Lecture 3 - Consumer Theory

Consumer Theory
Lecture 3
Assad Baunto
Econ 100.2 Introduction to Microeconomic Theory and Policy 1st semester, SY 2011-12
Consumer Theory Lecture 3
Individual demand is based on consumer theory:

Consumer preferences Budget Constraint
amount of goods purchased (individual demand curve)
I. Choice Three ways to depict consumer behaviour:
A. Preferences B. Indifference curves C.Utility function
A. Preferences, ~ A B
A ~ B
Properties of preferences:
1. Preferences can be ranked (complete) 2. No circularity of decisions (transitive). 3. More is better (monotonic) 4. Average is better than two indifferent bundles
(convex).
B. Indifference curve
I.C.
Properties of I.C.:
1.Any points on the I.C. curve gives the individual

consumer the same satisfaction. (e.g. pt. A and pt. B). Hence, the term indifference.
2.I.C. is (negatively, or) downward-sloping. 3.The shape of the I.C describes how a consumer is
willing to substitute one good for another good. Note: the rate at which an individual consumer is willing to substitute one good (say, broccoli) for one additional of another good (say, kangkong) is declining.
Marginal Rate of Substitution (MRS)

- how many units of y one is willing to give up in order to get one more unit of x.
MRS = - y = - MUy x MUx y x I.C.
Notes: (i) MRS is declining and (ii) MRS approximates the slope of the I.C. as the size of the movement along the I.C becomes very small.
Indifference curves
I.C3 I.C2 I.C1
For goods that are perfect substitutes, MRS is constant.
I.C.
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Goods that are perfect complements are shaped like right triangles.
I.C.
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When one good is a bad, then I.C. is upward sloping
I.C.
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C. Utility Functions Utility function assigns a level of utility to each basket of consumption.
Ordinal utility function: ranks the preferences, but does not say how much one is preferred to another.
Cardinal utility function: describes the extent to which one is preferred to another. Note: our concern is ordinal.
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Cardinal Utility the old school (Bentham and Jevons)
U(x)
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Note: Marginal utility is declining as one consumer additional unit of good x. Law of diminishing marginal utility
MU(x) or U(x)
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II. Budget Constraint

-Individual wants to buy goods given limited income and prices.
px . x + py . y < M or, y < M px . x py

Assumption: No savings from income (M) fully spend.
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Effect of in income on the budget constraint (B.C.):

-shifts the B.C
M < M < M px . x + py . y < M px . x + py . y < M px . x + py . y < M
Assumption: No savings from income (M) fully spend.
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Effect of in prices (px, py) on the budget constraint (B.C.):

-rotates the B.C
py < py < py px . x + py . y < M px . x + py . y < M
px . x + py . y < M In this example, the price of good y changes and not the price of good x.
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III. Optimal Allocation

-maximise your I.C. subject to your budget constraint.
qd* for good y
- px = - MUx py MUy
qd* for good x
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Optimal Allocation (cont.)

-As it turns out, when you maximise I.C. subject to your B.C, optimal allocation occurs at a point where the marginal utility of the last peso spent on one good is the same as the marginal utility of the last peso spent on any other good.
MUy = MUx = = MUi py px Pi
Equimarginal principle
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IV. Digression: Revealed Preferences So far, we focused our discussion on how individuals decide optimal consumption of goods from a utility functions/indifference curves and budget constraint.
Utility function/I.C, and Budget constraint Optimal demand or consumption
What if, we start from

Optimal demand, and Budget constraint Preferences
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V. Substitution Effect and Income Effect The total impact of a change in the price of a good can be divided by two effects: Substitution effect the change in a goods consumption associated with a change in the goods price, while utility is held constant
Income effect the change in a goods consumption associated with a change in the purchasing power, while the price is held constant.
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case: price of good y declines.
C C A B BC C BC
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Substitution Effect and Income Effect

Consider decline of price of good y BC rotates to BC optimal allocation from A to C. (total price effect). Change from A to B is called substitution effect. Change from B to C is called income effect. (note: increase in
real income results in increase in demand of good x, hence normal good).
Consider different position of C, say C or C. Change from B to C or C: increase in real income results in
decline in the demand of good x. Hence, inferior good.
If total effect A to C: decrease in price of good x results in the

decline in the demand of good x, the good x is called a Giffen good.
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Consumer Theory

Consumer Theory Lecture 3

Individual demand is based on consumer theory:

amount of goods purchased (individual demand curve)

Consumer Theory Lecture 3

I. Choice Three ways to depict consumer behaviour:

A. Preferences B. Indifference curves C.Utility function

Consumer Theory Lecture 3

Consumer Theory Lecture 3

Consumer Theory Lecture 3

Consumer Theory Lecture 3

1.Any points on the I.C. curve gives the individual

Consumer Theory Lecture 3

Marginal Rate of Substitution (MRS)

MRS = - y = - MUy x MUx y x I.C.

Consumer Theory Lecture 3

I.C3 I.C2 I.C1

Consumer Theory Lecture 3

For goods that are perfect substitutes, MRS is constant.

Consumer Theory Lecture 3

Consumer Theory Lecture 3

When one good is a bad, then I.C. is upward sloping

Consumer Theory Lecture 3

Consumer Theory Lecture 3

Cardinal Utility the old school (Bentham and Jevons)

Consumer Theory Lecture 3

Consumer Theory Lecture 3

II. Budget Constraint

px . x + py . y < M or, y < M px . x py

Consumer Theory Lecture 3

Effect of in income on the budget constraint (B.C.):

M < M < M px . x + py . y < M px . x + py . y < M px . x + py . y < M

Assumption: No savings from income (M) fully spend.

Consumer Theory Lecture 3

Effect of in prices (px, py) on the budget constraint (B.C.):

py < py < py px . x + py . y < M px . x + py . y < M

Consumer Theory Lecture 3

III. Optimal Allocation

qd* for good y

qd* for good x

Consumer Theory Lecture 3

Optimal Allocation (cont.)

Consumer Theory Lecture 3

What if, we start from

Consumer Theory Lecture 3

Consumer Theory Lecture 3

case: price of good y declines.

Consumer Theory Lecture 3

Substitution Effect and Income Effect

If total effect A to C: decrease in price of good x results in the

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