Choice

Ch 5: Choice
Ch 6: Demand (sec. 2,5,6,8 & appendix)
Ch 15: Market Demand (sec. 1& 2)
2
Rational Choice
The principal behavioral postulate is
that a decisionmaker chooses its
most preferred alternative from those
available to it.
In terms of our model, this means
choosing a bundle from the highest
indifference curve that can be
reached without exceeding the
budget set.
3
Rational Constrained Choice
x
1
x
2
Affordable
bundles
4
Rational Constrained Choice
Affordable
bundles
x
1
x
2
More preferred
bundles
5
Rational Constrained Choice
x
1
x
2
x
1
*
x
2
*
(x
1
*,x
2
*) is the most
preferred affordable
bundle.
6
Rational Constrained Choice
The most preferred affordable bundle
is called the consumers ORDINARY
DEMAND at the given prices and
budget.
Ordinary demands will be denoted by
x
1
*(p
1
,p
2
,m) and x
2
*(p
1
,p
2
,m).
7
Choice with monotonic preferences
Supposed preferences are monotonic,
i.e. more is better;
Then the consumer will always
choose a bundle that exhausts the
budget.
The chosen bundle is interior if it
contains strictly positive quantities of
both goods.
8
Rational Constrained Choice
When preferences are monotonic,
indifference curves are smoothly
convex and the chosen bundle is
interior, (x
1
*,x
2
*) satisfies two
conditions:
(a) the budget is exhausted;
p
1
x
1
* + p
2
x
2
* = m
(b) the slope of the budget constraint, -
p
1
/p
2
, and the slope of the indifference
curve containing (x
1
*,x
2
*) are equal at
(x
1
*,x
2
*).
9
Choice: The canonical case
x
1
x
2
x
1
*
x
2
*
(x
1
*,x
2
*) is interior .
(a) (x
1
*,x
2
*) exhausts the
budget; p
1
x
1
* + p
2
x
2
* = m.
(b) The slope of the indiff.
curve at (x
1
*,x
2
*) equals
the slope of the budget
constraint.
10
Solving for the optimum bundle
If the budget is exhausted, then the
optimum bundle must satisfy the
budget constraint with equality:
p
1
x
1
* + p
2
x
2
* = m
If the optimum bundle is interior,
then it must be a point at which the
slope of the budget line equals the
slope of the indifference curve, i.e.:
- p
1
/p
2
= MRS
We can use these two equations to
solve for the two variables x
1
*and x
2
*.
11
Computing Ordinary Demands -
a Cobb-Douglas Example.
Suppose that the consumer has
Cobb-Douglas preferences.
Then
U x x x x
a b
( , )
1 2 1 2
=
MU
U
x
ax x
a b
1
1
1
1
2
= =

c
c
MU
U
x
bx x
a b
2
2
1 2
1
= =

c
c
12
Computing Ordinary Demands -
a Cobb-Douglas Example.
So the MRS is
At (x
1
*,x
2
*), MRS = -p
1
/p
2
so
MRS
dx
dx
U x
U x
ax x
bx x
ax
bx
a b
a b
= = = =

2
1
1
2
1
1
2
1 2
1
2
1
c c
c c
/
/
.
= =
ax
bx
p
p
x
bp
ap
x
2
1
1
2
2
1
2
1
*
*
* *
.
(A)
13
Computing Ordinary Demands -
a Cobb-Douglas Example.
So now we know that
MRS = slope of budget line:
budget constraint is satisfied with
equality
x
bp
ap
x
2
1
2
1
* *
=
(A)
p x p x m
1 1 2 2
* *
. + = (B)
14
Computing Ordinary Demands -
a Cobb-Douglas Example.
x
bp
ap
x
2
1
2
1
* *
= (A)
p x p x m
1 1 2 2
* *
. + =
(B)
p x p
bp
ap
x m
1 1 2
1
2
1
* *
. + =
Substitute
and get
This simplifies to .
15
Computing Ordinary Demands -
a Cobb-Douglas Example.
x
bm
a b p
2
2
*
( )
. =
+
Substituting for x
1
* in
p x p x m
1 1 2 2
* *
+ =
then gives
x
am
a b p
1
1
*
( )
. =
+
16
Computing Ordinary Demands -
a Cobb-Douglas Example.
So we have discovered that the most
preferred affordable bundle for a consumer
with Cobb-Douglas preferences
U x x x x
a b
( , )
1 2 1 2
=
is
( , )
( )
,
( )
.
* *
( ) x x
am
a b p
bm
a b p
1 2
1 2
=
+ +
17
Computing Ordinary Demands
- a Cobb-Douglas Example.
x
1
x
2
x
am
a b p
1
1
*
( )
=
+
x
bm
a b p
2
2
*
( )
=
+
U x x x x
a b
( , )
1 2 1 2
=
18
Computing Ordinary Demands - a Cobb-
Douglas Example.
Try this with numbers instead of symbols:
Let a=1/3, b=2/3, m=75
Let prices be p
1
and p
2
for now
Then we get
The consumer spends 1/3 of her income on good
1, and 2/3 of her income on good 2. Once we
know the prices, we can compute the actual
quantities.
(This is true only for this class of utility functions.)
.
50
,
25
) , (
2 1
*
2
*
1
|
|
.
|

\
|
=
p p
x x
19
Rational Constrained Choice
When x
1
* > 0 and x
2
* > 0
and (x
1
*,x
2
*) exhausts the budget,
and indifference curves have no
kinks, the ordinary demands are
obtained by solving:
(a) p
1
x
1
* + p
2
x
2
* = y
(b) the slopes of the budget constraint, -
p
1
/p
2
, and of the indifference curve
containing (x
1
*,x
2
*) are equal at (x
1
*,x
2
*).
20
Another way to look at optimisation
Pick any level of x
1
, and suppose
consumer buys this much x
1
.
Then he spends p
1
x
1
, and has m-p
1
x
1
left to spend on the other good
with which he can buy [m -p
1
x
1
]/p
2
units of good 2
This gives him U(x
1
, [m -p
1
x
1
]/p
2
)
amount of utility
His problem is to pick x
1
so as to
maximise U(x
1
, [m -p
1
x
1
]/p
2
)
21
Another way to look at optimisation
Apply this to the case U(x
1
,x
2
)=x
1
x
2
.
To maximise we take a first derivative
and equate it to zero, to give
and substitute back in the
budget constraint to get
U x
m p x
p
x
m p x
p
mx
p
p x
p
( , ) [ ]
1
1 1
2
1
1 1
2
1
2
1 1
2
2

=

=
m
p
p x
p
x
m
p
2
1 1
2
1
1
2
0
2
= =
x
m
p
2
2
2
=
22
Examples of Corner Solutions --
the Perfect Substitutes Case
x
1
x
2
MRS = -1
Budget line:
Slope = -p
1
/p
2
with p
1
> p
2
.
23
Examples of Corner Solutions --
the Non-Convex Preferences Case
x
1
x
2
Which is the most preferred
affordable bundle?
24
Examples of Corner Solutions --
the Non-Convex Preferences Case
x
1
x
2
The most preferred
affordable bundle
25
Examples of Kinky Solutions -- the Perfect
Complements Case
x
1
x
2
MRS = -
MRS = 0
MRS is undefined
U(x
1
,x
2
) = min{ax
1
,x
2
}
x
2
= ax
1
26
Examples of Kinky Solutions -- the Perfect
Complements Case
x
1
x
2
U(x
1
,x
2
) = min{ax
1
,x
2
}
x
2
= ax
1
Which is the most
preferred affordable bundle?
27
Examples of Kinky Solutions -- the Perfect
Complements Case
x
1
x
2
U(x
1
,x
2
) = min{ax
1
,x
2
}
x
2
= ax
1
The most preferred
affordable bundle
28
Examples of Kinky Solutions -- the
Perfect Complements Case
x
1
x
2
U(x
1
,x
2
) = min{ax
1
,x
2
}
x
2
= ax
1
x
1
*
x
2
*
(a) p
1
x
1
* + p
2
x
2
* = m
(b) x
2
* = ax
1
*
29
Examples of Kinky Solutions -- the Perfect
Complements Case
(a) p
1
x
1
* + p
2
x
2
* = m; (b) x
2
* = ax
1
*.
Substitution from (b) for x
2
* in
(a) gives p
1
x
1
* + p
2
ax
1
* = m
which gives
A bundle of 1 commodity 1 unit and
a commodity 2 units costs p
1
+ ap
2
;
m/(p
1
+ ap
2
) such bundles are affordable.
.
ap p
am
x ;
ap p
m
x
2 1
*
2
2 1
*
1
+
=
+
=
30
Examples of Kinky Solutions --
the Perfect Complements Case
x
1
x
2
U(x
1
,x
2
) = min{ax
1
,x
2
}
x
2
= ax
1
x
m
p ap
1
1 2
*
=
+
x
am
p ap
2
1 2
*
=
+
Demand
Demand is the pattern of the consumers
(or markets) consumption behaviour as
prices and income change.
Demand curves trace these patterns
assuming that only one price changes,
while income and other prices remain
constant.
32
Demand
Here we trace how the quantity of a
good in the consumers chosen
bundle changes in response to
changes in
the price of that good
the price of the other good
the consumers income
In each case holding all the other
parameters constant
33
Properties of Demand Functions
Comparative statics analysis of
ordinary demand functions -- the
study of how ordinary demands
x
1
*(p
1
,p
2
,y) and x
2
*(p
1
,p
2
,y) change
as prices p
1
, p
2
and income y change.
34
Own-Price Changes
How does x
1
*(p
1
,p
2
,y) change as p
1
changes, holding p
2
and y constant?
Suppose only p
1
increases, from p
1
to
p
1
and then to p
1
.
35
Own-Price Changes
x
1
x
2
p
1
= p
1

p
1
= p
1

Fixed p
2
and y.
p
1
x
1
+ p
2
x
2
= y
36
Own-Price Changes
x
1
x
2
p
1
= p
1

p
1
=
p
1

Fixed p
2
and y.
p
1
= p
1

p
1
x
1
+ p
2
x
2
= y
37
x
2
x
1
x
1
*(p
1
)
Own-Price Changes
p
1
= p
1

Fixed p
2
and y.
38
x
2
x
1
x
1
*(p
1
)
p
1
x
1
*(p
1
)
p
1

x
1
*
Own-Price Changes
Fixed p
2
and y.
p
1
= p
1

Here we plot the

quantity demanded of
x
1
(from the horizontal
axis) against the price
p
1
implicit in the
budget line.
39
x
2
x
1
x
1
*(p
1
) x
1
*(p
1
)
x
1
*(p
1
)
p
1
x
1
*(p
1
)
x
1
*(p
1
)
p
1

p
1

p
1
= p
1

x
1
*
Own-Price Changes
Fixed p
2
and y.
40
x
2
x
1
x
1
*(p
1
) x
1
*(p
1
)
x
1
*(p
1
)
p
1
x
1
*(p
1
) x
1
*(p
1
)
x
1
*(p
1
)
p
1

p
1

p
1

x
1
*
Own-Price Changes
Fixed p
2
and y.
41
x
2
x
1
x
1
*(p
1
) x
1
*(p
1
)
x
1
*(p
1
)
p
1
x
1
*(p
1
) x
1
*(p
1
)
x
1
*(p
1
)
p
1

p
1

p
1

x
1
*
Own-Price Changes
Ordinary
demand curve
for commodity 1
Fixed p
2
and y.
42
x
2
x
1
x
1
*(p
1
) x
1
*(p
1
)
x
1
*(p
1
)
p
1
x
1
*(p
1
) x
1
*(p
1
)
x
1
*(p
1
)
p
1

p
1

p
1

x
1
*
Own-Price Changes
Ordinary
demand curve
for commodity 1
Fixed p
2
and y.
43
x
2
x
1
x
1
*(p
1
) x
1
*(p
1
)
x
1
*(p
1
)
p
1
x
1
*(p
1
) x
1
*(p
1
)
x
1
*(p
1
)
p
1

p
1

p
1

x
1
*
Own-Price Changes
Ordinary
demand curve
for commodity 1
p
1
price
offer
curve
Fixed p
2
and y.
44
Own-Price Changes
The curve containing all the utility-
maximizing bundles traced out as p
1
changes, with p
2
and y constant, is
the p
1
- price offer curve.
The plot of the x
1
-coordinate of the
p
1
- price offer curve against p
1
is the
ordinary demand curve for
commodity 1.
45
Own-Price Changes
What does a p
1
price-offer curve look
like for Cobb-Douglas preferences?
Take
Then the ordinary demand functions
for commodities 1 and 2 are
U x x x x
a b
( , ) .
1 2 1 2
=
46
Own-Price Changes
x p p y
a
a b
y
p
1 1 2
1
*
( , , ) =
+

x p p y
b
a b
y
p
2 1 2
2
*
( , , ) . =
+

and
Notice that x
2
* does not vary with p
1
so the
p
1
price offer curve is flat and the ordinary
demand curve for commodity 1 is a
rectangular hyperbola.
47
x
1
*(p
1
) x
1
*(p
1
)
x
1
*(p
1
)
x
2
x
1
p
1
x
1
*
Own-Price Changes
Ordinary
demand curve
for commodity 1
is
Fixed p
2
and y.
x
by
a b p
2
2
*
( )
=
+
x
ay
a b p
1
1
*
( )
=
+
x
ay
a b p
1
1
*
( )
=
+
48
Own-Price Changes
Usually we ask Given the price for
commodity 1 what is the quantity
demanded of commodity 1?
But we could also ask the inverse
question At what price for
commodity 1 would a given quantity
of commodity 1 be demanded?
49
Own-Price Changes
p
1
x
1
*
p
1

x
1

Given p
1
, what quantity is
demanded of commodity 1?
Answer: x
1
units.
The inverse question is:
Given x
1
units are
demanded, what is the
price of
commodity 1?
Answer: p
1

50
Own-Price Changes
Taking quantity demanded as given
and then asking what must be price
describes the inverse demand
function of a commodity.
51
Own-Price Changes
A Cobb-Douglas example:
x
ay
a b p
1
1
*
( )
=
+
is the ordinary demand function and
p
ay
a b x
1
1
=
+ ( )
*
is the inverse demand function.
52
Own-Price Changes
A perfect-complements example:
x
y
p p
1
1 2
*
=
+
is the ordinary demand function and
p
y
x
p
1
1
2
=
*
is the inverse demand function.
53
Income Changes
How does the value of x
1
*(p
1
,p
2
,y)
change as y changes, holding both p
1
and p
2
constant?
54
x
2
x
1
Income Changes
Fixed p
1
and p
2
.
y < y < y
55
x
2
x
1
Income Changes
Fixed p
1
and p
2
.
y < y < y
x
1

x
1

x
1

x
2

x
2

x
2

56
x
2
x
1
Income Changes
Fixed p
1
and p
2
.
y < y < y
x
1

x
1

x
1

x
2

x
2

x
2

Income
offer curve
57
Income Changes
A plot of the demand bundles at
different incomes is called the
income offer curve.
A plot of quantity demanded of one
good against income is called an
Engel curve.
58
x
2
x
1
Income Changes
Fixed p
1
and p
2
.
y < y < y
x
1

x
1

x
1

x
2

x
2

x
2

Income
offer curve
x
1
*
y
x
1

x
1

x
1

y
y
y
Note that the horizontal
axis in the right hand
diagram is x
1
, but the
vertical axis is income, y.
59
x
2
x
1
Income Changes
Fixed p
1
and p
2
.
y < y < y
x
1

x
1

x
1

x
2

x
2

x
2

Income
offer curve
x
1
*
y
x
1

x
1

x
1

y
y
y
Engel
curve;
good 1
60
x
2
x
1
Income Changes
Fixed p
1
and p
2
.
y < y < y
x
1

x
1

x
1

x
2

x
2

x
2

Income
offer curve
x
2
*
y
x
2

x
2

x
2

y
y
y
Engel
curve;
good 2
61
Income Changes and Cobb-
Douglas Preferences
An example of computing the
equations of Engel curves; the Cobb-
Douglas case.
The ordinary demand equations are
U x x x x
a b
( , ) .
1 2 1 2
=
x
ay
a b p
x
by
a b p
1
1
2
2
* *
( )
;
( )
. =
+
=
+
62
Income Changes and Cobb-
Douglas Preferences
x
ay
a b p
x
by
a b p
1
1
2
2
* *
( )
;
( )
. =
+
=
+
Rearranged to isolate y, these are:
y
a b p
a
x
y
a b p
b
x
=
+
=
+
( )
( )
*
*
1
1
2
2
Engel curve for good 1
Engel curve for good 2
63
Income Changes and Cobb-
Douglas Preferences
y
y
x
1
*
x
2
*
y
a b p
a
x =
+ ( )
*
1
1
Engel curve
for good 1
y
a b p
b
x =
+ ( )
*
2
2
Engel curve
for good 2
64
Income Changes
In the Cobb-Douglas example the
Engel curves were straight lines.
Q: Is this true in general?
A: No. Engel curves are straight lines
if the consumers preferences are
homothetic.
That is, the consumers MRS is the
same anywhere on a straight line
drawn from the origin.
Or, the indifference curves are blown
up versions of each other, projecting
out from the origin.
65
Income Effects -- A
Nonhomothetic Example
Quasilinear preferences are not
homothetic.
For example,
U x x f x x ( , ) ( ) .
1 2 1 2
= +
U x x x x ( , ) .
1 2 1 2
= +
66
Quasi-linear Indifference Curves
x
2
x
1
Each curve is a vertically shifted
copy of the others.
Each curve intersects
both axes.
67
Income Changes; Quasilinear
Utility
x
2
x
1
x
1
~
x
1
*
y
x
1
~
Engel
curve
for
good 1
68
Income Changes; Quasilinear
Utility
x
2
x
1
x
1
~
x
2
*
y Engel
curve
for
good 2
69
Additional
material for
self-study
70
More examples of demand curves
derived from known preferences:
perfect-complements utility function
perfect-substitutes utility function
71
Own-Price Changes
What does a p
1
price-offer curve look like
for a perfect-complements utility function?
} {
U x x x x ( , ) min , .
1 2 1 2
=
Then the ordinary demand functions
for commodities 1 and 2 are
x p p y x p p y
y
p p
1 1 2 2 1 2
1 2
* *
( , , ) ( , , ) . = =
+
With p
2
and y fixed, higher p
1
causes
smaller x
1
* and x
2
*.
72
p
1
x
1
*
Fixed p
2
and y.
x
y
p p
2
1 2
*
=
+
x
y
p p
1
1 2
*
=
+
Own-Price Changes
x
1
x
2
p
1

x
y
p p
1
1 2
*
=
+

p
1
= p
1

y/p
2
73
p
1
x
1
*
Fixed p
2
and y.
x
y
p p
2
1 2
*
=
+
x
y
p p
1
1 2
*
=
+
Own-Price Changes
x
1
x
2
p
1

p
1

p
1
= p
1

x
y
p p
1
1 2
*
=
+

y/p
2
74
p
1
x
1
*
Fixed p
2
and y.
x
y
p p
2
1 2
*
=
+
x
y
p p
1
1 2
*
=
+
Own-Price Changes
x
1
x
2
p
1

p
1

p
1

x
y
p p
1
1 2
*
=
+
p
1
= p
1

y/p
2
75
p
1
x
1
*
Ordinary
demand curve
for commodity 1
is
Fixed p
2
and y.
x
y
p p
2
1 2
*
=
+
x
y
p p
1
1 2
*
=
+
x
y
p p
1
1 2
*
. =
+
Own-Price Changes
x
1
x
2
p
1

p
1

p
1

y
p
2
y/p
2
76
Own-Price Changes
What does a p
1
price-offer curve look
like for a perfect-substitutes utility
function?
U x x x x ( , ) .
1 2 1 2
= +
Then the ordinary demand functions
for commodities 1 and 2 are
77
Own-Price Changes
x p p y
if p p
y p if p p
1 1 2
1 2
1 1 2
0
*
( , , )
,
/ ,
=
>
<

x p p y
if p p
y p if p p
2 1 2
1 2
2 1 2
0
*
( , , )
,
/ , .
=
<
>

and
78
Fixed p
2
and y.
Own-Price Changes
x
2
x
1
p
1
x
1
*
Fixed p
2
and y.
p
1

p
2
= p
1

p
1

x
y
p
1
1
*
=

0
1
2
s s x
y
p
*
y
p
2
p
1
price
offer
curve
Ordinary
demand curve
for commodity 1
79
The remaining slides
remind you of material you
have seen in micro 1.
It may be useful to
remember this material
now, and relate it to the
material you have
encountered in this course.
80
Cross-Price Effects
If an increase in p
2
increases demand for commodity 1 then
commodity 1 is a gross substitute for
commodity 2.
reduces demand for commodity 1 then
commodity 1 is a gross complement for
commodity 2.
81
Cross-Price Effects
A perfect-complements example:
x
y
p p
1
1 2
*
=
+
( )
c
c
x
p
y
p p
1
2
1 2
2
0
*
. =
+
<
so
Therefore commodity 2 is a gross
complement for commodity 1.
82
Cross-Price Effects
p
1
x
1
*
p
1

p
1

p
1

y
p
2

Increase the price of

good 2 from p
2
to p
2

and
83
Cross-Price Effects
p
1
x
1
*
p
1

p
1

p
1

y
p
2

Increase the price of

good 2 from p
2
to p
2

and the demand curve

for good 1 shifts inwards
-- good 2 is a
complement for good 1.
84
Cross-Price Effects
A Cobb- Douglas example:
x
by
a b p
2
2
*
( )
=
+
so
85
Cross-Price Effects
A Cobb- Douglas example:
x
by
a b p
2
2
*
( )
=
+
c
c
x
p
2
1
0
*
. =
so
Therefore commodity 1 is neither a gross
complement nor a gross substitute for
commodity 2.
86
Income Effects
A good for which quantity demanded
rises with income is called normal.
Therefore a normal goods Engel
curve is positively sloped.
87
Income Effects
A good for which quantity demanded
falls as income increases is called
income inferior.
Therefore an income inferior goods
Engel curve is negatively sloped.
88
x
2
x
1
Income Changes; Goods
1 & 2 Normal
x
1

x
1

x
1

x
2

x
2

x
2

Income
offer curve
x
1
*
x
2
*
y
y
x
1

x
1

x
1

x
2

x
2

x
2

y
y
y
y
y
y
Engel
curve;
good 2
Engel
curve;
good 1
89
Income Changes; Good 2 Is Normal, Good 1
Becomes Inferior
x
2
x
1
Income
offer curve
90
x
2
x
1
x
1
*
x
2
*
y
y
Engel curve
for good 2
Engel curve
for good 1
Income Changes; Good 2 Is Normal, Good 1
Becomes Inferior
91
Ordinary Goods and Giffen Goods
A good is called ordinary if the
quantity demanded of it always
increases as its own price decreases.
If, for some values of its own price,
the quantity demanded of a good
rises as its own-price increases then
the good is called Giffen.
92
Ordinary Goods
Fixed p
2
and y.
x
1
x
2
p
1
price
offer
curve
x
1
*
Downward-sloping
demand curve
Good 1 is
ordinary

p
1
93
Giffen Goods
Fixed p
2
and y.
x
1
x
2
p
1
price offer
curve
x
1
*
Demand curve has
a positively
sloped part
Good 1 is
Giffen

p
1