MICROECONOMICS Session 5 Slides

Topic 3: Consumer Behaviour

Part 1: The Analytics of Utility Maximization
Question: How does a rational economic agent make economic decisions?
Answer: By solving a “constrained optimization problem” that involves
the following three steps:
Step 1: Clearly specify the “objective function”: associate “potential
choices” to “levels of well-being (profits / utility / …)”
Step 2: Clearly specify the “constraint (feasibility) set”: delineate which
of the “potential choices” are feasible given “resources / know-how /
income”
Step 3: Maximize, i.e., identify the “maximal feasible choice”

Basic rationality postulate of consumer choice theory:

Every consumer has well-defined preferences over consumption of
goods & services, and given his/her constraints (prices and incomes),
(s)he chooses a commodity bundle that maximizes his/her well-being

Studying Decision-Making as solving Optimization problems

• An analytic example: The Travelling Salesperson Problem

Given a list of cities and the road network between them, determine the
shortest possible route that visits each city and returns to origin city.
 Minimize distance to be travelled subject to the constraint that the path
has to be a closed loop touching all cities
• A not-so-analytic example: Consumer Utility Maximization
Given budget B, choose amounts of a set of consumption goods {X, Y, Z, …}
(given their prices) whose consumption maximizes your state of well-being.
If your preferences over {x, y, z, …} combinations satisfy a set of
“regularity properties”, then we can reformulate the problem as:
Maximize U(x, y, z, …) subject to constraint PX.x + PY.y + PZ.z +…  B

• Another analytic example: The tunnel-digging problem

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MICROECONOMICS Session 5 Slides

Two “related” optimization problems:

Utility maximization: Joy is deciding on his weekly consumption of wheat
(w in kgs) & rice (r in kgs) to maximize his “state of well-being” (utility),
subject to the “budget constraint”: price of wheat (pw) is Rs.10/kg, price
of rice (pr) is Rs.20/kg, and weekly budget (income) = Rs.800.
• Joy’s preference structure :
• For any two bundles of wheat and rice {w1, r1} and {w2, r2}, Joy strictly
prefers the first bundle if w1r1 > w2r2, he strictly prefers the second if
w2r2 > w1r1, and is indifferent between the bundles if w1r1 = w2r2.
• Joy’s problem is to determine his optimal weekly consumption bundle
{w*, r*} that will enable him to attain the highest possible utility

Tunnel-digging: Ron is standing at the base of a mountain. He can dig a

tunnel @ one km/hr. He is given two hours. After he digs for 2 hrs in a
particular direction, his monetary compensation = height of stopping point
Ron’s initial location is (0,0) and the shape of the mountain is: At any
(x, y)2+, height of mountain is H(x,y) = max{0, 200 – [(x–10)2 + (y–10)2]}
Ron’s aim is to choose stopping point to maximize monetary compensation

The consumer utility maximization problem

• Joy’s “constrained optimization” problem: choose W and R to

maximize a well defined objective function (his state of well-being)
subject to a feasibility constraint (budget constraint)

The data of the problem:

- pW = Rs. 10/kg, pR = Rs. 20/kg, and I = Rs. 800
- Joy’s preferences satisfy the following condition: At every
....bundle (W, R), Joy’s well-being is proportional to W  R

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MICROECONOMICS Session 5 Slides

The Utility Maximization Problem – in details

Consumer’s Feasibility Set:
A ‘commodity bundle’ (W, R) is feasible whenever the
budget constraint pW.W + pR.R  I is satisfied
Rice
ABO = budget set
B AB = budget line

0 A Wheat
Each point in consumption space denotes a commodity bundle (W, R)
A: (Wheat = I/pW, Rice = 0); B: (Wheat = 0, Rice = I/pR)
Slope of budget line = - pW/pR = - (price of x-axis good)
(price of y-axis good)
Abs. value of budget-line slope = pW/pR = relative price of W w.r.t. R
= number of kgs of R that has to be given up to get 1 more kg of W

Objective function: quantification of desire (draw hill of well-being)

What properties of preferences allow drawing a contour map of hill of well-being?
1. Completeness Property: One can compare any two commodity
bundles A and B in terms of preference (A › B or B › A) or indifference
(A ~ B) {each bundle is a vector of goods} [one can always compare]
2. Transitivity Property: If bundle A is preferred to bundle B,
and B is preferred to D, then A is preferred to D
[one can always make consistent choices]
3. Continuity Property: : If bundle A is preferred to bundle B, and B is
preferred to D, then there is a bundle C “between” A and D that is
indifferent to B [one’s tastes don’t change discontinuously]
In addition, we will assume:
Monotonicity Property: For any good more is (weakly) preferred to
less, and more of all goods is strictly preferred to less of all goods
[i.e., there is a clear direction of improvement in well-being]
- to accommodate ‘bads’ (like pollution) in the analysis, consider
their ‘opposites’ (i.e., clear air) as ‘goods’

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MICROECONOMICS Session 5 Slides

Consumer Preferences: Indifference Curves

• For all individuals: All bundles north-east of A strictly preferred to A,
A strictly preferred to all bundles south-west of A, B (weakly) preferred to H,
Rice and H and D (weakly) preferred to G
(kgs per week) • If a person Bob is indifferent betw’n
50 B A, B, and D, then the three bundles
lie on an Indifference Curve ICBOB
H
40 E • Another person Rita may be
indifferent between A and H,
A and prefer them to D
30
ICRITA
D
20 ICBOB
G

10

Wheat
10 20 30 40 (kgs per week)
Making costless, but mutually exclusive choices between pairs of bundles

Consumer Preferences: Indifference Map

For all individuals:

Rice
(kgs per week) • IC through every point (completeness
& continuity)
• ICs do not intersect (transitivity)
 • ICs slope downwards and
Z
 higher IC  higher satisfaction
Y (monotonicity)
 IC3
X
IC2

IC1
Wheat
(kgs per week)
• Indifference map & budget set are independent entities
- specifically, the indifference map is independent of prices & income

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MICROECONOMICS Session 5 Slides

Shape of Indifference Curves: trade-offs in well-being

Rice

A
6
r

1
IC
2
Wheat
For Joy, at bundle A:
marginal rate of substitution (MRS) of R for W is the amount of rice
that he is willing to give up for an additional incremental amount of
wheat in order to keep his level of satisfaction unchanged
- this trade-off rate is specific to the individual
- MRS at A is measured by the absolute value of slope of IC at A
We will always ‘read’ these rates from left to right - how much of
y-axis good needs to be reduced for an incremental amt of x-axis good
Difference in MRS between two people given their ‘endowments’ form
the basis of “gainful barter” between them

Property of Diminishing Marginal Rate of Substitution

Y-axis good
16 8Y for 1 X
A
14 Typically, MRS(Y for X) falls as we move
down an IC  ICs are convex to the origin
12
When I have a lot of one good and
10 little of the other, I am ‘more willing’
B to trade the former for the latter
8

6 1.5 Y for 1 X
D
4 • MRS(X for Y) =
E
1/MRS(Y for X)
2

1 2 3 4 5 X –axis good

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MICROECONOMICS Session 5 Slides

Trade-off rate (MRS) captures the degree of substitutability in

consumption between pairs of goods …
My preferences between Coke and Pepsi:
Coke
(litres)
4
Perfect
Substitutes
3
Constant MRS

Pepsi
0 1 2 3 4 (litres)

… and the degree of complementarity in consumption between

pairs of goods
Our preferences between Right & Left Shoes:
Left
Shoes
4

Perfect
3 Complements

MRS goes from infinity

2 to zero ‘over the kink’

0 1 2 3 4 Right Shoes

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MICROECONOMICS Session 5 Slides

Finding the Optimal Consumption Bundle

• Given her budget set and her indifference map, a consumer’s
problem is to “locate” that point on the budget set that “attains” the
highest Indifference Curve
• That point will represent the ‘optimal consumption bundle’
• Either the ‘optimal consumption bundle’ will have positive amounts
of all goods (an interior optimum), in which case the bundle will lie
on a point of tangency between the budget set and an Indifference
Curve
• Or the ‘optimal consumption bundle’ will have positive amounts of
only a few of the goods (a corner optimum), in which case bundle
will lie at a ‘corner’ of the budget set

Checking for Optimum:

Rice PW = 10 PR = 20 I = 800
(kgs per week) Bundle B not an optimal choice
as a higher IC can be attained
40 At B, willing to give up 1.5 R for
1 W, but market will give 3 W for
1.5 R
B
30 With diminishing MRS, go
further down the budget line

Budget Line
20

IC1

0 20 40 80 Wheat
(kgs per week)

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MICROECONOMICS Session 5 Slides

Attaining an Interior Optimum:

Rice PW = 10 PR = 20 I = 800
(kgs per week)
At bundle A, the budget line
40 and the indifference curve are
tangent and no higher level of
satisfaction can be attained.
B
30

A
20 At A:
MRS = PW /PR = 0.5

IC1 IC2
Budget Line
0 20 40 80 Wheat
(kgs per week)

Consumer Choice Rules:

• An interior optimum containing all goods (X and Y) must
lie on the budget line, and have MRS(Y for X) = pX/pY
[coincidence of desire at the margin and cost at the margin]
• When the optimal consumption bundle is a corner optimum where
at least one good (say X) is not consumed, the marginal rate of
substitution of Y for X is no more than the relative price of that good
with respect to a good that is consumed (say Y)
• My preference between Hollywood and Bollywood
Holly CD movies are such I am always willing to give up less
than one 1 Hollywood CD for 1 Bollywood CD
A  when CD prices are the same, I only buy Holly CD

IC
At A, my MRS(H for B) < pB/pH = 1

Bolly CD

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