GHANA INSTITUTE OF

MANAGEMENT AND
PUBLIC ADMINISTRATION

GRADUATE PROGRAMME
[MICROECONOMICS ANALYSIS-ECO407A]
•
Dr Rebecca Nana Yaa Ayifah
Microeconomics
Theory 1
Choice, Preference and Utility
 Introduction
• When most people think about microeconomics, they
think first about the slogan supply equals demand
and its picture, shown here in Figure 1, with a rising
supply function intersecting a falling demand function,
determining an equilibrium price and quantity.

price

s upply

equilibrium
pric e

d em and

qu antity
equilibrium
qu antity
 Introduction Cont.
• These functions arise from choices, choices by firms and by
individual consumers.

• Hence, microeconomic theory begins with choices. Indeed, the

theory not only begins with choices; it remains focused on them
for a very long time.

• Most of this lecture is concerned with modeling the choices of

consumers, with some attention paid to the choices of profit-
maximizing firms; choices under uncertainty given the risky
behaviour of consumers and toward the end do we will examine
inter-temporary consumption since individuals live for more than
one period.
 Some Logic Notation
Some logic notation
A ∨ B means A is true or B is true (possibly both are true).
A ∧ B means A and B are both true.
¬A means A is not true.
A ⇒ B means A implies B.
A ⇔ B means A implies B and B implies A.
∃x∈X means there exists an element x in the set X
∀x∈X means for every element x in the set X.
 Building Blocks of
Consumer Choice
Any model of consumer choice has four building blocks
•Consumption Set, feasible set, preference relation and
behavioural assumption
•Consumption Set
– A consumption set X represents the set of all alternatives or
complete consumption plans that the consumer can conceive or
imagine whether achievable or not. This is also called Choice Set
– Thus, consumption set contains consumption bundles or baskets
•Consumption bundle or plan is a complete list of the goods and
services that the consumer must choose from.
•These goods and services are assumed to be of non-negative
units. That is it is possible to have no unit of any particular good or
commodity
 Building Blocks of
Consumer Choice Cont.
• Feasible sets
– These are those alternative consumption bundles or plans that are
both conceivable and realistically obtainable given the consumer’s
circumstances (achievable given the consumer’s economic
realities)
• Preference relation
– It gives information about the consumer’s tastes for the different
objects of choice. This specifies the limits on the consumer’s ability
to perceive in situations involving choice the form of consistency or
inconsistency in the consumer’s choices.
• Behavioural Assumption
– This expresses the guiding principle the consumer uses to make
final choices and so identifies the ultimate objectives in choice
Preference Relation
Preference Relation Cont.
Axioms of Consumer
Choice
Axioms of Consumer
Choice Cont.
Axioms of Consumer
Choice Cont.
Axioms of Consumer
Choice Cont.
 Axioms of Revealed
Preference Cont.
Convexity: “Diversity is good”
Convex preferences are an individual's ordering of various
outcomes, typically with regard to the amounts of various goods
consumed, with the property that, "averages are better than the
extremes“

•This means that any linear combination of points will be in the

interior of the set

•For any two distinct bundles that are each viewed as being at least
as good as a third bundle, a weighted average of the two bundles
(including a positive amount of each bundle) is viewed as being
strictly better than the third bundle
Axioms of Consumer Choice
Cont.
Smoothness or Differentiation of the
Utility function
•This states that the Marginal Rate of Substitution
(MRS) between any two goods is uniquely defined

•MRS measures at any point the rate at which the

consumer is just willing to give up good two for a unit of
good one received. That is the consumer is indifferent
after the exchange.
Implications of Some of the
Axioms Cont.
Transitivity: This implies that indifference curves do not cross or
intersect
 Implications of Some of the
Axioms Cont.
Convexity: The slope of the of the indifference curve (IC) increases
as we move down the IC while the MRS decreases
Implications of Some of the
Axioms Cont.
 Indifference Curve
• Indifference curve.
– An indifference curve shows a set of consumption
bundles about which the individual is indifferent. That is,
set of consumption bundles that provide the same level
of utility.
• The slope of the indifference curve is negative, showing
that if the individual is forced to give up some Y, he or she
must be compensated by an additional amount of X to
remain indifferent between the two bundles of goods.
• The slope of the indifference curve is the negative of the
marginal rate of substitution (MRS)
Indifference Curve Cont.
Indifference Curve Cont
Utility Function
 Utility Function:
Measurement of Utility
• Cardinal Approach says consumer could
measure the satisfaction derived from the
consumption of goods or services in terms of a
number. The unit of that measurement is ”Utils”
or ”the money”.
• Ordinal Approach holds that Utility is a
psychological feeling and therefore can not be
quantified. The ordinal hypothesis implies that
the consumer is capable of simply comparing
the different levels of satisfaction.
• Ordinal Utility means ranking the utilities
derived from the consumption of goods and
services.
Utility Function: Cobb-
Douglas
Utility Function: Perfect
Substitute
Utility Function: Perfect
Complement
Utility Function Constant
Elasticity of Substitution
(CES)
Utility Function CES Cont.
Budget Constraint
 Budget Constraint Cont.
• Budget Line and Budget Set
• Line A-B below represents the budget
line whilst the shaded portion of the
budget line is the budget set.
Slope of Budget Line
 The Budget Constraint
• Assume that an individual has I dollars
to allocate between good x and good y
px x + p y y  I
Quantity of y The individual can afford
If all income is spent
I on y, this is the amount to choose only combinations
of y that can be purchased of x and y in the shaded
py
triangle

If all income is spent

on x, this is the amount
of x that can be purchased

Quantity of x
I 32
px
Utility Maximization
Utility Maximization Cont.
Utility Maximization Cont.
 First-Order Conditions for a
Maximum
• We can add the individual’s utility map
to show the utility-maximization process
Quantity of y The individual can do better than point A
by reallocating his budget
A
C The individual cannot have point C
B because income is not large enough
U3
Point B is the point of utility
U2
maximization
U1

Quantity of x
36
 First-Order Conditions for a
Maximum
• Utility is maximized where the indifference curve is
tangent to the budget constraint

Quantity of y px
slope of budget constraint 
py

dy
slope of indifferen ce curve 
B dx U constant

px dy
U2 - MRS
py dx U constant

Quantity of x
37
Second-Order Conditions for a
Maximum
• The tangency rule is only necessary but
not sufficient unless we assume that MRS
is diminishing
– if MRS is diminishing, then indifference curves
are strictly convex
• If MRS is not diminishing, then we must
check second-order conditions to ensure
that we are at a maximum
38
 Second-Order Conditions for a
Maximum
• The tangency rule is only a necessary
condition
– we need MRS to be diminishing
Quantity of y
There is a tangency at point A,
but the individual can reach a higher
level of utility at point B
B

A
U2
U1

Quantity of x 39
 Corner Solutions
• In some situations, individuals’ preferences
may be such that they can maximize utility by
choosing to consume only one of the goods

At point A, the indifference curve

Quantity of y U1 U2 U3 is not tangent to the budget constraint

Utility is maximized at point A

Quantity of x
A 40
 Exapmle:Cobb-Douglas
Demand Functions
• Cobb-Douglas utility function:
U(x,y) = xy
• Setting up the Lagrangian:
L = xy + (I - pxx - pyy)
• First-order conditions:
L/x = x-1y - px = 0 (1)
L/y = xy-1 - py = 0 (2)
L/ = I - pxx - pyy = 0 (3) 41
 Cobb-Douglas Demand
Functions
• First-order conditions imply:
y/x = px/py
y = xpx/  py (

• Since  +  = 1:
pyy = (/)pxx = [(1- )/]pxx

• Substituting into the budget constraint:

I = pxx + [(1- )/]pxx = (1/)pxx 42
 Cobb-Douglas Demand
Functions
• Solving for x yields
I
x* 
px
• Solving for y yields
I
y* 
py
• The individual will allocate  percent of his income to
good x and  percent of his income to good y
• The X and the Y are the Marshallian or
Uncompensated Demand Functions 43
Exercise

44
Answer

45
Properties of Marshallian
Demand Function

46
Properties of Marshallian
Demand Function Cont.

47
 Indirect Utility Function
• We can use the optimal values of the xs to find the
indirect utility function
• When we substitute the Marshallian demand
functions into the direct utility function we get Indirect
Utility Function
maximum utility = U(x*1,x*2,…,x*n)
• Substituting for each x*i, we get
maximum utility = V(p1,p2,…,pn,M)
• The optimal level of utility will depend indirectly on
prices and income

48
Indirect Utility Function

49
Properties of Indirect Utility
Function

50
Exercise 2

51
Answer

52
 Expenditure Minimization
• Dual minimization problem for utility
maximization
– allocating income in such a way as to achieve
a given level of utility with the minimal
expenditure
– this means that the goal and the constraint
have been reversed

53
 Expenditure Minimization
• Point A is the solution to the dual problem

Expenditure level E2 provides just enough to reach U1

Quantity of y

Expenditure level E3 will allow the

individual to reach U1 but is not the
minimal expenditure required to do so
A
Expenditure level E1 is too small to achieve U1
U1
Quantity of x
54
Expenditure Minimization
Expenditure Minimization
 Expenditure Function
• The expenditure function shows the
minimal expenditures necessary to
achieve a given utility level for a particular
set of prices
minimal expenditures = E(p1,p2,…,pn,U)
• The expenditure function and the indirect
utility function are inversely related
– both depend on market prices but involve
different constraints
57
 Two Expenditure Functions
• The indirect utility function in the two-good,
Cobb-Douglas case is
I
V ( p x , py , I ) 
2 px0.5 py0.5
• If we interchange the role of utility and
income (expenditure), we will have the
expenditure function
E(px,py,U) = 2px0.5py0.5U
58
 Two Expenditure Functions
• For the fixed-proportions case, the indirect
utility function is
I
V ( p x , py , I ) 
px  0.25 py
• If we again switch the role of utility and
expenditures, we will have the
expenditure function
E(px,py,U) = (px + 0.25py)U
59
 Important Points to Note:
• To reach a constrained maximum, an
individual should:
– spend all available income
– choose a commodity bundle such that the
MRS between any two goods is equal to
the ratio of the goods’ prices
• the individual will equate the ratios of the
marginal utility to price for every good that is
actually consumed

60
 Important Points to Note:
• Tangency conditions are only first-
order conditions
– the individual’s indifference map must
exhibit diminishing MRS
– the utility function must be strictly quasi-
concave

61
 Important Points to Note:
• Tangency conditions must also be
modified to allow for corner solutions
– the ratio of marginal utility to price will be
below the common marginal benefit-
marginal cost ratio for goods actually
bought

62
 Important Points to Note:
• The individual’s optimal choices
implicitly depend on the parameters of
his budget constraint
– choices observed will be implicit functions
of prices and income
– utility will also be an indirect function of
prices and income

63
 Important Points to Note:
• The dual problem to the constrained
utility-maximization problem is to
minimize the expenditure required to
reach a given utility target
– yields the same optimal solution as the
primary problem
– leads to expenditure functions in which
spending is a function of the utility target
and prices
64