Lecture: Consumer Choice

Consumer Choice

Example of Constrained Maximization

Imagine a hill with height shown by contours.
You want to climb as high as possible.

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450

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200

Consumer Choice

Example of Constrained Maximization (Continued)

A path runs up the hill from point A to the summit.
But a fence BC runs across the hill barring access to the public.
This means that you cannot climb higher up the hill than point Z on
the 300 contour line:

100

B
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200

C
Consumer Choice

Example of Constrained Maximization (Continued)

Good 2

Now instead of a physical hill that you climb, imagine a mountain of

pleasure, with pleasure measured in terms of, say, utility.
The top is unreachable, because you have limited income.
This is the basic idea of how we model consumer behavior.
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Good 1
Consumer Choice

Consumer Preferences

We start the analysis by examining consumer preferences.

Consumers choose how to allocate their money to buy a bundle of
dierent goods.
To explain how these choices are made, economists assume that
consumers have a set of tastes.
These tastes may dier among individuals.
Consumer preferences are essentially a ranking of the dierent
bundles of goods.
This ranking is assumed to satisfy certain properties. Some of these
properties must always hold, some can be violated.

Consumer Choice

Graphical Representation of Preferences

To represent preferences graphically, we use indierence curves and
indierence maps.
An indierence curve is the set of all bundles that make a consumer
indierent.
If we plot all indierence curves we get an indierence map.
x2

Increasing
utility

x1
Consumer Choice

Properties of Consumer Preferences

Mandatory Properties

To be able to make consistent predictions about consumer behavior,

all preferences must satisfy the two requirements below.
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 statements is true:
the consumer prefers the rst bundle to the second; or
the consumer prefers the second bundle to the rst; or
the consumer is indierent between the two bundles.

Transitivity. The consumers preferences over bundles must be

consistent. If he weakly prefers bundle x to bundle y and he weakly
prefers bundle y to bundle z, he must also weakly prefer x to z!
If preferences are complete and transitive, they are called rational.

Consumer Choice

Properties of Consumer Preferences

Common Properties

The next properties are intuitive. They simplify the analysis.

More is better. This property is also called monotonicity (a weaker
version is called nonsatiation). All else constant, bundles containing
more of some commodity are preferred to bundles containing less.
In other words, the commodity is a good and not a bad.
This property gives us downward sloping indierence curves.

Consumer Choice

Properties of Consumer Preferences

Common Properties (Continued)

Note: it is possible that some of the commodities are goods, while

others are bads (e.g. pollution x and fertilizer y).
In that case, the indierence curves will be upward-sloping.
y

Increasing
utility

Consumer Choice

Properties of Consumer Preferences

Common Properties (Continued)

It is also possible that we do not care about one of the commodities.

Then indierence curves will be at or vertical.
y
Increasing
utility

x yields no
utility at all!

Consumer Choice

Properties of Consumer Preferences

Common Properties (Continued)

Continuity. Loosely speaking, preferences are continuous if the

following is true:
if a consumer prefers bundle a to bundle b, he must also prefer bundle
c to bundle b if c is su ciently close to a.

Continuity is needed for the representation of preferences with a

utility function.
Example of discontinuous preferences: lexicographic preferences.
Consider 2 goods, x and y, and 2 bundles, ( x1 , y1 ) and ( x2 , y2 ).
Consumers really care about good 1, so ( x1 , y1 ) is preferred to ( x2 , y2 )
whenever x1 > x2 .
If x1 = x2 , consumers prefer the bundle that has more of good y.

With lexicographic preferences, indierence curves are single points.

Consumer Choice

Properties of Consumer Preferences

Common Properties (Continued)

Strict convexity. Preferences are convex when consumers prefer

averages to extremes.
Suppose that a buyer is indierent between bundle A and bundle B.
Then the consumer will prefer a bundle that is a weighted average of A
and B, C = A + (1 ) B, to both A and B.

This property gives us indierence curves that are bowed in:

y
B
C

A
x
Consumer Choice

Properties of Consumer Preferences

Common Properties (Continued)

If convexity is violated, then the preference map may look like this:
y

Increasing
utility

B
C
A

Consumer Choice

Properties of Consumer Preferences

Common Properties (Continued)

Preferences that are weakly convex, but not strictly convex, have
linear indierence curves:
y
C is preferred
equally with A
and B

B
C

Consumer Choice

Implications of These Properties for Indierence Maps

The properties suggest the following features of indierence maps.

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4
5

Bundles on indierence curves farther form the origin are preferred to

those on indierence curves closer to the origin (nonsatiation).
Indierence curves are downward sloping (nonsatiation) and bowed in
(convexity).
There is an indierence curve through every possible bundle
(completeness).
Indierence curves cannot cross (transitivity).
Indierence curves cannot be thick (nonsatiation)

Consumer Choice

Implications for Indierence Maps

Indierence Curves that Cross

The consumer is indierent between A and R and between A and Q.

Transitivity implies he must be indierent between R and Q.
But R has more of both goods than Q, so indierence between R and
Q would violate more is better.
Increasing
utility

A
Q

x
Consumer Choice

Implications for Indierence Maps

Thick Indierence Curves

Suppose the indierence curve is thick, so it contains both a and b.

Then the consumer is indierent between a and b.
But b has more of both goods, so this violates more is better.

Consumer Choice

Utility Functions
The utility function U is the relationship between utility measures and
every possible bundle of goods.
If we know the utility function, we can summarize the indierence
map succinctly.
If the bundle ( x1 , y1 ) is preferred to the bundle ( x2 , y2 ), then
U ( x1 , y1 ) > U ( x2 , y2 ).
p
Consider the utility function U = q1 q2 .
p
The bundle (16, 9) yields utility p16 9 = 12.
The bundle (13, 13) yields utility 13 13 = 13.
So the above utility function suggests that the second bundle is
preferred to the rst.

An indierence curve is implicitly dened by the equation

U ( x, y) = U.

Consumer Choice

Ordinal vs. Cardinal Utility

The ranking of the bundles is an ordinal measure.
The utility function is a cardinal measure: it assigns a specic number
to a bundle.
However, there could be many such assignments of numbers that can
preserve the relative ranking of bundles.
Thus, there can be many utility functions that represent the same
preferences.
In general, if U ( x, y) represents some consumer preferences, so will
any positive monotonic transformation of U ( x, y).
p
Consider our example with U = q1 q2 .
p
The utility function V = a + b q1 q2 , where b > 0, will represent the
same preferences.
So will the utility function W = q1 q2 .

Consumer Choice

Marginal Utility
Marginal utility: the additional utility from an extra unit consumed
(keeping all else constant).
Mathematically,
U ( x, y)
.
x
p
Consider the utility function U = q1 q2 .
q
The marginal utility of good q1 is U/q1 = 21 q1 1/2 q1/2
= 12 qq21
2
MUx =

It is usually assumed that, as we consume more of some good, the

extra utility is positive but decreasing.
This is knows as diminishing marginal utility.
Our example satises this property:

U
q1

1
2

Consumer Choice

q2
q1

is decreasing in q1 .

Willingness to Substitute Between Goods

The slope of the indierence curve at a given point is called the
marginal rate of substitution (MRS).
It is the maximum amount of one good that a consumer will sacrice
to obtain one more unit of another good.

Let us characterize the MRS analytically.

The equation of an indierence curve is U (q1 , q2 ) = U.

Let q2 (q1 ), be the amount of good 2 that, given q1 , delivers utility U:

U (q1 , q2 (q1 )) = U.
Dierentiate with respect to q1 :
MU1 + MU2

dq2
= 0.
dq1

Solving for the slope dq2 /dq1 we get

MRS =

dq2
=
dq1

MU1
.
MU2

Consumer Choice

Willingness to Substitute Between Goods

Graphical interpretation of the marginal rate of substitution.
The MRS at e is the slope of the indierence curve going through it.

Consumer Choice

Examples of Utility Functions

Cobb-Douglas Utility

The Cobb Douglas utility function has the form

U (q1 , q2 ) = q1 q12

It has a convenient expression for MRS:

MRS =

q1 1 q12
MU1
q2
=
=

MU2
(1 ) q1
(1 ) q1 q2

The two goods are imperfect substitutes. The indierence map is:
q2

Increasing
utility

q1
Consumer Choice

Examples of Utility Functions

Linear Utility

The linear utility function has the form

U (C, G ) = iC + jG.
Its MRS is given by
MRS =

MUC
=
MUG

i
j

Goods C, G are perfect substitutes (e.g. coke and pepsi). The

indierence map is

Consumer Choice

Examples of Utility Functions

Leontief Utility

The Leontief utility function is

U ( A, V ) = minfiA, jV g.
At the kink the MRS is not dened.
Goods A, V are perfect complements (e.g. left shoe, right shoe). The
indierence map is

Consumer Choice

Homothetic Utility Functions

For any ray from the origin, MRSC = MRS A = MRSD .
Example of a homothetic utility function: Cobb-Douglas utility.

U4

U3

U2
U1

Consumer Choice