Topic 2: Theory of Consumer Choice and Utility Maximization

Neoclassical economics and behavior economics

2 theories of consumer choice

behavioral economics

economic agents can make “irrational” decisions due to cognitive limitations, emotions, and biases

neoclassical economics

all economics agents are perfectly rational

theory of consumer choice

“consumers will consume the best bundle of good that they can afford”

preference

a greater liking for one alternative over others

weak preferences, strong preference, indifference

3 preference relations what are they in order?

Weak Preference

A is at least as desirable as B or

A is weakly preferred to B

Strong Preference

A is more desirable than B or

A is strictly preferred to B

indifference

A and B are equally desirable

The consumer is indifferent between A and B

completeness

• Individuals can rank consumption bundles and are not paralyzed by indecision

• either A > B, B > A or A~B; depends on preference

transitivity

• Individuals’ choices are internally consistent

• if A~B and D > B, then D > A

non-satiation

• Individuals will always prefer more of a good than less of it

• D is the most preferred bundle

convexity

• More balanced bundles are preferred to extremes

• C > A,C > B

utility

The subjective pleasure or usefulness that a person derives from

consuming a good or a service.

cardinal utility approach and ordinal utility approach

2 utility approaches

cardinal utility approach

Consumers can assign to every good or a combination of goods a number representing amount of utility associated with it (i.e., utils)

ordinal utility approach

Consumers rank bundles of commodities instead of assigning numbers.

utility function

A mathematical representation of preferences.

U(X1,X2 , ...,Xn)

• not unique

• continuous first & 2nd-order partial derivatives

• w/ reference to consumption during specified period

utility number assigned

• ______ _____ ______ to any commodity combination indicates that it’s preferable or superior to all combinations yielding lower utility numbers and vice-versa (Uo)

total utility (TU)

The total satisfaction received from consuming a

good or a service.

Marginal Utility

refers to the additional satisfaction derived from consuming an additional unit of a good.

Law of Diminishing Marginal Utility

satisfaction added to a unit of a good decreases when indiv. consumes more of the good

Indifference Curve

• A curve that shows a set of consumption bundles about which the

individual is indifferent.

• locus of pts of goods X and Y where a consumer derives same lvl of satisfaction or utility

indifference curve map

a set of indifference curves indicating increasing utility levels moving in the northeast direction on the X-Y plane

downward sloping

complete it. indifference curves are always?

higher, lower

________ indifference curves are preferred more than _____ ones?

higher commodity quantities for both X and Y

when there are higher indifference curves, what does that mean?

never intersect

indifference curves never ______

to prevent violation of the transitivity axiom

how come indifferent curves never intersect?

1. higher indifference curves are preferred more than lower ones

2. always downward sloping

3. never intersect

4. convex to origin

what are the 4 characteristics of indifference curves

convex to the origin

indifference curves are _____

not perfect substitutes

Relative substitutability of the goods/goods are _______

marginal rate of substitution (MRS)

• The rate at which the consumer is willing to substitute one good for the other.

• slope of the indifference curve

• max amount of Y that a consumer is willing to give up to get an additional unit of X, while maintaining the same level of

  utility.

• “psychic rate of tradeoff”

willing to tradeoff 2 units of Y for 1 unit of X

how to interpret this?

willing to tradeoff ½ unit of Y for 1 unit of X

how to interpret this?

diminishing marginal rate of substitution

As the amount for X good increases, the amount of Y good that the individual is willing to give up in exchange for X decreases, and so is MRSxy

negative function

marginal utility is a ____ ____ of quantity

consuming X good → your MU decreases → more willing to trade X off for Y

consuming X good → your MU decreases → more willing to trade X off for Y

Budget Constraint

shows all the bundles of goods and services that the consumers can afford given their income and the prices of commodities.

Budget Line

The set of bundles that just exhaust the consumer’s income

Budget Set

A set consisting all bundles that do not cost any more than the consumer’s

income.

Px/Py

slope = ?

reps market rate of trade-off/market exchange rate

what does this represent?

affordable bundles

bundles that cost less than the budget

Just Affordable Bundles

bundles that cost exactly the budget (complete budget exhaustion)

Not affordable bundles

bundles that cost more than budget

price decrease

• Shift or Rotation of the Budget Line

• No old choice is lost.

• New choices are added.

Price Increase

• Shift or Rotation of the Budget Line

• Some old choices are lost.

Income Increase

• Shift or Rotation of the Budget Line

• outward parallel shift

• enlarges budget set

• new affordable consumption choice

Income Decrease

• Inward parallel shift

• Shrinking the budget set

• Fewer affordable consumption choices

Tangency Condition

• slope of the indifference curve = slope of the budget line

slope of the indifference curve = slope of the budget line

define tangency condition

best bundle that can be afforded

what’s constrained utility maximization?

indifference curve must be tangent to budget line

how to maximize utility?

Bundle A – optimal bundle

Bundle B – higher utility level, but not affordable

Bundle C – affordable, but lower utility level

identify what each bundle means in this graph.

Equimarginal Principle

An individual will achieve max. utility when the marginal utility of the

last peso spent on a good (X) is exactly the same as the marginal utility of the last peso spent on the other good (Y)