Intermediate

Microeconomics - Notes

Spring 2015

Musatti

Unit 1- The Consumer Choice Model: The Set Up (Perloff, Ch.3)

The first unit of the course focuses on trade and on the forces that shape what people buy or sell. Why do we
buy one item instead of another? Offered a discount, will we buy more? Is it better to be offered a store
discount or product-specific coupons? The unit also explores the incentives consumers respond to as well as
the most common types of responses. Lets make the connection to our every days life: last week, you did not
buy Q-tips, why? Would CC or SEAS students take fewer credits if instead of a flat tuition they had to pay per
credit like students from the School of General Studies? Are there demographic differences between people
signing up for a pay-as-you-go phone plan and those opting for a flat fee plan?

The consumer choice model will help us investigate these questions.

The Consumer Choice Model

In a nutshell:

What consumers buy (or sell) depends on what they can afford and on what they like.

Economists use the concepts of opportunity set and budget line to talk about what consumers can afford,
and they use the concepts of preferences, utility function and indifference curves to describe what
consumers like.

The model assumes that consumers are rational. This means that consumers know what they like and what
they dont like and they are so well aware of their tastes that they are able to rank affordable alternatives
from the one they like the least to the one they like the most. The model also assumes that consumers make
rational purchases: that is consumers buy the affordable combination of items that they like best.

The details:

1. The Opportunity Set: What a Consumer can Afford

When you visit the supermarket, you buy many items: milk, cereal, chips, yogurt, Economists call these
generic combinations of items bundles. A bundle is feasible if it can be produced. For example, three apples,
four gallons of milk and a pony form a feasible bundle, while a visit to Mars, time travel to the middle ages,
and a ride on the unicorn form a bundle that is NOT feasible.

To keep the math simple (i.e. to allow the use of calculus micro with no calculus, believe it or not, is much
harder), economists assume that all feasible bundles are infinitely divisible and they represent bundles as
points in Euclidean spaces and/or arrays of non negative real numbers.

So the common representation of a generic bundle of N products is the array
(1.1)

To represent what a consumer can afford, economists use the concept of opportunity set. The opportunity
set is the set of feasible bundles that the consumer can afford given her endowment.

Consumers can finance their purchases using a monetary endowment (ex. cash at hand) or by selling
something they own (Note: in financial markets where short-selling is allowed, consumers can finance their
purchases also by selling assets they do not yet own).

The opportunity set when the consumer has a monetary endowment

Suppose a consumer has a monetary endowment of M (like Professor Musatti when she goes grocery
shopping at West Side Market) the shape of the opportunity set depends on whether the consumer is a
price taker or a price maker.

Consumer Choice: the set-up - Lectures 1 & 2

Intermediate Microeconomics - Notes

Spring 2015

Musatti

A consumer is a price taker if the unit price she pays does not depend on her demographic characteristics or
on the amount she buys.

On the contrary, if the price a consumer pays depends on a modifiable demographic characteristics or on the
quantity she purchases, we say the consumer is a price maker.

The Opportunity Set of a Price Taker

The generic expression of a price takers opportunity set is

S = {(q1,qN) : p1q1+ p2q2+pNqN M} (1.2)

Where i=1,2,N indicates the n available items, and qi and pi indicate respectively the quantity and the unit
price of item i.

Working in N-dimensional spaces is cumbersome hence we restrict our attention to choices between two
items. Results dont loose generality and can be illustrated our in two-dimensional diagrams.

In the two products case, the opportunity set of a price-taking consumer can be written as

S = {(qX,qY) : pXqX+pYqY M} (1.3) or as S = {(qX,qY) : qY M/pY (pX/pY) x qX} (1.3 bis)

If we drew this generic opportunity set in a X/Y diagram we would get the triangle above the X axis, to the
right of the Y axis and below the budget line qY = M/pY pX/pY x qY

Example: Jo has $10 to buy pizza and soda. A slice of pizza costs $2, a can of soda costs $1. Jos opportunity set
is
S = {(qC,qP) : qP $10/$2 $1/$2 x qC = 5-0.5qC}


Slices of

Pizza
5



Jos budget line

qP= 5 0.5qC

Opportunity
Set



10 Cans of Coke



Fig. 1.1 Jos budget constraint.

The slope of the budget line represents the consumer opportunity cost of buying one more unit of product
1 in terms of units of product 2 and is called the Marginal Rate of Transformation (MRT). It is equal to the
negative of the relative prices (- P1/P2).

More money, a higher M, shifts the budget line up in a parallel way. Changes in either price rotate the
budget set. The rotation is inward for price increases and outward for price drops.

QY

QY

PX

QY

PY

QX

QX

QX

Fig. 1.2 Effects of an increase in M, PX or PY on the Position and Shape of the Budget Set.

Consumer Choice: the set-up - Lectures 1 & 2

Intermediate Microeconomics - Notes

Spring 2015

Musatti

Price Makers

The budget set of a price maker has a more complicated shape. The budget line could be piecewise linear, or it
could have jumps, or it could even be curvy. When the consumer is a price maker, there is no general
shape for his opportunity set, the algebraic expression of the budget line and the shape of the opportunity set
must be figured out on a case by case way.

Example 1: A copy shop charges 10c per copy on print jobs of fewer than 500 copies, 8c per copy on print
jobs between 501 and 1000 copies and 5c per copy on larger print jobs. You have $100, what is your budget
set?
S = {(qc, M) : $0.1qc +$M $100 if qc 500; $0.08qc +$M $100 if 500 qc 1,000; $0.05qc +$M $100 if qc
> 1,000}

Example 2: A copy shop charges 10c per copy on the first 500 copies, 8c per copy on copies 501 through
1000 copies and 5c per copy on copies above the 1000th. You have $100, what is your budget set?
S = {(qc, M) : $0.1qc +$M $100 if qc 500; $0.08(qc-500)+$M $50 if 500 qc 1,000; $0.05(qc-1000)+$M
$10 if qc > 1,000}

Practice Exercise: At Columbia University, students enrolled in Intermediate Microeconomics are charged
differently depending on what school they belong to. Students from the College pay a flat tuition of $21,500
regardless of the number of credits they take, while students from the school of General Studies, pay $1,400
per credit up to 17 credits and a flat tuition of 23,000 for more than 17 credits. In a diagram, draw a students
opportunity set if he has a monetary endowment of $100,000 to spend on Columbia credits or other items.
First assume the student is from the College, in a second time assume he is from the school of General Studies.
What is the opportunity cost of enrolling in Intermediate Micro for a student from the College? and for a
student from the school of General Studies? Which type of student is more likely to enroll in five or more
courses each semester? Why do you think different schools use different price schedules?

Real Endowment
In many instances, consumers go to market carrying goods (or assets, or services) instead of cash. They
finance their purchases with the proceeds of the sale of the goods they choose to sell. For example, most
adults pay their bills with their wages. They sell labor services to employers and use the proceeds of these
sales to buy food, clothes and pay rent. In the past, cavemen used to barter furs for meat, and nowadays
commodity traders go long on coffee by shorting orange-juice.

In these cases, the consumers initial endowment is a bundle of the generic form =(1,N).

If the consumer is a price taker, and the prices he charges as a seller are equal to the prices he is charged as a
buyer, his opportunity set can be written as

S = {(q1,qN) : p1q1+.pNqN p11++pNN } (1.4)

In the two products case:
S = {(qX,qY) : pXqX+pYqY pXX+pYY } (1.5)

In a X/Y diagram, the opportunity set is the triangle below the budget line
qY = (pXX+pYY)/pY (pX/pY) x qX (1.6)

Even if the shape of the budget set is the same as in the case when the endowment is in cash, the two cases
are quite different. When the consumer has a commodity endowment, a change in the price of either product
rotates the budget line around the initial endowment bundle, not around one of the opportunity sets two
corners.

An increase in the price of good X, steepens the budget line, an increase in the price of good Y flattens the line.
If product X becomes more expensive, the consumer can finance a larger acquisition of product Y by selling
the units of product X he owns. If I receive a raise, my wages can buy more goods and services than before. An

Consumer Choice: the set-up - Lectures 1 & 2

Intermediate Microeconomics - Notes

Spring 2015

Musatti

increase in the stock price of ATT allows an investor to buy more shares of HSBC by selling his interest in the
telecommunication company.

Example: Abel, the shepherd, has six sheep and twelve goats. The diagram below illustrates Abels
opportunity set when one sheep is exchanged for one goat and when one sheep is exchanged for two goats.

Goats


24

Budget Line when one sheep

is exchanged for two goats.

18



12

Budget Line when one sheep

is exchanged for one goat.





6
12
18 Sheep


Practice exercise: Abel can sell sheep only in a village where people pay two goats for one sheep and can buy
sheep only in a village where people pay one sheep for one goat. Draw Abels opportunity set.

The Opportunity Sets: a summary

1. The opportunity set describes a consumers affordable bundles. The boundary of the opportunity set is
called the budget line.
2. The slope of the budget line at a bundle is called the Marginal Rate of Transformation and is equal to the
negative of the relative prices.
3. When consumers are price takers, the opportunity set is a triangle.
4. When consumers are price makers, the opportunity set has a less regular shape.
5. A higher (lower) price of good X steepens (flattens) the budget line and raises (lowers) the positive part of
the MRT. A higher (lower) price of good Y flattens (steepens) the budget line and lowers (raises) the positive
part of the MRT.
6. Changes in the size of the initial endowment shift the budget line in a parallel way.

Consumer Choice: the set-up - Lectures 1 & 2

Intermediate Microeconomics - Notes

Spring 2015

Musatti

2. Preferences and Utility: what consumers like

When talking about consumers tastes, economists use the concepts of preference relation, utility function,
and indifference curve. To guide their understanding of consumers behavior, they make strong
assumptions on what peoples preferences and utility function look like.

The consumer choice models key behavioral assumption is that consumers are rational: they know what
they like and are able to fully rank any set of feasible bundles from worst to best. A rational person is able
to rank any feasible job offer, or any feasible spring-break vacation package, health-care plan or interest rate
swap.

Preferences and Rationality.

A language we can use to describe consumers tastes is a preference relation.

A preference relation is a binary relation R that reads weakly preferred to (or likes at least as much as much
as ), so that given two bundles a and b, the statement a R b reads the consumer weakly prefers a to b, that is
she likes a at least as much as b. In plain English, this means the consumer either prefers bundle a to bundle
b or he is indifferent between the two.

A consumer is rational (let me remind you, rational means being able to rank any set of feasible bundles from
worst to best) if his preference relation satisfies two conditions:

1. completeness. Formal language: taken any two feasible bundles a and b either aRb or bRa or both.
Intuition: offered any two bundles, the consumer is able to say if he likes one better than the other or if he is
indifferent between the two. This assumption rules out indecision, framing effects, state dependencya lot of
fun stuff.

2. transitivity. Formal language: taken any three feasible bundles a, b and c, if aRb and bRc then aRc.
Intuition: If a consumer prefers going to the game to going to the movies and he prefers going to the movies to
going to the ballet, he is rational only if he also prefers going to the game to going to the ballet. This is similar
to saying that if a number A is greater than a number B, and the number B is greater than a number C, then A
is surely greater than C as well.

Example: Martha is into classic English rock. Suppose Martha prefers The Pink Floyd to The Joy Division and
she also prefers The Joy Division to The Clash, however when given the choice between listening to the Pink
Floyd and the Clash she opted for the Clash, than Marthas preferences are NOT transitive.

Utility
If a consumer is rational (his preferences are complete and transitive) and if his preferences do not jump
around too much (in econ parlance, if his preferences are continuous), we can use a mathematical function
called a utility function to summarize his tastes. That is we can find a function that always agrees with his
tastes so that every time the consumer likes a bundle a better than a bundle b, the function assigns a higher
numerical value to a than to b.; and every time the consumer is indifferent between two bundles, the function
assigns the same numerical value to both.

In summary, if a consumer is rational there is a one to one relationship between his preference relation and
his utility function and the expression U(a)U(b) has the same meaning as the expression aRb, the same way
the words Je taime have the same meaning as the words I love you.

Example: I prefer a two slices of pizza and two cans of cola combination (2,2) to a three slices of pizza and one
can of cola combination (3,1) and to a one slice of pizza and three cans of cola combination (3,1). I also prefer
a one slice of pizza and three cans of cola combination (1,3) to a three slices of pizza and one can of cola
combination (3,1).
We can use a preference relation to describe my preferences over these three bundles: we should write
(2,2)R(3,1), (2,2)R(1,3), and (1,3)R(3,1). My preferences over the three bundles are complete and transitive
and there is a mathematical function that agrees with my preferences, for example the function

Consumer Choice: the set-up - Lectures 1 & 2

Intermediate Microeconomics - Notes

Spring 2015

Musatti

U(qP,qC) = (qP )2 x (qC)3 as U(2,2) = 4 x 8 = 32 > 27 = 1 x 27= U(1,3) and U(2,2) = 4x8 = 32 > 9 = 9 x 1= U(3,1)
and U(1,3) = 27 > 9 = U(3,1). The function U(qP,qC) = (qP )2 x (qC)3 can be used to illustrate my tastes and can
be called my utility function.



Marginal Utility
The increase in utility a consumer feels from receiving one more unit of a product is called the products
marginal utility.
If the utility function is differentiable, the marginal utility of product x is the partial derivative of the utility
function respect to x. MUX = U(qX,qY)/x .

Example: If the utility function is U(qX,qY) = 3qX+2ln(qY), the marginal utility of x is MUX = 3 and the marginal
utility of y is MUY = 2/qY.

How to Interpret the Utility Function
Consumers that can rank alternative bundles but are unable to tell how much more they like one bundle than
another, have what economists call ordinal preferences and any strictly monotonic transformation of their
utility function (V = V(U) where V is everywhere positive or everywhere negative) summarizes their
preferences correctly.
If the consumer is able to say how much more he likes a bundle than another, then we say he has cardinal
preferences. In this case, only affine transformations of his utility function (linear transformations of the
form V = a + b x U) summarize his preferences correctly. Also the ratio in marginal utilities has an economic
interpretation: if the consumers marginal utility when he has three apples is 3 and when he has 5 apples is 1,
he enjoys receiving an apple in the former case three times more than in the latter one.

Indifference curve maps
A third useful way to represent a consumers tastes is using an indifference curve map.
An indifference curve is a set in an X/Y diagram that shows the combinations of good X and good Y the
consumer likes equally, keeping the amounts of all other products (if any) constant.
As the name suggests, a consumer is indifferent between any two bundles (any two points) along the same
indifference curve. An indifference curve is like a contour line on a hiking map, the same way a hiker walking
along a contour line does not gain or loose altitude, a consumer who exchanges a bundle for another along the
same indifference curve does not gain or loose utility.
An indifference curve map is a full system of indifference curves, one for each possible level of the consumers
utility.

Economists say that consumers have separable preferences, if changing the amount of a third product does
not affect the shape of the indifference curves between any other two products (Ex. if changing the number of
socks in your drawer, does not affect how you feel about pizza and soda. It does not change the shape of your
indifference curves for pizza and soda).

If a consumer has complete, transitive and continuous preferences:
1. He is rational - weve seen this already
2. His preferences can be summarized with a utility function and we have seen this already.
but also:
3 - His indifference curves are continuous lines (otherwise they could be individual points, as is the case
for lexicographic preferences or blobs, they could have gaps and/or jumps)
4 - His indifference curves never cross.

Monotonicity
For the rest of this unit, we will consider only cases where all the products the consumer faces are goods.
These are products the consumer likes and for which he feels that more is better. In economic parlance we
say that we consider only cases where the consumers preferences are monotonic in all products.
In real life, there are many things we consume that we dont like, for example second hand smoke or noise.
These are bads, not goods. In these cases, instead of focusing on the amount of the bad we will consider how
the consumer feels about the bads reduction (for example noise abatement), which is clearly a good.

Consumer Choice: the set-up - Lectures 1 & 2

Intermediate Microeconomics - Notes

Spring 2015

Musatti

If his preferences are complete, transitive, continuous AND monotonic, a consumers indifference curves
are also
- downward sloping and
- the higher the curve, the higher the consumers welfare.

In class exercise: Electricity is a good but air pollution is a bad. What is the shape of a rational consumers
indifference curves for electricity and pollution?

Consumers attitudes towards mixing

Many interesting results of economic theory are driven by how consumers feel about mixing two products. Do
they prefer balanced bundles of these products to unbalanced ones, the same way we would rather wear a
pair of pants and a shirt to two shirts and no pants? Are they indifferent to mixing, the way we are indifferent
between Washington State and Chilean apples? Do they need to consume the products in exact proportion,
one left shoe for each right shoe? The answer to these questions turns out to be very important. So now we
will learn the language economists use to talk about mixing.

Preference for mixing: Most of us prefer wearing a pair of pants and a shirt to wearing two pair of pants and
no shirt or to wearing two shirts and no pants. In other words we have a preference for balanced mixes of
pants and shirts. In economic parlance we call products a consumer would rather mix imperfect substitutes.

Preferences for imperfect substitutes are strictly convex that is for any two bundles a and b where aRb then
for any >0 the bundle c = a+(i- )b satisfies cRSb where RS is the strict part of the R relationship.

When preferences are strictly convex, indifference curves are also strictly convex (concave up) as in the
figure below.



Y







I3

I2

I1


X

Fig. 1.3 Indifference curves for a consumer with well-behaved preferences


Utility functions that are commonly used to summarize a consumers tastes for imperfect substitutes (strictly
convex preferences) are:

-
Cobb-Douglas (CD): U(qX,qY) = qX qY
- Quasi-Linear (QL): U(qX,qY) = v(qX)+qY

1/
- Constant Elasticity of Substitution (CES): U(qX,qY) = [ qX + (1-) qY ]


The Marginal Rate of Substitution
The marginal rate of substitution of Y for X (MRSY,X) is the slope of the indifference curve at a given
bundle. The MRS can be interpreted in either one of two ways: 1) the highest amount of product Y a consumer
is willing to give up so as to receive one more unit of good X or 2) the smallest amount of product Y a
consumer must receive to be fully compensated for the loss of one unit of product X.

The MRS gives us an idea of the rates at which a consumer is willing to trade product Y for product X.
Offered to exchange Y for X at a rate higher than his MRS the consumer would sell X and buy Y, offered to
trade at a rate lower than his MRS, the consumer would buy X and sell Y.

Consumer Choice: the set-up - Lectures 1 & 2

Intermediate Microeconomics - Notes

Spring 2015

Musatti

If a consumers utility function is differentiable, his MRSY,X is equal to the opposite of the ratio of his marginal
utility of X to his marginal utility for Y: MRSY,X = - UX/UY .

Example: Suppose Oris preferences for X-box videogames (X) and Yankees baseball caps (Y) are summarized
by the utility function U = XY0.5. Oris marginal rate of substitution of Yankees baseball caps for X-box games
when he has 4 caps and 4 games is MRSY,X = - UX/UY = - Y0.5/ 0.5XY-0.5 = - 2Y/X = - 8/4 = -2. He would certainly
give up one cap for a game, however he would give up a game for three caps.

If a consumer considers two products imperfect substitutes, his indifference curves become flatter and flatter
as we move rightward away from the origin. The consumers MRS increases (becomes less and less negative)
as the consumer has larger amounts of product X and smaller amounts of product Y. This means that the
more of product X the consumer has, the more easily he is to give some up for even small amounts of product
Y. This mathematical result captures our intuition that the more a consumer has of an item, the easier he
would let go of some of it.


Y



w0



MRS

I3




X

Fig. 2.3 Marginal Rate of Substitution strictly convex preferences

Other attitudes towards mixing

Perfect Substitutes

Consumers consider some goods perfect substitutes and are willing to trade them always at the same rate
regardless of the amount of each they already own.

An example of perfect substitutes is small amounts of nickels and dimes. Regardless of how many nickels and
dimes you have in your pocket, you are always willing to trade 2 nickels for a dime and the trade doesnt
make you feel either better or worse off.

Indifference curves for perfect substitutes are straight lines.
The typical function used to illustrate preferences for perfect substitutes is the linear utility function of the
form U(qX,qY) = qX+qY.


Dimes







2




1




2 4 Nickels

Fig. 2.4 Indifference curve mapping perfect substitutes

Exercise: Do you consider large amounts of nickel and dimes perfect substitutes? If not, what is the shape of
your indifference curves for large amounts of nickels and dimes?

Perfect Complements

Consumer Choice: the set-up - Lectures 1 & 2

Intermediate Microeconomics - Notes

Spring 2015

Musatti

Some products we like to consume in exact proportions: one left shoe for each right shoe, one lap-top screen
for each two processors, two parts of tonic for each part of gin.

Products that a consumer wants to consume in exact proportions are called perfect complements.

Indifference curves for perfect complements are L shaped with vertices aligned according to the fixed
proportion the consumer likes.

Example: Sarah doesnt like rum or Cola, however she loves her Cuba Libres. A good Cuba Libre is
prepared with 1 ounce of rum for each 3 ounces of cola. Sarahs indifference curves for rum and cola are


Rum in

ounces









2


1



3 6 Cola in ounces

Fig. 2.5 Indifference curve mapping perfect complements

The utility function for perfect complements is U(qX,qY) = min{qX , qY } where is the ratio in which the
consumer wants to consume the two products.

Preferences: a summary

1. Economists represent consumers tastes using preference relations, utility functions and indifference
curves.
2. Rational consumers have preferences that are complete and transitive and can rank all possible bundles
from worst to best.
3. When rational consumers have continuous preferences, their tastes can be summarized using a utility
function.
4. Indifference curves illustrate combinations of two products a consumer likes equally. They are contour
lines of the utility function.
5. Economists call goods products consumers like and for which they feel that more is better.
6. If consumers consider two products imperfect substitutes, their preferences and indifference curves are
strictly convex (their utility function is quasi-concave). If they consider two products perfect substitutes, their
indifference curve and utility function are linear. If they consider two products perfect complements, their
indifference curves are L shaped.
7. The MRS is the slope of the indifference curve at a bundle. It gauges the rate of exchange at which
consumers can no longer benefit from trade. It is equal to the (opposite of the) ratio of the products marginal
utilities.

Consumer Choice: the set-up - Lectures 1 & 2

Intermediate Microeconomics - Notes

Key Concepts:
Opportunity Set


Budget Line
Marginal Rate of Transformation
Relative Price
Price Taker/Maker
Initial Endowment
Preferences
Utility Function
Rationality
Indifference Curve/Map
Marginal Rate of Substitution
Imperfect Substitutes
Perfect Substitutes
Perfect Complements

Commonly Used Utility Functions

Spring 2015

Musatti

Consumer Choice: the set-up - Lectures 1 & 2

10