Economics 3030

Intermediate Microeconomic Theory

Topic 2: Consumer Theory (ii)
1. Utility Maximisation

 Budget line shows the consumer’s affordable

bundles given the market environment.

 The indifference map shows the consumer’s

desired bundles

 To complete the model we assume rational

maximisation - i.e. the consumer chooses the
affordable bundle that maximises his utility.
1. Utility Maximisation

 This is a non-trivial point. We are implicitly

assuming that the consumer only derives utility
from the consumption of x and y.

 Moreover, rational maximisation implies

consumer processes huge amount of information
before choosing his most preferred bundle

 In reality, perhaps we ‘satisfice’

1. Utility Maximisation

 The optimal choice bundle will be that point at which

an indifference curve just touches the budget line

 That is, where an indifference curve is tangent to the

budget line

 In words, where the consumer’s marginal rate of

substitution (MRS) and economic rate of substitution
(ERS) are in accord
1. Utility Maximisation

 Marginal Rate of Substitution (MRS)

Amount of y consumer willing to sacrifice for one
extra unit of x
Slope of indifference curve

 Economic Rate of Substitution (ERS)

Amount of y the consumer is obliged to sacrifice for
one extra unit of x
Slope of budget line
 Figure 1: Equilibrium (MRS = ERS)
y

E1
y1
I2

I1
I0

0 x
x1
 Figure 2: Disequlibrium (MRS ≠ ERS)
y

E0

I0
0 x
1. Utility Maximisation

 Since preferences are unique, individuals will not choose

identical bundles, even when confronted by same market
environment

 But they will all move to point where MRS = ERS

 Even with different preferences, since ERS is the same for

everyone (i.e. we all face same relative prices), it must be
the case that in equilibrium:

 MRS1 = ERS = MRS2

1. Utility Maximisation

 In most cases, the optimal choice implies a (unique)

tangency between an indifference curve and the budget
line

 What is the economic intuition for this?

 Consider now the exceptions

 ‘Non-tangency’ optimal choices

2. Non-Tangency Optimisation

 Kinky Tastes
 Boundary optimum
 More than one tangency
 Perfect Substitutes
 Perfect Complements
 Bads
 Neutral Goods‘Non-tangency’ optimal choices