LECTURE 3: 4

Consumer Choice
 Topics

1. Preferences.
2. Utility.
3. Budget Constraint.
4. Constrained Consumer Choice.
5. Behavioral Economics.

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 Premises of Consumer Behaviour

• Individual tastes or preferences determine

the amount of pleasure people derive from
the goods and services they consume.

• Consumers face constraints or limits on their

choices.

• Consumers maximize their well-being or

pleasure from consumption, subject to the
constraints they face.

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 Three Assumptions about the
Properties of Consumer Preferences

• Completeness - when facing a choice

between any two bundles of goods, a
consumer can rank them so that one and
only one of the following relationships is
true:
– The consumer prefers the first bundle to the
second,

– prefers the second to the first,

–
– or is indifferent between them.

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 Three Assumptions about the Properties of
Consumer Preferences (cont.)

• Transitivity - a consumer’s preferences over

bundles is consistent in the sense that:

– if the consumer weakly prefers Bundle a to Bundle b (likes

a at least as much as b)

– and weakly prefers Bundle b to Bundle c,

– the consumer also weakly prefers Bundle a to Bundle c.

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 Three Assumptions about the Properties of
Consumer Preferences (cont.)

• More Is Better - all else being the same,

more of a commodity is better than less of
it.
– Good - a commodity for which more is preferred
to less, at least at some levels of consumption.

– Bad - something for which less is preferred to

more, such as pollution.

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 Preference Maps

• Indifference curve - the set of all bundles

of goods that a consumer views as being
equally desirable.

• Indifference map - a complete set of

indifference curves that summarize a
consumer’s tastes or preferences.

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 Figure 4.1 Bundles of Pizzas and
Burritos Lisa Might Consume

(a) (b)
Lisa prefers any bundle
Which of these in area A over e

itos per semester

itos per semester

two bundles would

c A c
25 be preferred by 25
Lisa?
f
20 20
Lisa prefers bundle fe
over bundle e,
d, since fe

B, Burr
B, Burr

e
15 15
e has more of both
a a
d goods: Pizza and
10 b 10 b I1
Burritos
5
B
15 25 30 15 25 30
, ZPizzas per semester , ZPizzas per semester

Lisa
If Lisa
prefers
is indifferent
bundle ebetween
to we can draw an indifferent
any
bundles
bundle
e, a,inand
areac B
….. curve over those three points

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 Figure 4.1 Bundles of Pizzas and
Burritos Lisa Might Consume

(a) (c)
itos per semester

itos per semester

c A c
25 25

f f
20 20

e I2
15 15
e
B, Burr

B, Burr
a a
d d
10 b 10 I1

5
B I0

15 25 30 15 25 30
, ZPizzas per semester , ZPizzas per semester

we can draw an indifferent

curve over those three points

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 Properties of Indifference Maps

1. Bundles on indifference curves farther from

the origin are preferred to those on
indifference curves closer to the origin.
2. An indifference curve goes through every
possible bundle.
3. Indifference curves cannot cross.
4. Indifference curves slope downward.

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 Willingness to Substitute Between
Goods

• Marginal rate of substitution (MRS) -

the maximum amount of one good a
consumer will sacrifice to obtain one more
unit of another good.
• Lisa’s marginal rate of substitution of
burritos for pizza is

B
MRS 
Z
– MRS is the slope of the indifference curve.

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 Figure 4.3(a) Marginal Rate of
Substitution

Indifference Curve Convex to the Origin

r per semester

a From bundle a to bundle b, Lisa is

8 willing to give up 3 Burritos in exchange
for 1 more Pizza…
–3
itos

From bundle b to bundle c, Lisa is willing to give up 2

B, Bur

b
5
1 Burritos in exchange for 1 more Pizza…
-2
c From bundle c to bundle d, Lisa is willing to give up 1
3
1
-1 d Burrito in exchange for 1 more Pizza…
2
1
I

0 3 4 5 6
, ZPizzas per semester

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 Figure 4.3(a) Marginal Rate of
Substitution (contd.)

• The MRS from bundle

r per semester

a to bundle b is -3.
– This is the same as the
a
8 slope of the
indifference curve
–3 between those two
itos

points.
B, Bur

b
5
1
-2 • From b to c,
c
3
1
– MRS = -2.
-1 d – This is the same as the
2
1 slope of the
I
indifference curve
0 3 4 5 6 between those two
, ZPizzas per semester points.

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 Curvature of Indifference Curves

• Casual observation suggests that most

people’s indifference curves are convex to
the origin.
• Special Cases:
– Perfect substitutes - goods that a consumer is
completely indifferent as to which to consume.
– Perfect complements - goods that a consumer
is interested in consuming only in fixed
proportions.

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Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
 Application: Indifference Curves
Between Food and Clothing

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 Utility

• Utility - a set of numerical values that

reflect the relative rankings of various
bundles of goods.

• Utility function - the relationship between

utility measures and every possible bundle
of goods:
U(Z, B)

U ( Z , B)  BZ

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 Ordinal Preferences

• If we only know a consumer’s relative

ranking of bundles, the measure of pleasure
is ordinal.
– Tells us the relative ranking of two things but not
how much more one rank is than another (letter
grades).
• A cardinal measure is one by which absolute
comparisons between ranks may be made
(money).

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 Utility and Indifference Curves

• An indifference curve consists of all those

bundles that correspond to a particular level
of utility.
• If Lisa’s utility function is U(Z, B), then an
indifference curve is given by

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 Marginal Utility

• Marginal utility - the extra utility that a

consumer gets from consuming the last
unit of a good.
– the slope of the utility function as we hold the
quantity of the other good constant.

• Marginal utility of good Z is:

U
MU Z 
Z
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 (a) Utility

U, Utils
350 Utility function,
U (10,Z)

250 DU = 20
230 U
MU Z 
Figure 4.6 Utility and DZ = 1 Z

Marginal Utility
• As Lisa consumes more
pizza, holding her
consumption of burritos 0 1 2 3 4 5 6 7 8 9 10
constant at 10, her total , ZPizzas per semester
(b) Marginal Utility
utility, U, increases…

utility of pizza
– and her marginal utility of 130
pizza, MUZ, decreases
(though it remains
positive).
, Marginal

• Marginal utility is the

Z

slope of the utility function

MU

as we hold the quantity of Marginal utility of pizza, MUz

20
the other good constant.
0 1 2 3 4 5 6 7 8 9 10
, ZPizzas per semester

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 Utility and Marginal Rates of
Substitution
• The MRS is the negative of the ratio of the
marginal utility of another pizza to the
marginal utility of another burrito.
• Formally,

B MU Z
MRS  
Z MU B

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 Budget Constraint

• Budget line (or budget constraint) - the

bundles of goods that can be bought if the
entire budget is spent on those goods at
given prices.
• Opportunity set - all the bundles a
consumer can buy, including all the bundles
inside the budget constraint and on the
budget constraint.

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 Budget Constraint (cont.)

• If Lisa spends all her budget, Y, on pizza

and burritos, then
pBB + pZZ = Y

– where pBB is the amount she spends on burritos

and pZZ is the amount she spends on pizzas.

• This equation is her budget constraint.

– It shows that her expenditures on burritos and
pizza use up her entire budget.

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 Budget Constraint (cont.)

• How many burritos can Lisa buy?

– To answer solve budget constraint for B
(quantity of burritos):

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 Budget Constraint (cont.)

• From previous slide we have:

– Lisa can buy more burritos with a higher

income, a lower price of burritos or pizza, or
if she buys fewer pizzas.
– If pZ = $1, pB = $2, and Y = $50, then:

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 Table 4.1 Allocations of a $50 Budget
Between Burritos and Pizza

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 Figure 4.7 Budget Constraint

Amount of Burritos  From previous slide we

consumed if all income have that if:
r per semester

is allocated for Burritos. pZ = $1, pB = $2, and Y =

a $50, then the budget
25 = Y/pB
constraint, L1, is:
b
20 $50  ($1 Z )
B  25  0.5Z
L1
itos

$2
B, Bur

c Amount of Pizza
10 consumed if all income
Opportunity set is allocated for Pizza.

d
0 10 30 50 = Y/pZ
, ZPizzas per semester

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 Slope of the Budget Constraint

• We have seen that the budget constraint for Lisa

is given by the following equation:

Slope = D B/D Z = MRT

– The slope of the budget line is also called the
marginal rate of transformation (MRT).

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 Solved Problem 4.2

• A government rations water, setting a quota

on how much a consumer can purchase. If a
consumer can afford to buy 12 thousand
gallons a month but the government
restricts purchases to no more than 10
thousand gallons a month, how does the
consumer’s opportunity set change?

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 Solved Problem 4.2: Answer

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 Figure 4.8(a) Changes in the Budget
Constraint: Price of Pizza Doubles

Y - PZ = $1
$2
r per semester

Slope = -$1/$2 = -0.5

B= PB Z
PB
25 If the price of pizza
doubles, (increases
L1 (p Z = $1) from $1 to $2) the
itos

slope of the budget line

B, Bur

increases

Loss
L2 (pZ = $2) This area represents
the bundles she can no
longer afford
0 25 50
, ZPizzas per semester
Slope = -$2/$2 = -1

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 Figure 4.8(b) Changes in the Budget
Constraint: Income Doubles

PZ
B = $100
$50 - Z
PB PB
B, Burritos per semester

If Lisa’s income
50 increases by $50 the
L3 (Y =$100)
budget line shifts to the
right (with the same
slope!)
25
This area represents the
Gain
new consumption
L1 (Y = $50) bundles she can now
afford!!!
0 50 100
, ZPizzas per semester

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 Solved Problem 4.3

• Is Lisa better off if her income doubles or if the

prices of both the goods she buys fall by half?

• Her budget line and her opportunity set are the

same with either change.

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 Constrained Consumer Choice

• Given information on Lisa’s preferences and

how much she can spend, we can determine
her optimal bundle.
• Her optimal bundle is the bundle out of all
the bundles that she can afford that gives
her the most pleasure.

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 Figure 4.9 Consumer
Maximization, Interior Solution
•Bundle
Would
 Would e Lisa
Lisa isbe be able
called
able to
atoconsumer’s
consume
r per semester

anyconsume
optimum.
bundle along any Ibundle
1
? along
IYes;
3
If(i.e.
shebundle
Lisa could f)? bundles
afford
is consuming this d,
c,– and
No! a.Lisa does not have
bundle, she has no incentive
 Nevertheless, there areto other
itos

enough income afford any

to change her behavior by
B, Bur

25 affordable bundles
bundle along I 3that should be

20
c f substituting
preferred one good for
and affordable.
 For instance bundle e
another.
B e
10
I3
d I2
A a
I1
0 10 30 50
, ZPizzas per semester

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 Figure 4.9 Consumer Maximization,
Interior Solution (cont.)

 The budget constraint and the indifference

r per semester

curve have the same slope at point e where

they touch. Therefore, at point e:

MU Z PZ
MRS     MRT
itos

MU B PB
B, Bur

25

Slope of I2
e Slope of BL

I2

0 50
, ZPizzas per semester

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 Behavioral Economics

• By adding insights from psychology and

empirical research on human cognition and
emotional biases to the rational economic
model, economists try to better predict
economic decision making.

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