Topic 2 Chapter 3 page 1

Topic 2
Chapter 3
Rational Consumer Choice
 Topic 2 Chapter 3 page 2

Objective: We want to solve for the optimal bundle, which

is a combination of goods that a “rational consumer” will
purchase.

Assumptions: 1) The existence of feasible set or budget

constraint.
2) The existence of a consumer’s preference
described by their utility function.

Method: both graphical and mathematical.

 Topic 2 Chapter 3 page 3

Key Concepts:
Budget constraint and the feasible set.
What causes changes in the budget constraint?

Consumer preferences
The utility function
Indifference curves
Lagrange multipliers
 Topic 2 Chapter 3 page 4

The Budget Constraint and Feasible Set

Consumers cannot afford all the goods and services they

desire. Consumers are limited by their income and the
prices of goods.

Budget Constraint: It is the set of all bundles that can be

purchased with a given level of income and prices, when all
income is spent.

Feasible Set: The bundles on or within the budget triangle

are referred to as the feasible set. That is, the bundles for
which the required expenditure at given prices is less than or
equal to the income available.
 Topic 2 Chapter 3 page 5

Budget Constraint: Review

Consumers cannot afford all the goods and services they desire.
Consumers are limited by their income and the prices of goods.

Model Assumption:
Consumers spend all their income (no savings).
Let:
M=Income
X and Y are two goods
Px=price of each unit of good X
Py = price of each unit of good Y
 Topic 2 Chapter 3 page 6

Budget Constraint: numerical expression of which market baskets the

consumer can afford.

PxX + PyY = M
Total expenditure = Income
Rearranging the above expression for the budget constraint, we are able to
determine how many units of good Y we can consume for any given quantity of
good X:
M PX
Y   X
PY PY
This equation of a straight line illustrates the trade-off between Y and X.

PX
Note: PY is referred to as the marginal cost (in terms of good Y) of an
M
additional unit of good X along the budget constraint and PY is the intercept.
 Topic 2 Chapter 3 page 7

Y
The slope of the
M
budget equation,
Py
Px PX
 . 
PY , is negative
Slope of budget constraint is Py
because in order to
purchase more units of
Y, the consumer must
give up units of X.

X
M
0 Px
Dividing income by the price of Y yields the maximum number of units of Y that
can be purchased when no units of X are purchased.
Dividing income by the price of X yields the maximum number of units of X that
can be purchased when no units of Y are purchased.
These are the intercepts of the budget line.
 Topic 2 Chapter 3 page 8

M PS 100 5
F   S  F   S  F  10  0.5 S  Budget line
Food and Shelter: PF PF 10 10
 Topic 2 Chapter 3 page 9

Shifts in the Budget Constraint

What happens to the budget constraint when: (1) income changes, (2) the price
of X changes or (3) the price of Y changes?
 Topic 2 Chapter 3 page 10

1) Income changes
Let M0= initial income
M1=new income
0
M
When income changes the Y intercept changes from PY
to
0 1
M
1 M M
PY
and the X intercept changes from PX to PX .
PX
The slope of the budget line remains unchanged at  .
PY

Hence, a change in income is shown as a parallel shift inward

or outward of the budget constraint.
 Topic 2 Chapter 3 page 11

# Units of Y

1
M
PY
Budget line after an
increase in income.

0
M
PY

BL 0 BL1 #Units of X
0 1
M M
0 Px Px
 Topic 2 Chapter 3 page 12

(2) A Change in the price of good X (horizontal axis):

A change in the price of good X does not change the amount of

good Y the consumer could buy if he or she spent all their income
on Y. (i.e. the intercept remains the same.)

The budget line does change:

For price increases, the budget line becomes steeper
For price decreases, the budget line becomes flatter.

M PX
Y   X
PY PY
 Topic 2 Chapter 3 page 13

# Units of Y
1
M
PY

Budget line after a

decrease in the
price of X.

BL0 BL1 #Units of X

M M
0 Px
0
Px
1

0
Let PX = the initial price of good X.
1
Let PX = the new (lower) price of X.
When the price of X decreases, the consumer can now purchase more of good X.
The budget constraint swings outward and becomes flatter.
 Topic 2 Chapter 3 page 14

For A price increase in shelter, the slope of the budget line becomes steeper.

M PS 100 5
F   S  F   S  F  10  0.5 S  Budget line
PF PF 10 10

M PS 100 10
F   S  F   S  F  10  S  New Budget line
PF PF 10 10
 Topic 2 Chapter 3 page 15

(3) A Change in the Price of Good Y (Vertical Axis):

A change in the price of good Y does not change the amount of X
the consumer could buy if he or she spent all their income on X.
(I.e. the X intercept remains the same.)

However, the budget line does change:

For price increases the budget constraint becomes flatter.

For price decreases the budget constraint becomes steeper.
(I.e. the Y intercept increases.)

M PX
Y   X
PY PY
 Topic 2 Chapter 3 page 16

# Units of Y

M
1
Budget line after a
P y
decrease in the
price of Y.

M
0
Py

BL1
BL0
#Units of X
M
0 0
Px
0
Let PY = the initial price of good Y.
1
Let PY =the new (lower) price of Y.
Note: If all prices and income change by the same proportion, the budget
constraint is unaffected.
 Topic 2 Chapter 3 page 17

Summary:

1) Income Changes (Parallel shift)

The effect of a change in income is much like the effect
of a proportional change in all prices. For example,
cutting income by 50% has the same effect as doubling
the prices of the goods.

2) Relative Price Changes ( Slope changes)

A change in price of one good relative to another will
rotate the budget constraint or change the slope of the
budget constraint.
 Topic 2 Chapter 3 page 18

Special Case: The Kinked Budget Constraint

This occurs when the slope of the budget constraint is

not constant across all bundles of goods.

(Terrible example! Usually, once a customer uses a certain

amount, price rises for any additional electricity consumed.)
 Topic 2 Chapter 3 page 19

We can view this situation as if there are two budget

constraints.

If we assume X≤ 1000 (kwh/mo), then the budget constraint

is
M PX
Y   1
X
PY PY .

Otherwise, when X> 1000 (kwh/mo), the budget line is

M PX
Y   2
X
PY PY
 Topic 2 Chapter 3 page 20

Quantity Surcharge: Suppose electricity cost $0.01 per kwh

if use up to 5000, but $0.02 per kwh
for all kwh over 5000:

# Units of Y

0.01
Slope = − 𝑃𝑦

0.02
Slope = − 𝑃𝑦

0 Kwh

5000
 Topic 2 Chapter 3 page 21

Quantity Discount: Fertilizer is $5 per 10kg bag. If you buy

more than 20 bags, price is $4 per bag.
Suppose you have $200 to spend on fertilizer, and all
other goods (AOG). Let the price of all other goods be $1.

# Units of AOG

200
Slope = −5

100
Slope = −4

0 20 40 50 Bags of fertilizer (x)

 Topic 2 Chapter 3 page 22

What is the budget line if there is no kink?

5x + y = 200

Where is the kink? (i.e. At what point does the slope

change?)
X = 200, Y= 100.

What is the price beyond the kink?

$4
What is the maximum number of bags that can be
purchased?
X= 50 bags.
 Topic 2 Chapter 3 page 23

Consumer’s Preference
Consumer’s preference is used to rank different bundles of
goods. Based on how a consumer feels, he or she can
determine which combination of goods they prefer to other
combinations of goods.
They can state whether they prefer or are indifferent
between “bundles.”
 Topic 2 Chapter 3 page 24

Assumptions of the Consumer’s Preference Model:

1) Completeness – Consumer is able to rank all possible

bundles.
2) Non-satiation – Consumer always want more of a
product, ceteris paribus.
3) Transitivity – If bundle A is better than bundle B, and
bundle B is better than bundle C, then bundle A must
be better than bundle C.
4) Convexity – Consumer prefers a little of everything.
 Topic 2 Chapter 3 page 25

Indifference Curves:

Consumer’s preference is graphically expressed by the

indifference curve.
One indifference curve represents a set of bundles which are
equally preferred.
The typical indifference curve is convex toward the origin.
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Topic 2 Chapter 3 page 27
Topic 2 Chapter 3 page 28
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The slope of the indifference curve at a point is called the

marginal rate of substitution (MRS) – which reflects how
many (vertical) units of one good a person is willing to give
up to get an additional (horizontal) unit of the other good.
 Topic 2 Chapter 3 page 30

Gave up 3 Y for 1 X; 1 Y for 1 X; ¼ Y for 1 X…….

 Topic 2 Chapter 3 page 31

Remember: All consumers feel differently about their

consumption choices. This is reflected by the shape of their
indifference curves.
Topic 2 Chapter 3 page 32
 Topic 2 Chapter 3 page 33

Properties of Indifference Curves

1) Non-satiation: indifference curves slope downward.

2) Non-satiation + transitivity: indifference curves cannot
cross each other.
3) Non-satiation: indifference curves that are farther from
the origin represent higher levels of utility.
4) Convexity: indifference curves are bowed inward
(convex).
 Topic 2 Chapter 3 page 34

Mathematical Expressions of a consumer’s preference –

Utility Function:
a) Additive utility functions ( if goods are perfect
substitutes) – linear functions
Examples: U(x,y) = x+y
U(x,y)= ax + by
b) Multiplicative utility functions – Cobb Douglas; Convex
to the origin utility function.
Examples: U(x,y)=xy
U(x,y) = xayb
c) Perfect Complements – Leontief; L-shaped utility
function.
 Topic 2 Chapter 3 page 35

Examples: U(x,y) = min[x,y]

U(x,y) = min[2x, 3y]
 Topic 2 Chapter 3 page 36

The Consumer’s Problem:

max U ( x , y )
x,y

subject to
Px x  Py Y  M

Choose the optimal bundle (x,y) so as to maximize utility

subject to the budget constraint, taking prices and income as
given.
 Topic 2 Chapter 3 page 37

The Consumption Decision:

The objective of the consumer is to maximize satisfaction subject
to his or her budget (income) constraint.

We must bring together the concepts of budget constraint and

preference to determine the consumer’s consumption decision.
That is, the basket of goods the consumer eventually purchases is
determined by individual taste and affordability.

We know that all market baskets on the budget constraint are

attainable because they are affordable. The consumer will choose
the basket of goods that is on his or her highest attainable
indifference curve.
 Topic 2 Chapter 3 page 38

Graphically we have the following:

Units of Y
Px Y
M RS y , x   
Py X

Budget line is tangent to the

10 highest attainable IC.
B
7 A
D I3
I2
2 C
I1
I0
Units of X
0 4 5 7 10
The consumer maximizes utility at market basket A, where the MRS
equals the slope of the budget constraint.
 Topic 2 Chapter 3 page 39

A necessary condition for the consumer to maximize utility

subject to the budget constraint is:

PX
MRS YX  
PY

The consumer divides total income between the two goods so

that the MRS between the two goods equals the negative of the
price ratio which equals the slope of the budget constraint.
“When selecting a market basket containing both goods, a
consumer maximizes utility by equating his or her marginal
rate of substitution with the market’s marginal rate of
substitution.”
Topic 2 Chapter 3 page 40
 Topic 2 Chapter 3 page 41

Slope of the Indifference Curve

Recall that the slope of an indifference curve equals the (negative)

marginal rate of substitution.
Slope IC= -MRS
U U
U ( x , y )  constant  dx  dy  0
x y

U

  x  
dy MU x
slope IC=
dx U MU y
y
MU x
In other words, MRS of y for x = MU y
 Topic 2 Chapter 3 page 42

Solving the Rational Consumer’s Problem:

(I) Cobb Douglas Utility Functions

Two Methods to solve: i) Lagrangean multiplier

ii) Two equations/ two unknowns
Example: Question:
Tom spends all his $100 weekly income on two goods, X and
Y. His utility function is given by U(X, Y) = XY.

If Px= $4/ unit and Py=$10/ unit, how much of each good
should he buy to maximize utility?
 Topic 2 Chapter 3 page 43

Method 1: Lagrangean Multipliers: L

First, transform the constrained maximization problem into
the following unconstrained maximization problem:

Max L  U ( X , Y )   ( Px X  Py Y  M )
X ,Y , 

The Lagrangean multiplier’s (  ) role is to assure that the

budget constraint is satisfied.

The first order conditions for a maximum of L are obtained

by taking the first partial derivatives of L with respect to X, Y
and  , and equating them to zero:
 Topic 2 Chapter 3 page 44

Using the ratio of the first two FOCs, get an expression for Y.
Inserting the expression for Y into the budget constraint,
solve for X.
Substituting X into the expression for Y, solve for Y.

Px X  Py Y  M
The budget constraint equals: 4 X  10Y  100

Transform the constrained maximization problem into the

following unconstrained maximization problem:

Max L  U ( X , Y )   ( Px X  Py Y  M )
X ,Y , 
 Topic 2 Chapter 3 page 45

M ax L  XY   (4 X  10Y  100)
X ,Y , 

L
 Y  4  0
X
L
 X  10   0
Y
L
  1(4 X  10Y  100)  0

Now: Using the ratio of the first two FOCs:

Y  4 Y 4
 0   0.4
X  10  X 10 

Y  0.4 X Expression for Y

 Topic 2 Chapter 3 page 46

Inserting the expression for Y into the budget constraint:

4 X  10Y  100
4 X  10( 0 .4 X )  100
8 X  100
X  12 .5
Substituting X=12.5 into the expression for Y:

Y  0.4 X
Y  0.4( 12 .5)  5
The bundle X=12.5 and Y=5 will maximize utility while

constrained at M=100.
 Topic 2 Chapter 3 page 47

Method 2: Solve the budget constraint for Y in terms of X

and substitute the result wherever Y appears in the utility
function. Utility then becomes a function X alone and we
can maximize it by taking its first derivative with respect to X
and equating that to zero. The value of X that solves that
equation is the optimal value of X, which can then be
substituted back into the budget constraint to find the
optimal value of Y.

Px X  Py Y  M  budget constraint
4 X  10Y  100
rearrange :
Y  10  0.4 X
 Topic 2 Chapter 3 page 48

The utility function:

U ( X , Y )  XY
U ( X , Y )  X ( 10  0.4 X )  10 X  0.4 X
2

M ax Utility wrt X :
U
 10  0.8 X  0
X
10  0.8 X
X = 12.5
Y = 10 - 0.4X = 10 - 0.4(12.5) = 5

Same answer: (X=12.5, Y=5)

 Topic 2 Chapter 3 page 49

Graphically:

Y
10

Budget line

5 U=62.5

0 12.5 25 X
 Topic 2 Chapter 3 page 50

(II) Perfect Substitute Linear Function

The slope of the utility function (MRS) is constant.

The MRS is either equal, greater than or less than the
slope of the budget line.
Px
If equal: MRS = Py , there are multiple optimal
bundles along the indifference curve/ budget line.

Budget line
 Topic 2 Chapter 3 page 51

Px
If greater: MRS > Py , corner solution, where the
optimal bundle is at the intersection between the budget
line and the horizontal axis (consuming only good X). ICs
are steeper than the budget line.
 Topic 2 Chapter 3 page 52

Px
If less: MRS < Py , corner solution where the optimal
bundle is at the intersection between the budget line and
the vertical axis (consuming only good Y).
 Topic 2 Chapter 3 page 53

Example: For Al, coffee and tea are perfect substitutes.

One cup of coffee is equivalent to one cup of tea.
Suppose Al has $90 per month to spend on these
beverages, and coffee costs 90¢/cup while tea
costs $1.20 /cup. Find Al’s best
affordable/optimal bundle of tea and coffee.
How much could the price of a cup of coffee rise
without harming Al’s standard of living? Similarly,
how much could the price of a cup of tea rise?
 Topic 2 Chapter 3 page 54

Graphically:

Tea Px
125 utility curves: MRS=-1 MRS > Py

100
75 Budget line: slope -0.9/1.20= -.75
50

0 50 75 100 125 Coffee

Any increase in the price of coffee would force Al to a lower
indifference curve and lower standard of living.
An increase in the price of tea, would have no effect on her
standard of living. Al does not consume tea.
 Topic 2 Chapter 3 page 55

(III) Perfect Complement L-Shaped Utility Function

Notice U=min(aX,bY)
This implies the optimal ratio is always aX=bY
Use the optimal ratio and the budget constraint to solve for the optimal
solution for X and Y.
 Topic 2 Chapter 3 page 56

Example: Carlo budgets $9/week for his coffee and milk. He

likes his beverage only if it is prepared with 4 parts coffee, 1
part milk or U=min(C,4M). Coffee costs $1/ unit and milk
50¢/unit. How much coffee and how much milk will Carlo
buy per week?

milk 4 parts Coffee

4 parts milk = 1 part coffee
 Topic 2 Chapter 3 page 57

Let C= coffee and M = milk.

Based on Carlo’s preferences, C=4M.
Budget line:
9 = C + 0.5M
C = 9 – 0.5M
Inserting Carlo’s preference of C=4M into the budget line:
4M= 9 - 0.5M
4.5M = 9
M = 2;
If milk = 2, then coffee is 8.
 Topic 2 Chapter 3 page 58

Coffee
utility curve
12
10 Budget line

8
4
2
0

0 2 4 6 8 10 11 12 14 16 18 Milk