Chapter 4

Consumer Choice

Copyright (c)2014 John Wiley & Sons, Inc. 1

 Chapter Four Overview

1.
1. The
The Budget
Budget Constraint
Constraint

2.
2. Consumer
Consumer Choice
Choice

3.
3. Duality
Duality

4.
4. Some
Some Applications
Applications

5.
5. Revealed
Revealed Preference
Preference

Copyright (c)2014 John Wiley & Sons, Inc. 2

Chapter Four
 Key Definitions
Budget Set:
The set of baskets that are affordable

Budget Constraint:
The set of baskets that the consumer
may purchase given the limits of the
available income.

Budget Line:
The set of baskets that one can purchase
when spending all available income.

PxX + PyY = I

Copyright (c)2014 John Wiley & Sons, Inc. 3

Chapter Four
 The Budget Constraint

Assume only two goods available: X and Y

Price of x: Px ; Price of y: Py
Income: I
Total expenditure on basket (X,Y):
Px X + P y Y
The Basket is Affordable if total
expenditure does not exceed total
Income:

PPXXX
X ++ PPYYYY II
Copyright (c)2014 John Wiley & Sons, Inc. 4
Chapter Four
A Budget Constraint Example

Two goods available: X

and Y

I = $10
Px = $1
Py = $2
All Budget
BudgetLine
Line1:
Allincome
incomespent
spenton
onXX
1:
I/P 1X
1X++2Y
2Y==10
I/Px units
x unitsof
ofXXbought
bought 10
Or
Or
All
Allincome
incomespent
spenton
onYY
YY==55X/2
X/2
I/P
I/Py units
unitsof
ofXXbought
bought
y
Slope
Slopeof
ofBudget
BudgetLine
Line=
=-P
-Pxx/P
/Pyy=
=
-1/2
-1/2

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Chapter Four
 A Budget Constraint Example
Y

Budget line = BL1

I/PY= 5 A

-PX/PY = -1/2
C B

I/PX = 10 X
Copyright (c)2014 John Wiley & Sons, Inc. 6
Chapter Four
 Budget Constraint

Location of budget line shows what

the income level is.
Increase in Income will shift the
budget line to the right.
More of each product becomes
affordable
Decrease in Income will shift the
budget line to the left.
less of each product becomes
affordable
Copyright (c)2014 John Wiley & Sons, Inc. 7
Chapter Four
 A Budget Constraint Example
Y Shift
I = $12 Shift of
of aa budget
budget line
line
PX = $1
PY = $2 If income rises, the budget line shifts
parallel to the right (shifts out)

6Y = 6 - X/2 . BL2 If income falls, the budget line shifts

5 parallel to the left (shifts in)

BL2

BL1

10 12 X
Copyright (c)2014 John Wiley & Sons, Inc. 8
Chapter Four
 Budget Constraint

Location of budget line shows what

the income level is.
Increase in Income will shift the
budget line to the right.
More of each product becomes
affordable
Decrease in Income will shift the
budget line to the left.
less of each product becomes
affordable
Copyright (c)2014 John Wiley & Sons, Inc. 9
Chapter Four
A Budget Constraint Example
Y Rotation
Rotation of
of aa budget
budget line
line

If the price of X rises, the

budget line gets steeper
and the horizontal
intercept shifts in
I = $10
6 PX = $1 If the price of X falls, the
5 P1Y = $3
BL budget line gets flatter
and the horizontal
intercept shifts out
Y = 3.33 - X/3 . BL2
3.
33
BL2
10
Copyright (c)2014 John Wiley & Sons, Inc. 10 Four
Chapter X
A Budget Constraint Example

Two goods available: X

and Y

I = $800
Px = $20
Py = $40
All Budget
BudgetLine
Line1:
Allincome
incomespent
spenton
onXX
1:
I/P 20X
20X++40Y
40Y==800
I/Px units
x unitsof
ofXXbought
bought 800
Or
Or
All
Allincome
incomespent
spenton
onYY
YY==20
20X/2
X/2
I/P
I/Py units
unitsof
ofXXbought
bought
y
Slope
Slopeof
ofBudget
BudgetLine
Line=
=-P
-Pxx/P
/Pyy=
=
-1/2
-1/2

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Chapter
A Budget Constraint Example

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Chapter
 Consumer Choice

Assume:

Only non-negative quantities

"Rational choice: The
consumer chooses the basket
that maximizes his satisfaction
given the constraint that his
Consumers
Consumers
budget imposes.
Problem:
Problem:

Max
Max U(X,Y)
U(X,Y)

Subject
Subject to:
to: PPxxXX +
+ PPyyYY
<
< II
Copyright (c)2014 John Wiley & Sons, Inc. 13 Four
Chapter
 Interior Optimum
Interior Optimum: The optimal
consumption basket is at a point where the
indifference curve is just tangent to the
budget line.

A tangent: to a function is a straight line

that has the same slope as the function
MRSx,y = MUx/MUy = Px/Py
therefore.

The
The rate rate at at which
which the
the consumer
consumer would would bebe
willing
willing to to exchange
exchange XX for for YY is
is the
the same
same as as
the
the raterate at at which
which they
they areare exchanged
exchanged in in the
the
marketplace.
marketplace.
Copyright (c)2014 John Wiley & Sons, Inc. 14 Four
Chapter
 Interior Consumer Optimum
Y
B

Preference Direction

Optimal Choice (interior solution)

IC

C BL
0 X
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Chapter
 Interior Consumer Optimum

Copyright (c)2014 John Wiley & Sons, Inc. 16 Four

Chapter
 Interior Consumer Optimum
Assumptions
U (X,Y) = XY and MUx = Y while MUy = X
I = $1,000
P = X$50 and P Y = $200
Basket A contains (X=4, Y=4)
Basket B contains (X=10, Y=2.5)
Question:
Is either basket the optimal choice for the consumer?

Basket MRSx,y = MUx/MUy = Y/X = 4/4 =

A: 1
Slope of budget line = -Px/Py =
-1/4
Basket MRSx,y = MUx/MUy = Y/X = 1/4
B:
Copyright (c)2014 John Wiley & Sons, Inc. 17 Four
Chapter
 Interior Consumer Optimum
Y
Example

50X + 200Y = I

2.5 U = 25

0 X
10
Copyright (c)2014 John Wiley & Sons, Inc. 18 Four
Chapter
 Equal Slope Condition

MUx/Px = MUy/Py

At the optimal basket, each

good gives equal bang for the
buck
Now, we have two equations to solve for two
unknowns (quantities of X and Y in the
optimal basket):
1.1. MU
MUxx/P/Pxx =
=
MUMUYY/P
/PYY
2.2. PPxxXX +
+ PPyyYY =
= II
19 Four
Copyright (c)2014 John Wiley & Sons, Inc.
Chapter
 Contained Optimization

What
What are are the
the equations
equations that
that the
the
optimal
optimal consumption
consumption basket
basket must
must
fulfill
fulfill ifif we
we want
want to
to represent
represent the
the
consumers
consumers choice choice among
among three
three
goods?
goods?

MU / P =
X MU
X / P Y is Yan example of marginal reasoning to maximize

P X + XP Y =Y I reflects the constraint

Copyright (c)2014 John Wiley & Sons, Inc. 20 Four

Chapter
 Contained Optimization

U(F,C)
U(F,C)==FC
FC
PPFF==$1/unit
$1/unit
PPCC==$2/unit
$2/unit
II==$12
$12

Solve for optimal choice of food

and clothing

Copyright (c)2014 John Wiley & Sons, Inc. 21 Four

Chapter
 Some Concepts
Corner Points: One good is not
being consumed at all Optimal
basket lies on the axis

Composite Goods: A good that

represents the collective
expenditure on every other good
except the commodity being
considered

Copyright (c)2014 John Wiley & Sons, Inc. 22 Four

Chapter
 Some Concepts

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Chapter
 Some Concepts

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Chapter
 Some Concepts

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Chapter
 Some Concepts

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Chapter
 Some Concepts

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Chapter
 Duality
The mirror image of the original (primal)
constrained optimization problem is called
the dual problem.
Min PxX + PyY
(X,Y) subject to: U(X,Y) = U*

where: U* is a target level of utility.

IfIf U*
U* is
is the
the level
level of
of utility
utility that
that solves
solves
the
the primal
primal problem,
problem, thenthen anan interior
interior
optimum,
optimum, ifif itit exists,
exists, of
of the
the dual
dual
problem
problem also also solves
solves thethe primal
primal
problem.
problem.
Copyright (c)2014 John Wiley & Sons, Inc. 28 Four
Chapter
 Optimal Choice
Y

Example:
Example: Expenditure
Expenditure
Minimization
Minimization

Optimal Choice (interior solution)

U = U*
Decreases in
expenditure levelPXX + PYY = E*
0 X
Copyright (c)2014 John Wiley & Sons, Inc. 29 Four
Chapter
 Optimal Choice
Y
Example: Expenditure
Minimization
50X + 200Y = E

25
25==XY
XY (constraint)
(constraint)
Y/X
Y/X==1/4
1/4 (tangency
(tangency
condition)
condition)

2.5 U = 25

0 X
10
Copyright (c)2014 John Wiley & Sons, Inc. 30 Four
Chapter
 Revealed Preference

Suppose
Suppose that
that preferences
preferences areare
not
not known.
known. Can
Can we
we infer
infer them
them
from
from purchasing
purchasing behavior?
behavior?

If
If A
A purchased,
purchased, it
it must
must be
be
preferred
preferred to to all
all other
other
affordable
affordable bundles
bundles

Copyright (c)2014 John Wiley & Sons, Inc. 31 Four

Chapter
 Revealed Preference

Suppose
Suppose that
that preferences
preferences are
are standard
standard
then:
then:

All
All baskets
baskets to
to the
the Northeast
Northeast of
of AA must
must
be
be preferred
preferred to
to A.
A.

This
This gives
gives us
us aa narrower
narrower range
range over
over
which
which indifference
indifference curve
curve must
must lie
lie

This
This type
type of
of analysis
analysis is
is called
called revealed
revealed
preference
preference analysis.
analysis.
Copyright (c)2014 John Wiley & Sons, Inc. 32 Four
Chapter