Diploma Preparatory Course: Microeconomics

Mikhail Safronov

[email protected]

Lecture 2

Consumer’s Choice

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What we did last time

Consumer’s choice - which bundles of goods (x1 , x2 ) to choose

Constraints - budget set: p1 x1 + p2 x2 ≤ m
Preferences - determine ranking of bundles. Can be
represented by utility function U(x1 , x2 ).

The consumer chooses the most preferred bundle in the budget

set. Can write it as

max U(x1 , x2 ) subject to p1 x1 + p2 x2 ≤ m

Assuming monotonicity - the consumer makes a choice on the

budget line.
If function U(x1 , x2 ) is “nice”, can find the interior optimal
solution from the tangency condition MRS1,2 = −p1 /p2 .

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Cobb-Douglas utility

The consumer’s problem is:

max U(x1 , x2 ) = x1a x2b a,b>0 subject to p1 x1 + p2 x2 ≤ m

ax1a−1 x2b
We have MRS1,2 (x1 , x2 ) = − MU
MU2 = −
1 ax2
= − bx .
bx1a x2b−1 1

p1 bx1 p1
Set it equal to price ratio: − ax
bx1 = − p2 . Hence, x2 =
2
a p2 .

Substitute it into the budget constraint: p1 x1 + p1 bxa1 = m.

a m b m
Hence, optimum x1∗ = a+b ∗
p1 . Respectively, x2 = a+b p2 .
Note the total amount spend on each good is proportional to
the degree in utility function.
1 2
For example, U(x1 , x2 ) = x13 x23 - spend one third of money on
good 1, and two thirds on good 2.

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More than one solution

If we have perfect substitutes U(x1 , x2 ) = x1 + x2 , and the

prices are the same p1 = p2 = 1, then it does not matter where
to spend money.
x2

x1 + x2 = m

x1

Which property guarantees that the optimal solution is unique

- transitivity, monotonicity or strict convexity? Why?

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Demand. Comparative statics.

From now on let’s assume that preferences are strictly convex

and monotonic.
Now that we know how to find the optimal solution. Let’s refer to
it as demand.
We can do comparative statics: How the solution changes if
either income m, or prices p1 , p2 change?
That is, answer questions of sort: Will the consumer buy more
food as income goes up? Will the consumer buy more food if its
price goes down?

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Change in income

If income goes up, the budget set grows.

The consumer is better off.

But does that mean the

consumer buys more of
each good?

 
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Normal goods

If her demand for a good rises as her income rises, then this
good is a normal good for her (in that income range).

 
For Cobb-Douglas, all goods are normal at every income level.
 

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Inferior goods
If her demand for the good goes down as her income goes up, then it
is an inferior good for her (in that income range).

Frozen pizza might be an inferior good for some range of income.  

 
Question: Can any good be inferior for ALL possible values of
 
income?
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Own price effects: ordinary goods

As p1 goes up, the budget set gets smaller.

x2

For ordinary goods,

x1∗ goes down as p1
goes up.
Y X

x1

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Own price effects: Giffen goods
Demand for a Giffen good goes up when its price goes up.

AE original budget line

AC budget line after p1 goes up
A
X

C E x1

This case seems strange, but not unrealistic. To understand the

driving forces behind it, need to introduce new concepts.
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A closer look at price effects
When p1 goes up, the consumer will feel a number of economic
forces.

In the case of two goods, let’s look at these forces:

I Since good 1 becomes relatively more expensive,

compared with good 2, it gets less attractive than before:

substitution effect

I Even though the monetary income stays constant, the

budget set becomes smaller, and effectively the consumer
is poorer:
income effect

There are many ways in which one can decompose change in

demand into income and substitution effect.
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Ordinary goods: Hicks’ decomposition
x2

Y X

x1
IE SE

One way to decompose into income and substitution effect is as

follows: Draw a line parallel to the new budget line such that it
touches the original indifference curve. Obtain point Z .
The “slide” from X to Z is substitution effect. Higher price on good 1
makes the consumer substitute good 1 for good 2. Utility - fixed.
The “parallel shift” from Z to Y is income effect. Under new prices,
the consumer becomes poorer, and reaches the new level of utility.
Prices - fixed.
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Giffen good - decomposition
AE original budget line
AC budget line after p1 goes up
A
ZX

SE C E x1
IE

Let’s do the same for Giffen good. Note that substitution effect (X to
Z ) decreases x1∗ , the income effect (Z to Y ) increases x1∗ , and the
latter effect is stronger. Hence, x1∗ increases.
To have a Giffen good, we need an inferior good (lower income
increasing x1∗ ). Observe that the direction of substitution effect is
always in conflict with existence of Giffen good.
Large income effect: large fraction of income spent on the good.
Small substitution effect: no close substitutes (similar goods).
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Work vs leisure

A key constraint in life: there are only 24 hours a day!

Time is scarce and it has alternative uses. An economic

problem!

Let’s explore the trade-off between work and leisure.

The consumer enjoys consumption and leisure.

Consumption is possible only with the money earned by

working.

So more consumption implies less leisure. Thus the trade-off.

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Constraints
Suppose the wage per hour of work is w. h hours work
provides an income of hw.

An hour of not working is an hour of leisure. → ` = 24 − h.

Say the consumption good costs px per unit. Then, x is

determined by the choice of `:

(24 − `)w
x=
px
That is,
xpx + `w = 24w
A budget line!
The consumer has budget 24w. Consumption x is a good with
price px . Leisure ` is a good with price w.

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Optimization

Preferences over consumption (x) and leisure (`) are given by

u(x, `)

The consumer’s problem, then, is:

max u(x, `) subject to xpx + `w = 24w

So, if the optimal solution involves x ∗ , `∗ > 0, then

MUx MU`
= at (x ∗ , `∗ ).
px w

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Graph of the labour supply as a function of wage rate

hours supplied

24 − `0

24 − ` = 24 − `00

w w0 w00 wage rate

When wage increases from w 0 to w”, leisure ` increases.

Question: Is leisure a Giffen good?

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Wage changes → budget set changes

Time
• Time gets more expensive
Wage goes up
=⇒
24 from w to w0
• But the budget set expands,
because the worker is
the original owner of time

Consumption
24w 24w0

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Example: backward bending labour supply
Time w < w0 < w00

↓ ↓ ↓
24
` `0 `00

` = `00
`0

24w 24w0 24w00 Cons.

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From endowment to income

A consumer comes to a marketplace with an initial endowment

of goods, and is free to trade at market prices.

There are n types of goods, she owns ωi units of good i, so her

initial bundle is
ω = (ω1 , . . . , ωn )
The prices of these goods are p1 , . . . , pn , so the monetary
equivalent of her endowment is

m = ω1 p1 + · · · + ωn pn

And her budget set is the set of all bundles she can afford:

B = {x | x ≥ 0, x1 p1 + · · · + xn pn ≤ m}

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Budget line

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Rotation around endowment

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Revisiting the notion of “income effect”

We talked about the income effect in the context where the consumer
begins with a given monetary income m.

So, when the prices went down, the consumer felt unambiguously
richer, because her budget set got strictly bigger.

If, instead, the consumer begins with an initial endowment of goods, a

rise in prices might have a more ambiguous effect.

The new budget set is not necessarily strictly bigger than before,
however the parts of the old budget set she loses were revealed to be
less preferred to her options still available to her. Thus, in this case
she will feel richer.

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When a decrease in price hurts the consumer

Original budget line

Original choice when prices are (p1 , p2 )

New choice when prices are (p̃1 , p2 )

ω2
The endowment (ω1 , ω2 )

New budget line with p̃1 < p1

ω1

The consumer might suffer from p1 going down if she is a net supplier
of good 1 to begin with. Question: Is it possible for the consumer to
benefit?
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Worst case?

Question: For a given initial endowment (ω1 , ω2 ), price level

affects the final utility of the consumer after trade. What is the
worst price level for the consumer?
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Market (aggregate) demand

We refer to the sum (i.e., the aggregate) of all individuals’

demands as the “market demand”.
Say if there are 50 consumers each demanding 3 units of good,
then the market demand is 150 units.
Can we use insights from the individual demand theory to
understand market demand?
Yes, if market demand behaves like individual demand (i.e., as
if it is consistent with well-behaved preferences).

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Demand curve
Demand on good 1, x1∗ , depends on income m, and both prices
p1 , p2 .
Most times, a dependence on own price, p1 , is discussed. In
particular, relevant for firms that sell good 1.
Below is the demand curve. Note that price is on vertical axis -
that is, inverse demand function.
It shows that at price p, the consumer demands q units.
price

quantity
q

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Case of two people

How to obtain the aggregate demand curve from individual

ones?
Let’s look at an example with two consumers, with individual
demand curves - red and blue:
price

quantity

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Case of two people
Sum the two curves “horizontally” - obtain the aggregate (or
market) demand.
price

Q1 Qtot
Q2

quantity

For the selected price, Qtot = Q1 + Q2

Note the aggregate demand coincides with the individual (red)
demand curve at prices where the other consumer demands
zero quantity.
Analyzing the market demand is similar to analyzing individual
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A unit-free measure: elasticity

Suppose we want to compare markets in different countries.

There is an issue: different countries have different measures
for currency, and, perhaps, for volumes of sales.
Consider the ratio
percentage change in quantity
percentage change in price

For example, if a 5% increase in the price of milk leads to a 2%

decrease in the demand for milk, we would end up with the
number − 52 .
We can now use elasticity to estimate how responsive is
demand on certain good as its price changes.
This can be compared across countries!

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Price elasticity of demand. Elastic demand.

Let’s look at how demand on a certain good i changes with its

price.
When considering small changes, the ratio of percentage
changes is equal to:
dxi∗
xi∗ pi dxi∗
=
dpi xi∗ dpi
pi

Since xi∗ can depend on other parameters, we rewrite this ratio

∂x ∗
as: xp∗i ∂pii for good i.
i

It is called the price elasticity of demand and denoted (p).

This concept is important for firm(s) that sell the good!

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Elastic demand

We say that good has elastic demand at price p if |(p)| > 1,

That is, raise in price by 1 percent causes demand to fall by
more than 1 percent.
That is, a firm that sells a good for which demand is elastic
cannot raise its price without having its sales fall considerably.
For example, designer clothes. If price increases, can always
find a cheaper substitute.
On the graph, the demand curve has low slope. In the extreme
case with |(p)| = ∞, the demand curve is horizontal. We call it
perfectly elastic.

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Perfectly elastic demand curve

price

quantity

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Inelastic demand

We say that good has inelastic demand at price p if |(p)| < 1,

That is, raise in price by 1 percent causes demand to fall by
less than 1 percent.
A firm selling its good for which demand is inelastic can raise its
price without having its sales fall too much.
For example, cigarettes and alcohol. Also food (assuming you
have little choice in type of food).
On the graph, the demand curve has high slope. In the extreme
case with |(p)| = 0, the demand curve is vertical. We call it
perfectly inelastic.

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Perfectly inelastic demand curve

price

quantity
q

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Unit elasticity

We say that good has unit elastic demand at price p if

(p) = −1.
For example, for Cobb-Douglas utility U(x1 , x2 ) = x1a x2b , we
a m
have derived x1∗ = a+b p1
the price elasticity of demand for good 1 at prices p1 , p2 is

p1 ∂x1∗ p12 a + b a m
∗ = ×− = −1
x1 ∂p1 m a a + b p12
Thus, C-D demand is unit elastic for each good at every price.
In other words, total amount spent, p1 x1∗ on good 1, does not
depend on p1 !

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Elasticity and Revenue

Revenue from the sales of a good is

R = pq

where p is the unit price of the good and q = q(p) is the market
demand for the good at price p.

To understand how R changes with p, look at

dR dq
= q+p
dp dp
 
p dq
= q 1+ = q(1 + )
q dp

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From the expression

dR
= q(1 + )
dp
we can say
I If the demand for the good is elastic at price p, then a
(marginal) increase in the price would hurt revenue.
I If the demand for the good is inelastic at p, then a
(marginal) increase in the price would increase revenue.

Put it differently, elasticity (p) tells whether consumers will

spend more money on the good as its price changes.

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Changing elasticity

Note that elasticity (p) is defined for small changes.

Can happen that for some prices demand is elastic, for some
other prices - inelastic! Below is the example for linear demand:
price
|ε(p)| > 1

ε(p) = −1

|ε(p)| < 1

quantity

Will be important later when we discuss producer’s choice!

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From demand analysis to welfare analysis

We have studied how changes in prices or income affect

consumer’s demand. Can also observe it.
However, another important aspect is by how much consumer’s
well-being has changed. Many policy questions/answers
appeal to a notion of welfare.
Can we say that welfare = change in utility? Not useful. For
example, not comparable across different consumers.
Let’s develop a measure of welfare - in money. This is useful:
can compared across different consumers.

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Willingness to pay
Say your maximum willingness to pay for n apples is given by

willing for your detailed accounting

to pay
£2 1 apple 2
£3.50 2 apples 2 + 1.50
£4.50 3 apples 2 + 1.50 + 1
£5.00 4 apples 2 + 1.50 + 1 + .50
£5.25 5 apples 2 + 1.50 + 1 + .50 + 0.25
£5.40 6 apples 2 + 1.50 + 1 + .50 + 0.25 + 0.15

You are indifferent between all of the following: buy nothing, buy
1 apple for £2, buy 2 apples for £3.50, buy 3 apples for £4.50,...

In some sense, the first apple is worth £2. The second apple
is worth £1.50. The third apple is worth £1. And so on...

If the price of an apple is 90p, how many apples would you buy?
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The fourth apple, as every apple, costs 90p, but

w(4) − w(3) = £5 − £4.50 = 50p < 90p.

But, you were willing to buy four apples for £5, and they would
cost you only £3.60, so why not buy the fourth?
Well, because, the “added value of the fourth” is only 50p, and
you’d rather spend your 90p on something else.

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Now you have bought three apples for £2.70.

How satisfied are you with this purchase?

How much better off are you due to this trade?

You gave up £2.70, but acquired something for which you would
be willing to give up any amount up to £4.50.

Your “welfare” has improved by

£4.50 − £2.70 = £1.80.

→ the consumer’s surplus (CS) from this trade.

Question: Suppose the price for an apple changes to 20p.

For the new price, calculate how many apples you would
buy, and your CS.

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“The demand curve” and CS
r1 : willingness to pay for the first apple, surplus: r1 − p
r2 : willingness to pay for the second apple, surplus: r2 − p
..
.

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CS from buying x units of a good

The demand curve is the graph of

P(q), where q is the quantity
demanded at price P(q).

So it is really the graph of the inverse

demand function.

In the graph on the left, quantity x is

demanded at price p.

Z x
If the good is divisible, then CS = P(q)dq − xp(x).
0

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CS associated with a decrease in price
Suppose the price of the good decreases from p0 to p00 .

p0

p00

x(p0 , m) x(p00 , m) x

“The change in CS due to the price drop” is the shaded area.

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Reading

Varian, Intermediate Microeconomics, chapters 5, 6, 8, 9, 14,

15.

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Review questions

If a consumer’s preferences over bundles (x1 , x2 ) are given by

u(x1 , x2 ) = x1 + v (x2 ), then they are called quasi-linear in x1 .
1. Suppose v satisfies v 0 > 0 and v 00 < 0. Verify that the
preferences represented by u are strictly convex.
2. For a given income m, say the optimal bundle involves
x1∗ > 0 and x2∗ > 0. What happens to the optimal choice of
the second good if the income goes up?
3. Suppose instead v 0 > 0 and v 00 > 0. Does this consumer
have an optimal choice from every standard budget set?
When she does have an optimal choice, is it unique? What
else can you say about the optimal choices?

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Question: Suppose you buy 2 frozen pizzas each month at your
current income. Show that at a certain range of income frozen
pizza is a normal good.
Question: Suppose a consumer’s preferences are quasi-linear
in x2 :
u(x1 , x2 ) = v (x1 ) + x2
where v 0 > 0 and v 00 < 0.

1. Let m < m0 < m00 be three income levels, and suppose the
optimal bundle at income m involves positive amounts of
both goods. Draw the indifference curves associated with
the optimal bundles at these three income levels. How do
these curves relate to each other?
2. Within this income range (i.e., between m and m00 ), classify
whether these goods are normal, inferior, Giffen or
ordinary.

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Question. Suppose Cindy has preferences between two goods.
How many of these goods (that is, 0, 1 or 2 ) can be inferior?
Explain your answer.

Question. A consumer lives for two periods. Her utility function

is u(c1 , c2 ) = c12 c23 , where c1 , c2 are consumptions in the first
and second period, respectively. The unit price for consumption
is 1 in both periods. Her income is 100 in the first period and
150 in the second period.
1. If the consumer could save or borrow without any interest,
what would be the optimal consumption?
2. if the interest rate is 50 percent (that is, one unit of
consumption today is equivalent to 1.5 units of
consumption tomorrow), what would be the optimal
consumption?

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Tough one! Backward-bending labour supply curve
Bob has a time endowment of 16 hours and he can work at an hourly
wage of w. There is one good - chocolate, which costs 2£ per unit.
Free time gives him no utility unless it is spent in the gym, and the
gym costs 1£ per hour. Bob’s utility is given by

uB (c, g) = min{c, g}

where c is the amount of chocolate he consumes, and g is the

number of hours he spends in the gym.

1. Derive Bob’s budget constraint in terms of c and g;

2. Find Bob’s optimal choice of labor supply, L, as a function of
wage w. Draw the graph of L(w);
3. Now assume that Bob gets a disutility from working. That is, if he
works for L hours, his utility is

ûB (c, g) = min{c, g} − L2

Find Bob’s new labor supply curve, L(w), and plot its graph;
4. Explain the difference in graphs in parts (b) and (c).
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Ann has income m0 and can consume two goods: apricots A and
cabbage C. The prices of the two goods are p0A and p0C , respectively.
Assume that apricots are a normal good and cabbages are an inferior
good. Answer the following (appealing to income and substitution
effects):

1. Putting cabbage on the horizontal axis, draw an indifference

curve diagram for Ann. Draw her budget constraint and mark the
consumption levels of A and C that Ann will choose.
2. Suppose Ann’s income falls to m1 < m0 , while the prices of the
two goods remain unchanged. Show the new combination of A
and C that Ann will consume.
3. Would your answer to (ii) change if C were a normal good?
4. Consider an increase in the price of apricots to p1A > p0A . Will the
quantity of A that Ann buys rise or fall? What happens to the
quantity of C if C is normal? And if C is inferior?
5. Now suppose the price of apricots stays at p0A but that the price
of cabbage rises to p1C > p0C . How will the quantities of A and C
change? Consider both the case where C is normal and where it
is inferior.
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Marge knows she has two years to live. She will receive an income of
£20,000 this year and an income of £40,000 next year. She intends to
plan her consumption so that she leaves no assets and no debt.
1. Suppose she can borrow or save at an annual interest rate of
r = 20%. Plot a graph of her consumption possibilities, depicting
this year’s consumption on the horizontal axis and next year’s
consumption on the vertical axis.
2. Say she is a saver when r = 20%. If the interest rate for saving
and borrowing were to change to r = 25%, how would her
budget set (i.e., set of consumption possibilities) change? How
does the new set compare with the old set? How would her
saving/borrowing behaviour change?
3. Denote by u(r ) the value of Marge’s utility from the optimal
saving/borrowing choice, as dependent on the interest rate, r .
Argue that there is a “worst-case” value r = r w that would
minimize u(r ). What is the relation between r w and the MRS
estimated at the endowment point?
4. Part (b) states that Marge is a saver when r = 20%. Is the value
r = 20% higher or lower than the value r w found in part (c)?
Assume that the interest rate falls from r = 20% to r1 < 20%.
Will Marge become necessarily worse off? Discuss. 53/54
A consumer has a time endowment of 24 hours, and he can work at
an hourly wage of w = 2. There is one good X which costs px = 1
per unit. Free time gives him no utility unless it is spent at the cinema,
but the cinema costs £1 per hour. His utility is given by
√
u(x, c) = x + c
where x is amount of good X , c is time spent at the cinema.
1. How much of X does he consume? How much does he spend at
the cinema?
2. Suppose that the consumer experiences a negative utility of -1
for every hour that he does not spend working or at the cinema.
Show his new utility function and budget constraint. How much
of X and c does he consume? Discuss.
3. Suppose instead that he can go to the cinema (at price of £1 per
hour) or to the pub (at a cost of £2 per hour). Assume that his
new utility function is
√ √ √
u(x, c, p) = x + c + p
where p is the time at the pub. Find the optimal values of x, c, p.
4. Suppose that the price per hour of the pub decreases to £1.
What are the new optimal values of x, c, p? Discuss.
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