 54 2 5 53 3
6 51 3 6 52 1 15
 The Rule of Equal Marginal Utility per Rupee Spent

 Unfortunately, you do have a budget constraint: You have only Rs.10 to

spend. To buy 5 slices of pizza (at Rs.2 per slice) and 5 cups of coke (at Rs.1
per cup), you would need Rs.15.

 To select the best way to spend Rs.10, remember this key economic principle:
Optimal decisions are made at the margin.

 The key to making the best consumption decision is to maximize utility by

following the rule of equal marginal utility per rupee: As you decide how much
to spend your income, you should buy pizza and coke up to the point where
the last slice of pizza purchased and the last cup of coke purchased give you
equal increases in utility per rupee.

 It is important to remember that to follow this rule you must equalize your
marginal utility per rupee spent, not your marginal utility from each good.
Buying season membership for Delhi Cricket Association (DCA), or buying a
BMW may give you a lot more satisfaction than drinking a coke, but the
season tickets may well give you less satisfaction per Rupee spent.

16
The Rule of Equal Marginal Utility per Rupee Spent

(3) (6)
Marginal Marginal
(2) Utility (5) Utility
Marginal per Rupee Marginal per Rupee
(1) (4)
 MU Coke 
Slices Utility  MU Pizza


 Cups Utility 
 P 

(MUPizza)  P  (MUCoke)  
of Pizza  Pizza  of Coke Coke

1 20 10 1 20 20

2 16 8 2 15 15

3 10 5 3 10 10

4 6 3 4 5 5

5 2 1 5 3 3

6  -- 6 1 --

17
 The Rule of Equal Marginal Utility per Rupee Spent

Marginal Utility
Combinations of Pizza per Rupee
and Coke with Equal (Marginal Total
Marginal Utilities per Rupee Utility/Price) Spending Total Utility
Rs.2 + Rs.3 =
1 Slice of Pizza and 3 Cups of Coke 10 Rs.5 20 + 45 = 65
Rs.6 + Rs.4 =
3 Slices of Pizza and 4 Cups of Coke 5 Rs.10 46 + 50 = 96
Rs.8 + Rs.5 =
4 Slices of Pizza and 5 Cups of Coke 3 Rs.13 52 + 53 = 105

We can compactly summarize the two conditions for maximizing utility as

follows:
1. MUPizza / PPizza = MUCoke / PCoke

2. Spending on pizza + Spending on Coke = Amount available to be spent

18
 Water, Water, Everywhere
 Diamonds

• Not a necessity; expensive; relatively scarce

 Water

• Necessity; cheap; abundant

 Diamonds-Water paradox

• TUwater >TUdiamonds

• Last gallon of water MUwater very low

• Last diamond MUdiamond high

• Pdiamond > Pwater

19
 Marginal Utility and Law of Demand
Adjusting Optimal Assume that prize of pizza has fallen to
Consumption to a Lower Price Rs.1.50 per slice, other things remaining
of Pizza constant

Marginal Marginal Marginal

Utility Utility per Marginal Utility per
Number from Last Rupee Number Utility Rupee
of Slices Slice of Cups from Last Cup
of Pizza (MUPizza) of Coke (MUCoke)
1 20 13.33 1 20 20
2 16 10.67 2 15 15
3 10 6.67 3 10 10
4 6 4 4 5 5
5 2 1.33 5 3 3
6  – 6 1 –
20
 Marginal Utility and Law of Demand

 Examining the table, we can see that the fall in the price of pizza will result in
your eating 1 more slice of pizza; so your optimal consumption now becomes 4
slices of pizza and 4 cups of coke.

 You will be spending all your Rs.10, and the last rupee spend on pizza will
provide you with about the same marginal utility per rupee as the last rupee you
spend on coke.

 You will not be receiving exactly the same marginal utility per rupee spend on
the two products. But this is as close as you can come to equalizing marginal
utility per rupee for the two products, unless you can buy a fraction of a slice of
pizza or a fraction of a cup of Coke.

21
 Marginal Utility and Law of Demand

Max U; budget = Rs.10

• Qp = 3; Pp = Rs.2; one point on D curve

• (Qc = 4 ; Pc = Rs.1)

 Price of pizza drops to Rs.1.50, other things constant

Max U; budget = Rs.10

• Qp = 4; Pp = Rs. 1.50; second point on D curve

• (Qc = 4 ; Pc = Rs.1)

Draw the demand curve on your own

22
Individual Consumer Demand

 An individual’s demand curve for a specific commodity relates

utility-maximizing quantities purchased to market prices

 Other things are held constant

 Slope of demand curve illustrates law of demand—quantity

demanded varies inversely with price
Deriving a Demand Curve
100
Quantity of Y

Px=$10

Px=$8

Px=$5

0
50 65 90 100 125 200
Quantity of X

10
Price of X ($)

Demand for X

0 50 65 90
Quantity of X
 Limitations to the Marginal Utility Approach

 We analyzed consumer behaviour using the assumption that satisfaction, or

utility, is measurable in utils. Although this assumption made our analysis
easier to understand, it is unrealistic.

 Indeed, we can use the more realistic assumption that consumers are able to
rank different combinations of goods and services in terms of how much utility
they provide.

 In other words, a consumer is able to determine whether he or she prefers 2

slices of pizza and 1 can of Coke or 1 slice of pizza and 2 cans of Coke, even if
the consumer is unsure exactly how much utility he or she would receive from
consuming these goods.

25
The Consumer’s Optimization Problem

 Individual consumption decisions are made with the goal of

maximizing total satisfaction from consuming various goods and
services

 Subject to the constraint that spending on goods exactly

equals the individual’s money income
Consumer Theory

 Assumes buyers are completely informed about:

 Range of products available

 Prices of all products

 Capacity of products to satisfy their incomes

 Requires that consumers can rank all consumption bundles based

on the level of satisfaction they would receive from consuming
the various bundles
Typical Consumption Bundles for
Two Goods, Good X & Good Y
Properties of Consumer Preferences
Basic Assumptions/Properties

 Completeness
 For every pair of consumption bundles, A and B, the consumer can
say one of the following:
• A is preferred to B
• B is preferred to A
• The consumer is indifferent between A and B
Thus, our consumer can always make up his mind when confronted with choices.

 Transitivity
 If A is preferred to B, and B is preferred to C, then A must be
preferred to C
The transitivity property implies that the consumer’s choices must be consistent in some sense.

 Non-satiation
 More of a good is always preferred to less (Monotonicity) Economists
refer to this the nonsatiation principle. Thus if bundle A contains more of at least one good than
bundle B, and no less of anything else, then A will be preferred to B.
This nonsatiation assumption is not always realistic:

(i) It is not true of things like pollution and garbage, where more
is worse rather than better. These are called ‘bads’ to distinguish
them from the ‘good’ commodities.

(ii) Even in case of ordinary ‘goods’, too much consumption can

lead to a point where more is not better.

30
 Utility

 Benefits consumers obtain from goods & services they consume is

utility

 A utility function shows an individual’s perception of the utility

level attained from consuming each conceivable bundle of goods
U = f(X, Y)
Indifference Curves

 Set of points representing different bundles of goods & services,

each of which yields the same level of total utility

 Downward-sloping & convex

Typical Indifference Curve
Indifference Curves

Plotting the Preferences for

Pizza and Coke

34
 Properties of Indifference Curves

 Indifference Curves slope downward to the right (follows from the assumption
of non-satiation)

 Indifference Curves cannot intersect each other (follows from the assumptions
of transitivity and non-satiation).

 Bundles on higher indifference curves are preferred to bundles on lower

indifference curves (follows from the assumption of non-satiation).

 Indifference curves are convex to the origin.

35
 Marginal Rate of Substitution

 We already know that indifference curves are downward sloping. The less of
clothing (say) the consumer has, more the food he requires to be as well off as
before.

 For small movements along an indifference curve, the slope –dC/dF represents
the rate at which the consumer is willing to substitute food for clothing.

 This, the slope of indifference curve at a point, is called the marginal rate of
substitution (MRS). In other words, it represents the rate at which a consumer
would be willing to trade off one good for another.

36
Marginal Rate of Substitution (MRS)
Good (y)

Movement from A to B involves a A

y1
‘loss’ in utility in terms of y, i.e.,
-yMUy = (y1-y2)MUy and ‘gain’ -y
in utility in terms of x, i.e.,
xMUx = (x2-x1)MUx; and the B

sum of these ‘loss’ and ‘gain’ y2 x

adds up to zero, i.e.,
-yMUy + xMUx = 0
u0

Δy MU x 0 x1 x2
MRS  -  Good (x)
Δx MU y

Marginal utility (MU) represents an additional utility made by the consumption

of an extra unity of a good by the consumer.
Marginal Rate of Substitution (MRS)
 MRS measures the number of units of Y that must be given up
per unit of X added so as to keep utility constant
 Negative of the slope of the indifference curve

 Diminishes along the indifference curve as X increases & Y

decreases
 Ratio of the marginal utilities of the goods

Y MU X
MRS    
X MUY
Slope of an Indifference Curve &
the MRS

A
600
Quantity of good Y

C (360,320)
320
I
T’

B
0 360 800
Quantity of good X
 Law of Diminishing Marginal Rate of
Substitution
 The fourth property of indifference curve – the indifference curves are convex –
is derived from the assumption of law of diminishing MRS.

 Diminishing MRS implies that as X is substituted for Y along an indifference

curve, the MRS of X for Y diminishes. This is only possible when indifference
curve is bowed out towards the origin – that is, the indifference curve is convex
to the origin.

 The intuitive reasoning is as follows: When goods X are relatively scarce, the
added value of another units of goods X will be large in relation to the value of
another unit of goods Y (say) sacrificed. Conversely, when goods X are
relatively abundant, the added value of another units of goods X will be small in
relation to the value of another unit of goods Y sacrificed. In other words, as
more and more of one good is consumed, we can expect that a consumer will
prefer to give up fewer and fewer units of a second good to get additional units
of the first one.

 The convexity property ensures that consumer prefers average bundles to

extreme bundles. Rather than have a great deal of one good and a little bit of
the other, he likes to have moderate amounts of both.
40
The Marginal Rate of Substitution
● marginal rate of substitution (MRS) Maximum amount of a good
that a consumer is willing to give up in order to obtain one additional
unit of another good.

The Marginal Rate of Substitution

The magnitude of the slope of an

indifference curve measures the
consumer’s marginal rate of
substitution (MRS) between two
goods.

In this figure, the MRS between clothing

(C) and food (F) falls from 6 (between A
and B) to 4 (between B and D) to 2
(between D and E) to 1 (between E and
G).
Convexity The decline in the MRS
reflects a diminishing marginal rate of
substitution. When the MRS
diminishes along an indifference curve,
the curve is convex.
 Importance of MRS for a firm

Quick Thinking!

 Consider the preference orderings of a couple – Bijoy and Bijoya – for two
goods: dal and ice-cream. Bijoya is willing to give up more ice-cream than Bijoy
for an additional cup of dal. Draw their indifference curves.

 Predicting trade-offs is important in business decision making. Products have

many different characteristics. Managers making long-range decisions often try
to determine the relative values that consumers place on these different
characteristics, and one product generally cannot incorporate all the desirable
characteristics.

 For example, an ice-cream manufacturer must decide how much fat to put into
a new product. Fat makes ice-cream taste good, but for dietary reasons many
consumers value low-fat, low cholesterol food. The manufacturer must evaluate
consumer trade-offs between taste and health.

 All products have some substitutes, and consumers are willing to trade one
product for another at some rate. The important thing is estimating the rate at
which they are willing to make trade-off.
42
 Designing New Automobiles: A Case Study
 Suppose you worked for the Ford Motor Company and had to help plan new models to
introduce. Should the new models emphasize interior space or outlook of the model?
Horsepower or gas mileage?
 To decide, you want to know how people value the various attributes of a car, such as
power, size, outlook, gas mileage, and so on. The more desirable the attributes, the more
people would be willing to pay for the car. However, the better the attributes, the more
the car will cost to manufacture.
 How should Ford trade off these different attributes and decide which ones to emphasize?
The answer depends in parts on the cost of production, but it also depends on consumer
preferences.
 The management of Ford Motor Company may, encounter consumer’s considerations
like price of the car, the cost of maintenance, mileage per litre, interior space, engine
power, outlook of the model, the social status reflected through the model, etc.
 Identifying the two most important attributes (e.g., price and mileage per litre; model
outlook and interior space; etc.) the management of Ford may draw a set of
indifference curves with those two chosen attributes on the two axis and then finding
out MRS in case of each pair of attributes. This will reveal how consumers are ready
to trade-off one attribute for another, and thereby help the management in arriving at
the best attributes for its model. 43
 Designing New Automobiles: A Case Study

Preferences for automobile attributes can be described by

indifference curves. Each curve shows the combination of
acceleration and interior space that give the same
satisfaction.

PREFERENCES FOR AUTOMOBILE

ATTRIBUTES

Owners of Ford Mustang coupes (a) are The opposite is true for owners of
willing to give up considerable interior space Ford Explorers. They prefer interior
for additional acceleration. space to acceleration (b).
Indifference Maps

 An indifference map consists of several indifference curves

 The higher (or further to the right) an indifference curve, the

greater the level of utility associated with the curve

 Combinations of goods on higher indifference curves are

preferred to combinations on lower curves
Indifference Map

Quantity of Y

IV

III

II

Quantity of X
Marginal Utility

 Addition to total utility attributable to the addition of one unit of

a good to the current rate of consumption, holding constant the
amounts of all other goods consumed

MU  U X

Y MU X
MRS   
X MUY
 Some Non-Standard Cases of Preference
Ordering

 Consider a drunkard who would always prefer a combination of beer and bread
with more beer in it to one with less, regardless of the amount of bread. But if
the amounts of beer are the same, he will prefer the one with more bread.
Draw his indifference curve between beer and bread. (Example of lexicographic
ordering)

 Consider a typical consumer’s preference for tea and coffee. The consumer is
always willing to substitute one cup of coffee with one cup of tea, regardless of
how many cups of tea he is left with and how many cups of coffee were in
hand. Draw his indifference curve between tea and coffee. (Example of
substitutes)

 Suppose a consumer always take two spoons of sugar with one cup of tea.
Draw the indifference curve for tea and sugar for the consumer. (Example of
compliments)

48
 Some Non-Standard Cases of Preference
Ordering

 Consider a typical consumer’s preference for labour and income. The consumer
prefers income but hates to work. Draw his indifference curve between labour
and income. (Example of ‘good’ vs. ‘bad’).

 Consider a situation where the consumer is faced with two commodities, both of
which are bad. For example, suppose that the commodities in question are
“inflation” and unemployment”. Draw his indifference curve between these two
commodities (Example of ‘bad’ vs. ‘bad’).

 Suppose a consumer enjoys chocolate and lobster, but dislikes eating more
than three lobsters a day and two chocolates a day. How does his indifference
curve looks like?

 Consider the two commodities – return from an asset and the risk involved. The
consumer loves return, but is risk neutral. Draw the indifference curve for this
consumer between risk and return (Example of neutral goods)
49
 Perfect Substitutes and Perfect Complements
Perfect Substitutes and Perfect Complements
In (a), Bob views orange juice and
apple juice as perfect substitutes:
He is always indifferent between a
glass of one and a glass of the
other.
In (b), Jane views left shoes and
right shoes as perfect complements:
An additional left shoe gives her no
extra satisfaction unless she also
obtains the matching right shoe.
Consumer’s Budget Line

 Shows all possible bundles of goods that can be purchased at

given prices if the entire income is spent

M  PX X  PY Y

or

M PX
Y  X
PY PY
Consumer’s Budget Constraint
Typical Budget Line

M
PY
•A

M PX
Y  X
Quantity of Y

PY PY

B
•
M
Quantity of X
PX
 Shifting Budget Lines

R
120
A A
100

Quantity of Y
100
Quantity of Y

F
80

Z B N C B D
160 200 240 125 200 250

Quantity of X Quantity of X

Panel A – Changes in money income Panel B – Changes in price of X

 Different Shapes of Budget Line

 Suppose the government has imposed the rationing constraint, such

that the level of consumption of one good is fixed to be no larger than
some amount. Draw the consumer’s budget line.

 Suppose instead of imposing rationing constraint, the government

imposes a tax t on all consumption of one good, if it exceeds a certain
fixed level. Draw the consumer’s budget line.

 Suppose that a consumer can force the price of good 1 to rise by

purchasing more of good 1. Discuss the shape of the consumer’s
budget line.

55
Utility Maximization

 Utility maximization subject to a limited income occurs at the

combination of goods for which the indifference curve is just
tangent to the budget line

Y PX
  MRS  
X PY
Utility Maximization

 Consumer allocates income so that the marginal utility per dollar

spent on each good is the same for all commodities purchased

MU X PX
MRS  
MUY PY

MU X MU Y

PX PY

 Note: This is the Ordinal Utility Analysis counter-part of the Principle of Equi-marginal Utility
(Cardinal Utility Analysis)
Constrained Utility Maximization

50 At equilibrium point E,
A
45 • MRS 
MU X PX

40 •B •D
MUY PY
Quantity of pizzas

MU X MU Y
E IV or 
30
R
• PX PY
III
20
C
15 • II
T
10
I

0 10 20 30 40 50 60 70 80 90 100
Quantity of burgers
A consumer’s utility is maximized at point E, where indifference curve III is tangent to the budget line.
In this solution to the consumer’s choice problem, the consumer ends up buys both commodities. This will happen if
the indifference curves are nicely behaved, i.e., that is they have the correct curvature. We call such solutions as
interior solution.
 Example:
 Anima is a risk averse investor. She has Rs.1 lakh, which she
must allocate between government securities and common
stocks.
 If she invests it all in government securities, she will receive a
return of 5 percent, and there is no risk.
 If she invests it all in common stock, she expects a return of
10 percent, and there is considerable risk.
 How should this investor allocate the 1 lakh rupees between US
government securities and common stocks?

59
Utility Maximization, N Goods

 The utility maximization principle is easily extended to cover any

number of goods

X i Pj
  MRS  
X j Pi

MU1 MU 2 MU 3 MU N
   ... 
P1 P2 P3 PN
Corner Solution

 In many cases consumers spend their entire budget and choose

to purchase none of some specific good

 A corner solution exists when the utility maximizing bundle lies

at one of the endpoints of the budget line and the consumer
chooses to consume zero units of a good
Corner Solution: X* = 0
 Corner Solution

 For goods X and Y, a corner solution, in which the consumer

purchases none of good X, results when

MU X MUY

PX PY

 In general, a corner solution, in which the consumer purchases

none of good X, results when

MU X MU i MU j
  ... 
PX Pi Pj
 The n-Good Case
 The individual’s objective is to maximize
utility = U(x1,x2,…,xn)
subject to the budget constraint
I = p1x1 + p2x2 +…+ pnxn
 Set up the Lagrangian:

ℒ = U(x1,x2,…,xn) + (I - p1x1 - p2x2 -…- pnxn)

 The n-Good Case
 FOCs for an interior maximum:
ℒ/x1 = U/x1 - p1 = 0

ℒ /x2 = U/x2 - p2 = 0

•
•
•
ℒ /xn = U/xn - pn = 0
ℒ / = I - p1x1 - p2x2 - … - pnxn = 0
Implications of FOCs

 For any two goods,

U / x i pi

U / x j p j
• This implies that at the optimal allocation of income

pi
M RS ( x i for x j ) 
pj
Interpreting the Lagrangian Multiplier

U / x1 U / x 2 U / x n
   ... 
p1 p2 pn

M U x1 M U x2 M U xn
   ... 
p1 p2 pn
  is the marginal utility of an extra dollar of consumption
expenditure
 the marginal utility of income
 Quick Activity
 Derive the demand functions from the following utility
functions:
 U(x,y) = xy
 U(x,y) = min (x,y)

68
 Effects of Change in Money Income
 The solution to consumer’s optimization problem depends on his
preferences, the prices he faces and his money income.

 Assume that the consumer’s income increases. This will shift the
budget line upward and to the right. The movement is a parallel shift
because nominal prices are assumed to be constant.

 As income shifts, the point of consumer equilibrium shifts as well. The

line connecting the successive equilibria is called the income-
consumption curve (ICC). It is a locus of points in the commodity
space showing the equilibrium commodity bundles associated with
different levels of money income for constant money prices.

 Draw the ICC for two goods when (a) both are normal; (b) one is an
inferior good, and (c) both are inferior goods.
69
 The Engel Curve

 The ICC may be used to derive the Engel curve for each commodity.
An Engel curve is a function relating the equilibrium quantity
purchased of a commodity to the level of money income.

 Draw the Engel curve for (a) necessary good; (b) luxury good and (c)
inferior good.

 Draw an Engel curve for each of the two goods under Cobb-Douglas
utility function.

70
 Effect of Change in Prices
 Assume that the money income and the nominal price of good 2
remain constant while the nominal price of good 1 falls.
 The Price consumption curve (PCC) is the locus of points in the
commodity space showing the equilibrium bundles resulting
from variations in the price ratio, money income remaining
constant.

71
Derivation of Demand Curve
10
Video rentals per week

A reduction in the price of pizza rotates

(a)
the budget line rightward.
5 The consumer is back in equilibrium at
e”
4 PCC point e” along the new budget line.
e
I I”

0 3 4 5 6.67 Pizzas per week

Price per pizza

(b)
A drop in price of pizza
e increases quantity demanded
$8 e”
6
D

0 3 4 Pizzas per week 72