Lecture 3: Chap 5

Block 4: Consumer choice PART A

Utility, Consumer Tastes & its Assumptions

• Consumer’s tastes & utility:
o Utility: the satisfaction consumers get from consuming goods
▪ E.g. if a person prefers Italian food to French food, s/he would get more utility
from consuming Italian than French food.
o A consumption bundle contains different quantities of various (for simplicity, 2 types
of) goods a consumer would like to consume.
▪ E.g. A consumption bundle can contain 6 oranges & 4 apples.

• Assumptions about consumer tastes:

Good Y
Preferred
8 Region

D B
6

A B’
4

C C’ E
2
Dominated
Region
Good X
0 2 4 6 8
o Completeness: consumer can always rank alternative bundles of goods according
to the utility they provide. “I don’t know whether I like this bundle more or the same”

o Prefer more to less:

▪ Any point north, east or north-east (south, west or south-west) of Bundle A is
more (less) preferred to Bundle A as it offers more (less) of at least one of
the good. E.g. Bundle B ≻ (i.e. is more preferred to) Bundle & Bundle C ≺ (i.e.
is less preferred to) Bundle A.
▪ Unsure how points in the north-west & south-east compare with Bundle A. E.g.
compared to Bundle A, Bundle D or E have more of one good but less of the
other good. Someone who loves Good X might prefer Bundle E to A, but a
good Y lover would prefer Bundle D to A.
o Transitivity: the ranking of possible bundles is internally consistent. E.g. If
Bundle D ≻ Bundle A, & Bundle A ≻ Bundle E → Bundle D ≻ Bundle E.
“Additional”
Diminishing Marginal Utility
Marginal Utility • Marginal utility of a good or service is the
additional utility a person gains from
 Total consuming an additional unit of that good
or service.
A
10
• Diminishing marginal utility: as we
consume more & more of the same good,
the additional or marginal utility we derive
B from an additional unit of the same good
5 falls.
C
3 G
2 MU
Qty. of oranges
0 1st 2nd 3rd 4th

By Mr William Tan, using UOL EC1002 Subject Guide & David Begg’s Economics 11e
1|Page
 Lecture 3: Chap 5
Block 4: Consumer choice PART A

Indifference; Utility Curves

Good Y (e.g. apples)

Practice (Subject Guide Sample
Increasing Exam MCQ)
8 Utility If an agent has a utility function
U3
of the form u(x,y)=xy then:
B E
6
F
✓a. They will be
U = 24 U = 24
indifferent
between (6,4) & (3,8). U = 25
A XU = 24
b. They will prefer (6,4) over (5,5).
4
U1 = 150
c. They will be X
indifferent
between (6,4) & (5,5).
2
D C X
d. None of the above.
U0 = 100
U2 = 50
Good X (e.g. oranges)
0 2 3 4 6 8
• Indifference curve: represents all the combinations of consumption bundles that provide
the same level of utility for a consumer.
(the same)
o a consumer is indifferent between consuming any of the bundles that lie on a given
indifference curve. U(A) = U(B) = U(C). (𝑨 ~ 𝑩 ~ 𝑪)

o Indifference curve passes through every possible bundle faced by our consumer
due to the assumption of completeness of tastes.

Good Y Must -ve slope! o Because a consumer prefers more to less, indifference curves must slope
B downwards. Since more Good X  utility, some Good Y must be sacrificed to hold
A
X D
utility constant.

U0 o Higher indifference curves are associated with higher levels of utility because the
C consumer prefers more to less.
Good X

Good Y Must -ve slope! ▪ E.g. Bundle E offers more of both goods than Bundle A. Since consumers
B prefer more to less, U(E) > U(A). But all points on U0 yield the same utility as
A X ▪
each other → every point on U1 yields more utility than every point on U0.
Conversely, bundle D must yield less utility than A since it offers less of both
D
C
U0 goods → every point on U2 yields less utility than every point on U0.
Good X (for the same person)
o Indifference curves (of the same person) cannot cross; intersect or else it would
violate assumption that consumers prefer more to less & assumption of transitivity.
Good Y Cannot intersect! ▪ E.g. The dotted utility curve U3 crosses indifference curve U0. If the

A X assumption of transitivity holds, since B & F lie on U3 → consumer is

indifferent between B & F. And since B & A lie on the indifference curve U0 →
B C consumer is indifferent between B & A. Hence, consumer is also indifferent
U1 between A & F. But this is impossible, since consumer gets more of both goods
U0 at F than at A → intersecting indifference curves violates the assumption that
Good X
consumers prefer more to less.
▪ If we first assume consumers prefer more to less → F ≻ A since F has more
of both goods. B  A & B  F since they are on the same indifference curves.
Then consumer should be indifferent between F & A → intersecting
indifference curves also violate the assumption of transitivity.

o Indifference curve becomes flatter as we move along it to the right due to

diminishing marginal rates of substitution.

By Mr William Tan, using UOL EC1002 Subject Guide & David Begg’s Economics 11e
2|Page
 Lecture 3: Chap 5
Block 4: Consumer choice PART A

Diminishing Marginal Rate of Substitution (MRS)

• The marginal rate of substitution (MRS) tells us how many units of a good the consumer
is willing to exchange for an additional unit of another good without changing total utility.
Good Y ∆𝒀
o It is the slope of the indifference curve. MRS = = – MUX/MUY
∆𝑿

o Generally, tastes of a consumer exhibit diminishing marginal rate of substitution.

YA A ▪ When a consumer has a lot of one good (e.g. films), s/he is willing to give
up a relatively large amount of it to get a good of which s/he has relatively
YB B little (e.g. burgers), without changing the total utility.
YC C
D
YD
+1 +1 +1 U0 = 100 ▪ E.g. U(6 films, 0 meals) = U(3 films, 1 meal) = U(2 films, 2 meals). For the 1st
Good X meal, s/he is willing to give up 3 films in exchange. But for the 2 nd meal, s/he
0 1 2 3 4
is willing to sacrifices only 1 film.

Practice (*Activity)
Calculate the MRS as we move from one point to
∆𝐂
another, using the formula MRS = −
∆𝐅
Change Change Marginal
Movement in in rate of
clothing food substitution
= – 12/5
a to b – 12 5
= – 2.4
= – 5/5
b to c –5 5
= – 1.0
c to d = – 3/+5 Decreasing
13
–3 –3 +5 MRS
= – 0.6
= – 2/5
d to e –2 5
= – 0.4
+5 = – 1/5
e to f –1 5
= – 0.2
Person A Person B
Steeper I.C. Flatter I.C.
• High MRS → steep indifference curves
U2 Film buff
Films

→ willing to give more of Good Y for Good X

Films

→ Good X lover
U1 Film buff
• Low MRS → flat indifference curve U2 (glutton) U0 Film buff
→ willing to give less of Good Y for Good X U1 (glutton)
→ Good Y lover +1X U0 (glutton) +1X

Burgers Burgers
Slope of Indifference Curve MUX = marginal utility from an
additional unit of Good X
Good Y
8 • A → C:  in utility = (MUX)(∆X)
• C → B:  in utility = (MUY)(∆Y)
U(A) = 10 U(C) = 14
A C
6 • Since utility is unchanged from A to B
(on same utility curve!):

4 ∆Y (MUX)(∆X) + (MUY)(∆Y) = 0

U(B) = 10 (MUY)(∆Y) = – (MUX)(∆X)

B
2 ∆𝒀 𝑴𝑼𝑿
=−
∆X U0 = 10 ∆𝑿 𝑴𝑼𝒀
Good X
0 1 2 3 4

By Mr William Tan, using UOL EC1002 Subject Guide & David Begg’s Economics 11e
3|Page
 Y

A
Lecture 3: Chap 5 YA
 Y →  U (∵ prefer more to less)
Block 4: Consumer choice PART A
YB B
U = 100
 ∆U = 0 (∵ on same indifference curve) X
Practice (2018 Finals Zone B MCQ Q3) XA XB
 X →  U (∵ prefer more to less)
Which of the following statements is implied by the assumption that consumers prefer more to
less?
(𝑨 ≻ 𝑩) (𝑩 ≻ 𝑪)
a. If the consumer prefers bundle A to bundle B and bundle B to bundle C, then the consumer
(𝑩 ≻ 𝑪) prefers bundle A to bundle C. → transitivity holds
b. Moving along an indifference curve, increasing the amount of good 1 and decreasing the
amount of good 2, the indifference curve becomes flatter. → diminishing MRS ; ing marginal utility
c. A consumer comparing any two bundles of goods A and B can always say whether A is better
than B, B is better than A, or A and B are exactly as good as each other. → completeness
✓d. Indifference curves are downward sloping. → i.e. negative slope → if X , have to  Y to keep utility
unchanged on the same indifference curve → because prefers more to less

Budget Line / Budget constraint

• Budget line: shows the maximum combinations of goods that the consumer can afford, for
a given income & the prevailing prices.
Total spending on Gd. X Total spending on Gd. Y Income
• Budget line equation: PX X + PY Y = M
Price of Gd. X Qty. of Gd. Y
Qty. of Gd. X Price of Gd. Y
𝑀 𝑃𝑋
𝑌= − 𝑋
Vertical intercept 𝑃𝑌 𝑃𝑌 Slope; Gradient

QX PXQX = $2 x QX QY PYQY = $4 x QY Total Spending = PXQX + PYQY

0 0 5 20 20
2 4 4 16 20
4 8 3 12 20
M
6 12 2 8 20
8 16 1 4 20
10 20 0 0 20
Good Y
𝑀 A
Max Y = =5
𝑃𝑌
B G
4
C
3
H D
2
𝑷𝑿 E
1 −
𝑷𝒀 F
Good X
0 2 4 6 8 10
𝑀
= 𝑃 = max X
𝑋

o Vertical intercept (Pt. A): max. amount of Good Y consumer can afford (X = 0).
▪ = 𝑰𝒏𝒄𝒐𝒎𝒆⁄𝑷𝒀 = 𝑴⁄𝑷𝒀

o Horizontal intercept (Pt. F): max. amount of Good X consumer can afford (Y = 0).
▪ = 𝑰𝒏𝒄𝒐𝒎𝒆⁄𝑷𝑿 = 𝑴⁄𝑷𝑿

o Slope: opportunity cost of an additional unit of Good X; how much Good Y must be
given up for an additional unit of Good X.
∆𝒀
▪ 𝑺𝒍𝒐𝒑𝒆 = ∆𝑿 = −𝑷𝑿⁄𝑷𝒀
▪ Negative slope illustrates opportunity cost: more of one good = less of the
other.
▪ Slope is constant → opportunity cost is constant.
▪ Inverse of the slope = opportunity cost of an additional unit of Good Y.
By Mr William Tan, using UOL EC1002 Subject Guide & David Begg’s Economics 11e
4|Page
 Lecture 3: Chap 5
Block 4: Consumer choice PART A

o Below the budget line (e.g. point H): affordable combinations/bundles of the two
goods that does not fully utilise the budget/income.

o On the budget line: affordable combinations/bundles of the two goods that fully
utilises the budget/income.

o Above the budget line (e.g. point G): unaffordable combinations/bundles of the two
goods because they cost more than the budget/income.

Practice (Subject Guide Activity 4.3)

The slope depends only on the relative prices of the two goods.
Draw budget constraints for the following three price combinations, assuming a total income of £120.

A: PX = £12 & PY = £20 B: PX = £20 & PY = £20 C: PX = £12 & PY = £15

Y Y Y
12X + 20Y = 120 20X + 20Y = 120 12X + 15Y = 120

8
𝟏𝟐𝟎 𝑴
𝒎𝒂𝒙 . 𝒀 = = = 6
𝟐𝟎 𝑷𝒀 6

𝑷𝑿 𝟏𝟐 𝟔
−
𝑷𝒀
=−
𝟐𝟎
=−
𝟏𝟎
=– 0.6 X
–1
X
– 0.8 X
0 10 0 6 0 10
𝑴 𝟏𝟐𝟎
= = = 𝒎𝒂𝒙 . 𝑿
𝑷𝑿 𝟏𝟐
Utility Maximising Consumer Choice
• A rational consumer will choose the affordable bundle that maximizes his/her utility.
o i.e. s/he will select a consumption bundle/point on the budget line
Good Y
A
5
B G
4
C U3
3
D U2
2
E
1 U1
F
Good X
0 2 4 6 8 10

• All points on U3 are unattainable since it lies entirely above the budget line AF. A consumer
would like this high level of utility but cannot afford it.

• The consumer can afford bundle B & E but she will choose bundle C as it is also on the
budget line (i.e. affordable) but is on a higher indifference curve.

• Any other affordable bundle on the budget line is on a lower indifference curve.

• Hence Bundle C gives the maximum utility given the budget constraint.
o This is budget line & indifference curve are tangent

𝑼𝒕𝒊𝒍𝒊𝒕𝒚 𝑴𝒂𝒙𝒊𝒎𝒊𝒔𝒂𝒕𝒊𝒐𝒏 𝑪𝒐𝒏𝒅𝒊𝒕𝒊𝒐𝒏: 𝒔𝒍𝒐𝒑𝒆 𝒐𝒇 𝒖𝒕𝒊𝒍𝒊𝒕𝒚 𝒄𝒖𝒗𝒆 = 𝒔𝒍𝒐𝒑𝒆 𝒐𝒇 𝒃𝒖𝒅𝒈𝒆𝒕 𝒍𝒊𝒏𝒆

𝑴𝑼𝑿 𝑷𝑿
− = −
𝑴𝑼𝒀 𝑷𝒀
𝑴𝑼𝑿 𝑷𝑿 TIP! : The short-cut is to swop the
= position of these 2 circled terms.
𝑴𝑼𝒀 𝑷𝒀

By Mr William Tan, using UOL EC1002 Subject Guide & David Begg’s Economics 11e
5|Page
Lecture 3: Chap 5
Block 4: Consumer choice PART A

𝑴𝑼𝑿 𝑷𝒀 = 𝑴𝑼𝒀 𝑷𝑿

𝑴𝑼𝑿 𝑴𝑼𝒀
=
𝑷𝑿 𝑷𝒀

• MUX/PX = MUY/PY implies that the marginal utility from the last dollar spent on X must be
equal to the marginal utility of the last dollar spent on Y.

𝑴𝑼𝑿 𝑴𝑼𝒀
o If > : consumer derives more utility from the last dollar spent on good X
𝑷𝑿 𝑷𝒀
than the last dollar spent on good Y →  X &  Y to  utility.

𝑴𝑼𝑿 𝑴𝑼𝒀
o If < : consumer derives more utility from the last dollar spent on good Y
𝑷𝑿 𝑷𝒀
than the last dollar spent on good X →  X &  Y to  utility.

𝑴𝑼𝑿 𝑴𝑼𝒀
o Consumer should continue to adjust their spending in this way until = .
𝑷𝑿 𝑷𝒀

Utility maximising choice

Good Y
𝑀 E
𝑃𝑌 B
Y A
U2 = 10
Y C
U1 = 5
F
Good X
X 𝑀
X
𝑃𝑋

At B, |slope| I.C. > |slope| B.L. At C, |slope| I.C. < |slope| B.L.
𝑀𝑈𝑋 𝑃𝑋 𝑀𝑈𝑋 𝑃𝑋
> <
𝑀𝑈𝑌 𝑃𝑌 𝑀𝑈𝑌 𝑃𝑌
𝑴𝑼𝑿 𝑴𝑼𝒀 𝑴𝑼𝑿 𝑴𝑼𝒀
> <
𝑷𝑿 𝑷𝒀 𝑷𝑿 𝑷𝒀
→ additional utility from last dollar spent on X → additional utility from last dollar spent on X
> additional utility from last dollar spent on Y < additional utility from last dollar spent on Y
→ to  utility, X & Y → to  utility, Y & X

Practice (Subject Guide Sample Exam MCQ)

Judith spends all her money buying wine & cheese & wants to maximise her utility from consuming
these two goods. The marginal utility of the last bottle of wine is 60, & the marginal utility of the last
block of cheese is 30. The price of wine is $3, & the price of cheese is $2. Judith:
𝑴𝑼𝑾𝒊𝒏𝒆 𝑴𝑼𝑪𝒉𝒆𝒆𝒔𝒆
a. is buying wine & cheese in the utility-maximising amounts (false as 𝑷𝑾𝒊𝒏𝒆
 𝑷𝑪𝒉𝒆𝒆𝒔𝒆
)

✓
b.
c.
should buy more wine & less cheese
should buy more cheese & less wine 𝟐𝟎 =
𝟔𝟎 𝑴𝑼𝑾𝒊𝒏𝒆
= >
𝑴𝑼𝑪𝒉𝒆𝒆𝒔𝒆 𝟑𝟎
= = 𝟏𝟓
$𝟑 𝑷𝑾𝒊𝒏𝒆 𝑷𝑪𝒉𝒆𝒆𝒔𝒆 $𝟐
d. is spending too much money on wine & cheese. →  W &  C

Note:
• As W  & C , MUwine  & MUCheese .
• This is due to ing MU from more of the same good;ing MU from less of the same good.
𝑴𝑼𝑾𝒊𝒏𝒆 𝑴𝑼𝑪𝒉𝒆𝒆𝒔𝒆
• Hence eventually the condition = will be achieved & utility is maximised.
𝑷𝑾𝒊𝒏𝒆 𝑷𝑪𝒉𝒆𝒆𝒔𝒆

By Mr William Tan, using UOL EC1002 Subject Guide & David Begg’s Economics 11e
6|Page
 Lecture 3: Chap 5
Block 4: Consumer choice PART A

Practice (Subject Guide Activity 4.4)

Jeremy has $M & wants to buy a combination of books & shoes. Books cost PB each & shoes cost
PS per pair. Both are normal goods to him. Describe graphically & in equations how he will decide
on an optimal combination of the two goods that maximises his total utility. What is the intuition
behind this?

• Jeremy will choose a combination of books & shoes

where his indifference curve is tangent to his
budget constraint.
Max. Books = • The budget constraint shows what is possible
for him to buy given his income & the prices of
the goods, while his indifference curves show his
preferences.
• The further from the origin an indifference curve
𝑷𝑺 lies, the greater his overall utility from the
− combinations represented by this curve.
𝑷𝑩

= Max. Shoes
• Choosing a point where the budget constraint is tangent to an indifference curve allows him to
maximise his utility given what is feasible/affordable for him.
• Slope of budget constraint: – PS / PB

• Slope indifference curve: – MUS/MUB

• Hence when the lines are tangent, the slopes are equal:
– MUS/MUB = – PS / PB
MUS/PS = MUB/PB

• i.e. the marginal utility derived from the last pound spent on books equals the marginal utility
of the last pound spent on shoes.
• Hence point A (ShoesA, BooksA) fulfils this & offers him the optimal combination of shoes and
books.

Practice (Subject Guide Activity 4.13)

Calculate the optimal quantity of each of Good X & Y & consumer’s total utility given PX = 1, PY = 2,
M = 80, & U(X,Y) = XY, where MUX = Y & MUY = X. Recall budget line equation: PxX + PYY = M
X + 2Y = 80 --- (2)
How would you represent this graphically?
∆𝑼 𝒅𝑼 𝒅(𝑿𝒀)
𝑴𝑼𝑿 = = = =𝒀 • Utility is maximized when the budget line &
∆𝑿 𝒅𝑿 𝒅𝑿
Y utility curve are tangent: MUX/MUY = PX/PY
∆𝑼 𝒅𝑼 𝒅(𝑿𝒀)
40 𝑴𝑼𝒀 = = = =𝑿
∆𝒀 𝒅𝒀 𝒅𝒀 𝑌 1 U = XY
• i.e. =
𝑋 2 = (40)(20)
2𝑌 = 𝑋 --- (1) = 800
Y = $2 each, 20 • Subs. Equation (1) into (2)
→ $40 is spent on Y
U0 2𝑌 + 2𝑌 = 80
− 1ൗ2 4𝑌 = 80
X 𝒀 = 𝟐𝟎
Total spending 40 80
= $40 + $40 X = $1 each,
= $80 → $40 is spent on X • Hence using Equation (1),
𝑿 = 2(20) = 𝟒𝟎

By Mr William Tan, using UOL EC1002 Subject Guide & David Begg’s Economics 11e
7|Page
 Lecture 3: Chap 5
Block 4: Consumer choice PART A

Impact of changes in Income

Good Y
𝑀1
=7 C
𝑃𝑌
Max. Y  6
𝑀0 A
=5
𝑃𝑌 Income 
H
4
Max. Y  G
3 Income  H’ U1
2 U1’
U0
E 2 𝑷𝑿 𝑷𝑿
1 − =− −
F 4 𝑷𝒀 B 𝑷𝒀 D
Good X
0 2 4 6 8 10 12 14
𝑀0 𝑀1
Max. X  = =
𝑃𝑋 Max. X  𝑃𝑋
• () income (e.g. $20 to $28) → parallel shift in budget line right (left) from AB to CD (EF).
o Maximum amount of Good X & Y consumer can afford increases (decreases).
o The slope remains unchanged since prices have not changed.

• If at the higher income consumer choice changes from G to H:

o  quantity demanded of both goods → both are normal goods
▪ 40%  in income (IED > 1)
→ 50%  in Good X demanded → YEDX = 50%/40% = 1.25 → luxury good
▪ 40%  in income (0 < IED < 1)
→ 33.3%  in Good Y demanded → YEDY = 33.3%/40% = 0.83 → necessity

• If at the higher income consumer choice changes from G to H’:

o  quantity demanded of Good X → normal good
o  quantity demanded of Good Y → inferior good _ _
PXX + PYY = M X
• Note that both goods cannot be inferior: e.g. when income  but prices remain unchanged,
consumer cannot consume less of both goods & yet remain on their (new) budget line.

Practice (Modified from Subject Guide Activity 4.5)

Draw budget constraint & indifference curve for the following scenario: Susan buys 1 cabbage & 8
carrots. Cabbages cost $2 per kilo & carrots cost $1 per kilo. Her income  from $10 to $6 and she
buys 1 more cabbage.

• Let X be quantity of cabbage & Y be quantity of

Carrots
carrots. Let PX be price of cabbage & PY be
10 price of carrots.
A • Budget Constraint: PXX + PYY = M
𝟔
=
𝑵𝒆𝒘 𝒊𝒏𝒄𝒐𝒎𝒆 8 (2)X + (1)Y = 6
𝟏 𝑷𝒄𝒂𝒓𝒓𝒐𝒕𝒔
U1 2X + Y = 6
= New max. cabbages = 6
• When income falls to $6, quantity of cabbage
4 bought  by 1 to 2 cabbages. (i.e. X = 2)
• Hence using the budget constraint, 2(2) + Y = 6
2 B 4+Y=6
Y=2
U2
• Hence
Cabbage the new optimal consumption bundle is 2
0 1 2 3 4 5 s cabbages & 2 carrots.
𝑵𝒆𝒘 𝒊𝒏𝒄𝒐𝒎𝒆 𝟔
= New max. cabbages = =
𝑷𝒄𝒂𝒃𝒃𝒂𝒈𝒆 𝟐

By Mr William Tan, using UOL EC1002 Subject Guide & David Begg’s Economics 11e
8|Page
Lecture 3: Chap 5
Block 4: Consumer choice PART A

Impact of a Price Change

C
A
10
Max. Y 
8
Good Y

Good Y
𝑀 A
6 −
PX  PX  𝑃𝑌0
PY
4 E Max. Y 
D PY
2 U0
25 10 U0 5 𝑃𝑋0
− − − − 0
5 D 5 B 5 C 𝑃𝑌 B
0 0 𝑀
2 4 5 6 8 10 − 0
𝑃𝑋
Good X Good X

• Budget line AB above is for a consumer with an income of $50, with PX = $10 & PY = $5.

• Suppose PX  () to $25 ($5).

o Since PY remains unaltered, $50 income still buys 10Y when all income is spent on Y.
→ max. Y unchanged.

o Since PX (), $50 income buys 2X (10X) instead of 5X when all income is spent on X
→ max X. () Pt. B → Pt. D(C)].

o Hence budget line rotates inwards (outwards) around point A; max Y.

• When PX (), Consumer can no longer (can more than) afford the original bundle E
→ utility ()

*Practice
In the diagram above on the right, illustrate the cases of an  in PY and a  in PY.

Acknowledgements & References

Economics 11e by David Begg, Gianluigi Vernasca, Stanley Fischer, Rudiger Dornbusch
ISBN: 0077154517. Publisher: Mc Graw Hill

Subject Guide 2016 for EC 1002 Introduction to Economics by O. Birchall assisted by D. Verry
University of London International Programmes

By Mr William Tan, using UOL EC1002 Subject Guide & David Begg’s Economics 11e
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