Chapter 3: Consumer choice
We will study the behaviour of consumers.
Budget constraint
Is a consumption bundle containing x1 units of commodity 1; x2 units of commodity 2
and so on up to xn units of commodity n.
When p1x1 + p2x2 + … + pnxn <= m is affordable. m is the consumer’s disposable
income.
The more you have, the happier you are you want to spend as much as you have in
order to improve your life.
For Two Commodities
Budget constraint = p1x1 + p2x2 = m
x2 = -(p1/p2)x1 + m/p2
Slope = -p1/p2 (price ratio) Increasing x1 by 1 must reduce x2 by p1/p2
If I want to consume one unit more of x1, I will have to give up x units of x2. The
budget constraint is JUST THE LINE; the budget set is the area below the line (line +
area below).
Budget set = p1x1+p2x2 <= m
How much you have to give up of x2 in order to increase x1 (p1/p2) How much you
have to give up of x1 in order to increase x2 (p2/p1).
Income
HIGHER INCOME GIVES MORE CHOICE as you can now afford more, the area
increases but the slope is the same. When income is lower, the area reduces but the
slope also stays the same.
Price
When the price of one of the products decreases the area increases and the slope also
changes. The slope is now flatter.
Utility and preferences
The theory of consumer behaviour has been formulated entirely in terms of consumer
preferences. The consumer ranks the consumption bundles describes the consumer’s
preferences.
Utility is only a way to describe preferences. A utility function is a way of assigning a
number to every possible consumption bundle such that the most-preferred bundles
get assigned larger numbers than less-preferred bundles.
To represent consumer’s preferences, we need the utility function for that particular
consumer with respect to the goods in question. Graphically, we will represent the
level curves (indifference curves) of that utility function.
- strict preference: x is more preferred than is y. (x ≻ y)
Preference relations:
- weak preference: x is as at least as preferred as is y. (x ≽ y)
- indifference: x is exactly as preferred as is y. (x ∼ y)
If x ≽ y and y ≽ x then x ∼ y
If x ≽ y but not y ∼ x then x ≻ y
Assumptions about preference relations:
≽ y or y ≽ x or both)
- Completeness: We assume that any two different bundles can be compared. (x
- Reflexive: We assume that any bundle is at least as good as itself. (x ≽ x)
- Transitive: If x ≽ y and y ≽ z then we assume that x ≽ z
Well-behaved preferences
A preference relation is “well-
behaved” if it is monotonic and
convex.
Monotonicity: More of a
commodity is always preferred.
Convexity: Averages are prefered to
extremes.
Slopes of indifference curves
The slope of an indifference curve is its
marginal rate-of-substitution (MRS). It
measures the rate at which a consumer is
just willing to substitute one good for the
other.
Main Utility Functions:
- Cobb-Douglas utility function:
a b
U ( x 1 , x 2 )=x 1∗x2
- Perfect Substitutes utility function:
U ( x 1 , x 2 )=ax1∗bx 2
- Perfect Complements utility function:
U ( x 1 , x 2 )=min { ax 1 , bx 2 }
If we have to goods that are bad for the consumers, the slope will be negative and the
growth will go the other way around.
d
−
dx1
MRS=
d
dx 2
