Microeconomic
Course 2
Nicholson Ch.3& 4, Pyndick Ch. 3
Theory of consumer behavior
“How consumers allocate incomes among different goods and services
to maximize their well-being (utility)”
Consumer behavior is best understood in three distinct steps:
1. Consumer Preferences
2. Budget Constraints PREFERENCE BUDGET
CHOICE
AND UTILITY CONSTRAINT
3. Consumer Choices
Preference and Utility
Preference Utility
• Indifference Curve
Basic • MRS
Assumption • Types of utility
function
• Some Basic Assumptions about Preferences : Rational
Choice
1. Completeness: Preferences are assumed to be complete. In other words,
consumers can compare and rank all possible baskets. Thus, for any two market
baskets A and B, a consumer will prefer A to B, will prefer B to A, or will be
indifferent between the two. By indifferent we mean that a person will be equally
satisfied with either basket.
Note that these preferences ignore costs. A consumer might prefer steak to
hamburger but buy hamburger because it is cheaper.
2. Transitivity: Preferences are transitive. Transitivity means that if a
consumer prefers basket A to basket B and basket B to basket C, then the
consumer also prefers A to C. Transitivity is normally regarded as
necessary for consumer consistency.
3. Continuity. If an individual reports “A is preferred to B,” then situations
suitably “close to” A must also be preferred to B.
Utility from consumption of goods
• U = u (x1, x2, …; ceteris paribus)
• X refers to goods
• Utility function U = U (x,y)
• X,Y refers to goods
Consumer Preferences
● market basket (or bundle) List with specific quantities of one or more
goods.
To explain the theory of consumer behavior, we will ask whether consumers
prefer one market basket to another.
• Indifference Curves
DESCRIBING INDIVIDUAL
PREFERENCES
Because more of each
good is preferred to less,
we can compare market
baskets in the shaded
areas.
Basket A is clearly
preferred to basket G,
while E is clearly preferred
to A.
However, A cannot be
compared with B, D, or H
without additional
information.
● indifference curve Curve representing all combinations of market
baskets that provide a consumer with the same level of satisfaction.
Indifference Maps
● indifference map Graph containing a set of indifference curves
showing the market baskets among which a consumer is indifferent.
AN INDIFFERENCE MAP
An indifference map is a set
of indifference curves that
describes a person's
preferences.
Any market basket on
indifference curve U3, such
as basket A, is preferred to
any basket on curve U2
(e.g., basket B), which in
turn is preferred to any
basket on U1, such as D.
CAN INDIFFERENCE CURVES INTERSECT ?
•The Shape of Indifference Curves
THE MARGINAL RATE OF
SUBSTITUTION
The magnitude of the slope of
an indifference curve
measures the consumer’s
marginal rate of substitution
(MRS) between two goods.
In this figure, the MRS
between clothing (C) and
food (F) falls from 6 (between
A and B) to 4 (between B and
D) to 2 (between D and E) to
1 (between E and G).
•The Marginal Rate of Substitution
● marginal rate of substitution (MRS) Maximum amount of a good
that a consumer is willing to give up in order to obtain one additional
unit of another good.
CONVEXITY
Observe that the MRS falls as we move down the indifference
curve. The decline in the MRS reflects our fourth assumption
regarding consumer preferences: a diminishing marginal rate of
substitution. When the MRS diminishes along an indifference curve,
the curve is convex.
Exercise : Utility and MRS
• U = x0.5 y0.5
• Utility = 10
• 10 = x0.5 y0.5
• 100 = xy
• Y = 100/x
• Dy/dx = -100/x2 MRS declines as x increases
• MRS at (5, 20) = 100/x2 100/25 = 4 person is willing to give up 4 Y to get 1 more X
• MRS at (20, 5) = 100/x2 100/400 = 0,25 person is willing to give 0,25 Y to get 1
more X
• Utility di titik C : U = 12.50.5 12.50.5= 12.5
Derivative concept Review
• Y = f (X)
• To calculate the changes of Y caused by small changes of X
• Properties of natural logarithm
Mathematical Derivation
• U = f (x,y)
• U = = x0.5 y0.5
Convexity of Indifference Curves
X increase, y decrease MRS diminishing convex
X increase, y decrease MRS diminishing convex
• UTILITY AND UTILITY FUNCTIONS : Cobb Douglas utility function
● utility Numerical score representing the satisfaction that a
consumer gets from a given market basket.
● utility function Formula that assigns a level of utility to individual
market baskets.
UTILITY FUNCTIONS AND
INDIFFERENCE CURVES
A utility function can be
represented by a set of
indifference curves, each with
a numerical indicator.
This figure shows three
indifference curves (with
utility levels of 25, 50, and
100, respectively) associated
with the utility function:
u (F,C )
= FC
Utility Function
Cobb Douglas Utility Function
• MRS diminishing
• Convexity
• Untuk mempertahankan utilitas, maka setiap peningkatan 1 unit x,
akan mengurangi Y dalam jumlah yang lebih sedikit.
Perfect Substitute Utility Function
• MRS constant
• Untuk mempertahankan utilitas, setiap tambahan 1 unit x akan
mengurangi Y sebesar 1 unit.
• perfect substitutes Two goods for which the marginal
rate of substitution of one for the other is a constant.
Perfect complement Utility Function
• MRS = 0
• Untuk mempertahankan
utilitas yang sama maka
setiap penambahan x
harus diikuti dengan
penambahan Y dengan
proporsi tertentu
Budget Constraints
● budget constraints Constraints that consumers face as a result
of limited incomes.
• The Budget Line
● budget line All combinations of goods for which the total amount of money
spent is equal to income.
PF F PC C I
A BUDGET LINE
A budget line describes the
combinations of goods that
can be purchased given the
consumer’s income and the
prices of the goods.
Line AG (which passes
through points B, D, and E)
shows the budget associated
with an income of $80, a price
of food of PF = $1 per unit,
and a price of clothing of PC =
$2 per unit.
The slope of the budget line
(measured between points B
and D) is −PF/PC = −10/20 =
−1/2.
C ( I / PC ) ( PF / PC ) F (3.2
• The Effects of Changes in Income and Prices
EFFECTS OF A CHANGE IN
INCOME ON THE BUDGET
LINE
INCOME CHANGES
A change in income (with
prices unchanged) causes the
budget line to shift parallel to
the original line (L1).
When the income of $80 (on
L1) is increased to $160, the
budget line shifts outward to
L2.
If the income falls to $40, the
line shifts inward to L3.
EFFECTS OF A CHANGE IN
PRICE ON THE BUDGET
LINE
PRICE CHANGES
A change in the price of one
good (with income
unchanged) causes the
budget line to rotate about
one intercept.
When the price of food falls
from $1.00 to $0.50, the
budget line rotates outward
from L1 to L2.
However, when the price
increases from $1.00 to
$2.00, the line rotates inward
from L1 to L3.
Consumer Choice
The maximizing market basket must satisfy two conditions:
1. It must be located on the budget line.
2. It must give the consumer the most preferred combination of goods and
services.
MAXIMIZING CONSUMER
SATISFACTION
A consumer maximizes
satisfaction by choosing
market basket A. At this
point, the budget line and
indifference curve U2 are
tangent.
No higher level of
satisfaction (e.g., market
basket D) can be attained.
At A, the point of
maximization, the MRS
between the two goods
equals the price ratio. At B,
however, because the
MRS [− (−10/10) = 1] is
greater than the price ratio
(1/2), satisfaction is not
maximized.
Satisfaction is maximized (given the budget constraint) at the
point where MRS = PF/PC
● marginal benefit Benefit from the consumption of one additional unit
of a good.
● marginal cost Cost of one additional unit of a good.
So, we can then say that satisfaction is maximized when the marginal
benefit—the benefit associated with the consumption of one additional
unit of food—is equal to the marginal cost—the cost of the additional unit
of food. The marginal benefit is measured by the MRS.
Corner Solutions
● corner solution Situation in which the marginal rate of substitution
for one good in a chosen market basket is not equal to the slope of the budget
line.
A CORNER SOLUTION
When a corner solution
arises, the consumer
maximizes satisfaction by
consuming only one of the
two goods.
Given budget line AB, the
highest level of satisfaction is
achieved at B on indifference
curve U1, where the MRS (of
ice cream for frozen yogurt) is
greater than the ratio of the
price of ice cream to the price
of frozen yogurt.
Marginal Utility and Consumer Choice
● marginal utility (MU) Additional satisfaction obtained from
consuming one additional unit of a good.
● diminishing marginal utility Principle that as more of a good is consumed,
the consumption of additional amounts will yield smaller additions to utility.
0 MU F (F ) MU C (C )
(C / F ) MU F / MU C
MRS MU F / MU C
MRS PF / PC
MU F / MU C PF / PC
or MU F / PF MU C / PC
● equal marginal principle
• Principle that utility is maximized when the consumer has equalized the
marginal utility per dollar of expenditure across all goods.
• each good purchased should yield the same marginal utility per dollar spent
on that good.
Example
• Utility function : U = Xa Yb
• Budgent line function : I= Px. X + Py. Y
• Transform to lagrange :
• Necessary condition : 1st derivative= 0
The higher is the relative
price of x, the smaller will
be the share of income
spent on that good.
Exercise 1
Jane receives utility from days spent traveling on vacation domestically (D) and
days spent traveling on vacation in a foreign country (F), as given by the utility
function U(D,F) = 10DF. In addition, the price of a day spent traveling domestically
is $100, the price of a day spent traveling in a foreign country is $400, and Jane’s
annual travel budget is $4000.
Question :
1. Find the MRS of vacation domestically (D) and on vacation in a foreign country
(F)
2. Show the Budget line function.
3. Find Jane’s utility maximizing choice of days spent traveling domestically and
days spent in a foreign country.
Exercise 2:
Julio receives utility from consuming food (F) and clothing (C) as given by the
utility function U(F, C) = FC. In addition, the price of food is $2 per unit, the price
of clothing is $10 per unit, and Julio’s weekly income is $50
Question :
1. Findthe MRS of Food (F) and Clothing (C)
2. Show the Budget line function.
3. Find Julio’s utility maximizing choice of food and clothing.
