Ronny Goes to the Supermarket

A Theory of Optimal Consumption

Important concepts

● Consumption bundles
● Preferences/utility
● Budget line
● Lines of equal preferences—indifference curves
● Rationality/optimal consumption
A Theory of Optimal Consumption

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Ronny
A Theory of Optimal Consumption

Ingredients of the
theory
1. Products I need
to choose from
2. Prices
3. My wallet
(income) Ronny

And…
A Theory of Optimal Consumption

4. Preferences:
How I feel about
different baskets
of products I buy
(consumption
bundles) Ronny
A Theory of Optimal Consumption: Rationality
as Our Prediction of What Ronny Will Do

A rational agent, Ronny, will

always consume a
consumption bundle that
optimises her preferences
Ronny
given her income and the
prices of the goods that are
available.
A Theory of Optimal Consumption: Rationality
as Our Prediction of What Ronny Will Do

But how do I calculate

my optimal
consumption bundle?

Ronny
 Theory of Choice: A Simple,
Two-Product Reduction

PGranny = 5
PPink = 4

I = 100
Distraction: Ronny Goes Hiking…
Distraction: Ronny Goes Hiking…

Ronny
Distraction: Ronny Wants to
Reach the Highest Point…

Ronny
 Distraction: Ronny Wants to
Reach the Highest Point…

But, there is a fence!

Where shall
I go?
 Distraction: Ronny Wants to
Reach the Highest Point…

Going North

Going East
 Distraction: Ronny Wants to
Reach the Highest Point…

Going North The highest point in

the fenced area
is on the highest
altitude line still
passing in the
fenced area.

Going East
 Distraction: Ronny Wants to
Reach the Highest Point…

Going North At the highest point the

slope of the fence

equals the

slope of the altitude

line!

Going East
 Distraction: Ronny Wants to
Reach the Highest Point…

Going North At the highest point the

slope of the fence

Next to consider: taking the hikingequals the
analogy back to our problem of Ronny in
slope of the altitude
the supermarket line!

Going East
Ronny Goes to the Supermarket
The End
 Maximisation:
What Did Ronny Buy?
 Flashback: Ronny Wants to
Reach the Highest Point…

Going North At the highest point the

slope of the fence

equals the

slope of the altitude

line!

Going East
 Flashback: Ronny Wants to
Reach the Highest Point…

Going North

Kilos of
Pink Lady
apples

Kilos of Granny Smith apples Going East

 Flashback: Ronny Wants to
Reach the Highest Point…

Kilos of Pink Mountain of

Lady apples
preferences

Kilos of Granny Smith apples

 Flashback: Ronny Wants to
Reach the Highest Point…

Kilos of Pink Mountain of

Lady apples
preferences

Line of equal
preference in
consumption
(“indifference
curves”)

Kilos of Granny Smith apples

 100/PPink
Kilos of Pink
Lady apples The budget line
Y
PPink × Y + PGranny × X = £100

Kilos of 100/PGranny
Granny
X
Smith apples
 25
Kilos of Pink
Lady apples The budget line
Y
PPink × Y + PGranny × X = £100

20
Kilos of
Granny
X Smith
apples
 25
Kilos of Pink
Lady apples The budget line
Y
PPink × Y + PGranny × X = £100

Can afford
points of
consumption
below the
budget line

20
Kilos of
Granny
X Smith
apples
 25
Kilos of Pink
Lady apples The budget line
Y
PPink × Y + PGranny × X = £100

Cannot afford
points of
consumption
above the
budget line

20
Kilos of
Granny
X Smith
apples
 25
Kilos of Pink
Lady apples The budget line
Y
PPink × Y + PGranny × X = £100

A point of
consumption
that is on the
budget line
means that the
consumer has
spent all his
income!
20
Kilos of
Granny
X Smith
apples
Assumptions About Ronny’s Preferences and Behaviour

● About Ronny’s preferences

○ Apples are goods: Ronny always enjoys
Pink Lady and Granny Smith apples.
○ Non-satiation: Ronny would always
strictly prefer to get an extra Pink Lady
or an extra Granny Smith apple.
● No saving (we will go over saving later)
○ Ronny has no use for extra money left
over from her shopping in the
supermarket.
 100/PPink
Kilos of Pink
Lady apples

Y
PPink × Y + PGranny × X = £100

Lines of
equal
preferences

Kilos of 100/PGranny
Granny
X Smith
apples
 100/PPink
Kilos of Pink
Lady apples

Y
PPink × Y + PGranny × X = £100

Lines of
equal
preferences

Always
decreasing,
why?

Kilos of 100/PGranny
Granny
X Smith
apples
 100/PPink
Kilos of
Pink Lady
apples
Y
PPink × Y + PGranny × X = £100

This line represents

points of
consumption that are
better than the other
line!

Why?

Kilos of 100/PGranny
X Granny
Smith
apples
 100/PPink
Kilos of Pink
Lady apples

Y
Optimal
consumption
bundle!

Kilos of 100/PGranny
X Granny
Smith
apples
 100/PPink
Kilos of Pink
Lady apples

Y
At optimal consumption
bundle:

Slope of budget line

=
Slope of indifference
curve

Kilos of 100/PGranny
X Granny
Smith
apples
 100/PPink
Kilos of Pink
Lady apples

Y
At optimal consumption
bundle:

Exchange rate in
markets

=
Exchange rate in
preferences

Kilos of 100/PGranny
X Granny
Smith
apples
Optimal Consumption Rule

At optimal consumption:

Exchange rate in the market

=
Exchange rate in preferences
Exchange Rate in Markets = Exchange Rate in
Preferences

At optimal consumption bundle:

MUGranny MUPink
PGranny = PPink

Marginal Marginal
benefit/utility of benefit/utility of
consuming one consuming one
less Granny more Pink Lady
Smith per pound per pound
 What Have We Learned So Far?
● Learned how a rational consumer chooses what to
buy
● Ingredients of our model
○ The consumer knows the different goods he/she
could buy
○ The consumer knows the price of each good
○ The consumer has a fixed amount of income they
want to spend on the goods
○ The consumer has “well-defined” preferences
○ Our prediction: The consumer will consume at a
point that maximises her preferences!
 What Have We Learned So Far?
● The optimal consumption satisfies:
○ Consuming at the point at which the slope of the
indifference curves is tangent to the slope of the
budget line
○ Exchange rate in market = Exchange rate in
preferences
Maximisation: What Did Ronny Buy?
The End