Consumer Choice

NCHNUEC441M Principles of Microeconomics

In this lecture

Chapter 4 Perloff ‘Microeconomics;

Preferences.
Utility.
Budget Constraint.
Constrained Consumer Choice.
Stats

• Of Americans younger than 35, half the women but only a

quarter of the men have tattoos.
Harper’s Index, Harper’s Magazine, August 2014.
 Premises of Consumer Behavior
Microeconomics provides powerful insights into the questions and choices
facing consumers. To answer questions about individual decision making,
we need a model of individual behavior. Our model of consumer behavior
is based on the following premises:

• 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.
Properties of Consumer
Preferences (1 of 3)
• 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.
Properties of Consumer
Preferences (2 of 3)
• 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.
 Properties of Consumer
Preferences (3 of 3)

• 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.

“Having more money doesn’t make you happier. I have 50 million dollars but I’m
just as happy as when I had 48 million.” —Arnold Schwarzenegger.
Less scientific, but perhaps more compelling, is a
2005 survey of wealthy U.S. citizens who were asked,
“How much wealth do you need to live comfortably?”

On average, those with a net worth of over $1 million

said that they needed $2.4 million to live comfortably,
those with at least $5 million in net worth said that
they need $10.4 million, and those with at least $10
million wanted $18.1 million. Apparently, many people
never have enough.
Preference Maps
Surprisingly, with just the completeness, transitivity, and
more-is-better properties, we can tell a lot about a
consumer’s preferences. One of the simplest ways to
summarize information about a consumer’s preferences is
to create a graphical interpretation— a map—of them.
• 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.
Bundles of Pizzas and Burritos Lisa
Might Consume (1 of 2)
Lisa prefers any bundle
(a) in area A over e (b)

B , Burritos per semester

B , Burritos per semester

c A c
25 25

f
20 20
Lisa prefers bundle f
over bundle e, since f 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
Z , Pizzas per semester Z , Pizzas per semester

Lisa prefers bundle e to We can draw an indifferent

any bundle in area B curve over those three points
Bundles of Pizzas and Burritos Lisa
Might Consume (2 of 2)
Properties of Indifference Map
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.
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

– where, ΔZ is the number of pizzas given up to get ΔB, more

burritos, or vice versa, and pizza (Z) is on the horizontal
axis.
– MRS is the slope of the indifference curve.
Marginal Rate of Substitution
Curvature of Indifference Curves (1 of 2)

• Casual observation suggests

that most people’s indifference
curves are convex to the origin.
• Diminishing marginal rate of
substitution: The marginal rate
of substitution approaches zero
as we move down and to the
right along an indifference
curve.
Curvature of Indifference Curves (2 of 2)
• 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.
Application: Indifference Curves
Between Food and Clothing

• At relatively low quantities of

food and clothing, the
indifference curves, such as
I1, are nearly right angles:
perfect complements.
• As we move away from the
origin, the indifference curves
become flatter: closer to
perfect substitutes.

According to these estimates, food and clothing are perfect complements

when the consumer has little of either good and perfect substitutes when the
consumer has large quantities of both goods.
Utility
We can summarize a consumer’s preferences by
assigning a numerical value to each possible bundle to
reflect the consumer’s relative ranking of these bundles.
• Utility - a set of numerical values that reflect the relative
rankings of various bundles of goods.
– The statement that “Bonnie prefers Bundle x to Bundle y” is
equivalent to the statement that “consuming Bundle x gives
Bonnie more utility than consuming Bundle y.” Bonnie prefers x to
y if Bundle x gives Bonnie 10 utils (util is the name given to a unit
of utility) and Bundle y gives her 8 utils.

• Utility function - the relationship between utility values

and every possible bundle of goods: U(Z, B)
U(Z,B) = BZ
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, sports podium).

• A cardinal measure is one by which absolute comparisons

between ranks may be made. Money is a cardinal
measure.
 Utility and Indifference Curves

• Utility is an ordinal measure,

we should not put any weight
on the absolute differences
between the utility associated
with one bundle and another
• An indifference curve
consists of all those bundles
that correspond to a
particular level of utility.
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
MUZ =
Z
 Utility and Marginal Utility
Using Lisa’s utility function for burritos
and pizza, we can show how her utility
changes if she gets to consume more
of one of the goods. We now suppose
that Lisa has the utility function in
panel (a). The curve shows how Lisa’s
utility rises as she consumes more
pizzas, while we hold her consumption
of burritos fixed at 10. Because pizza
is a good, Lisa’s utility rises as she
consumes more pizza.
If her consumption of pizzas increases
from Z = 4 to 5, ΔZ = 5 - 4 = 1, her
utility increases from U = 230 to 250,
ΔU = 250 - 230 = 20. The extra utility
(ΔU) that she gets from consuming the
last unit of a good (ΔZ = 1) is the
marginal utility from that good.
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 MUZ
MRS = =−
Z MUB
Budget Constraint (1 of 3)
• 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.
Budget Constraint (2 of 3)
• If Lisa spends all her budget, Y, on pizza and burritos,
then
pB B + pZ Z = Y
– where pB B is the amount she spends on burritos and
pZ Z 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.
Budget Constraint (3 of 3)
• How many burritos can Lisa buy?
– To solve budget constraint for B (quantity of burritos):
PB B + PZ Z = Y
PB B = Y − PZ Z
Y PZ
B= − Z
PB PB

Lisa can buy more burritos with a higher income, a

lower price of burritos or pizza, or if she buys fewer
pizzas.
Allocations of a $50 Budget Between
Burritos and Pizza
Allocations of a $50 Budget Between Burritos and Pizza

Y PZ
B= − Z
PB PB

If pZ = $1, pB = $2, and Y = $50, then:

Bundle Burritos, B Pizza, Z

a 25 0
b 20 10
c 10 30
d 0 50
Budget Constraint
Slope of the Budget Constraint
• We have seen that the budget constraint for Lisa is
given by the following equation:

– The slope of the budget line is also called the marginal

rate of transformation (MRT).
Changes in the Budget Constraint:
Price of Pizza Doubles
Changes in the Budget Constraint:
Income Doubles
Solved Problem
Is Lisa better off if her income doubles or if the prices of
both the goods she buys fall by half?
Answer: Her budget line and her opportunity set are
the same with either change.
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.
Consumer Maximization, Interior
Solution (1 of 2)
Consumer Maximization, Interior
Solution (2 of 2)