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Consumer Choice

Theory
Why study economics?

• A classical definition of economics is that it studies how to


efficiently allocate scarce resources
• Example1 – Do I spend my money on buying cloth, or buying
food??
• Example2 – Do I spend my time attending this class, or sleeping in
my hostel room?
• Example3 – should government support the poor through
transfer of cash, or in kind?
• Example4 – should the government support free trade with other
countries or not?

• Is efficiency always desirable? Is there a trade-off with equity?


The progression of economic analysis

• Microeconomics – studies economic decision making of


individuals and firms

• Macroeconomics – studies the levels and fluctuations of


aggregate economic variables: GDP, employment and
inflation

• International economics – studies interactions among


several economies
What we have learned so far
• Shapes of demand curve
• Shape of the supply curve
• Shift and movement along these curves
• Cost curves – fixed cost, variable cost, average cost,
marginal cost curves
• Demand analysis
What we shall learn today
• Principles underlying consumer demand
• How consumers allocate their incomes among different
goods so that their ‘satisfaction’ is maximized

• Two elements of consumer choice theory are:


• Consumer preferences
• Budget constraint

• Reference – Microeconomics by Robert Pindyck and


Daniel Rubinfeld
Rationality in preferences Assumption

• Consumers are ‘rational’.


• Does not necessarily mean they are ‘selfish’

• But are consumers rational? Always?


• Violation of this assumption has given birth to a
new sub-field within economics, and two Nobel
prizes so far.
Properties of preferences
• Completeness: Consumers can rank all possible
baskets/bundles
• Given two bundles of goods ‘X’ and ‘Y’, one of the three
conditions has to be satisfied: X > Y, X < Y, X = Y.
• Example of violation?

• Transitivity: For three bundles of goods X, Y and Z, if X >


Y and Y > Z, then X > Z
• Example of violation?

• Monotonicity: Implies more is always better than less.


- How do we account for ‘bads’, like pollution in this
framework?
Violation of Transitivity property

Laptop (Rs. 50,000) Mouse (Rs. 500) Choice Symbol


Discount No Discount X
No Discount Discount Y
No Discount No Discount Z

Z is preferred to X and Y is preferred to Z. Therefore, Y is preferred to X.

Now, the discount is given on either item. That makes X equivalent to Y.


This violates transitivity property.
Indifference curves

• Represents all combinations of market baskets that provide


a consumer with the same level of satisfaction.

Indifference map is a set of indifference curves that describes a person’s


preferences
Properties of the indifference curves
• Indifference curves are not ‘thick’
• Cannot intersect with each other
• Slope downward – follows from monotonicity
property
• May have different shapes for different set of goods
• May have different shapes for different consumers

• Bend toward the origin


Marginal rate of substitution (MRS)
• The amount of a good
that a consumer is
willing to give-up in
order to obtain one
additional unit of
another good
∆𝐶
• 𝑀𝑅𝑆𝐹,𝐶 = −
∆𝐹

• MRS diminishes as we
move along the curve
from left to right,
resulting in inward
bending shape
Perfect Substitutes and Perfect Complements

• Perfect Substitutes:
Two goods for which
the marginal rate of
substitution is a
constant.

• Perfect complements:
Two goods for which
the MRS is zero or
infinite; the
indifference curves are
shaped as right
angles.
Budget constraints
• This is the second element of consumer choice theory
• Consumers face budget constraint due to their limited
incomes.
• Typical equation for a budget line is: 𝑃𝐹 . 𝐹 + 𝑃𝐶 . 𝐶 = 𝐼

Clothing

I/ 𝑃𝐶

𝑃𝐹 . 𝐹 + 𝑃𝐶 . 𝐶 = 𝐼

I/ 𝑃𝐹 Food

𝑃𝐹
• Slope of the budget line: −
𝑃𝐶
Effect of change in Income and Price on the
budget line

• What happens when Income changes?


• The budget line shifts outward (inward) for an increase
(decrease) in income
• What happens for change in price for one good,
while the price of the other good (and also income)
remains same?
• The budget line rotates about one intercept.
The concept of utility
• Numerical score for the level of satisfaction obtained
from consuming a market basket
• Utility functions assign a level of utility to each market
basket. Example: 𝑈 𝑥, 𝑦 = 50𝑥 + 𝑦
• On any Indifference curve, utility is constant
• Cardinality and ordinality of utility functions

• Marginal utility: additional utility obtained by


consuming one additional unit of a good.
𝜕𝑈 𝜕𝑈
• In the above example: = 50 and =1
𝜕𝑥 𝜕𝑦
Consumer choice
• A rational consumer maximizes her utility, given her
budget constraint
• The consumption basket must lie on the budget line
• It must give the most preferred combination of goods
for the consumer
At the optimum, slopes of
indiff. Curve and budget
line are same

i.e. 𝑀𝑅𝑆𝐹,𝐶 = 𝑃𝐹 / 𝑃𝑐
Marginal utility and consumer choice

• Let us say 𝑈 = 𝑓 𝑥, 𝑦
𝜕𝑓 𝜕𝑓
• Then 𝑀𝑈𝑥 = and 𝑀𝑈𝑦 =
𝜕𝑥 𝜕𝑦
• Total derivative of 𝑈 is: 𝑑𝑈 = 𝑀𝑈𝑥 𝑑𝑥 + 𝑀𝑈𝑦 𝑑𝑦
𝑑𝑦 𝑀𝑈𝑥
• Therefore, on an indifference curve, = −
𝑑𝑥 𝑀𝑈𝑦
𝑀𝑈𝑥
• In other words, MRS = .
𝑀𝑈𝑦
• Then the optimality condition becomes:
𝑀𝑈𝑥 𝑀𝑈𝑦
=
𝑃𝑥 𝑃𝑦
Problem 1
Consider the utility function 𝑈 𝑥, 𝑦 = 𝑥 0.4 𝑦 0.6 (This
is called Cobb-Douglas utility function)
a) Is the assumption that more is better satisfied for
both goods?
b) Does the marginal utility of x diminish, remain
constant, or increase as the consumer buys more x?
c) What is 𝑀𝑅𝑆𝑥,𝑦 for this utility function?
Problem 2
The utility that an economic agent receives by
consuming food F and clothing C is given by U(F, C) =
FC + F.
Food costs $1 a unit, and clothing costs $2 a unit.
The agent’s income is $22.
Find the utility-maximizing choice of food and
clothing.
Thank you!

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