The document discusses the concept of optimal choice in consumer theory, explaining that consumers will choose the bundle of goods that maximizes their utility given their budget constraint. It provides examples of how optimal choice varies for different types of preferences like perfect substitutes, perfect complements, and Cobb-Douglas preferences. The document also discusses how to estimate consumer utility functions based on their optimal choices.
The document discusses the concept of optimal choice in consumer theory, explaining that consumers will choose the bundle of goods that maximizes their utility given their budget constraint. It provides examples of how optimal choice varies for different types of preferences like perfect substitutes, perfect complements, and Cobb-Douglas preferences. The document also discusses how to estimate consumer utility functions based on their optimal choices.
The document discusses the concept of optimal choice in consumer theory, explaining that consumers will choose the bundle of goods that maximizes their utility given their budget constraint. It provides examples of how optimal choice varies for different types of preferences like perfect substitutes, perfect complements, and Cobb-Douglas preferences. The document also discusses how to estimate consumer utility functions based on their optimal choices.
The document discusses the concept of optimal choice in consumer theory, explaining that consumers will choose the bundle of goods that maximizes their utility given their budget constraint. It provides examples of how optimal choice varies for different types of preferences like perfect substitutes, perfect complements, and Cobb-Douglas preferences. The document also discusses how to estimate consumer utility functions based on their optimal choices.
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ECN 301
Intermediate Microeconomics Instructor: Nabila Maruf Independent University, Bangladesh Lecture Note: 5 Chapter 5: Choice 5.1 Optimal Choice Consumers choose the most preferred bundle from their budget sets.
We want to find the bundle in the budget set that is on
the highest indifference curve.
Since preferences are well-behaved, so that more is
preferred to less, we can restrict our attention to bundles of goods that lie on the budget line and not worry about those beneath the budget line. 5.1 Optimal Choice 5.1 Optimal Choice The choice (x∗1, x∗2) is an optimal choice for the consumer (interior optimum)
At this choice, the indifference curve is tangent to the budget
line.
There might be cases where the tangency condition at optimal
choice may not hold
What is always true is that at the optimal point the
indifference curve can’t cross the budget line 5.1 Optimal Choice 5.1 Optimal Choice Suppose that the optimal point occurs where the consumption of some good is zero
Then the slope of the indifference curve and the
slope of the budget line are different, but the indifference curve still doesn’t cross the budget line.
This represents a boundary optimum
5.1 Optimal Choice 5.1 Optimal Choice Necessary condition that the optimal choice must satisfy: If the optimal choice involves consuming some of both goods—so that it is an interior optimum—then necessarily the indifference curve will be tangent to the budget line.
But is the tangency condition a sufficient condition for
a bundle to be optimal? 5.1 Optimal Choice 5.1 Optimal Choice In general, the tangency condition is only a necessary condition for optimality, not a sufficient condition.
However, there is one important case where it is
sufficient: the case of convex preferences
In the case of convex preferences, any point that
satisfies the tangency condition must be an optimal point 5.1 Optimal Choice In general there may be more than one optimal bundle that satisfies the tangency condition.
However, again convexity implies a restriction.
If the indifference curves are strictly convex, then
there will be only one optimal choice on each budget line. 5.1 Optimal Choice MRS must equal slope of the budget at interior optimum: MRS = -p1/p2
Whenever the MRS is different from the price ratio,
the consumer cannot be at his or her optimal choice. 5.2 Consumer Demand The optimal choice of goods 1 and 2 at some set of prices and income is called the consumer’s demanded bundle
In general when prices and income change, the
consumer’s optimal choice will change
The demand function is the function that relates the
optimal choice—the quantities demanded—to the different values of prices and incomes. 5.2 Consumer Demand We will write the demand functions as depending on both prices and income: x1(p1, p2,m) and x2(p1, p2,m)
For each different set of prices and income, there will
be a different combination of goods that is the optimal choice of the consumer.
Different preferences will lead to different demand
functions 5.3 Some Examples Perfect Substitutes We have three possible cases. If p2 > p1, then the slope of the budget line is flatter than the slope of the indifference curves. In this case, the optimal bundle is where the consumer spends all of his or her money on good 1. If p1 > p2, then the consumer purchases only good 2. Finally, if p1 = p2, there is a whole range of optimal choices—any amount of goods 1 and 2 that satisfies the budget constraint is optimal in this case. 5.3 Some Examples 5.3 Some Examples Thus the demand function for good 1 will be
x1 =⎧ m/p1 when p1 < p2;
⎨ any number between 0 and m/p1 when p1 = p2; ⎩ 0 when p1 > p2;
If two goods are perfect substitutes, then a consumer will
purchase the cheaper one.
If both goods have the same price, then the consumer doesn’t care which one he or she purchases. 5.3 Some Examples Perfect Complements The optimal choice must always lie on the diagonal, where the consumer is purchasing equal amounts of both goods, no matter what the prices are.
Example: right shoes and left shoes
We know that this consumer is purchasing the same
amount of good 1 and good 2, no matter what the prices. 5.3 Some Examples Let this amount be denoted by x. Then we have to satisfy the budget constraint p1x + p2x = m.
Solving for x gives us the optimal choices of goods 1
and 2: x1 = x2 = x = m/p1+p2 5.3 Some Examples 5.3 Some Examples Demand function quite intuitive
Since the two goods are always consumed together, it
is just as if the consumer were spending all of her money on a single good that had a price of p1+p2.
Neutrals and Bads
In the case of a neutral good the consumer spends all of her money on the good she likes and doesn’t purchase any of the neutral good. 5.3 Some Examples The same thing happens if one commodity is a bad.
Thus, if commodity 1 is a good and commodity 2 is a
bad, then the demand functions will be
x1 = m/p1 x2 = 0 5.3 Some Examples Discrete Goods Good 1 = Discrete good, available only in integer units Good 2 = Money to be spent on everything else
If the consumer chooses 1, 2, 3, · · · units of good 1,
she will implicitly choose the consumption bundles (1,m−p1), (2,m−2p1), (3,m−3p1), and so on. 5.3 Some Examples 5.3 Some Examples 5.3 Some Examples Concave Preferences The optimal choice for these preferences is always going to be a boundary choice
Cobb-Douglas Preferences The utility function: u(x1, x2) =x1cx2d Solving for the optimal choice for this utility function, we get x1 = (c/c+d)(m/p1) x2 = (d/c+d)(m/p2) 5.3 Some Examples Consider the fraction of his income that a Cobb- Douglas consumer spends on good 1. If he consumes x1 units of good 1, this costs him p1x1 So a fraction p1x1/m of total income. Substituting the demand function for x1 we have p1x1/m = (p1/m) (c/c+d) (m/p1) = c/c+d Similarly for x2 p2x2/m = (p2/m) (d/c+d) (m/p2) = d/c+d 5.4 Estimating Utility Functions u(x1, x2) =x11/4x23/4
