Ch 4

The Theory of Consumer

Utility
Equilibrium price is determined by the market demand and market supply. Market demand is the Horizontal Summation of individual demands. Q: How to get the consumers demand curve? A: The theory of Utility.

Utility
Three assumptions about Consumer preference: 1.Completeness:
A consumer is always able to rank two baskets
Basket A is preferred to Basket B Basket B is preferred to Basket A Basket A and B are indifferent

2.Transitivity
Consumerpreferred to C is consistent A is preference
A is preferred to B, B is preferred to C

Utility
To represent a consumer preference, we use a number called Utility. Utility is a numerical measure of an individuals happiness / level of satisfaction. It is an arbitrary assigned number to consumption baskets.
Utility assigned by different consumer cannot be compared. The different between two utility is

Utility Function
The utility function shows the relationship between the Total Utility(U) that a person obtains through consumption and the amount of the good being consumed. Assuming there is one good, x, only:
U = f(x) U TUx
Total Utility curve

Utility Function
Properties of Utility function:
U
TUx

1.TU increases with the quantity of x.

More is preferred

2.TU increases at a decreasing rate.

Diminishing Marginal Utility

Marginal Utility
The extra level of satisfaction derived from consuming an extra unit of good x.
TU MUx = x

Diminishing Marginal Utility:

The MUx (extra level of satisfaction) from the 2nd unit is smaller than that from the 1st unit.

Marginal Utility
How many times will you watch a movie?

Marginal Utility
How often will you buy a new cloth?

Marginal Utility
U
14
10 x TU x 1 2 TU

TUx

TU TU > x x
MU > MU Diminishing Marginal Utility

Marginal Utility
Question: Is it possible to have a downwards sloping TU curve?
U TUx

x Bad, less is preferred

Marginal Utility
Question: Is it possible to have a semi-circle shaped TU curve?
U TUx x

Good

Bad

Indifference Curve
Assuming there are two goods, x & y, to be consumed:
U = f(x, y)

Q: Can we draw the above utility function in the following graph?

U NO! We need a 3-D graph! Or, we use the indifference curves to represent it!

Indifference Curve
Indifference curve (IC) connects all the consumption baskets which give the same level of utility to a consumer. Every single point on the IC will be indifferent to the consumer.
Basket A: 10 pieces of $10 note and 10 pieces of $20 note Basket B: 20 pieces of $10 note and 5 piece of $20 note A and B will be indifferent and lie on the same IC

Indifference Curve
y

U3 U2 U1

Properties of IC: 1.Downwards sloping 2.IC cannot intersect 3.Convex to the origin 4.Utility increases as IC moves towards north-east: U3>U2>U1

Properties of IC
1. Downwards sloping
the consumer likes both good x and y x and y are goods to the consumer The consumer is willing to give up some y for one more unit of x.
y Same utility -y +x
U1

Properties of IC
2. IC cannot intersect
According to the assumption of transitivity: A and C are indifferent; B and C are indifferentB are indifferent A and
y
A C

Inconsistent with the assumption

U1 U2

Properties of IC
3. Convex to the origin
Marginal Rate of Substitution (MRS) MRS: the amount of good y that the consumer is willing to give up for one more unit of x, holding the sameAutility level. y MRS y MRS= x A
y
x
B

=Slope of IC (If the two points are =Slope of the tangent line of close) the IC at that point

U1

Properties of IC
3. Convex to the origin
Diminishing Marginal Rate of Substitution (DMRS) The consumer is less willing to give up good y for one y more unit of x, holding the same utility y MRS= level. x A y y x > x y x B C U1 SlopeAB > SlopeBC y
x

MRSAB > MRSBC

Properties of IC
4. Utility increases as IC moves towards north-east: U3>U2>U1
y
As we get same y but more x at B, B gives us higher utility
A B U3 U2 x1 x2

y1

Indifference Map
Question: What should the IC between a good and a bad look like ?
Exam (bad) U2 U3

Leisure (good)

Indifference Map
Question: What should the IC between a bad and a good look like ?
Leisure (good)
U3 U2

Exam (bad)

Indifference Map
Question: What should the IC between two bads look like ?
HW (bad)

U2 U3

Exam (bad)

Indifference Map
y
Good, Bad Bad Highest Utility y1 Bad, Bad

Good Good, Good x1 Bad, Good

Good

Bad

Perfect Substitutes
Question: How to draw a IC for Perfect Substitutes?
$10 note

Linear IC
Constant MRS

U2

U3 $20 note

No matter how many pieces $20 note you have, you are willing to give up two pieces of $10 note for one more

Perfect Complements
Question: How to draw a IC for Perfect Complements?
LHS shoe

L shaped IC

Fix proportion of You will never buy the 2nd unit of RHS if consumption you have 1 unit of U3 LHS only.
U2 RHS shoe

Budget Constraint
The budget constraint shows all the consumption baskets that are affordable. Assumption:
Only two goods: x & y The consumer lives for one period only No lending; No borrowing The consumer has a constant income I.

Pxx + Pyy I

Budget Line
The budget line (BL) shows all the consumption baskets that consumers can buy when spending all of their income. y Pxx + Pyy = I
I Py x Pxx + Pyy = I Pxx + Pyy < I I Px
x

y I Py 0

I Px

Budget Line
y

I Py

-y
+x

Slope of the budget line = relative price of x = no. of y need to be I given up for one unit Py -y Px of x BL= Slope = =
I Px
x

+x

I Px

Py

MRS vs Relative Price

MRS
Slope of the indifference curve
The consumers willing to pay for one more unit of x

Relative Price
Slope of the budget line
The consumers need to pay for one more unit of x

Subjective Can be changed by consumers

Objective Cannot be changed by consumers

MUx = MU y

Px =P y

Changes in Budget Line

Question: How will the BL change when the consumer income increases, from I0 to I1?
y
I1 Py I0 Py

Pxx + Pyy = I0

Pxx + Pyy = I1
Income increases, parallel shift to the right
I0 Px I1 Px

Income decreases, x parallel shift to the left

Changes in Budget Line

Question: How will the BL change when the relative price increases, ie, Px increases but Py y unchanged? Px0x + Pyy = I
I0 Py

Px1x + Pyy = I
Px/Py increases, rotate inwards
I0 Px1 I0 Px0

Px/Py decreases, rotate x outwards

Utility Maximization
IC and BL jointly determine the optimal consumption basket. Optimal basket: the basket allows the consumer getting the highest possible level of utility. The optimal basket must lie on the budget line.
There is no saving in the model.

The procedure of finding this basket is called Utility Maximization. Utility Maximization will not be meaningful if the budget constraint is not defined.

Utility Maximization
y

I Py

Which is the optimal basket, A, B, or C? To answer this question, we compare MRS and Relative Price. Optimal bundle A: MRS > Px/Py B Buy more x, buy less U2 y! C U1 B: MRS = Px/Py x No way to improve! I C: MRS < Px/Py Px Buy less x, buy more y!

Utility Maximization
Implication: With DMRS, we should have interior solution, instead of corner solution. Interior solution: the optimal bundle is not on the two intercepts.
Consumers prefer diversified consumption

Corner solution: the optimal bundle is on either x or y intercept.

Consumers prefer specialized consumption

Change in Budget Line

Question: How income increases, from I0 to I1, affect the consumption choice? Pxx + Pyy = I0
y I1 Py B U2 A U2 U1 C I0 Px I1 Px

Pxx + Pyy = I1 A: more x, more y x and y are normal goods B: less x, more y x is inferior; y is normal U2 C: more x, less y x x is normal; y is inferior

I0 Py

Comparative Static
Question: Is it possible to have both goods to be inferior?
y I1 Py

I0 Py
U1 I0 Px I1 Px

No, at least one to be Normal good.

Comparative Static
Question: How relative price decreases, ie Px decreases but Py unchanged, affect the consumption choice?
y I0 Py
B A U2 U2 C

Px0x + Pyy = I A: same x Px1x + Pyy = I Edx = 0 B: less x x is Giffen good (violate the law of demand). U2 x C: more x the law of demand.

I0 Px0

I0 Px1

Application
There are two goods to be consumed: foods and other goods. Originally, Price of foods = Pf, Price of other goods to Pog. If the restaurant is now offering the choice of Buffet, how will the other goods consumers behavior change?
After paying a lump sum B, Pf = 0 Pf =0 Pog SlopeBL = 0 I Pog I-B Pog U1

MRS > Pf/Pog

U2

U3

As MRS > relative price, the consumer will try to eat as much as possible.

x1

I Pf

foods

Application
To encourage further study, the government is now subsidizing the learners. Do you prefer to have this subsidy in form of i) cash (c) or ii) Cash Increase in income reimbursement (r)? Your choice depends on your
Buy more other goods and have more years of study Reimbursement Free quantities on studying Buy more years of study only

Other goods preference on studying I+c Pog C: cash is better

I Pog A: two are the same

B: two are the same U1

1 2 3

I Ps

I+c Ps

Years of study

Deriving the demand curve

y I Py

A U2 Px Px0 Px1
D x0 x1 x0

I Px0

x1

I Px1

1. Originally, Px = Px0, Qdx = x0 2. Px decreases from Px0 to Px1 3. BL rotates outwards 4. To maximize utility, consumer shifts to basket A. 5. Qdx increases to x1. 6. Connecting the two

Concept Map
Competition Price Competition Market Economy How market work?
P P1 D S

Non-Price Competition
(Order)

Command Economy

Q1

Demand
The theory of consumer (Utility)