CHAPTER 4

CONSUMER CHOICE

Budget Constraint
Budget constraint
Set of baskets that a consumer can purchase with a
limited amount of income

Budget line
Set of baskets that a consumer can purchase when
spending all of his or her available income
Pxx + Pyy = I

Slope of budget line

How many units of y a consumer must forgo to
obtain an additional unit of x
2

Budget Constraint (cont.)

Budget Constraint (cont.)

Location of budget line shows what the
income level is
Increase in income will shift the budget line to the
right
More of each product becomes affordable
Slope remains unchanged

Decrease in income will shift the budget line to the

left
Less of each product becomes affordable
Slope remains unchanged
4

Budget Constraint (cont.)

Budget Constraint (cont.)

Increase in the price of x
Moves the intercept on x-axis toward the origin
Slope increases

Consumers purchasing power declines

Decrease in the price of x

Moves the intercept on x-axis away from the
origin
Slope reduces

Consumers purchasing power increases

6

Budget Constraint (cont.)

Budget Constraint (cont.)

Optimal Choice
Optimal choice
Optimal amount of each good to purchase
Maximise satisfaction (utility)
Live within budget constraint

Consumer chooses the basket that maximizes his

satisfaction given the constraint that his budget
imposes
Consumer problem
max U(x,y)
subject to: Pxx + Pyy = I
9

Optimal Choice (cont.)

Interior optimum
The optimal consumption basket is at a point
where the indifference curve is just tangent to the
budget line
MUx / MUy = Px / Py
MUx / Px = MUy / Py
The rate at which the consumer would be willing to
exchange X for Y is the same as the rate at which they
are exchanged in the marketplace
The extra utility per dollar spent on good x is equal to
the extra utility per dollar spent on good y
10

Optimal Choice (cont.)

11

Optimal Choice (cont.)

12

Optimal Choice (cont.)

Utility maximisation
max Utility = U(x,y)
subject to: Pxx + Pyy = I
Exogenous: Px, Py, I; Endogenous: x, y, U

Expenditure minimisation
min expenditure = Pxx + Pyy
subject to: U(x,y) = U
Exogenous: Px, Py, U; Endogenous: x, y

Both are dual to one another

Lead to same utility and expenditure
13

Optimal Choice (cont.)

14

Optimal Choice (cont.)

15

Optimal Choice (cont.)

Corner points
A solution to the consumers optimal choice
problem at which some good is not being
consumed at all
E.g. not all consumers purchase tobacco and alcohol

The optimal basket lies on an axis

Budget line is not tangent to an indifference curve at the
optimal basket
MUx / MUy > Px / Py: Consume all the X and zero Y

16

Optimal Choice (cont.)

17

Optimal Choice (cont.)

18

Optimal Choice (cont.)

19

Optimal Choice (cont.)

20

Optimal Choice (cont.)

21

Coupons & Cash Subsidies

Composite good
A good that represents the collective expenditure
on every other good except the commodity being
considered

Income subsidy
Increase in income shifts the budget line

Housing voucher
Budget line for consumer increases
Maximum amount spend on other goods still the same
22

Coupons & Cash Subsidies (cont.)

23

Coupons & Cash Subsidies (cont.)

24

Joining A Club
Club membership
Let consumer purchases goods and services at a
discount
Need to pay a membership fee
E.g. joining a CD club
Able to buy more CDs due to price reduction
Buy less composite goods because have less income
New and old budget lines intersect indicates that
consumer is no worse-off
Increase utility
25

Joining A Club (cont.)

26

Borrowing & Lending

Borrow
Able to spend more on the composite goods this
year but decrease consumption next year
I1 + I2 / (1+r)

Lend
Able to spend more on the composite goods next
year
Decrease consumption this year
I2 + I1 (1+r)
27

Borrowing & Lending (cont.)

28

Quantity Discounts
Discount
E.g. electricity
With discount consumer can purchase more
electricity
The budget line become flatter after certain
amount of consumption
Slope reduces

Consumer has a higher level of satisfaction

Higher indifference curve
29

Quantity Discounts (cont.)

30

Revealed Preference
Can we infer preferences from purchasing
behaviour?
Suppose that preferences are not known

Revealed preference
To analyse consumers ordinal ranking of baskets
by observing how his or her choices of baskets
change as prices and income vary
Consumers choices of baskets reveal information
about his preferences
31

Revealed Preference (cont.)

If A is purchased, it must be preferred to all
other affordable bundles
All baskets to the Northeast of A must be preferred
to A
A C, C > B, A > B
A is strongly preferred to any basket on the segment EH
because A > B

This gives us a narrower range over which

indifference curve must lie
32

Revealed Preference (cont.)

33

Revealed Preference (cont.)

At initial price
Basket 1 is more preferred than basket 2
Assuming:
Pxx1 + Pyy1 Pxx2 + Pyy2

At new price
Basket 2 is more preferred than basket 1
Assuming:
Pxx2 + Pyy2 Pxx1 + Pyy1

At new price, basket 2 cannot cost more than

basket 1, otherwise basket 1 is chosen
34

Revealed Preference (cont.)

35

Revealed Preference (cont.)

36

Revealed Preference (cont.)

37

Revealed Preference (cont.)

38