Section 2 - Consumer Theory

• Consumer theory attempts to explain

why consumers make choices: one
good or bundle of goods over another
good or bundle of goods.

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 Section 2 - Consumer Theory

• In Consumer Theory we will discuss:

–Consumer Utility (Chapter 3)
–Utility and Constraints
(Chapter 4)
–Utility and the Demand Curve
(Chapter 5)

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 Chapter 3 – Consumer Preferences
and the Concept of Utility
• Every day, people make choices about
what they prefer:
– Buy a red car with a sunroof or a green
truck with 4 wheel drive
– Buy Edo and a chocolate milk or
MacDonalds and a Diet Coke
– Buy a desktop computer with a 26” LED
screen and windows or a laptop with a
14” screen with an apple on it 3
 Chapter 3 – Consumer Preferences
and the Concept of Utility
• In this chapter we will study:
3.1 Preferences and Ranking
3.2 Utility Functions
3.3 Indifference Curves
3.4 Marginal Rates of Substitution
3.5 Special Utility Functions

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 3.1 Preference Definitions
• Basket (bundle) – any combination of
goods and services
– 3 hot dogs, 2 pop and 1 ice cream
– Haircut, manicure and 20 min massage
– 2 punches in the gut, 1 kick in the groin
• Consumer preferences – any ranking of
two baskets
– I prefer 2 hot dogs and a coke to a hot
dog, coke and ice cream 5
 Preference Assumptions

1) Preferences are complete

- A consumer can always rank
preferences:
a) A is preferred to B: A  B
b) B is prefered to A: B  A
c) A consumer is indifferent between A
and B: A ≈ B
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 Preference Example
1)Preferences are complete
- “I would rather go to a movie with Bobby than go
skiing with Mark.” (valid)
-“I prefer a computer with a good video card and large
screen to a computer with a good sound card and
good speakers.” (valid)
- “I hate everyone equally!” (valid)
- “I can’t decide whether Ruth or Victoria is cuter!”
(invalid) 7
 Preference Assumptions

2) Preferences are transitive

- Choices are consistent:
If
a) A is preferred to B: A  B
b) B is preferred to C: B  C
then
a) A is preferred to C: A  C
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 Preference Example

2) Choices are transitive

- “I would rather see the movie Star Wars than Tears
and Feelings. I prefer seeing Oceans 13 to Star
Wars. Therefore, I prefer Oceans 13 to Tears and
Feelings.” (valid)
-“Ruth is hotter than Victoria and Susan is cuter than
Ruth. Victoria is more attractive than Susan,
however.” (invalid)
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 Preference Assumptions
3) More is better
- A consumer always prefers having
more of a good
Examples:
-“I prefer seven hot dogs to 3.”
-“It’s better to have loved and lost than
never to have loved at all!”
-“2 heads are better than 1.”
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 Ranking
Ordinal Ranking
-baskets are ordered or compared to each
other without any quantitative
information or intensity of preference
-ie: “I like dogs more than cats.”
Cardinal Ranking
-baskets are quantitatively compared
-ie: “I like dogs ten times more than
cats.” 11
3.2 Utility
•util: unit of pleasure.
• utility: a number that represents
the level of satisfaction that the
consumer derives from consuming
a specific quantity of a good.

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Total Utility, Marginal Utility
• TU (total utility):
–the total amount of satisfaction that you
get from consuming a product.
• MU (marginal utility):
–the increase in TU that comes about as
a result of consuming one more unit of
the product.
–The slope of the total utility function
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 Marginal Utility
• If one more unit of a good is consumed, the
marginal utility is equal to the increased utility
from that extra good
• Mathematically:

 U tility
MU 
 G oods 14
 Law of Diminishing MU
• The MU (marginal utility) of a good or
service will decline as more units of that
good or service are consumed.

•Marginal utility is what counts for

rational consumer decisions.

• The “More is Better” assumption is

violated if MU ever becomes negative (ie:
eating 23 pieces of pizza) 15
 Maximizing Unconstrained Utility

Total utility is
34 maximized...
Total Utility (utils per week)

Marginal Utility (utils per week)

28 10
8
6
22 4

2
0
2 3 4 5 6 7

Performances per Week

0 2 3 4 5 6 7 8 …where marginal
Performances per Week utility equals zero.
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 Marginal Utility Example
• Let Utility (U) depend on how much pizza you
eat (P), therefore

U(P)  2 P

• Therefore the first piece of pizza gives you 2

“utils” of pleasure, but 4 pieces of pizza give
you 4 “utils” of pleasure, not 8 (2x4)…marginal
utility is diminishing:
1
MU(P) 
P
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 Utility With 2 or More Goods
• Utility and 1 good can be measured on a 2-
dimensional graph
• Utility and 2 goods must be measured on a 3-
dimensional graph
• Here Marginal Utility uses the ceteris paribus
assumption: how does utility change when 1 good
changes, everything else held constant?

U
MU x  y held constant
X
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 Marginal Utility Example
• Let Utility (U) depend on how much pizza (P)
and hot dogs (H) you eat, therefore

U(P)  2 PH

• If hot dogs are held constant, each additional

pizza yields less utility:
H
MU(P) 
P
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 3.3 Indifference Curves
• 3 dimensional graphs are difficult to
graph and understand
• In practice, consumer preference is
graphed using 2 goods on the X and
Y axis and INDIFFERENCE CURVES
• Each INDIFFERENCE CURVE plots
all the goods combinations that yield
the same utility; that a person is
indifferent between
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y
Consider the utility function U=(xy)1/2.
Each indifference curve below shows
all the baskets of a given utility level.
Consumers are indifferent between
baskets along the same curve.

2 • •
1 • • U=2

U=√2
0 1 2 4 x 21
y
From the indifference curves, we know
that: A ≈ B, C ≈ D
C A & C  B,
D A & D B

A C
2 • •
B D
1 • • U=2

U=√2
0 1 2 4 x 22
1). Completeness => each basket lies on
only one indifference curve
2). Transitivity => indifference curves do
not cross
3). Negative Slope => when a consumer
likes both goods (MUa and MUb are positive),
the indifference curve is downward sloping
4). Thin curves => indifference curves are
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not “thick”
y

B  A. (different indifference curves)

A ≈ C (same indifference curve)
B ≈ C (same indifference curve)
IC2
Therefore:
IC1 B ≈ A by transitivity
B Contradiction!
•
• A
C
•
x 24
y

More of any good is more preferred and

less of a good is less preferred, so an
indifference curve cannot extend into
areas I or II; it must slope downward

I: Preferred to A

II: Less • A

preferred
IC1
x 25
y
Since more is better, baskets B and C
should be preferred to basket A
BUT
they all lie on the same indifference
curve, implying indifference.
C
• B
A• •
2

0 1 2 4 x 26
 Renegade Indifference Curves

• Note that some specialized models

produce indifference curves that violate
one or more of our assumptions
• These models may still be useful, but their
violations must always be kept in mind

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North

Example of “more is better” violation

C
•B
•
• A
IC3
University
Of Alberta
IC2

IC1

28
East
 3.4 Marginal Rate of Substitution
(MRS)
• All along an individual’s indifference curve, an
individual consumes different baskets of goods while
remaining at the same utility
• The individual is willing to SUBSTITUTE one good for
another
• An individual must be compensated by an increase in
one good if the other good decreases
– Ie) if Bob is equally happy with 3 hot dogs and 1
soda or 2 hot dogs and 2 soda, he is willing to give
up 1 hot dog for 1 soda or 1 soda for 1 hot dog
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 Marginal Rate of Substitution (MRS)
• The marginal rate of substitution (MRS) is the change
(loss) in one good needed to offset the change (gain) in
another good
– In this case, MRS is the trade-off (loss) of y for a small
increase in x
-”The Marginal Rate of Substitution of x for y”
-x is gained, so how much y must be given up
-alternately, if x is given up, how much more y do we
need?
• The MRS is equal to the SLOPE of the indifference
curve (slope of the tangent to the indifference curve)

 y
MRS x , y  utility constant 30
x
 Marginal Rate of Substitution (MRS)
U  MU x x  MU y y
but since U  0 as one moves along the indifference curve,

-MU x xMU y y
MU x  y
MU y x utility constant

 y MU
 x  MRS
x
utility constant
MU y x, y
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 MRS Example
Let Utility  x  y
1 1
MU x  , MU y 
2 x 2 y
1
MU x 2 x
MRS x, y  
MU y 1
2 y
y
MRS x, y 
x 32
 Diminishing MRS
• In general, people tend to value more what they
have less of:
– Ie) If Frank has 30 chicken wings and 1
Pepsi, he is very willing to give up wings for
another Pepsi. If Frank has 10 chicken wings
and 2 Pepsi’s, he is less willing to give up
wings for Pepsi
• Therefore MRSx,y diminishes as x increases
along the indifference curve
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 Diminishing Marginal Utility
Pepsi

Very willing to give up Pepsi for wings

(steep slope=high MRS)
•

Less willing to give up Pepsi for wings

(flat slope = low MRS)

• IC1
Wings 34
 Diminishing MRS
• Due to Diminishing MRS, most indifference
curves are “bowed” towards the origin (0,0)
– As seen in the above graph
• If Diminishing MRS does not hold (ie: trading
quarters for loonies), the graph is not bowed
towards the origin

Exercise: Let Utility=(Pepsi)(Wings). For a utility

level of 16, sketch the graph and see if
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Diminishing MRS applies.
 3.4 Special Utility Functions
• In Economics, utility functions dealing with 2
categories of goods create unique indifferent
curves:
– Perfect Substitutes
– Perfect Complements
• Furthermore, 2 utility functions are widely used
by Economists for their desirable properties:
– Cobb-Douglas Utility Function
– Quasi-Linear Utility Function 36
 Perfect Substitutes
• Goods that are perfect substitutes can always
be substituted for each other using a FIXED
RATIO
– If a restaurant doesn’t carry Pepsi, you order
a Coke instead
– Therefore, MRSCoke, Pepsi=1 and MUCoke/MUPepsi
=1
– In general, MRS=a constant, and indifference
curves are a straight line
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 Perfect Substitutes: U = Ax + By

Where: A, B positive constants

 
MUx = A
MUy = B
 
MRSx,y = A/B
 1 unit of x is equal to
B/A units of y everywhere
(constant MRS). 38
Example: Perfect Substitutes (Tylenol, Extra-Strength Tylenol)
y

Slope = -A/B

IC1 IC2 IC3

0 x
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 Perfect Complements
• Some goods are only useful in a set ratio to
each other; extra of one good is useless without
extra of the other:
– Shoes: 1 Left shoe for every Right shoe
– Cars: 4 full-size tires for every car
– Kraft Dinner: 6 cups of water for every packet
– Marriage: 1 Bride for Every Groom
• Indifference curves are right angles
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3. Perfect Complements: U = A min(Bx,Cy)
 
where: A, B, and C are positive constants.
 
MUX = 0 or A
MUY = 0 or A
 
MRSX,Y is 0 (horizontal)
or infinite (vertical)
or undefined (at corner)
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Example: Perfect Complements (nuts and bolts)
b U = 5 min(n,b)

2 U=10

1 U=5

0 1 2 n
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 Cobb-Douglas Utility Function
• The Cobb-Douglas Utility function is the holy
grail of economic models for a variety of
reasons:
– It’s straightforward
– It’s easily modified to suit the model
– It has desirable mathematical properties
• The Cobb-Douglas Utility function also yields
“STANDARD” indifference curves
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 1. Cobb-Douglas: U = Axy
where:  +  = 1; A, , positive constants

MUX = Ax-1y (Positive)

MUY = Axy-1 (Positive)
 

MRSx,y = (y)/(x)

“Standard” case:
Downward sloping IC, diminishing MRS 44
y
Example: Cobb-Douglas
(speed vs. maneuverability)

Preference direction

IC2

IC1
x 45
 Quasi-Linear Utility Function
• Quasi-Linear Utility Functions often explain
consumer behavior without an overly complex
model
– It’s effective
– It’s simple
– It has a catchy name – “Quasi”
• In a Quasi-Linear Utility Function, MRS is equal
for all points above and below each other:
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 U = v(x) + Ay
Where: A is a positive constant.
 

MUx = v’(x) = V(x)/x, where  small

MUy = A

Example: U=4(x)1/2+2y
MUx=2/(x) ½ MUy=2
-Useful if one good’s consumption changes
little (ie:soap)
-linear in Y, non-linear in X (hence quasi-
linear) 47
movies Example: Quasi-linear Preferences
(movies and toothpaste)

IC’s have same slopes on any

vertical line

• IC2
• IC1
0 toothpaste
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 Chapter 3 Key Concepts
 Preferences
Preference Assumptions
 Utility
Marginal Utility
Diminishing Marginal Utility
 Indifference Curves
Indifference Curve Properties
 Marginal Rate of Substitution
Diminishing MRS 49
 Chapter 3 Key Concepts
 Special Utility Functions
Perfect Substitutes
Perfect Compliments
Cobb-Douglas
Quasi-Linear

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