CONSUMERS AND INCENTIVES

Adjunct Faculty: Fot-Chyi Wong

 Lesson Outline

PART A PART B
❑ Introduction to Consumer Theory  Budget Constraints
❑ Consumer Preferences ➢ Change in Income
➢ Change in Prices
➢ Properties of Preferences
 Optimum Consumer Choice
 Utility and Utility Function
➢ Utility Maximization
 Indifference Curves & Utility ➢ Optimality Condition: “Equal
 Marginal Utility & Marginal Rate of Bang for the Buck”
Substitution  Derivation of the Demand Function
 Examples of Utility Function ➢ When Price of A Good Falls
➢ Perfect Substitutes ➢ When Price of A Good Increases

➢ Perfect Complements ➢ Normal Goods, Inferior Goods,

Giffen Goods
 Lesson Outline

PART A
❑ Introduction to Consumer Theory
❑ Properties of Consumer Preferences
 Utility and Utility Function
 Indifference Curves & Utility
 Marginal Utility & Marginal Rate of Substitution
 Examples of Utility Function
❖ Perfect Substitutes
❖ Perfect Complements
Consumer Theory: Introduction

 A theory of microeconomics that relates preferences

for consumption goods and services to consumption
expenditures and ultimately to consumer demand
curves.
 The link between personal preferences, consumption,
and the demand curve is one of the most closely
studied relations in economics.
 A way of analyzing how consumers may achieve
equilibrium between preferences and expenditures by
maximizing utility as subject to consumer budget
constraints.
Consumer Theory: Introduction

To understand the behaviour of a individual as a rational

consumer, we need to analyze TWO separate sides of
the problem, viz:
➢ First, we want to be able to understand what she wants to
do, i.e. her preferences, described in terms of her
preferred choice of consumption bundles;
➢ Second, we need to analyze what the individual can do,
given what she has available, i.e. her budget constraint.
With these, we can then combine what she wants to do
and what she can do, to understand what she is going
to do.
Consumer Preferences
Properties of Consumer Preferences

Three (3) essential properties or axioms of individuals’

preferences assumed in consumer theory:
1. Completeness: preferences are complete if it is always
possible for the individual to compare different consumption
bundles.
 For example, if there are 2 consumption bundles A and B, a
consumer should be able to express one of the following
preferences:
A ≻ B : She prefers A to B
B ≻ A : She prefers B to A
A ~ B : She is indifferent between A and B
[Note: ‘≻’ means “prefers to” and ‘~’ means “indifferent to”]
Properties of Consumer Preferences

Three (3) essential properties or axioms of individuals’

preferences assumed in consumer theory:
2. Transitivity: preferences are transitive if whenever the
individual prefers bundle A to bundle B to bundle C, she also
prefers bundle A to bundle C, viz. if A≻B and B≻C, then A≻C.
This is a consistency assumption.

3. Non-satiation: preferences satisfy non-satiation if the

individual always prefers a bundle with more of any one good
to a bundle with less, i.e. “more is better”
Properties of Consumer Preferences
Consider a world of two economic goods, X and Y. The space of all
possible consumption bundles of economic goods is the positive quadrant
of the X-Y plane, thus:
Quantity of Good Y
Each point represents a
consumption bundle with different
quantities of goods X and Y.

Quantity of Good X
Properties of Consumer Preferences
With completeness in preferences, ALL the possible consumption bundles
in the positive quadrant (shaded region) can be compared and ranked
by the individual:
Y
Each point represents a
consumption bundle with different
quantities of goods X and Y.

X
Properties of Consumer Preferences
Let Point A depicts a consumption bundle with XA units of X and YA units
of Y, i.e. A=(XA, YA), thus:

A
YA

XA X
Properties of Consumer Preferences
Centering on Point A, four regions or quadrants can be delineated as
shown:

IV I

A
YA

III II

XA X
Properties of Consumer Preferences
With non-satiation in preferences, ALL consumption bundles in Region I
have more of either X or Y or both than at Point A and, thus, are
preferred to A
Y

IV I

A
YA

III II

XA X
Properties of Consumer Preferences
For example, at Point B(XB, YB), XB > XA and YB > YA.
Hence, B(XB, YB) ≻ A(XA, YA), i.e. consumption bundle B is preferred to
consumption bundle A. [≻ means “prefers to” and > means “greater
than”.] Y

IV I

B
YB
A
YA

III II

XA XB X
Properties of Consumer Preferences
In contrast, ALL consumption bundles in Region III have less of either X or
Y or both than at Point A and, thus, A is preferred to any point in Region
III.
Y

IV I

B
A
YA

III II

XA X
Properties of Consumer Preferences
For example, at Point C(XC, YC), XC < XA and YC < YA.
Hence, A(XA, YA) ≻ C(XC, YC), or consumption bundle A is preferred to
consumption bundle C.
Y

IV I

B
A
YA

III II
C
YC

XC XA X
Properties of Consumer Preferences
Hence, we have: B(XB, YB) ≻ A(XA, YA) ≻ C(XC, YC)

IV I

B
A
YA

III II
C

XA X
Properties of Consumer Preferences
A line connecting C to B must pass through either quadrant II or IV.
As one moves from an inferior point (C) to a superior one (B), one goes through a
point like D where one is indifferent between the two bundles A and D, as both
give the same satisfaction to the consumer.
Y

IV I

B
A
YA

D
III II
C

XA X
 Utility and Utility Function
 Somehow, from the millions of things that are available,
each consumer manages to sort out a set of goods and
services to buy. In so doing, he or she makes specific
judgments about the relative worth of things that are
very different.
 Economists have constructed a simple theory of consumer
choice based on the hypothesis that each consumer
spends income in the way that yields the greatest
amount of satisfaction, or utility.
 Utility and Utility Function
We now define the utility function to represent
preferences, as follows:

Definition:
The utility function U(X,Y) is a function that assigns to
each bundle (X,Y) a utility level for the consumer. It does
so in a way that represents the consumer preferences,
that is, U(X,Y) > U(X’,Y’) if and only if the bundle (X,Y) is
preferred to the bundle (X’,Y’).
 Utility and Utility Function
 Certain problems are implicit in the concept of utility.
➢ First, it is impossible to measure utility.
➢ Second, it is impossible to compare the utilities of different
people—that is, we cannot say whether person A or person B
derives a higher level of utility from, say, watching a movie.
 Despite these problems, however, the idea of utility helps us
better understand the process of choice.
➢ E.g. while we cannot answer the question “How many utils did you
get from the last movie you saw?”, we can probably answer the
question “How many hamburgers would you give up to get that
movie ticket?” Instead of hamburgers, we can consider monetary
units, e.g. S$, as a measure.
Indifference Curves & Utility
With utility function now defined, therefore we can indicate:
U(XB, YB) > U(XA, YA) > U(XC, YC)
U(XA, YA) = U(XD, YD)
Y

Note that we have

IV I changed the “prefer
B to” symbol “≻” to
the “greater than”
A symbol “>”.
YA

D
III II
C

XA X
Indifference Curves & Utility
Points of indifference can be plotted,
… which trace out the Indifference Curve corresponding to each level
of utility, thus:
Y

IV I

B
A
YA

D
III II
C

XA X
Indifference Curves

Indifference Curve:
Good Y
A curve that defines the combinations
of 2 or more goods that give a
consumer the same level of satisfaction.

Good X
Indifference Curves
Numerous indifference curves (IC) for the individual consumer can be
plotted, giving rise to an indifference map:
Indifference Map:
Good Y
Graph containing a set of indifference
curves showing the consumption baskets
among which a consumer is indifferent.

IC4

IC3

IC2
IC1

Good X
Indifference Curves
Bundles of goods X and Y on the same IC provide the consumer the
same satisfaction or utility, as measured by units of utils.
For example, depending on the functional form
Good Y for preferences,
• each bundle on IC3 provides, say, 30 utils of
satisfaction, while
• each bundle on IC2 provides, say, 20 utils of
satisfaction, lower than that on IC3
• and so on.

IC3

IC2
IC1

Good X
Indifference Curves
One plausible utility function which satisfies the 3 properties of
preferences is 𝑈 = 𝑋. 𝑌, which plots the indifference curves as shown:
160

140

120
Note that only 3 indifference curves
100 with their corresponding utility
values are shown for illustration.
Good Y

80

𝑼 = 𝟓𝟎
60

40 𝑼 = 𝟑𝟎

20
𝑼 = 𝟏𝟎
0
0 20 40 60 80 100 120 140

Good X
Indifference Curves
Completeness – Consumer is capable of expressing preferences (or
indifference) between all possible bundles. (“I don’t know” is NOT an
option!) For example:
Good Y If the only bundles available to a consumer
are A, B, and C, then the consumer
▪ is indifferent between A and C, i.e. A ~ C
(since they are on the same IC).
▪ will prefer B to A, i.e. B ≻ A.
▪ will prefer B to C, i.e. B ≻ C.

A B IC3

C
IC2
IC1

Good X
Indifference Curves
Non-Satiation or “More is Better” – Bundles that have at least as much
of every good and more of some good are preferred to other bundles.
For example:
Increasing utility
Good Y or satisfaction ▪ Bundle B ≻ A, ∵ XB > XA
even if YB = YA.
▪ Bundle B ≻ C, ∵ YB > YC
even if XB = XA.
▪ More generally, bundles on
an IC further in the north-
easterly direction provide
A B IC3 greater satisfaction or utility
YA = YB

C
IC2
YC
IC1

XA XC = XB Good X
Indifference Curves
Transitivity – ensures consistency in consumer choice. For the three
bundles A, B, and D, the transitivity property implies that if D ≻ B and B
≻ A, then D ≻ A.
Good Y

D
A B IC3

IC2
IC1

Good X
Indifference Curves
Non-satiation and transitivity in preferences ensure that the individuals
are consistent and rational, such that an individual’s indifference curves
do not cross.
Good Y

IC1

Good X
Indifference Curves
If this were not so, we would obtain the following inconsistent results:
P~R
R~Q
Good Y
P~Q
But R lies northeast of Q with
R more of both good X and
Q good Y, and hence:
R≻Q
P Inconsistent!!!
IC1

Good X
Indifference Curves
Non-satiation in preferences also implies that indifference curves do not
bend backwards…
… as “more is better” => A ≻ B NOT A ~ B
Good Y
C ≻ D NOT C ~ D
A

C IC

Good X
Marginal Rate of Substitution (MRS)

Shape of Indifference Curve (IC): convex to the origin

➢ All indifference curves exhibit diminishing marginal rate of
substitution (MRS)
Good Y As we move along the IC, the
relatively more units of one good the
consumer has, the more willing she is
to give it up for the good of which
she has relatively little.

IC

Good X
Marginal Rate of Substitution (MRS)

Marginal rate of substitution (MRS) of good X for good Y (MRSXY) is

the rate at which the consumer is willing to substitute good Y for one
additional unit of good X to remain indifferent.
Good Y
For example:
All bundles A, B, C and D on the same IC have the
same level of utility or satisfaction.
From A to B, MRSXY = (100 – 50)÷(2 – 1) = 50
100 A From B to C, MRSXY = (50 – 33⅓)÷(3 – 2) = 16⅔
From C to D, MRSXY = (33⅓ – 25)÷(4 – 3) = 8⅓
50 B
C Diminishing MRS
33⅓ D
25
IC

1 2 3 4 Good X
Marginal Rate of Substitution & Marginal Utility

… and diminishing Marginal Rate of Substitution (MRS) is

a result of diminishing Marginal Utility (MU) in
consumption:

Definition:
The marginal utility of good X, MUx, is the marginal
increase in the utility generated by a marginal increase
in the consumption of X.
Marginal Utility & Marginal Rate of Substitution

Graphically, a utility function U(X,Y) can be represented

as follows, with MU given by the slope of the curve:
Utility, U

ΔU

ΔX

∆𝑼 ∆𝑼
ΔU 𝑴𝑼𝑿 = at X1 > 𝑴𝑼𝑿 = at X2
∆𝒙 ∆𝒙

ΔX
Note: The symbol ∆ means “change”.

X1 X2 Good X (or Good Y)

Marginal Utility & Marginal Rate of Substitution

Principle of Diminishing Marginal Utility: as the consumption of a good

increases, the marginal utility from an additional unit of the good
diminishes.
Utility, U

ΔU

ΔX

∆𝑼 ∆𝑼
ΔU 𝑴𝑼𝑿 = at X1 > 𝑴𝑼𝑿 = at X2
∆𝒙 ∆𝒙

ΔX
Note: The symbol ∆ means “change”.

X1 X2 Good X (or Good Y)

Marginal Utility & Marginal Rate of Substitution

The marginal rate of substitution of good X for good Y (MRSXY)

at point A is given by the absolute value of the slope of the
tangent at A:
Y

∆𝐘
|Slope|= = MRSXY
∆𝐗
A Note: |Z|– the two vertical lines means
∆Y
to take the non-negative value of Z.

IC
∆X

Note: The symbol ∆ means “change”.

X
Marginal Utility & Marginal Rate of Substitution

Intuitively, the slope implies that one is giving up ∆Y units of good

Y in exchange for ∆X units of good X.
By definition of MU, the loss in utility
Y in giving up ∆Y = ∆Y.MUY and the
gain in utility in exchange for ∆X =
∆X.MUX , where:
A MUX = Marginal utility of X
∆Y MUY = Marginal utility of Y

IC
∆X

Note: The symbol ∆ means “change”.

X
Marginal Utility & Marginal Rate of Substitution

To be indifferent (i.e. on the same IC), the loss in utility = gain in

utility. Hence:
∆Y.MUY = ∆X.MUX
Y
∆Y MUX
 =
∆X MUY

∆𝐘 𝐌𝐔𝑿
∆Y
A MRSXY = =
∆𝐗 𝐌𝐔𝒀

IC
∆X

Note: The symbol ∆ means “change”.

X
Marginal Utility & Marginal Rate of Substitution

Due to diminishing MU in consumption of X, MRSXY also diminishes with

rising quantity of X, i.e. the slope of the utility function flattens out with
X, thus:
Y
𝐌𝐔𝑿 𝐌𝐔𝑿 ↓ as X ↑
MRSXY = 𝐌𝐔𝒀 ↑ as Y ↓
𝐌𝐔𝒀

A
=> MRSXY ↓

IC
Decreasing Y

Diminishing MRSXY

Increasing X

X
Examples of Utility Function – Special Case #1

Examples of the utility function: Perfect Substitutes – 2 goods for

which the MRS is a constant.
Y
❖ Linear indifference curves (IC)
❖ MRS is constant along IC, i.e.
consumer is willing to exchange X
for Y at a fixed ratio, e.g. 1 unit of
Y for 1 unit of X in which case
slope of IC is –1.
IC3
IC2
E.g. Coca-Cola and Pepsi
IC1

X
Examples of Utility Function – Special Case #2

Examples of the utility function: Perfect Complements – 2 goods for

which the MRS is zero or infinite; the IC are shaped as right angles
Y
❖ Indifference curves (IC) are L-shaped
❖ Both goods must increase in right
proportions for utility to increase
❖ Elbows / kinks of curves are collinear
IC3
(e.g. with slope = 3 if one always
consumes X and Y in the fixed
IC2 proportion of 1 unit of X with 3 units
of Y )
IC1
❖ Example: Left shoes and right shoes
(in 1:1 proportions).
X
Examples of Utility Function

Shapes of Utility Function or Indifference Curves:

PREFERENCES FOR AUTOMOBILE ATTRIBUTES

“Steep” IC “Flat” IC

Owners of Ford Mustang coupes (a) The opposite is true for owners of
are willing to give up considerable Ford Explorers. They prefer interior
interior space for additional space to acceleration (b).
acceleration.
 Diagrams for In-Video Quiz

(a) Perfect Substitutes (b) Perfect Complements

Good Y Good Y

IC3
IC3
IC2
IC2
IC1
IC1

Good X Good X
 Connecting-the-Dots
 Giffen Goods:
➢ WSJ - Economists’ Hunt for a Giffen Good Might Have Ended, 16
July 2007
 Veblen Goods:
➢ Economist - Luxury - Exclusively for everybody, 13 Sep 2014
➢ WSJ - Soaring Luxury-Goods Prices Test Wealthy's Will to Pay, 02
Mar 2014
➢ WSJ - New iPhone X Tests Economic Theory, 18 Sep 2017
 Substitutes and Complements:
➢ Economist - Taxis v Uber - Substitutes or complements, 10 Aug
2015
➢ ST - Pricey food court fare irks diners, 27 Dec 2010
End of Session
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