Principles of

Microeconomics
LECTURE 5
PREFERENCES AND UTILITY.
(THEORY OF CONSUMER CHOICE I)
Recap on demand and supply elasticity
• What are price ceilings and floors?

• How to know if they are binding?

• Do they really help households and firms?

• What are the problems caused by such price controls?

• What can you tell about the long run and short run impacts of price controls?

• Who bears larger burden of the tax? How?

Recall price
ceiling
In panel (a), the government
imposes a price ceiling of $4.
Because the price ceiling is
above the equilibrium price
of $3, the price ceiling has
no effect, and the market
can reach the equilibrium of
supply and demand. In this
equilibrium, quantity
supplied and quantity
demanded both equal 100
cones.
Recall price
ceiling
In panel (b), the government
imposes a price ceiling of $2.
Because the price ceiling is
below the equilibrium price
of $3, the market price
equals $2. At this price, 125
cones are demanded and
only 75 are supplied, so
there is a shortage of 50
cones.
Recall price floor
In panel (a), the government
imposes a price floor of $2.
Because this is below the
equilibrium price of $3, the
price floor has no effect. The
market price adjusts to balance
supply and demand. At the
equilibrium, a quantity supplied
and quantity demanded both
equal 100 cones.
Recall price floor
In panel (b), the government
imposes a price floor of $4,
which is above the equilibrium
price of $3. Therefore, the
market price equals $4. Because
120 cones are supplied at this
price and only 80 are
demanded, there is a surplus of
40 cones.
Are Price Controls helpful?
Price control policies by the governments are usually aimed for good deeds:
- policymakers are led to control prices because they view the market’s outcome as unfair;
- rent-control laws try to make housing affordable for everyone;
- minimum-wage laws try to help people escape poverty.
Yet price controls often hurt those they are trying to help. Rent control may keep rents low, but
it also discourages landlords from maintaining their buildings and makes housing hard to find.
Minimum-wage laws may raise the incomes of some workers, but they also cause other workers
to be unemployed.
So, the price should never be dictated by the government, instead it should be based on the free
market mechanism!
Instead…
The governments could:
- make housing more affordable by paying a fraction of the rent for poor families. Unlike rent
control, such rent subsidies do not reduce the quantity of housing supplied and, therefore,
do not lead to housing shortages.
- pay wage subsidies to raise the living standards of the working poor without discouraging
firms from hiring them. An example of a wage subsidy is the tax back payments or earned
income tax credit, a government program that supplements the incomes of low-wage
workers.

Although these alternative policies are often better than price controls, they are not perfect.
Rent and wage subsidies cost the government money and, therefore, require higher taxes. As we
see in the next section, taxation has costs of its own
How the Burden of a Tax Is Divided
❖ We saw that when a good is taxed, buyers and sellers of the good share the burden of the tax.
❖ Only rarely will it be shared equally. But how exactly is the tax burden divided?
❖ In order to answer the above question, we should review elasticity of supply and demand.
- a tax in a market with very elastic supply and relatively inelastic demand. That is, sellers are
very responsive to changes in the price of the good (so the supply curve is relatively flat),
whereas buyers are not very responsive (so the demand curve is relatively steep). When a tax
is imposed on a market with these elasticities, the price received by sellers does not fall much,
so sellers bear only a small burden. By contrast, the price paid by buyers rises substantially,
indicating that buyers bear most of the burden of the tax.
- a tax in a market with relatively inelastic supply and very elastic demand. In this case,
sellers are not very responsive to changes in the price (so the supply curve is steeper), whereas
buyers are very responsive (so the demand curve is flatter). The figure shows that when a tax
is imposed, the price paid by buyers does not rise much, but the price received by sellers falls
substantially. Thus, sellers bear most of the burden of the tax.
How the Burden
of a Tax Is
Divided
In panel (a), the supply curve is
elastic, and the demand curve is
inelastic. In this case, the price
received by sellers falls only
slightly, while the price paid by
buyers rises substantially. Thus,
buyers bear most of the burden
of the tax.
How the Burden
of a Tax Is
Divided
In panel (b), the supply curve is
inelastic, and the demand curve
is elastic. In this case, the price
received by sellers falls
substantially, while the price
paid by buyers rises only
slightly. Thus, sellers bear most
of the burden of the tax.

A tax burden falls more heavily on the side of the market that is less elastic!
The Theory of
Consumer Choice
PART I
Introduction to consumer choice
• How do consumers choose the goods and services
they buy?

• One possibility is that consumers behave randomly

and blindly choose one good or another without any
thought.

• However, consumers appear to make systematic

choices. For example, most consumers buy very
similar items each time they visit a grocery store.
Introduction to consumer choice (cont.)
• To explain consumer behavior, economists
assume that consumers enter the marketplace
with well-defined preferences. Taking prices
as given, their task is to allocate their incomes
to best serve these preferences.

• To explain consumer behavior, economists assume that consumers enter the marketplace with
well-defined preferences. Taking prices as given, their task is to allocate their incomes to best
serve these preferences.
Introduction to consumer choice (cont.)
• To analyze consumer choice, we go through two steps:
- The first step is to describe the various bundles of goods the consumer is able to
buy. These bundles depend on both his income level and the prices of the goods.
- The next step is to select from among those feasible bundles the particular one
that he prefers to all others.
• Analysis of the second step requires some means of describing an individual’s
preferences, in particular, a summary of his ranking of the desirability of all feasible
bundles.
• Once formulated, the theory of consumer choice provides a foundation for the demand
curves we studied in previous lectures.
The budget constraint
• People consume less than they desire…

… because their spending is constrained, or limited, by their income.

• We begin our study of consumer choice by examining this link between income and
spending.
The budget constraint (cont.)
• Suppose that there is some set of goods from which the consumer can choose. In real
life there are many goods to consume, but for our purposes it is convenient to consider
only the case of two goods, since this greatly simplifies the problem without altering the
basic insights about consumer choice.
• We will indicate the consumer’s consumption bundle by (𝑥1 , 𝑥2 ). This is simply a list
of two numbers showing the amounts of good 1 and good 2 that the consumer is
choosing to consume.
• In a similar manner, we can denote the prices of the two goods by (𝑝1 , 𝑝2 ). If the
amount of money the consumer has to spend is 𝑚, then the expression
𝑝1 𝑥1 + 𝑝2 𝑥2 ≤ 𝑚
shows the consumer’s budget constraint—the limitation on the consumption bundles
that the consumer can afford.
The budget
constraint (cont.)
•The consumer’s affordable
consumption bundles are
those that do not cost any
more than his given income,
𝑚. We call this set of
affordable consumption
bundles at prices (𝑝1 , 𝑝2 ) and
income 𝑚 the budget set, or
opportunity set, of the
consumer.
•The opportunity set of the
consumer is bounded by the
budget line—the set of
bundles that just exhaust the
consumer’s income—given by:
𝑝1 𝑥1 + 𝑝2 𝑥2 = 𝑚
The budget line
• We can rearrange the equation of the budget line to get the following formula:

• This is the formula for a straight line with a vertical intercept of 𝑚/𝑝2 and a slope of –
(𝑝1 , 𝑝2 ). The formula tells us how many units of good 2 the consumer needs to consume
in order to just satisfy the budget constraint if he is consuming 𝑥1 units of good 1.
• The horizontal and vertical intercepts of the budget line measure how much the
consumer could get if he spent all of his money on good 1 and good 2, respectively. The
slope of the budget line has a nice economic interpretation: it measures the rate at which
the consumer is able to trade good 2 for good 1 on the market. Let us see why this is so.
The budget line (cont.)
• Suppose, for example, that the consumer is going to increase his consumption of
good 1 by Δ𝑥1 . How much will his consumption of good 2 have to change in order to
satisfy his budget constraint? Let Δ𝑥2 indicate his change in the consumption of good 2.

• Note that, if he satisfies his budget constraint before and after making the change, he
must satisfy

and
The budget line (cont.)
• Subtracting the first equation from the second gives

• The above equality says that the total value of the change in his consumption must be
zero. Solving for Δ𝑥2 /Δ𝑥1 , the rate at which good 2 can be traded for good 1 while still
satisfying the budget constraint, gives

•But this is just the slope of the budget line. The negative sign is there since Δ𝑥1 and
Δ𝑥2 must always have opposite signs. If you consume more of good 1, you have to
consume less of good 2 and vice versa if you continue to satisfy the budget constraint.
This is the trade-off between the two goods.
The budget line (cont.)
• Notice that (the absolute value of) the slope of the budget line equals
the relative price of the two goods — the price of good 1 in terms of
good 2.

• In this sense, the slope of the budget line measures the opportunity
cost of consuming good 1:
- In order to consume one more unit of good 1, you have to give up
𝑝1 /𝑝2 units of good 2.
Changes in the
budget line
• When prices and incomes
change, the set of goods
that a consumer can afford
changes as well.
• Consider, for example,
increasing price 1 while
holding price 2 and income
fixed. Since both income
and the price of good 2 are
unchanged, the vertical
intercept of the consumer’s
budget line stays the same.
The rise in the price of good
1 rotates the budget line
inward about this intercept.
Changes in the
budget line
(cont.)
• The effect of a change in
income (with prices
unchanged) is to shift the
budget line parallel to the
original line. Thus, an
increase in income will result
in a parallel shift outward of
the budget line as in the
figure on the right. The same
happens if the prices of both
the goods fall in the same
proportion.
• Similarly, a decrease in
income or an equal
proportionate rise in the
prices of the both goods will
cause a parallel shift inward.
Budgets with more than two goods
• We initially assumed that there are only two goods on which the budget
is to be spent. However, we can generalize this assumption for any
number of goods without complicating the graphical (and the
mathematical) representation of the budget constraints.

• We can often interpret one of the goods as standing for everything else
the consumer might want to consume. The consumer’s choice in this
case would be viewed as being one between a particular good (𝑥1 ) and
an amalgam of other goods (𝑥2 ). This amalgam is generally called the
composite good.
Budgets with more than two goods (cont.)
• By convention, the units of the composite good are defined so that its price is $1 per
unit. This convention enables us to think of the composite good as being the dollars that
the consumer can use to spend on other goods.
• The budget constraint with the composite good will take the form

𝑝1 𝑥1 + 𝑥2 ≤ 𝑚

The above expression simply says that the amount of money spent on good 1, 𝑝1 𝑥1 , plus
the amount of money spent on all other goods, 𝑥2, must be no more than the total
amount of money the consumer has to spend, 𝑚.
Preferences
• Having considered what the consumer can afford to buy, let us now turn to
considering what he prefers to buy given a choice among different consumption
bundles.
• The consumer’s preferences allow him to choose among different bundles of
goods. Once offered two different bundles, the consumer chooses the one that
best suits his tastes. If the two bundles suit his tastes equally well, the consumer
is said to be indifferent between the two bundles.
• We will suppose that given any two consumption bundles, (𝑥1 , 𝑥2 ) and (𝑦1 , 𝑦2 ),
the consumer can rank them as to their desirability. That is, if we denote the
bundle (𝑥1 , 𝑥2 ) simply by 𝑋, and the bundle (𝑦1 , 𝑦2 ) by 𝑌, then the consumer can
determine whether 𝑋 is better than 𝑌, 𝑌 is better than 𝑋, or 𝑋 and 𝑌 are equally
attractive.
Preferences (cont.)
• If, given a choice between bundles 𝑋 and 𝑌, the consumer definitely wants 𝑋
rather than 𝑌, then we say that ‘bundle 𝑋 is strictly preferred to bundle 𝑌’. This
is written as 𝑋≻𝑌.
• If the consumer is indifferent between bundles 𝑋 and 𝑌, we write 𝑋∼𝑌.
• If the consumer likes bundle 𝑋 at least as much as bundle 𝑌, we say that
‘bundle 𝑋 is weakly preferred to bundle 𝑌’. This is then written as 𝑋≽𝑌.
• These relations of strict preference, weak preference, and indifference are not
independent concepts; the relations are themselves related! For example, if 𝑋≽𝑌
and 𝑌≽𝑋, we can conclude that 𝑋∼𝑌. Similarly, if 𝑋≽𝑌 but we know that it is not
the case that 𝑋∼𝑌, we can conclude that we must have 𝑋≻𝑌.
Preferences (cont.)
• Economists usually make some assumptions about the “consistency” of consumers’
preferences. For example, it seems unreasonable (and contradictory) to have a situation
where 𝑋≻𝑌 and, at the same time, 𝑌≻𝑋. So, we usually make some assumptions about
how the preference relations work.

• Completeness. Preferences are assumed to be

complete, meaning that consumers can compare
and rank all possible bundles of goods. Even if this
assumption may seem too simplistic (since there
are many goods we know too little about to be
able to evaluate), its real intent is to rule out the
possibility, for instance, that someone starves to
death because he is unable to choose between
slices of beef and lamb in front of him.
Preferences (cont.)
• Transitivity. The ranking of possible
bundles is assumed to be internally
consistent, i.e. if 𝑋≽𝑌 and 𝑌≽𝑍, then
𝑋≽𝑍.

• More is better. Goods are assumed

to be desirable — i.e., to be good.
Consequently, consumers always
prefer more of any good to less.
Preferences (cont.)
• Convexity. Mixtures of goods are preferable to extremes. That is, given any two
bundles 𝑋 and 𝑌, if 𝑋∼𝑌, then ½(𝑋+𝑌)≽𝑋. This means that a bundle containing half of 𝑋
and half of 𝑌 is at least as desirable as either of the original bundles. For example,
suppose you are indifferent between 𝑋=(4,0) and 𝑌=(0,4). If your preferences are
convex, you will prefer the bundle (2,2) to each of the more extreme bundles.
Indifference curves
• Interestingly, by examining the implications of the above four assumptions we can tell
a lot about a consumer’s preferences. These preferences can be represented
graphically by using a construction known as indifference curves.

• Consider the figure on the right where the two axes represent a consumer’s
consumption of goods 1 and 2. Let us pick a certain consumption bundle 𝑋=(𝑥1 , 𝑥2 ) and
shade in all of the bundles that are weakly preferred to 𝑋. This is called the weakly
preferred set. The bundles on the boundary of this set—the bundles that the consumer
views as equally desirable as 𝑋—form the indifference curve.
Indifference
curves
Consider the figure on the
right where the two axes
represent a consumer’s
consumption of goods 1 and
2. Let us pick a certain
consumption bundle 𝑋=( 𝑥1 ,
𝑥2 ) and shade in all of the
bundles that are weakly
preferred to 𝑋. This is called
the weakly preferred set.
The bundles on the boundary
of this set—the bundles that
the consumer views as
equally desirable as 𝑋—form
the indifference curve.
Indifference curves (cont.)
• We can draw an indifference curve through any
consumption bundle we want. The indifference curve
through a consumption bundle consists of all bundles of
goods from which the consumer derives the same level
of satisfaction; consequently, each of the bundles on
this curve leave the consumer indifferent to the given
bundle.
• An indifference map, or a preference map, is a
complete set of indifference curves that summarize a
consumer’s preferences.
• Higher indifference curves correspond to higher
levels of satisfaction. Accordingly, bundles on
indifference curves farther from the origin are preferred
to those on indifference curves closer to the origin.
Indifference curves (cont.)
• An important principle about indifference
curves is that indifference curves (from
the same indifference map) cannot
cross. To see why, suppose that two
indifference curves did, in fact, cross as in
the figure below.
• By assumption, the two indifference
curves represent two distinct levels of
preference. Because bundles 𝑋 and 𝑌 lie
on two different indifference curves, it
must be the case that either 𝑋≻𝑌 or 𝑌≻𝑋
(but never 𝑿∼𝒀). We know that 𝑋∼𝑍 and
𝑍∼𝑌, and the assumption of transitivity
implies that 𝑿∼𝒀. But this contradicts our
earlier inference. So, indifference curves
cannot cross.
Indifference curves (cont.)
• An important property of a consumer’s preferences is the rate at which he is willing to
trade, or substitute, one good for another. This rate is represented at any point on an
indifference curve by the marginal rate of substitution (MRS), which is defined as the
absolute value of the slope of the indifference curve at that point.
• Note that the word ‘marginal’ means “very small” and is used in relation to small
changes in variables.
• Suppose that we take a little of good 1, Δ𝑥1 , away from the consumer. Then we give
him Δ𝑥2 , an amount that is just sufficient to put him back on his indifference curve, so
that he is just as well off after this substitution of 𝑥2 for 𝑥1 as he was before. Then the
rate at which the consumer is willing to substitute good 2 for good 1 is given by:
Indifference
curves (cont.)
The convexity assumption we
made about preferences tells
us that along any indifference
curve, as more and more of
one good is consumed, a
consumer will prefer to give up
fewer and fewer units of a
second good to get additional
units of the first one.
Stated differently, MRS
declines (i.e. an indifference
curve becomes flatter) as we
move downward to the right
along the indifference curve.
Indifference curves with
diminishing marginal rates
of substitution are thus
convex—or bowed outward—
when viewed from the origin.
Perfect
substitutes
• There are two extreme
versions of downward-sloping
indifference curves: straight-
line and right-angle
indifference curves.
• One extreme case is
perfect substitutes: goods
that a consumer is
completely indifferent as to
which to consume (e.g. Coke
and Pepsi for some people).
In this case, the consumer is
willing to substitute one good
for the other at a constant
rate. So the MRS is constant
for perfect substitutes.
Perfect
complements
The other extreme case is
perfect complements:
goods that are always
consumed together in fixed
proportions (e.g. right shoes
and left shoes). In this case,
the consumer will not
substitute between the two
goods. The indifference
curves for perfect
complements are L-shaped.
So the MRS is zero along the
horizontal part and infinite
along the vertical part of the
indifference curve.
Utility
• So far we have seen that consumer theory relies only on the presumption that
consumers can provide relative rankings of different bundles of goods, without need to
associate a numerical level of satisfaction with each bundle consumed. Nonetheless, it
is often useful to assign numerical values to individual bundles. Using this numerical
approach, we can describe consumer preferences by assigning scores to the levels of
satisfaction associated with each indifference curve. This concept is known as utility.
• Utility is an abstract measure of the satisfaction or benefit that a consumer gets from
a bundle of goods.
• Because the consumer prefers points on higher indifference curves, bundles of
goods on higher indifference curves provide higher utility. And because the consumer
is equally satisfied with all points on the same indifference curve, all these bundles
provide the same utility. One can think of an indifference curve as an “equal-utility”
curve.
The utility function
• A utility function is a mathematical relationship that assigns a level of
utility to every possible consumption bundle.

• A consumer’s utility function 𝑢(𝑥1 , 𝑥2 ) tells us how much utility he gets

from 𝑥1 units of good 1 and 𝑥2 units of good 2. If the consumer prefers
bundle (𝑥1 , 𝑥2 ) to bundle (𝑦1 , 𝑦2 ), this is because the utility obtained from
the first bundle is larger than the utility obtained from the second bundle:
in symbols,
(𝑥1 , 𝑥2 ) ≻(𝑦1,𝑦2) if and only if 𝑢(𝑥1 , 𝑥2 ) > 𝑢(𝑦1,𝑦2).
Ordinal vs. cardinal utilities
• It is important to stress that the utility function is simply a way of ranking different
consumption bundles. The magnitude of the utility difference between any two bundles
does not really tell anything.
- For example, the fact that 𝑢(𝑋) has a level of utility of 100 and 𝑢(𝑌) has a level of
50 does not mean that bundle 𝑋 generates twice as much satisfaction as bundle 𝑌.
This is so because we have no means of objectively measuring a person’s
satisfaction or level of well-being obtained from a consumption bundle.

• A utility function that generates a ranking of consumption bundles in the order of most
to least preferred is called an ordinal utility function. This kind of utility function does
not indicate by how much one bundle is preferred to another and does not allow for
interpersonal comparisons.
Ordinal vs. cardinal utilities (cont.)
• There are some theories of utility that attach a significance to the
magnitude of utility. These are known as cardinal utility theories. These
theories try to make absolute comparisons between ranks and describe
by how much one consumption bundle is preferred to another.
• However, in order to understand consumer choice, we only have to
know how consumers rank different bundles (i.e. their relative utilities).
Knowing how much larger the utility is from one bundle than another does
not add anything to our description of choice behavior. Therefore, we will
work only with ordinal utility functions.
Utility and indifference curves
• An indifference curve consists of all those bundles that correspond to a particular level
of utility. If a consumer’s utility function is 𝑢(𝑥1 , 𝑥2 ), then the expression for one of the
corresponding indifference curves is

• The above expression determines all those bundles of 𝑥1 and 𝑥2 that give the consumer 𝑢ത
level of utility.
• For example, if a consumer’s utility function is

then his indifference curve u=4 includes any (𝑥1 , 𝑥2 ) bundles such that 𝑥1 *𝑥2 =16,
including the bundles (4,4), (2,8), (8,2), (1,16), and (16,1).
Types of utility functions
Marginal utility
• Consider a consumer who is consuming some bundle of goods, (𝑥1 , 𝑥2 ). How does this
consumer’s utility change as we give him a little more of good 1?
• This rate of change is called the consumer’s marginal utility with respect to good 1
and shows the extra utility obtained from consuming one additional unit of that good:

Similarly,
Diminishing marginal utility
• The consumption of any good, in general, is subject to principle of
diminishing marginal utility.

• The principle of diminishing marginal utility states that the more of a

good the consumer already has, the lower the extra utility provided by an
additional unit of that good.
Marginal utility and MRS
• A utility function 𝑢(𝑥1 , 𝑥2 ). can be used to measure the marginal rate of substitution that
we defined earlier. Recall that the MRS is interpreted as the rate at which the consumer
is just willing to substitute a small amount of good 2 for good 1.
• Consider a change in the consumption of each good, (Δ𝑥1 , Δ𝑥2 ), that keeps utility
constant—that is, a change in consumption that moves us along the indifference curve.
Then we must have (recall the total derivative):

• Solving for the slope of the indifference curve we have:

Thank you for your attention!!!
References
Pindyck and Rubinfeld, Chapter 2, Sections 2.4, 2.5

Mankiw, G. N. (2012) Principles of Microeconomics, sixth edition. South-Western Cengage

Learning. ISBN 13: 978-0-538-45304-2.

Nicholson, W. Snyder, C. (2010) Microeconomic Theory: Basic Principles and Extensions,

Eleventh edition. South-Western Cengage Learning ISBN-13: 978-111-1-52553-8.

Sloman, J. and A. Wride (2009), “Economics”, 7th edition.