ECO 401: Advanced Microeconomics
Review: Consumer Behaviour
Consumer behaviour: how should rational consumers choose?
Consumers have well defined rational preferences, and choose the
most preferred bundle subject to the constraints faced
We will focus on constraints that can be translated into monetary
constraints and express this as the budget constraint
Review: Budget Constraint
A consumption bundle is a vector (x1 , x2 , . . . , xn ) indicating the
quantities of all consumable goods that the consumer considers
Commodity prices indicated by a price vector (p1 , p2 , . . . , pn )
Let the consumer’s income be M > 0
The budget set indicates the consumption bundles that are
affordable, i.e. it comprises of consumption bundles (x1 , x2 , . . . , xn )
such that p1 x1 + p2 x2 + . . . + pn xn ≤ M , with each xi ≥ 0
Review: Budget Constraint
Graphical representation in the two good case
Slope of the budget line: dx2
dx1 = − pp12
How does the budget constraint change with respect to a change in
prices? To a change in income?
Review: Preferences
Since a consumer chooses the most preferred bundle subject to the
budget constraint, one needs to define the consumer’s preferences
Consider two bundles x = (x1 , x2 ) and y = (y1 , y2 )
The preference relation is denoted by ≿
x ≿ y: x is at least as preferred as y
x ≻ y: x is more preferred than y
x ∼ y: x and y are equally preferred bundles
Note: preferences are ordinal!
Review: Preferences
Assumption: preferences are rational, i.e. preferences are:
1. Complete: x ≿ y or y ≿ x
2. Transitive: x ≿ y and y ≿ z implies x ≿ z
Reflexivity, i.e. x ≿ x is implied by completeness
Indifference curves
Well behaved preferences:
1. Monotonicity
2. Convex preferences and strictly convex preferences
MRS: Slope of the indifference curve
Review: Utility Representation of
Preferences
A utility function represents a preference function ≿ if and only if
there is a function U (·) that maps from the set of consumption
possibilities to the real line, and x ≿ y ⇔ U (x) ≥ U (y)
This implies that:
1. x ≻ y ⇔ U (x) > U (y)
2. x ∼ y ⇔ U (x) = U (y)
Utility is ordinal
Indifference curve represents bundles with the same utility level
When can preferences be represented by a utility function?
Whenever the preference relation is rational (i.e. complete and
transitive) and continuous
M RS = slope of an indifference curve = − M U1
M U2
Review: Rational Choice
The most preferred feasible bundle is chosen, i.e. if preferences can
be represented by a utility function, then the feasible bundle that
gives the highest utility is chosen; so one can think of this as a
maximisation problem
For interior solutions, slope of IC = slope of budget line
The chosen optimal bundle is a function of prices and income, and
so one can analyse various comparative statics (for eg, w.r.t. price
changes, income changes)
Income effect, the Engel curve, the income offer curve, normal and
inferior goods
Choice and Price Change
Utility maximisation and choice
Suppose that there are only two goods, and the price of one good
changes
Two effects: the relative price changes, and the real income changes
How does each of these two affect the consumption?
Substitution effect and Income effect: Hicksian and Slutsky
decomposition
Compensated demand curves
Additional Reference: Gravelle and Rees, Microeconomics (3rd edition).
Choice and Price Change
Utility maximisation, the utility maximising bundle, Indirect Utility,
Roy’s Identity
Expenditure minimisation, expenditure function, and the Hicksian
compensated demand
Consumer Duality
Additional Reference: Gravelle and Rees, Microeconomics (3rd edition).
