RMIT Classification: Trusted

ECON 1268
Managerial and
Business Economics

Topic 10: Consumer choice

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Topics for today's lecture . . .

1. Utility functions

2. The budget constraint

3. Optimal choice

4. Deriving demand

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Utility functions

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Definition: Consumption basket

A combination of goods and services that an individual might

consume.

A basket describes both which goods and services an

individual consumes, and the quantities consumed.

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Food & clothing

We will confine our attention to

baskets
that contain two goods. In this
example,
• x represents number of meals,
and,
• y represents number of items of
clothing.
Each point on the graph describes
a different basket.
For example, basket A contains 10
meals, and 8 items of clothing.

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Utility functions

A utility function assigns a number to every possible basket of goods

and services.
For a basket A, we write U(A) to indicate the utility that a consumer
derives from consuming the basket.
Bigger is better: A > B implies U(A) > U(B), and vice versa.
• The sizes of any two numbers can be compared, therefore a utility
function can only represent complete preferences.
• The `greater than' relation is transitive, therefore a utility function
can only represent transitive preferences.

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A utility function with two goods

This graph illustrates a total utility

function with two goods.
Each point on the horizontal plane
corresponds to a consumption
basket.
The utility created by this
consumption basket is represented
by the hight of the function.
For this consumer U(12; 3) = 6.

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The marginal utility of x

Treat the quantity of good y as

fixed.
The marginal utility of x is the
slope of the utility function in the
direction of an increase in x.
This is the partial derivative of the
utility function with respect to x,
MUx = .
The marginal utility of y is similarly
defined.

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Indifference curves

An indifference curve is a line

indicating all points on the utility
function at the same level.
Higher indifference curves
correspond to higher levels of utility.
We can only illustrate a few
indifference curves at a time.

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Definition: More is better

An assumption that having more of a good is always better for a

consumer.

The more is better assumption (also called monotonicity)

provides a great deal of structure to consumer preferences.

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Flattening the utility function

Consider the indifference curve

corresponding to utility U = 4.
If the more is better assumption is
satisfied, the indifference curves for
lower
levels of utility lie below and to the
left. (Why?)
While, the indifference curves for
higher levels of utility lie above and
to the right.

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1. Indifference curves slope down

The more is better assumption

allows us to derive three properties
of indifference curve.
Pick any basket A that lies on the
indifference curve U1.

The consumer prefers A over any

basket that is below and to the left.
The consumer prefers any basket
that is above and to the right, over
A.

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2. Indifference curves do not intersect

More is better tells us that B > A.

Therefore, the utility of every basket
on U2, must be higher than the
utility of every basket on U1.

But C lies on both indifference

curves, implying that U1 = U2.

It is not possible to have both

U1 = U2 and U1 < U2, therefore we
can conclude that indifference
curve cannot intersect.
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3. Indifference curves are not thick

If an indifference curve is thick then

we can pick a basket A at the
bottom edge of the curve.
We can also pick a basket B that is
above and to the right of A, but still
on U1.

More is better implies B > A,

therefore A and B cannot lie on the
same indifference curve.

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Quiz 1

Suppose E and F lie on the same

indifference curve, and that the
more is better assumption is
satisfied.
Which basket(s) CANNOT lie on
the same indifference curve as E
and F?
a. B only.
b. B and C.
c. C and D.
d. B, C and D.

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Marginal rate of substitution

The rate at which units of x are exchanged for units of y along the
indifference curve (the negative of the slope of the indifference
curve) is called the marginal rate of substitution or MRSx,y .
The MRSx,y can be derived from the total differential of the utility
function,

Along an indifference curve utility is constant, and therefore

dU(x; y ) = 0.
Substituting for dU(x; y ) and rearranging, gives us,

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Diminishing marginal rate of substitution

An indifference curve displays

diminishing marginal rate of
substitution if it gets flatter as x
increases.
• Basket A contains a lot of clothing
(good y ), but little food (good x).
• Basket B contains a lot of food, but
little clothing.
The diminishing MRSx;y assumption
implies a consumer would prefer a
more even mix of food and clothing,
over either extreme.

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The budget constraint

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The cost of a consumption basket

Suppose that:
• The price of food (good x) is
Px = $20 per meal.
• The price of clothing (good y ) is
Py = $100 per item.
Basket A, containing xA = 14 meals
and yA = 5 items of clothing, costs,

PX xA + Py yA = 20 x 14 + 100 x 5

= $780.
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Definition: Budget constraint

The set of baskets that a consumer can purchase given her/his

income and the prevailing prices.

The budget constraint describes the alternative consumption

possibilities that are available to a consumer.

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Affordable consumption baskets

Suppose that the consumer's

income is I = $1000.
• If the consumer spends all of
her/his income on food then,
50 meals.
• If the consumer spend all of
her/his income on clothing then,
= 10 items.

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The budget line

The equation of the budget

constraint is, Pxx + Pyy I.

The set of baskets that are only just

affordable is called the budget line.
Baskets that lie below the budget
line (such as A) are affordable.
(Why?)
Baskets that lie above the budget
line (such as B, which costs $1400)
are unaffordable.

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The trade-offs along the budget line

The slope of the budget line is the

negative of the ratio of prices,
slope = .
The ratio Px/Py is the number of
units of clothing (good y ) that must
be given up in order to obtain an
additional unit of food (good x).

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Quiz 2

Each week Sarah spends a total of $100 on coffee and cake. The
price of coffee is $4 per cup, and the price of cake is $12 per slice. If
Sarah purchases 7 slices of cake, how many cups of coffee does
she purchase?

a. 1.

b. 4.

c. 16.

d. 25.

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Quiz 3

Each week Sarah spends a total of $100 on coffee and cake. The
price of coffee is $4 per cup, and the price of cake is $12 per slice. If
Sarah wants to increase by 1 the number of slices of cake she
purchases, without altering the total amount she spends on coffee
and cake, how many cups of coffee must she give up?

a. 1/3. b. 1.

c. 3. d. 12.

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A fall in income

Suppose that the consumer's

income falls from $1000 to $500.

The slope of the budget line does

not change.
What would happen if the prices of
the two good were also halved?

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An increase in the price of food

Suppose that the price of food

increases from $20 to $40 per meal.
= 25 meals.
The y - intercept does not change.
The budget line is steeper
(-Px/Py = -2/5).
The consumer has fewer available
consumption baskets.

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Optimal choice

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Constrained optimisation

A consumer's objective is to
achieve the highest possible level
of utility (reach the highest available
indifference curve).
The budget constraint limits the set
of baskets from which the
consumer may choose.
The optimal choice is the basket
that maximises her/his utility, within
her/his budget constraint.

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The optimal consumption basket lies on

the budget line
Take any basket A that lies below
the budget line.
The more is better assumption
implies that any basket above and
to the right of A delivers a higher
level of utility.
Therefore, A cannot be optimal as
there must exist a basket B on the
budget line that is preferred to A.

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At the optimum, the indifference curve

does not cross the budget line
Take any basket A lying on the
budget line, at a point at which an
indifference crosses the budget
line.
There must exist a basket B, on the
same indifference curve as A, that
lies below the budget line.
Therefore, A cannot be optimal as
the basket C is preferred over B,
and the consumer is indifferent
between B and A.

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At the optimum, the indifference curve is

tangent to the budget line
The optimum must lie on an
indifference curve that touches, but
does not cross, the budget line.
Diminishing marginal rate of
substitution implies that we can
find the optimal basket A where the
indifference curve is tangent to the
budget line.
At most one consumption basket
can satisfy these conditions.

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Two conditions for an interior

optimum
The optimal consumption basket lies on the budget line, therefore,
Pxx + Pyy = I .

At the optimum the slope of the indifference curve is equal to the

slope of the budget line, therefore,

Note: These conditions are predicated on the more is better

assumption holding for both goods, and on a diminishing
marginal rate of substitution.

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Exercise: Finding the optimum

consumption basket
The utility Sarah derives from coffee (good x) and cake (good y ), is
given by the function . The corresponding marginal utilities are,
and
The price of coffee is Px = $4 per cup, the price of cake is Py = $12
per slice, and Sarah’s income is I = $120.
1. Derive the equation for Sarah's budget line.
2. Derive the expression for Sarah's marginal rate of substitution and
use it to construct Sarah's tangency condition.
3. Solve the two equations simultaneously to find Sarah's optimal
consumption basket.

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Bang for your buck

An alternative way of stating the tangency condition is,

In words, at an interior optimum the marginal utility per dollar must

be equal for all goods.
• The bang for your buck condition must hold for every pair of goods
an individual consumes, regardless of the number of goods in
her/his consumption basket.
Intuitively, if the marginal utility per dollar is higher for good x than for
good y , the consumer can increase her/his utility by reducing
spending on y , and increasing spending on x.

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Deriving demand

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Deriving demand from preferences

Tarquin's preferences over baskets containing cappuccinos (good x),

and cookies (good y ), are represented by the utility function
.
His corresponding marginal utilities are,
MUx = and MUy = 1.
The price of cookies is Py = $1, and Tarquin's income is $500.
How can we use this information to derive Tarquin's demand for
cappuccinos?

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Optimal choice & price changes

Tarquin's optimal consumption

basket varies with the price of
cappuccinos:
• If Px = $4 then x = 25
cappuccinos and y = 400 cookies.
• If Px = $2 then x = 100
cappuccinos and y = 300 cookies.
• If Px = $1 then x = 400
cappuccinos and y = 100 cookies.
(You should check these.)

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Plotting the demand curve

The x coordinate of Tarquin's

optimum is the number of
cappuccinos he demands at the
corresponding price.
The path described by these points
is Tarquin's demand curve.
Notice that Tarquin's income, and
the price of cookies, do not vary
along the demand curve.

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Questions?

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