ETP Econ Lecture Chapter 14

Chapter Four
Consumer
Choice
Consumer Choice
In this chapter, we examine four main
topics.
Preferences
Utility
Budget constraint
Constrained consumer choice
2007 Pearson Addison-Wesley. All rights reserved.
42
Preferences
To explain consumer behavior,
economists assume that consumers
have a set of tastes or preferences that
they use to guide them in choosing
between goods. These tastes differ
substantially among individuals.
43
Properties of Consumer
Preferences
Economists make three critical
assumptions about the properties of
consumers preferences. For brevity,
these properties are referred to as
completeness, transitivity, and more is
better.
44
Completeness
The completeness property holds that,
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.
45
Transitivity
The transitivity (or what some people refer to
as rationality) property is that a consumers
preferences over bundles is consistent in the
sense that, if the consumer weakly prefers
Bundle z to Bundle y (like z at least as
much as y ) and weakly prefers Bundle y to
Bundle x , the consumer also weakly prefers
Bundle z to Bundle x .
46
More is Better
The more-is-better property holds that,
all else the same, more of a commodity
is better than less of it (always wanting
more is known as nonsatiation).
47
Properties of Consumer
Preferences
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
48
Preference Maps
One of the simplest ways to summarize
information about a consumers
preferences is to create a graphical
interpretationa mapof them.
49
Preference Maps
indifference curve
the set of all bundles of goods that a
consumer views as being equally desirable
indifference map (or preference map)

a complete set of indifference curves that
summarize a consumers tastes or
preferences
410
Indifference Curves
All indifference curve maps must have
four important properties:
Bundles on indifference curves farther from
the origin are preferred to those on
indifference curves closer to the origin.
There is an indifference curve through
every possible bundle.
Indifference curve cannot cross.
Indifference curves slope downward.
411
Figure 4.1 Bundles of Pizzas and

Burritos Lisa Might Consume
(a)
(b)
A
25
20
15
10
c
f
20
e
15
e
d
25
a
b
10
a
b
I1
5
B
15
25 30
Z, Pizzas per semester
15
25 30
412
Figure 4.1 Bundles of Pizzas and

Burritos Lisa Might Consume (contd)
(c)
25
c
f
20
15
10
I2
e
d
I1
I0
15
25
30
413
Figure 4.2
Impossible Indifference Curves
(a) Crossing
(b) Upward Sloping
b
a
I1
I0
414
Figure 4.2 Impossible Indifference

Curves (contd)
(c) Thick
b
a
415
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
416
Willingness to Substitute Between

Goods
The marginal rate of substitution of burritos
for pizza is
B
MRS
Z
where Z is the number of pizzas Lisa will

give up to get B more burritos or vice versa
and pizza (Z) is on the horizontal axis. The
marginal rate of substitution is the slope of
the indifference curve.
417
Curvature of Indifference Curves

An indifference curve doesnt have to
be convex, but casual observation
suggests that most peoples
indifference curves are convex. When
people have a lot of one good, they are
willing to give up a relatively large
amount of it to get a good of which they
have relatively little. However, after that
first trade, they are willing to give up
less of the first good to get the same
amount more of the second good.
418

This willingness to trade fewer burritos
for one more pizza as we move down
and to the right along the indifference
curve reflects a diminishing marginal
rate of substitution: The marginal rate of
substitution approaches zero as we
move down and to the right along an
indifference curve.
419
Figure 4.3 Marginal Rate of

Substitution
(a) Indifference Curve Convex to the Origin
3
2
3
5
(b) Indifference Curve Concave to the Origin
b
1
2
d
1
1
3
c
1
1
3 4 5 6
c
1
3 4 5 6
420

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
421
Figure 4.4 Perfect Substitutes, Perfect

Complements, Imperfect Substitutes
(a) Perfect Substitutes
(b) Perfect Complements
4
3
1
I1
I2
I3
d
a
I3
I2
I1
I4
1
2
3
4
Pepsi, Cans per week
2
3
Pie, Slices per week
422
Figure 4.4 Perfect Substitutes, Perfect

Complements, Imperfect Substitutes
(contd)
(c) Imperfect Substitutes
I
423
Application (Page 83) Indifference

Curves Between Food and Clothing
I4
I3
I2
I1
Clothing per year
424
Utility
Utility
a set of numerical values that reflect the
relative rankings of various bundles of
goods
Utility Function
the relationship between utility values and
every possible bundle of goods
425
Ordinal Preferences
If we know only consumers relative
rankings of bundles, our measure of
pleasure is ordinal rather than cardinal. An
ordinal measure is one that tells us the
relative ranking of two things but not how
much more one rank is than another.
Because utility is an ordinal measure, we
should not put any weight on the absolute
differences between the utility associated
with one bundle and another. We care only
about the relative utility or ranking of the
two bundles.
426
Utility and Marginal Utility

Marginal Utility
the extra utility that a consumer gets from
consuming the last unit of a good
Thus marginal utility is the slope of the

utility function
U
MU Z
Z
427
Figure 4.5
Utility and
Marginal Utility
(a) Utility
350
Utility function, U (10, Z )
250
230
Z =1
U = 20
(b) Marginal Utility
7
8
9
10
130
20
0
MUZ
1
7
8
9
10
428
Utility and Marginal Rates of

Substitution
The marginal rate of substitution (MRS)
is the slope of the indifference curve.
The marginal rate of substitution can
also be expressed in terms of marginal
utilities.
The marginal rate of substitution can be
written as
(4.1)
B
MU Z
MRS
Z
MU B
429
Budget Constraint
Consumers maximize their well-being
subject to constraints. The most
important constraint most of us face in
deciding what to consume is our
personal budget constraint.
For simplicity, we assume that each
consumer has a fixed amount of money
to spend now, so we can use the terms
budget and income interchangeably.
430
Budget Constraint
If Lisa spends all her budget, Y, on pizza and
burritos, then
p B B pZ Z Y
(4.2)
where pB B is the amount she spends on

burritos and pZ Z is the amount she spends
on pizzas.
431
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
432
Slope of the Budget Constraint

Marginal Rate of Transformation (MRT)
the trade-off the market imposes on the
consumer in terms of the amount of one
good the consumer must give up to obtain
more of the other good
The marginal rate of transformation is

the rate at which Lisa can trade burritos
for pizza in the marketplace:
pZ
B
MRT
Z
pB
(4.5)
433
Table 4.1 Allocations of a $50

Budget Between Burritos and Pizza
434
Figure 4.6 Budget Constraint
25 = Y/p B
20
10
a
b
L1 (p Z = $1, Y = $50)
c
Opportunity set
d
10
30
50 = Y/p Z
435
Effect of A Change in Price on

Consumption
If the price of pizza doubles but the
price of burritos is unchanged, the
budget constraint swings in toward the
origin in panel a of Figure 4.7.
436
Figure 4.7 Changes in the

Budget Constraint
(a) Price of Pizza Doubles
(b) Income Doubles
50
25
L3 ( Y = $100)
L1 (p Z = $1)
25
Loss
Gain
L1 (Y = $50)
L 2 (p Z = $2)
0
25
50
50
100
437
Effect of a Change in Income on

Consumption
If the consumers income increases, the
consumer can buy more of all goods.
The budget constraint shifts outward
away from the originand is parallel to
the origin constraint in panel b of Figure
4.7.
A change in income affects only the
position and not the slope of the budget
line. The slope is determined solely by
the relative prices of pizza and burritos.
438
Page 91 Solved Problem 4.2

Quota
Budget line
A
0
B
10
12
Water, Thousand gallons per month
439
The Consumers Optimal Bundle

The optimal bundle must be on the budget
constraint. Bundles that lie on indifference
curves above the constraint, such as those
on I3, are not in the opportunity set.
For any bundle inside the constraint (such
as d on I1), there is another bundle on the
constraint with more of at least one of the
two goods, and hence she prefers that
bundle. Therefore, the optimal bundle
must lie on the budget constraint.
440
The Consumers Optimal Bundle

Bundles that lie on indifference curves that cross
the budget constraint (such as I1, which crosses
the constraint at
and )aare lessc desirable
than certain other bundles on the constraint.
Thus the optimal bundle must lie on the budget
constraint and be on an indifference curve that
does not cross it. Such a bundle is the
consumers optimum.
The optimal bundle must lie on an indifference
curve that touches the budget constraint but
does not cross it.
441
Figure 4.8
Consumer
Maximization
(a) Interior Solution

Budget line
g
25
20
10
A
0
10
30
(b) Corner Solution
25
I3
I2
I1
50
I3
I2
Budget line
I1
50
442
Interior Solution
For the indifference curve I2 to touch the
budget constraint but not cross it, it must be
tangent to the budget constraint: The budget
constraint and the indifference curve have the
same slope at the point e where they touch.
MU Z
pZ
MRS
MRT
MU B
pB
Rearranging terms, this condition is

equivalent to
MU Z MU B
pZ
pB
(4.6)
443

Corner Solution
1
eN
l
LB
LN
eB
1
SUVs per decade
444
Figure 4.9 Optimal Bundles on Convex

Sections of Indifference Curves
(a) Strictly Concave Indifference Curves
(b) Concave and Convex Indifference Curves
e
Budget
line
Budget
line
d
e
I1
I2
I3
I2
I1
445
Buying Where More is Better

If both goods are consumed in positive
quantities and their prices are positive, more
of either good must be preferred to less.
In summary, we do not observe consumer
optima at bundles where indifference curves
are concave or consumers are satiated.
Thus we can safely assume that indifference
curves are convex and that consumers
prefer more to less in the ranges of goods
that we actually observe.
446

LF
LA
a
I1
I2
American meals per year

447
Food Stamps
Cash preferred to food stamps
Poor people who receive cash have more
choices than those who receive a
comparable amount of food stamps.
448
Figure 4.10 Food Stamps

Versus Cash
Budget line with cash
Y + 100
f
C
I3
I2
I1
B
A
Original
budget line
100
Budget line with

food stamps
Y + 100
Food per month
449

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Chapter Four

2007 Pearson Addison-Wesley. All rights reserved.

2007 Pearson Addison-Wesley. All rights reserved.

2007 Pearson Addison-Wesley. All rights reserved.

2007 Pearson Addison-Wesley. All rights reserved.

2007 Pearson Addison-Wesley. All rights reserved.

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indifference map (or preference map)

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Figure 4.1 Bundles of Pizzas and

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Figure 4.1 Bundles of Pizzas and

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(b) Upward Sloping

Z, Pizzas per semester

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Z, Pizzas per semester

Figure 4.2 Impossible Indifference

Z, Pizzas per semester

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Willingness to Substitute Between

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Willingness to Substitute Between

where Z is the number of pizzas Lisa will

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Curvature of Indifference Curves

Curvature of Indifference Curves

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Figure 4.3 Marginal Rate of

(b) Indifference Curve Concave to the Origin

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Curvature of Indifference Curves

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Figure 4.4 Perfect Substitutes, Perfect

(b) Perfect Complements

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Figure 4.4 Perfect Substitutes, Perfect

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Application (Page 83) Indifference

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Utility and Marginal Utility

Thus marginal utility is the slope of the

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Utility function, U (10, Z )

(b) Marginal Utility

Utility and Marginal Rates of

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where pB B is the amount she spends on

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2007 Pearson Addison-Wesley. All rights reserved.

Slope of the Budget Constraint

The marginal rate of transformation is

Table 4.1 Allocations of a $50

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Figure 4.6 Budget Constraint

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Effect of A Change in Price on

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Figure 4.7 Changes in the

(b) Income Doubles

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