Chapter 4.

Consumer Choice

1
Learning Objectives
4.1 Preferences.
4.2 Utility.
4.3 Budget Constraint.
4.4 Constrained Consumer Choice.
4.5 Behavioral Economics.

2
Premises of Consumer Behavior
• Individual tastes or preferences determine the amount of
pleasure people derive from the goods and services they
consume.

• Consumers face constraints or limits on their choices.

• Consumers maximize their well-being or pleasure from

consumption, subject to the constraints they face.

3
Properties of Consumer Preferences
(1 of 3)
• Completeness - when facing a choice between any two bundles
of goods, a consumer can rank them so that one and only one of
the following relationships is true: The consumer prefers the first
bundle to the second, prefers the second to the first, or is
indifferent between them.

≿ weakly prefer
≻ strictly prefer
∼ indifferent
a ≿b, b ≿ a, or both relationship hold, so that a ∼ b

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Properties of Consumer Preferences
(2 of 3)
• Transitivity - a consumer’s preferences over bundles is
consistent in the sense that, if the consumer weakly prefers (≿)
Bundle a to Bundle b (likes a at least as much as b) and weakly
prefers Bundle b to Bundle c, the consumer also weakly prefers
Bundle a to Bundle c.

a ≿ b and b ≿ c ⟹ a ≿ c

If completeness and transitivity hold, then the preference relation is

said to be rational.

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Properties of Consumer Preferences
(3 of 3)
• More Is Better - all else being the same, more of a commodity is
better than less of it.
– Good - a commodity for which more is preferred to less, at least
at some levels of consumption.
– Bad - something for which less is preferred to more, such as
pollution.

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Preference Maps
• Indifference curve - the set of all bundles of goods that a
consumer views as being equally desirable.
• Indifference map - a complete set of indifference curves that
summarize a consumer’s tastes or preferences.

7
Figure 4.1 Bundles of Pizzas and
Burritos Lisa Might Consume (1 of 2)

8
Figure 4.1 Bundles of Pizzas and
Burritos Lisa Might Consume (2 of 2)

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Properties of Indifference Map

1. Bundles on indifference curves farther from the origin are

preferred to those on indifference curves closer to the origin.
2. An indifference curve goes through every possible bundle.
3. Indifference curves cannot cross.
4. Indifference curves slope downward.

10
Figure 4.2 Impossible Indifference
Curves

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Solved Problem 4.1
• Can indifference curves be thick?

• Answer:
– Draw an indifference curve that is at least two bundles
thick, and show that a preference property is violated.

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Willingness to Substitute Between
Goods
• Marginal rate of substitution (MRS) - the maximum amount of
one good a consumer will sacrifice to obtain one more unit of
another good.

• Lisa’s marginal rate of substitution of burritos for pizza is

MRS = Δ B / ΔZ

– MRS is the slope of the indifference curve.

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Figure 4.3(a) Marginal Rate of
Substitution

14
Figure 4.3(b) Marginal Rate of
Substitution

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Curvature of Indifference Curves (1 of
2)
• Casual observation suggests that most people’s
indifference curves are convex to the origin.

• Diminishing marginal rate of substitution: The marginal rate of

substitution approaches zero as we move down and to the right
along an indifference curve.

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Curvature of Indifference Curves (2 of
2)

• Special Cases:

– Perfect substitutes - goods that a consumer is completely

indifferent as to which to consume.

– Perfect complements - goods that a consumer is interested in

consuming only in fixed proportions.

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Curvature of Indifference Curves (2 of
2)

• Special Cases:

– Perfect substitutes - goods that a consumer is completely

indifferent as to which to consume.

– Perfect complements - goods that a consumer is interested in

consuming only in fixed proportions.

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Figure 4.4(a) Perfect Substitutes

19
Figure 4.4(b) Perfect Substitutes

20
Figure 4.4(c) Imperfect Substitutes

21
Application: Indifference Curves
Between Food and Clothing

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Utility
• Utility - a set of numerical values that reflect the relative rankings
of various bundles of goods.

• Utility function - the relationship between utility values and

every possible bundle of goods: U(Z, B)

U(Z, B) = ZB

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Ordinal Preferences
• If we only know a consumer’s relative ranking of bundles, the
measure of pleasure is ordinal.

– Tells us the relative ranking of two things but not how much more
one rank is than another (letter grades).

• A cardinal measure is one by which absolute comparisons

between ranks may be made. Money is a cardinal measure.

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Utility and Indifference Curves

• An indifference curve consists of all those bundles that

correspond to a particular level of utility.

• If Lisa’s utility function is U(Z, B), then an indifference curve is

given by
Ū = U(Z, B)

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Figure 4.5(a) The Relationship Between
the Utility Function and Indifference
Curves

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Figure 4.5(b) The Relationship Between
the Utility Function and Indifference
Curves

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Marginal Utility
• Marginal utility - the extra utility that a consumer gets from
consuming the last unit of a good.
– the slope of the utility function as we hold the quantity of the
other good constant.

• Marginal utility of good Z is:

ΔU
MUZ =
ΔZ

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Figure 4.6 Utility and Marginal Utility

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Utility and Marginal Rates of
Substitution
• The MRS is the negative of the ratio of the marginal utility of
another pizza to the marginal utility of another burrito.

• Formally,

ΔB MUB
MRS = =
ΔZ MUZ

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Budget Constraint (1 of 4)
• Budget line (or budget constraint) - the bundles of goods that
can be bought if the entire budget is spent on those goods at
given prices.

• Opportunity set - all the bundles a consumer can buy, including

all the bundles inside the budget constraint and on the budget
constraint.

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Budget Constraint (2 of 4)
• If Lisa spends all her budget, Y, on pizza and burritos,
Then

pBB + pZ Z = Y
– where pB B is the amount she spends on burritos and pZ Z is the
amount she spends on pizzas.

• This equation is her budget constraint.

– It shows that her expenditures on burritos and pizza use up her

entire budget.

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Budget Constraint (3 of 4)
• How many burritos can Lisa buy?

– To answer solve budget constraint for B (quantity of

Burritos):

pBB + pZ Z = Y
Y pZ
B= − Z
pB pB

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Budget Constraint (4 of 4)
• From previous slide we have:
Y pZ
B= − Z
pB pB
– Lisa can buy more burritos with a higher income, a lower price of
burritos or pizza, or if she buys fewer pizzas.

– If pZ =$1,pB =$2,andY=$50,then:

34
Allocations of a $50 Budget Between
Burritos and Pizza

35
Figure 4.7 Budget Constraint

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Slope of the Budget Constraint
We have seen that the budget constraint for Lisa is given by the
following equation:
Y PZ
B= − Z
PB PB

ΔB
Slope = = MRT
ΔZ
The slope of the budget line is also called the marginal rate of
transformation (MRT).

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Solved Problem 4.2
• Suppose that a government rations water by setting a quota on
how much a consumer can purchase. If a consumer can afford
to buy 12 thousand gallons a month but the government restricts
purchases to no more than 10 thousand gallons a month, how
does the consumer’s opportunity set change?

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Figure 4.8(a) Changes in the Budget
Constraint: Price of Pizza Doubles

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Figure 4.8(b) Changes in the Budget
Constraint: Price of Pizza Doubles

40
 Solved Problem 4.3
Is Lisa better off if her income doubles or if the prices of both
the goods she buys fall by half?
Answer: Her budget line and her opportunity set are the
same with either change.

41
 Constrained Consumer Choice
• Given information on Lisa’s preferences and how much she
can spend, we can determine her optimal bundle.
• Her optimal bundle is the bundle out of all the bundles that
she can afford that gives her the most pleasure.

42
Figure 4.9 Consumer Maximization,
Interior Solution (1 of 2)

43
Figure 4.9 Consumer Maximization,
Interior Solution (2 of 2)

The budget constraint and the indifference

curve have the same at point e where they
touch. Therefore, at point e:

MUZ PZ
MRS = − =− = MRT
MUP PP

44
 Solved Problem 4.4
Nate’s utility function over jelly and peanut butter is U = JN.
Nate’s marginal utility from jelly is MUJ = N, and his
marginal utility from peanut butter is MUN = J. The price of
a jar of jelly is $5. The price of a jar of peanut butter is $10.
Nate has a budget of $100 to allocate to these two items. If
Nate maximizes his utility, how much of each good does he
consume?

45
 Solved Problem 4.4 answer
1. Derive Nate’s budget line by setting his expenditure equal
to his budget.
2. Find the relationship between N and J.
3. Substitute this utility-maximizing condition into the
budget equation to determine J and N.
4. Substitute the solution for J into the budget line to solve for
N.

46
Figure 4.10 Consumer Maximization,
Corner Solution

47
 Solved Problem 4.5
• The concentration of the active ingredient, sodium
hypochlorite, in Clorox is twice that of the generic brand.
Consequently, Chris views one cup of Clorox to be a
perfect substitute for two cups of the generic. If Clorox
costs $3 gallon, the generic costs $1, and Chris allocates Y
= $6 per year for bleach, what bundle does Chris buy? If
the price of Clorox falls to $2, how does Chris’s behavior
change?

48
Solved Problem 4.5 answer

49
Figure 4.11 Optimal Bundles on Convex
Sections of Indifference Curves

50
 Food Stamps (1 of 2)
• The U.S. Food Stamp Plan started in 1939.
• Renamed to Supplemental Nutrition Assistance Program
(SNAP) in 2008.
• 44 million people receive food stamps at a cost of $67 billion
in early 2016.
• The average benefits were $125 per person per month or
$4.12 per day.
• worried about having enough money to buy food in 2011
(U.S. Department of Agriculture).

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 Food Stamps (2 of 2)
• Would a switch to a comparable cash subsidy instead of
food stamps increase the well-being of people who receive
food assistance?
• Would recipients spend less on food and more on other
goods?

52
Figure 4.12 Food Stamps Versus
Cash

53
 Behavioral Economics
• By adding insights from psychology and empirical research
on human cognition and emotional biases to the rational
economic model, economists try to better predict economic
decision making.

54
 Test of Transitivity
• Adults tend to make transitive choices.
• Children are less likely to make transitive choices.

55
 Endowment Effect
• People place a higher value on a good if they own it than
they do if they are considering buying it.
• Consumer choice theory assumes a consumer’s endowment
does not affect the indifference curve map.
• Research has shown that experience significantly reduces
the endowment effect.

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Salience and Bounded Rationality (1
of 2)
• People are more likely to consider information if it is
presented in a way that grabs their attention or if it takes
relatively little thought or calculation to understand.
– For example, tax salience is awareness of a tax.

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Salience and Bounded Rationality (2
of 2)
• When a store’s posted prices exclude the sales tax,
consumers are much less likely to react to a change in the
price.
• Tax is not salient and some consumers ignore taxes.
• Bounded rationality - people have a limited capacity to
anticipate, solve complex problems, or enumerate all
options.

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Why Americans Buy More EBooks
Than Do Germans

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