HSS 205: Microeconomics

Lecture 7

Microeconomics

Consumer choice

Microeconomics

The budget constraint

Budget constraint: the set of baskets that a consumer can
purchase with a limited amount of income.
Budget line: the set of baskets that a consumer can
purchase when spending all of his or her available income.
Let the total income of consumer is I , the consumer consumes
x amount of good x and y amount of good y (the quantity
and the good have same notation here); the price of one unit
of good x is Px and one unit of good y is Py .
The budget line is given by
Px x + Py y = I
The budget constraint is given by,
Px x + Py y I
Microeconomics

Interpreting the slope of the budget line

The slope of the budget line is

y
Px
=
x
Py
The slope tells us if we want to buy one extra unit of good x
on the budget line, how many units of good y we need to sell.
One unit of good x costs Px amount and to buy one unit of
good x, we need Px amount of money.
By selling

Px
Py

units of y , we can raise Px amount of money to

buy one unit of good x (because

Px
Py

Py = Px ).

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How does a change in income affect the budget line?

Microeconomics

How does a change in price affect the budget line?

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Optimal choice
Optimal choice: consumer choice of a basket of goods that
(1) maximizes satisfaction (utility) while (2) allowing him to
live within his budget constraint.
The optimization problem for the consumer is
max U(x, y )
x, y

subject to: Px x + Py y I
The solution to this optimization problem (x , y ) is called the
optimal choice. Mathematically, we write (arg is for argument)
(x , y ) =
arg max U(x, y )
x, y

subject to: Px x + Py y I
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Illustration of optimal choice in the utility maximization

problem

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Computing optimal solution

Interior optimum: An optimal basket at which a consumer
will be purchasing strictly positive amounts of all
commodities.
We can see in the previous figure that at the interior
optimum, the slope of the budget line is equal to the slope of
the indifference curve.
The slope of the budget line is
Px
y
=
x
Py
The slope of the indifference curve is
MUx
y
=
x
MUy
Since both are equal at the interior optimum, we have,
MUx
Px
MRSx,y =
=
MUy
Py
Microeconomics

Equal bang for the buck

We can rewrite the conditon as
MUy
MUx
=
Px
Py
By spending Px dollars, we can buy one extra unit of x i.e.
x = 1. Since, MUx = U
x , therefore the change in total
utility U = MUx .
By spending Px dollars, the gain in total utility is MUx , so by
x
spending one dollar, the gain in total utility is MU
Px .
The above condition says at the interior optimum, the
marginal utility per dollar spent (gain in total utility (bang) by
spending one extra dollar (buck)) is equal for both x and y .
If there are more than two goods, the above condition can be
rephrased to at the interior optimum, the marginal utility per
dollar spent on each good is equal i.e. for each good, we
have equal bang for the buck.
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Expenditure minimization problem

The expenditure on the basket (x, y ) is Px x + Py y .

Expenditure minimization problem: consumer choice
between goods that will minimize total spending while
achieving a minimum level of utility.
The optimization problem is,
min Px x + Py y
x, y

subject to: U(x, y ) U

Microeconomics

Illustration of optimal choice in the expenditure

minimization problem

Microeconomics

Duality
The utility maximizaitn problem and the expenditure
minimization problem are called dual to each other.
You can notice that the objective function and the constraint
are reversed in the dual problems.
If U is the maximal value of the utility maximization problem
and I is the minimal value of the expenditure minimization
problem, then the duality says that under some conditions,
arg max U(x, y )
x, y

subject to: Px x + Py y I
=
arg min Px x + Py y
x, y

subject to: U(x, y ) U

Microeconomics

Corner points
Corner point: a solution to the consumers optimal choice
problem at which some good is not being consumed at all, in
which case the optimal basket lies on an axis.

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Corner point
In the previous figure, for all points on the budget line, the
slope of the budget line is higher than the slope of the
MUx
indifference curve i.e. MU
< PPyx
y
MU

y
MUx
x
This implies MU
> PPyx MU
Px > Py ( we can cross multiply
y
because more is better and prices are positive i.e.
Px , Py , MUx , MUy > 0)

If the bang for the buck for x is higher than the bang for the
buck for y at all points on the budget line, then the consumer
will keep consuming more of x until she/he cannot consumer
more of x on the budget line
This implies she/he ends up at the boundary of the budget
line on the x-axis. Thats why R is precisely the optimal
solution in the previous figure.
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Non Optimal Choice

B is not an optimal choice in the figure because the slope of
the indifference curve at B is less than the slope of the budget
line.
Therefore at B,

MUx
MUy

>

Px
Py

MUx
Px

>

MUy
Py

This implies, the consumer will keep consuming more of x on

the budget line (since the bang for the buck for x is higher)
MUy
x
until the bang for the bucks are equal i.e. MU
Px = Py which
happens at A.

Microeconomics

Reading

Application 4.1: The rising price of gasoline

Application 4.2: The Marginal Utility of Home Cooking
versus Eating Out: Exploring the Implications of the Equal
Bang for the Buck Condition

Microeconomics