otes Week 5

16 September 2021

Choices
put together the budget sets the theory of preferences in order to examine the optimal choice of the consumers ,
consumers

choose the most preferred bundle from their budget sets

•
Optimal choice

preferences are well-behaved ,

so that more is preferred to less , we can restrict our attention to bundles of goods that lie

on the budget line

> stop when we get to the highest > indifference curve that just touches the budget line

✗2

indifference curves

optimal
choice the choice ( ✗I ,
✗ E) is an optimal choice

✗ E - - - - - -
q > the optimal consumption position is where the indifference curve

i. is tangent to the budget line

"
:
X,
✗ it
the indifference curve weren't
tangent it would cross the budget line , there would be
If some nearby point on the budget
line that lies above the indifference curve

> we couldn't have started at an optimal bundle

• the optimal point of the indifference curve can't cross the
budget line

•
Kinky tastes

✗2

indifference curves

this case doesn't have much economic

significance ,
a nuisance than anything else

Kinky Tastes ,
an optimal consumption bundle where the indifference curve doesn't have
✗ it , a
tangent
- - - - - -

"

!
budget line
:
✗,
* Xp

The optimal point occurs when the consumption of some

good is Zero

•
the slope of the indifference curve is the slope of the budget line are different > doesn't cross each other

Boundary optimum ,
the optimal consumption involves consuming zero units of good 2 and the indifference curve is not
tangent
to the budget line

✗
2

indifference
curves

budget
line
Xp
•
*
✗,

Interior optimum ,
the optimal consumption position is where the indifference curve is tangent to the
budget line

> if we have an interior optimum with smooth indifference curves, the slope of the indifference curve S the slope of the budget line

must be the same

> if they were different ,

the indifference curve would cross the budget line and we couldn't be at the optimal point
 otes Week 5
16 September 2021

The condition is necessary condition for optimality sufficient condition

tangency only a
,
not a

✗2

"
More than one
tangency ,
the tangency condition is
necessary but not sufficient

non optimal
budget line
-

bundle
✗,

condition is sufficient if the preferences any point that satisfies the

Tangency are convex where
tangency condition must be an

optimal point
> convex indifference curves must curve
away from the budget line so
they can't bend back to touch it
again
that there will
> restriction implied in
convexity if ,
indifference curves are strictly convex ,
they don't have any flat spots meaning
optimal choice line
be only one on each
budget
• the MRS must equal to the slope of the budget line at an interior optimum

R
MRS =

Pz

Whenever the MRS is different from the price ratio , the consumer cannot be at his or her optimal choice

• Consumer demand
Demanded bundle ,
the optimal choice of goods 1 and 2 at some set of prices and income

When prices and income change choice will

> , the consumer 's optimal change
Demand function . the function that relates the optimal choice , the quantities demanded to the different , values of prices s incomes

✗, 1Pa Pz , ,
m ) and Xz ( Pn Pa
, ,
m )

Different preferences will lead to different demand function

• Some examples

Perfect substitutes if Pz > P, the slope of the

,
, budget line is flatter than the slope of the indifference curves .
The optimal bundle is when

the consumer spends all of his her good 1

or
money on

> if Pz < P, ,
the consumer purchases only good 2

> if Pz =P, , whole range of optimal choices (

any
amount of goods 1 and 2) that satisfies the budget constraint is optimal
> demanded function

¥ ,
when P, < Pz

Xp any number between 0 and ¥ When P, = Pz

0 When P, > Pz

• if two goods are perfect substitutes then ,

a consumer will purchase the cheaper one

if both goods have the same price , the doesn't which

• consumer care one he or she
purchase
✗2

indifference
curve >
slope = -1

The optimal choice will usually be on the boundary

budget
1in,
optimal
choice
•
Xp
it
✗ =
MP
,
 otes Week 5
16 September 2021

Perfect compliments ,
the optimal choice must
always lie on the diagonal where the consumer is
purchasing equal amounts of

both ( no
goods matter what the prices are )

> the same amount of good 1 and

good 2 is denoted by ✗

the budget constraint > P, X

,
+ Pzxz = m

the choice of goods 1

optimal and 2

m
✗, =
Xz = ✗ =

Pat P2
> the demand function for the optimal choice here is quite intuitive

an two goods are

always consumed
together , if the consumer were
spending all of her
money on a
single good that had a price of

Pat P2

✗2

indifference
curve the quantities demanded will
always lie on the
diagonal where
choice
optimal Xp = ✗z

✗ E - - - - -

q
,
1

" line
: budget
✗
* Xp
,

Neutrals and bads the consumer spends all of his / her on the good he / She likes s doesn't purchase any of the neutral
,
money
good
> if commodity 1 is good s commodity 2 is bad , the demand functions

M
×, = and ✗ 2=0
p,

Discrete goods the optimal bundle ,

is the one on the highest indifference "
curve
"

> if the price of good 1 is

very high , then the consumer will choose Zero units of consumption

find good
> as the price decreases ,
the consumer will it optimal to consume 1 unit of the
•
if the price decreases further the consumer will choose to consume more units of good 1

Zero units demanded 1 Unit demanded

✗2 ✗2

choice
•
,
optimal •
,
nugget
line
" '
•
,
'
budget line 9 n
'
optimal
\
'
•
-
'

,
-•
-
-
Choice
- • -
•
-
\ - - • , '
• '
•-
, , \ -
" ,- -
- •
-
-co '
'
'
to - •- - -
-
•
-
-
- •
✗
×' y
I
I

j
1 I '

l 2 3 z

The optimal choice for these preferences is

always going to be a
boundary choice because in nonconvex preferences , consumer don't like to

consume the two goods together so consumer will

spend all of their
money on one or the other

✗2

indifference Optimal choice with concave preferences the optimal choice the
curves
,
is
boundary
non optimal point ( Z) , not the interior
tangency point (X) because Z lies on a
higher
choice

✗ indifference curve
•

optimal
choice
2-
✗
,
 otes Week 5
16 September 2021

Cobb Douglas preferences utility

-

, function ulx, , ,
✗ 2) = Xixzd ,
the optimal choices for this utility function is

c m
✗n =

c + d P,

Ñ
C
Xz =

C 1- d

The Cobb -

Douglas preferences have a convinient property the demand function for

,
×,

thx , PX C MI C
= =

m my c + d PT c + d

The Cobb -

Douglas consumer always spends a fixed fraction of its income on each good , the size of the fraction is determined by the

exponent in the Cobb -

Douglas function
> the Cobb -

Douglas utility function in which the exponents sum to I

it ✗ i
a
the
-

✗ a)
•
if ulxn ,
= ✗
,
we can interpret a as fraction of income spent on good 1

• Estimating utility functions

Suppose that we observe a consumer's choices at several different prices and income levels

"" ""
Exp . a utility function of the form ulx, ,
✗ a) = ×, Xz ,
calculated the utility associated with each observation
using the estimated
" ""
Cobb ✗n "
Douglas utility function As
though the consumer is the function Ulxn ✗ 2) Xz further observation on the
-

maximizing
.
=
.
,

consumer 's behavior would lead this

us to reject hypothesis
> evaluate the impact of proposed policy changes ,
the government was
contemplating imposing a system of taxes that would

income
result in this consumer
facing prices (2,3) S having an
of 200

✗
,
=
÷, 2020 = 25

✗2 =
34 2300 =
50

estimated utility
U 1×1 ,
✗ 2) = 25
""
50%1 = 42

the new tax

policy would make the consumer better off than it was in year 2
,
but worse off than it was in
year 3

Given some observations on choice behavior , we to determine what , if

try anything ,
is
being maximized Once we have .
an

estimate of what it is that is

being maximized ,
we can use this both to predict choice behavior in new situations s to

evaluate proposed changes in the economic environment

> in reality data ,

on
group of individuals these groups may ,
have different preferences for different goods that are reflected
in their
patterns of consumption patterns and then use this estimated utility function to forecast demand and

evawat
policy proposals
income shares constant so that the Cobb Douglas utility function give pretty good fit
•
relatively would us
-

were a

•
Implications of the MRS condition
"
Price ratio determined of good 1 and 2 "
the amount Consumed by consumer

It is that
typical everyone faces roughly the same prices for goods everyone ,
is
optimizing and
everyone
is at an interior

solution then everyone must have the same

,
marginal rate of substitution

> the market is

offering everyone the same rate of exchange for goods ✗ and Y everyone
,
is
adjusting their consumption
" "

of goods
"
equals the market 's
"
the until their internal valuation of the two goods
own
marginal external

valuation of the two goods

•
people may value their total consumption of the two goods very differently ,
but everyone
who is
consuming the two

goods must have the same

marginal rate of substitution

The fact that price ratios measure of substitution to value

marginal rate is
very important for ,
it means that we have a
way
possible changes in consumption bundles
 otes Week 5
16 September 2021

Since prices the rate at which to substitute

measure
people are just willing one
good for another
, they can be used to value

policy proposals that involve

making changes in consumption
not arbitrary but reflect how people the
> the fact that prices are numbers value
things on margin is one of the most

fundamental s important ideas in economics

> if we observe one choice at one set of prices the MRS at

we get one
consumption point
•
if the prices change and we observe another choice , we get another MRS

• Choosing taxes

Quantity tax , a tax on the amount consumed of a

good
Income tax, a tax on income

Imposition of a
quantity tax

> exp .
original budget constraint > P, X
, + Pzxz = m

if tax the consumption of the viewpoint of the consumer it is if the price of good 1 has increased by
we
good 1 ,
just as an

amount t

( P, t ) ×, B. Xz
budget constraint
new > + + = m

a
quantity tax on a
good increases the price preceived
by the consumer , the optimal choice (✗it . ✗ z* ) must satisfy the

z*
*
t) ×,
budget constraint > ( p, + + B. ✗ = m

the revenue raised by this tax is R* = txt

> consider an income tax that raise the same amount of revenue , budget constraint > thx, + Pz ✗z = m -
R*
an
substituting for R* > P, ×, + Pzxz = m -
t ✗ y*
it has the same slope as the original budget line ,
¥
on the budget line with the income tax must pass through the point IX,
*
, ✗ z* )
✗2

curves
indifference
The consumer will be better
off under the income tax since consumer can
origin oil
choose point
higher indifference
"

opinmacnoi
income
tax
a on a curve
✗ z* - - -

q •
with
constraint
budget
optimal
choice
,
with income tax
> don't imply tax that will distort the market ( lump-sum income tax
%
with 1
•
quantity , slope =

is better )
tax
,
I
1
✗
✗
* 1
,
budget constraint
with
quantity tax
Pitt
slope = -

Pz

* * *
Pi X, + P, X , = m -
t ×, establishes that (X , * , ✗ z* ) lies on the income tax budget line , an affordable choice for the consumer but
,

it is not an optimal choice

> at 1×1*1 ,
✗ E) the MRS is ¥ , but income tax allows us to trade a rate of exchange of ¥
•
budget line cuts the indifference curve at (✗ it ,
✗ z* ) ,
there will be some point on the
budget line that will be preferred to

( X, * ,
✗ 2*1
Income tax is quantity tax in the sense that can raise the amount of revenue from
definitely superior to the you same a consumer

and still leave them better

off because it only implies to one consumer

> When the amount of income tax differs from person to person

> when an income tax is uniform for all consumer is not

necessarily better than a uniform quantity tax for all consumer

would quantity
•
if a consumer didn't consume
any of good 1 , then they certainly prefer the tax to a uniform tax because if we

impose the tax on income the consumer's income doesn't change

• assume that the income tax is
basically a lump-sum tax ( just changes the amount of money to spend but doesn't affect any choices of
the consumer )
dis"
tax "% after income will fall the amount taken the tax
an
income is earned >
expecting a tax <
by
In this left out the to the tax , but supply will also respond to the tax !
assumptions , we
totally supply response