4.

CONSUMER ECON1005 Principles of

Economics I
CHOICE (Microeconomics)
1. INDIVIDUAL CONSUMER
CHOICE
 In this topic, we focus on the demand side and explore the behavior of
individual consumers in detail. To understand any economic choice
individuals make, we must know what their objectives are and the constraints
they face in order to achieve them.

 For individual consumers, their objective is to maximize their overall

satisfaction from consuming and they are facing the constraint of spending
power.

 How an individual make his consumption choice?

 Among all the affordable choices, he chooses the one that he prefers most.
Budget constraint Preferences

Page 2
2. PREFERENCES
 Basic assumptions of consumers’ rational preferences:

 Completeness (People have preferences)

 If A and B are any two consumption baskets, the consumer can always rank them so that
one of the following three possibilities is true:
 A is preferred to B;
 B is preferred to A; or
 A and B are indifferent.

 Transitivity (Logically consistent)

 If If A is preferred to B and B is preferred to C, then A is preferred to C.

 Non-satiation (More is better)

 More of a good is preferred to less of it.

Page 3
3. UTILITY FUNCTIONS
 Utility: a set of numbers that is arbitrarily assigned to reflect the preference ordering of
consumption baskets.
 If a consumer prefers A to B, we would say the utility obtained from A is higher than the utility obtained
from B.
 Hence, it is also commonly interpreted as the measure of overall satisfaction obtained from consumption.
 It is not possible to compare utilities between different consumers.

 Utility function: shows the relationship between utility measures and quantity of goods
consumed.
𝑈=𝑈 ( 𝑞1 , 𝑞2 , ⋯ , 𝑞𝑛 )

where qi is the quantity of good i consumed.

 In the a single-good case, the utility function is:

𝑈=𝑈 ( 𝑞1 )
PAGE 4
 3. UTILITY FUNCTIONS
 The total utility curve: the graphical
U
representation of the utility function of a
Total Utility single good.

Note that the MU is

the slope of the total
42
∆U utility curve.  Marginal utility: the additional utility
30 that can be obtained by consuming one
∆q more unit of a good.

q1
1 2

 Two important assumptions about

utility function:
 More is preferred.
 Diminishing marginal utility

PAGE 5
APPLICATION:
FLAT
EXPECTATIONS
 In 2009, it seemed that 3D movie could rescue a film
business battered by falling DVD sales.
 Fully 71% of the box office spending on “Avatar” on its
opening weekend, in December 2009, went on the 3D
version.

 This lucrative business is now looking flat.

 Two years later, four of the past five 3D blockbusters –
“Pirates of the Caribbean”, “Kung Fu Panda 2”, “Green
Lantern” and “Harry Porter” – made more money from 2D
screens on their opening weekend than from 3D ones.
 In 2016, the 3D box office shrunk 8% in the US and
Canada to its lowest point since 2009.

 “People used to see something just because it was in 3D,”

Richard Gelfond, the boss of iMax said in 2011. Now they
ask how much pleasure the glasses will add.
 It’s apparent that the demand for 2D film is starting to
exceed that of 3D in North America, and we’ll be looking
to keep more of our films in 2D as a result.

(Source: 3D films struggle: Flat Expectations, The Economist, 23 July,

2011; The reign of 3D is over in US cinemas, Quartz, 28 July, 2017.)

PAGE 6
  The total utility curve: the graphical
U The total utility of
representation of the utility function of a single
consuming two units
of the good. Total Utility good.
56
 Marginal utility: the additional utility that can
50 Note that the MU is be obtained by consuming one more unit of a
the slope of the total
42 good.
∆U utility curve.
30
∆q

 Two important assumptions about utility

q1 function:
1 2 3 4
U  More is preferred.
The marginal utility of  Diminishing marginal utility
30 consuming the second
unit of the good.

 The utility function of a good for consumer A

can also be represented in the form of table as
12 follow:
Quantity of cola Total Utility Marginal Utility
8 0 0  
6 1 30 30
Marginal Utility
2 42 12
q1
1 2 3 4 3 50 8
4 56 6
5 58 2
PAGE 7
 In a two-good case, the utility function is:

U  U (q , q )
1 2

 A typical utility function can be represented in a three-dimensional diagram:

q1
q2
8
Keep q2 6
8 Keep q1
constant at 6
certain level 2 2 constant at
0 certain level
PAGE 8
3. UTILITY FUNCTIONS
 If we were to cut the utility hill vertically at a particular level of good 2, we can study
how utility level varies with the change in consumption of good 1, keeping q2 constant.
For example, if q2 is kept constant at 4 units, the total utility curve of good 1 can be
derived:

6 Total Utility
(when q2 = 4)

q1
4 9
PAGE 9
4. INDIFFERENCE CURVES
 If we cut the utility hill horizontally at a particular level of utility, and project the outside
edge of the hill on the floor. We derive an indifference curve that shows all the
combinations of good 1 and good 2 that yield the same level of utility.
U

U=6
c

U=4
a b
q1
q2
8
8 6
6
2 2
0
CONTOUR LINES

PAGE 11
4. INDIFFERENCE CURVES
 Indifference map: a graphical representation of a set of indifference curves.
q2

8 a

b
4

I (U  6)
2

I (U  4)
1

I (U  2)
3

q1
2 4
4. INDIFFERENCE CURVES q2
 Given the assumptions about preferences, indifference
Region I (upper right):
curves have four important properties:
Consumption baskets that
yield a higher level of
 Indifference curves slope downward and indifference utility
curves farther from the origin represent higher level of
utility. q21

 Indifference curves cannot intersect. Region II (lower left):

I1
Consumption baskets
that yield a lower level
 There is an indifference curve through every possible of utility
bundle.
q11 q1

 Indifference curves cannot be thick.

q2

q2 A> B
A
but B ~ C and A ~ D
(inconsistent!)
B C>D
B
C
A I2
D I1

q1 PAGE 13 q1
 4. INDIFFERENCE CURVES
 The downward sloping indifference curve q2
implies that a consumer is willing to give up
one good to consume more of another, to
keep his utility constant.
a

 Hence, the slope of the indifference curve Δq2

(magnitude) measures the amount of one b
good (good 2) that a consumer is willing to
give up for an extra unit of another good
(good 1), keeping utility level constant,
which is called the marginal rate of
substitution of good 2 for good 1 (MRS2,1).
I

 It can be shown mathematically that the

q1
MRS can be expressed as a ratio of the
Δq1
marginal utilities of the two goods. (For
those who are interested, refer to the
appendix to the handout.)
𝑀 𝑈1
|𝑀𝑅𝑆|=
𝑀𝑈 2
4. INDIFFERENCE CURVES
 Economists usually assume q2
the indifference curve is
convex to the origin.
 It means the MRS of good 1
declines as the consumer
increases his consumption
a
of good 1. This assumption
is called the diminishing
marginal rate of
substitution. b

q1
 5. BUDGET CONSTRAINT
 Budget constraint identifies all the combinations of goods that a consumer can buy with his
available income, at given prices.
p1q1  p2 q2  Y

 Budget Line: a graphical representation of the budget constraint, showing all the combinations of
goods that a consumer can buy spending all his available income, at given prices.

 Suppose the price of good 1 (p1) is $1, price of good 2 (p2) is $2 and the income available for the
consumer (Y) is $50, then the budget line can be drawn:
q2
 The slope of a budget line (magnitude) is
called the relative price of good 1: the
amount of one good (good 2) that a
consumer is required to give up for an Y
 25
extra unit of another good (good 1) from p2
Slope = 0.5
the market. That is (Relative price of good 1 = p /p )
1 2
p1
Relative price of good 1 
p2
L

Y q
 50 1
PAGE 16 p1
 5. BUDGET CONSTRAINT
 Example 1 (Change in income): q2
 Suppose the consumer’s income
rises from $50 to $100, with
prices remain unchanged at p1 = 100
 50
$1 and p2 = $2. How would the 2
budget line change?
Y 50 p1/p2 = 1
  25
p2 2
p1/p2 = 0.5
L2
 Example 2 (Change in price): L1
q1
 Suppose the price of good 1 Y 50
  25
Y 50
  50 100
 100
increases from $1 to $2, with the p1 2
'
p1 1 1
price of good 2 and the
consumer’s income remain
unchanged at p2 = $2 and Y =
$50. How would the budget line
change?
6. CONSUMER’S OPTIMAL
CHOICE
 How an individual make his consumption choice?
 Among all the affordable choices, he chooses the one that he prefers most.

 The consumer’s optimal choice is the consumption basket that maximizes his
utility subject to his budget constraint.
 It can be identified by putting the budget line and indifference curves together.

PAGE 18
Which point is 𝑝1
the consumer’s q2 |𝑀𝑅𝑆|>
optimal choice? 𝑝2

 Must lie on the 𝑝1

c |𝑀𝑅𝑆|=
budget line
𝑝2

 The point
where the a
budget line is e I3 𝑝1
tangent to the |𝑀𝑅𝑆|<
highest 𝑝2
attainable I2
indifference
curve. d
b
I1
L
q1
6. CONSUMER’S OPTIMAL
CHOICE
 The tangency condition implies:
𝑝1
|𝑀𝑅𝑆|=
𝑝2

 It means the amount of good 2 that the consumer is willing to give up for an additional
unit of good 1 is equal to the amount he is required to give up for it from the market, at
the optimal choice. (What is the intuition behind?)

PAGE 20
Which point is the 𝑀𝑈 1 𝑀 𝑝 𝑈12
consumer’s q2 |𝑀𝑅𝑆> |>
optimal choice? 𝑝1 𝑝𝑝2 2

 Must lie on the

c
𝑀𝑈 1 𝑀𝑝𝑈1 2⇒ 𝑀𝑈 1 𝑝 1
budget line |𝑀𝑅𝑆=|= ❑ =
𝑝1 𝑝𝑝22 𝑀𝑈 2 𝑝 2

 The point
where the a
budget line is
tangent to the
e I3 𝑀𝑈 1 𝑀𝑝𝑈1 2
|𝑀𝑅𝑆<|<
highest 𝑝1 𝑝𝑝22
attainable
indifference I2
curve. d
b
I1
L
q1
6. CONSUMER’S OPTIMAL
CHOICE
 The tangency condition implies:
𝑝1
|𝑀𝑅𝑆|=
𝑝2
 It means the amount of good 2 that the consumer is willing to give up for an additional unit of good 1 is
equal to the amount he is required to give up for it from the market, at the optimal choice. (What is the
intuition behind?)

 Recall that MRS = MU1/MU2. Rearranging the terms, the tangency condition also implies:
𝑀𝑈 1 𝑀 𝑈 2
=
𝑝1 𝑝2
 where MUi / pi is the marginal utility the consumer can obtain by spending an extra dollar on good i, which
is called marginal utility per dollar. Thus, the tangency condition means the marginal utility the consumer
can obtain by spending an extra dollar on each good is the same, at the optimal choice. (What is the
intuition behind?)
 At this point, there is no further gain from reallocating the spending on two goods.

PAGE 22
6. CONSUMER’S OPTIMAL
CHOICE
 The first interpretation is based on the indifference curve approach (in the appendix of
chapter 6) and the second interpretation is based on the marginal utility approach (in
the main content of chapter 6). Here we demonstrate that the two approaches
essentially yield the same conclusion.

 Suppose a consumer consumes n goods, the condition for the optimal input choice can
be generalized

𝑀𝑈 1 𝑀 𝑈 2 𝑀 𝑈𝑛
= =⋯=
𝑝1 𝑝2 𝑝𝑛

PAGE 23
6. CONSUMER’S OPTIMAL
CHOICE
 Example 3: Mark consumes only cookies and books. At his current consumption bundle, his
marginal utility from books is 10 and from cookies is 5. Each book costs $10, and each cookie
costs $2.
 Is he maximizing his utility? Explain.
 If he is not, how can he increase his utility while keeping his total expenditure constant?

 In order for him to be maximizing his utility, he must set his consumption such that the marginal
utility per dollar (MU­i/pi) of the last unit consumed is equal across commodities. In this case:

MU b 10 MU c 5
 1   2.5
pb 10 pc 2
MU b MU c

pb pc

 Specifically, the marginal utility per dollar is greater for cookies. Therefore, he should decrease
his consumption of books and increase his consumption of cookies. By consuming fewer books
and more cookies, MUb will rise and MUc will drop (why?). Mark should reallocate his spending
until MU­b/pb = MU­c/pc, at which he is maximizing his utility.
PAGE 24
7. COMPARATIVE STATICS
ANALYSIS
 Applying the consumer theory, we can examine the changes in the consumer
choices whenever there is a change in an exogenous variable. We attempt to
provide answers to two main questions:

 Will the consumer be better off?

 How will the consumer change his consumption choice?

PAGE 25
7. COMPARATIVE STATICS ANALYSIS:
CHANGES IN INCOME
q2
Suppose Income increases from Y1 to Y2
Will the consumer be better off?

e2 How will the consumption choice change?

• Normal good? Inferior good?
I2
e2

I2
e1
q 12

I1
L2
L1
q1
1
q
1 Page 26
APPLICATION: CHINA’S
SEAFOOD DEMAND
 Long the world’s top producer and exporter of
seafood, China is set to also be the world’s
biggest market for seafood in 2016, according
to the FAO.

 China has competitive advantages as a base

for low-cost species like tilapia.

 Rising income have fuelled the appetite for

luxury seafood.
 Ireland, Norway and Scotland are all seeking to
expand their salmon farms. French companies are
seeking licenses to breed oysters on Ireland’s
coastline to meet demand in China.

 China is buying premium Western seafood and

in return shipping cheap, farmed species to
Europe and the US, where supermarkets are
selling huge quantities of frozen white fish
tilapia and catfish.
(Source: China’s growing appetite for luxury seafood will push up
prices, South China Morning Post, April 22nd, 2015)
APPLICATION: CHINA’S SEAFOOD
DEMAND
q2 (Cheap fish)

e1
q 12 e2

I1

I2

L1 L2
q1 (Luxury fish)
1
q1
Page 28
8. COMPARATIVE STATICS
ANALYSIS: CHANGES IN PRICE
q2 1
Suppose price of good 1 decreases from p1 to p1
2

Will the consumer be better off?

e2 How will the consumption choice change?

e1 • Based on the law of demand (assumption),
we expect to increase as its price decreases
I2

I1

L1 L2
q1
1
q1 q1
2
Y p11 Y p 2
1 Page 29
8. COMPARATIVE STATICS
ANALYSIS: CHANGES IN PRICE
q2
In analyzing the price effect, our main focus is the impact of a change
in price of good 1 on the quantity of good 1 consumed. How about the
impact on good 2?
What if good 1 and good 2 are substitutes?
e3 What if good 1 and good 2 are complements?
e1 If the consumer view good 1 and 2 as substitutes
e2 (complements), a decrease in price of good 1 will
I2
reduce (increase) the her consumption in good 2.

I2

I1

L1 L2
q1
q1
1
q1 Y p
2 1
1 Y p 2
1
Page 30
 APPLICATION:
SANDWICHED
 Fast-food chains continued to be a rare bright spot for
Japan during its two-decade-long economic slump. Since
2008 the size of the market has increased from $35 billion
to $45 billion (those figured include convenience stores, or
konbini); that of restaurants has declined every year in that
period.

 Konbini offer everything from cheap egg-salad sandwiches

to rice lunch-boxes that can be reheated and eaten in-
store.
 According to Euromonitor, a market-research firm, 7-
Eleven, one of Japan’s three biggest konbini, accounts for
over a third of the fast-food market alone by value.

 But fast food is now being squeezed. Why?

 Many in the industry fret that a hike in Japan’s

consumption, or value-added, tax, planned for 2019, which
may not apply for food sold at konbini, will make fast-food
chains even less attractive as they try to raise prices.
(Source: Sandwiched, The Economist, Apr 22nd, 2017.)

Page 31
APPLICATION: SANDWICHED

q2 (Food from Konbini)

e2
e1

I1
I2

L2 L1
q1 (Fast food)
PAGE 32
 q2
 Suppose price of good 1
8. COMPARATIVE STATICS ANALYSIS: 1 2
decreases from p1 to p1 to p13
Y p2 CHANGES IN PRICE
e3
e1 e2  In this case, the amount of good 1
I 3
consumed increases
I2

I1
L1 L2 L3  Individual demand curve: shows
q1 the relationship between the
Y p11 Y p12 Y p13
p1 quantity demanded for a single
good and its price, keeping
income constant.
p11 E1

p12
E2  How about market demand
E3
curve?
p13
Individual
demand curve
q1
q11 q12 q13
Page 33