Micro 2: Individual/Consumer Choice – 1

1. Individual Utility

1.1. Deriving Indifference Curve

Preference –Indifference Curve

Movie

Moving from A to E, each additional

A unit of meal costs less and less movie
15

{
tickets while the individual’s utility is
kept at the same level.
5
The additional utility derived from the
10 B
3 { 7 C
extra unit of meal is diminishing.

2 { 5 D
1 { E
4

Indifference Curve

1 2 3 4 5Prepared by Dr.Zhang Jianlin MacDonald's Meal6

• All the points chosen give a curve called Indifference Curve.

• The position of the indifference curve represents the level of utility the
individual derives from consuming the combination of meals and movies.

• Utility is an abstract measurement of the usefulness and satisfaction derived

from consuming some amounts of goods.

• Notice that points on the same Indifference Curve give exactly the same level
of utility.

Exercise:
Can two indifference curves which represent the utility function of the same
individual intercept with each other?

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1.2. Marginal Utility

• Marginal utility measures the increase in utility with a small change in the
consumption of one good while the consumption of the other good is fixed.

• Using good x as an example, mathematically, marginal utility of good x is

expressed as,
dU
MU x =
dx

• In the case of two goods x and y, if we fix the quantity of y and increase the
quantity of x, the change in total utility is shown below.

U
U ( x, y )

24
18

10

x
1 2 3

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 • Notice that the additional unit of x gives lesser additional utility. This is called
diminishing marginal utility.

1.3. The slope of the Indifference Curve

• The slope of the indifference curve reflects an individual’s willingness to pay

for x in terms of y, or trade off one good for another, without changing total
level of utility.

• Moving from point A to point B, the individual gives up dy units of y and gains dx
units of x.

A
dy
B

dx U ( x, y)

• Loss in dy units of y will result in loss of utility by dy × MU y

• Gain in dx unit of x will result in gain of utility by dx × MU x

• From point A to point B, the total utility is kept at the same level. Hence, we have

dy MU x
dx × MU x = dy × MU y ⇒ =
dx MU y

dy
• Mathematically, the slope of the indifference curve is . It must also equal to
dx
MU x
.
MU y

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• If MUx = 10 and MUy = 2, the slope of the indifference curve between point A and
B is 5. It means that the individual will be willing to give up 5 units of y in order
to exchange for 1 unit of x.

MU x
• is also called marginal rate of substitution (MRS). It thus shows the rate at
MU y
which individuals can substitute y for x without changing the total level of
satisfaction.

Exercise:
What is the level of MRS when individual increases the consumption of x? Why?

2. The Budget Line

• In a world of two goods, let the price of x be Px and the price of y be Py, the
individual’s budget constraint can be written as,

Px x + Py y = I

Graphically, this is shown as,

I
Py

Px
Py
I x
Px

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• The budget line separates the world of economic goods to what is and what is not
possible (a bit like the Production Possibility Curve).

• The intercepts are the points where the individual uses his, or her, entire income
for the consumption of one good. In such a case, the individual will be able to buy
I
units of good i (where i =x,y)
pi

• If the individual consumes x and y such that his/her income is exhausted, the
combination of x and y must be on the budget line.

• The slope of the budget line gives us the market rate of exchange between x and y
or, which means, the price of x in terms of y.

• Suppose we are on the budget line, if we now choose to consume 1 less units of x,
how many more units of y will we be able to buy?

• If Px = $10 and Py = $5 then giving up one unit of x will leave $10 which we can
now spend on y.

• Given that the price of y is $5 we will be able to buy 2 units of y, if we gave up

one unit of x.

I0
Py0

y0 A

B
y1
C

Px0
Py0

x0 x0 +1 I0 x
Px0

• Therefore, the slope of the budget line reveals the exchange rate between x and y
that will be facilitated by the market. It also shows the opportunity cost of one
good in terms of the other.

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• As the Budget Line is a straight line, this rate of exchange is constant. Denoting
the initial value as ‘0’ and subsequent value as ‘1’, this can be shown as (see the
handwritten explanations),

Exercise 1:
1. In a world of two goods x and y, price of x is Px0 and price of y is Py0 . An
individual receives an income of I 0 for the consumption of x and y.
a. Draw the individual’s budget line clearly labelling the values of its intercepts on
x-axis and y-axis as well as its slope. For example, I 0 = 100; Px0 = 10; Py0 = 10 .
b. Show the change in the individual’s budget line when the individual’s income
increases while the prices of x and y remain at the same level. For example,
I1 = 120; Px0 = 10; Py0 = 10 .
c. Show the change in the individual’s budget line when the individual’s income
decreases while the prices of x and y remain at the same level. For example,
I 2 = 80; Px0 = 10; Py0 = 10 .

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 d. Starting from (a) ( where )
I = I 0 , Px = Px0 , Py = Py0 , show the change in the
individual’s budget line when the price of x decreases, while price of y and
income remain at the same level. For example,
I 0 = 100; Px0 = 10; Py0 = 10; Px1 = 5 .

I0
Py0

Px0
Py0
I0 x
Px0

e. Starting from (a) where ( )

I = I 0 , Px = Px0 , Py = Py0 , show the change in the
individual’s budget line when price of y increases while price of x and income
remain at the same level. For example, I 0 = 100; Px0 = 10; Py0 = 10; Py1 = 20 .
y

I0
Py0

Px0
Py0
I0 x
Px0

f. (
Starting from (a) where )
I = I 0 , Px = Px0 , Py = Py0 , show the change in the
individual’s budget line when price of x increases, at the same time, price of y

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 decreases while income remains at the same level. For example,
I 0 = 100; Px0 = 10; Py0 = 10; Px1 = 20; Py1 = 5 .
y

I0
Py0

Px0
Py0
I0 x
Px0

g. Initially, I 0 = 100; Px0 = 10; Py0 = 10; show the change in the individual’s budget
line: the price remains at the same level of $10 per unit for the purchase of first 5
units of good x. The price falls to $5 per unit for any additional unit purchased.
There is no change in the price of y and the individual’s income.

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3. Utility Maximization

• Given that the individual always wants more of all economic goods, we say that
all the individuals want to maximize their utility.

• When we have more x and y, the higher will be our utility curve. In other words,
utility is increasing in both x and y.

U2
U1
U0

• However, the individual is also constrained by the budget constrain. That is

Px x + Py y = I

• Recall that an economic problem is the problem that deals with “How do we
satisfy our unlimited desires or wants, with scarce or limited means?”

• Combining the utility and budget line, we say that the individual wants to
maximize utility (i.e. choose the most preferred bundle or, highest possible level
of utility curve) subject to the budget constraint (i.e. from the set of feasible
bundles).

• Graphically it means to choose the highest indifference curve possible.

• Given the shape of the indifference curve, the highest level of utility we can
achieve is when the indifference curve is tangent to the budget line.

• Tangency means that the slope of the indifference curve is the same as the slope
of the budget line at the point of tangency.

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 y
I0
Py0
y0

y*

y1

U0

x0 x1 I0 x
x*
Px0

dy MU x P
Recall that the slope of utility curve is = . As the slope of budget line is x ,
dx MU y Py
maximizing utility implies that at the point of tangency between the utility curve and
the budget line, it is necessary that
MU x Px
=
MU y Py

• The slope of indifference curve represents the level of MRS, the rate at which
individuals can substitute y for x without changing the total level of satisfaction.

• The slope of budget line reveals the exchange rate between x and y that will be
facilitated by the market. It also shows the opportunity cost of x in terms of y.

• At the optimum, the two rates must equal. Individuals must be compensated for
Px
units of y for giving up with 1 unit of x.
Py

4. Rational behaviour

• In neoclassical economics, individuals are assumed to behave rationally. Using

non-technical terms, rationally broadly means two aspects of behaviours.

1) First, individuals must always prefer the choice of goods that give higher level

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 of utility than those that give lower level of utility.

2) Second, the individual must always behave in this way consistently.

• Let point A which is the combination of ( x0 , y0 ) be the today’s choice made by

the individual. Today’s prices for x and y are Px0 and Py0 . The individual’s income
today is I 0 . That is, Px0x0 + Py0y0 = I0

• Let point B which is the combination of ( x1 , y1 ) be the tomorrow’s choice made

by the individual. Tomorrow’s prices for x and y are Px1 and Py1 . The individual’s
income tomorrow is I1 . That is, Px1x1 + Py1y1 = I1

• If the individual is rational, he/she needs to behave according to the following

rules:

a) If Px0 × x1 + Py0 × y1 ≤ I 0 and x0 ≠ x1 ; y0 ≠ y1 it must be that Px1 × x0 + Py1 × y0 > I1

Intuitively, this says that when B is affordable today, the individual does not buy
B. Instead, he/she chooses to buy A.

His/her choice of A reveals that the individual prefers A to B.

Tomorrow, when the individual goes to buy B instead of A, it must be because

that A is no longer affordable to him/her any more.

b) If Px0 × x1 + Py0 × y1 > I 0 and x0 ≠ x1 ; y0 ≠ y1 it must be that Px1 × x0 + Py1 × y0 ≤ I1

Today, the individual chooses to buy A because he/she cannot afford B. This
reveals that he prefers B to A.

When B is affordable tomorrow, the individual must then go to buy B.

However, the fact that the individual buys B implies that A must be also
affordable tomorrow.

• Graphically, if individual behave rationally:

1) The indifference curves must tangent to budget lines.

2) The indifference curves can not intersecting with each other.

• Before applying these requirements, we do the following exercises:

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 1. Today, the individual maximizes his/her utility by consuming x0 and y0 which
exhausts his/her income of Px0x0 + Py0y0 = I0.

2. Tomorrow, the individual maximizes his/her utility by consuming x1 and y1 which

exhausts his/her income of Px1x1 + Py1y1 = I1 when Px0 > Px1, Py0 < Py1 ,
x0 ≠ x1 and y0 ≠ y1 .

y y
I0
Py0

I1
Py1

A
y0

B
y1

U0

U1
I0 x
x0
Px0 x1 I1 x
Px1

3. If Px0x1 + Py0y1 = I0 ( x0 < x1 ; y0 > y1 ) , combining the two must show the
following:

I0
Py0

I1
Py1
y0 A

U0
y1 B

x0 x1 I0 I1 x
Px0 Px1

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4. If Px1x0 + Py1y0 = I1 ( x0 < x1 ; y0 > y1 ) , combining the two must show the
following:

y
I0
Py0

U0
I1
Py1

y0 A

B
y1

x0 x1 I0 I1 x
Px0 Px1

Example:
An individual with income I=90 consumes only two goods x and y when confronted
with prices Px = 20, Py = 10, he will choose to consume 3 units of both x and y. With
income of I = 120, and prices Px = 10 and Py =20, however, he will choose to
consume 2 units of x and 5 units of y. therefore, the consumer cannot be rational. True
of false, explain.

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 y
I0
Py0

I1
Py1

5
B

3 A

U0

I0 I1 x
2 3
Px0 Px1

The initial bundle ( x0 , y0 ) is on the old budget line as:

Px0x0 + Py0y0 = 20 × 3 + 10 × 3 = 90

The new bundle ( x1 , y1 ) is on the new budget line as:

Px1x1 + Py1y1 = 10 × 2 + 20 × 5 = 120

If point A is the intersecting point of both budget lines, A must be on the new budget
line as well. That is, new price times old bundle equals new income.

However, the amount of income required to purchase ( x0 , y0 ) is less than new level of
income, old bundles (point A) is under new budget line. This is shown below,

Px1x0 + Py1y0 = 10 × 3 + 20 × 3 = 90 < 120 = I1

If point B is the intersecting point of both budget lines, B must be on the old budget
line as well. This means that old price times new bundle equals old income. This is
the case as:

Px0x1 + Py0y1 = 20 × 2 + 10 × 5 = 90 = I0

Point B is thus on the old budget line as well as the new budget line, i.e., B is the
intersecting point for both budget lines.

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The above implies that both A and B are affordable today and the individual buys A.
His choice of A reveals that he/she prefers A than B. Thus, his choice of B tomorrow
can only imply that A is not affordable tomorrow. However, A is affordable
tomorrow. Hence, the individual is not rational.

Plotting the individual utility curve on it, we found that B is Not a rational choice!

Example:
An individual with income I=100 consumes only two goods x and y. When
confronted with prices Px = 10, Py = 10, he will choose to consume 5 units of both x
and y. With income of I = 120, and prices Px = 10 and Py =30, however, he will
choose to consume 3 units of x and 3 units of y. Therefore, the consumer cannot be
rational. True of false, explain.

y
I0
Py0

5 A

I1
Py1 B
3
U0

3 5 I0 I1 x
Px0 Px1

Old bundle ( x0 , y0 ) is on the old budget line as:

Px0x0 + Py0y0 = 10 × 5 + 10 × 5 = 100

New bundle ( x1 , y1 ) is on the new budget line as:

Px1x1 + Py1y1 = 10 × 3 + 30 × 3 = 120

As new prices time old bundle exceeds new income, point A is thus above the new
budget line.

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 Px1x0 + Py1y0 = 10 × 5 + 30 × 5 = 200 > 120

As x0 > x1 and y0 > y1 , point B must be below the old budget line.

Both A and B are affordable today and the individual buys A. His choice of A reveals
that he prefers A than B.

Tomorrow, the individual choose B. This must be because that A is not affordable
tomorrow. And indeed, A is not affordable tomorrow. Hence, the individual is
rational.

Plotting the individual utility curve on it, we found that the individual is rational.

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Homework

1. In a world of two goods x and y, draw the budget line when I = I 0 ; Py = Py0 .
However, price of x varies. For x ≤ x , Px = 0; x > x , Px > 0.

2. In a world of two goods x and y, draw the budget line when I = I 0 ; Py = Py0 .
However, price of x varies. For x ≤ x , Px = Px0 ; x > x , Px = Px1 , further,
0 < Px0 < Px1 .

3. You observe a consumer in two different market situations:

a) earning £100 and spending it on 5 units of x at the price of £10 each and 10 units
of y at the price of £5 each;
b) earning £175 and buying 3 units of x at the price of £15 and 13 units of y at the
price of £10
Is the consumer rational?

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