Market baskets orbundle Listwithspecific quantities ofone ormoregoods

Consumer theory
Preference relations
k
basedonindividuals attutitude towards alternatives

Binaryrelation yes or not

strictly preferred to AtB B A

weaklypreferred to AKB BYA
Indifferentto A BBA

BAxioms of consumerchoice

alwayscomparedrankallpossible
Completeness consumercan baskets

AB It is weaklypreferredtoB
LbB A Bis weaklypreferredtoA
IPboth A B
consistent
Transitivity choices are internally
IP ASB Btc then A C

Strict monotonicity more is better

Whengoodsarebad suchas air pollution preferredless

Redefinecommodity tobe a good negative bad

lairpollution cleanair

Diminishing MRS convexity slopeofindifference curve becomeslessnegative as it

moves downthecurve

IP ASBthenTAt tt BXB where t is a no in OD

b
IYwMefEbalanad
bundlespreened
Bjp y
ftp.B toheavilyweightedtowardone
commodity
 Indifference curves represents allcombinations ofmarketbasketsthatprovide a consumer

w theSAMElevelofsatisfaction

PointsL U Clothing
B A Bob
H bduetomonotonicity 50 E
It Bdbhavemorealonegoodbut
A B blurz 40 less of anothercompared toA
IP AaBand B H so
A Bduetotransitivity Anypoint U preferred
Zo B duetomonotonicity
G U
O AnypointLU NOTpreferred
1 I I 1 Food
10 20 30 40

map graph containing a setof

Indifference indifference curves

clothing Thecurvefurthestawayfromthe ORIGIN ater

go U 40 400 higherutility

µ
40 amines S.no xnEYmielsipieie no qngniona

10
I l l 1 Food
10 20 30 40

Impossible alternative curves

Figt Figt Figt
clothing clothing clothing
go go go

n
no no B 40
so so A so A
B
w w w
lo lo lo D
i i 1 Food i i i 1 Food l I i 1 Food
to 20 30 40 to 20 so yo to 20 so yo

Indiffcurveshould thereshouldNOTbe PlumesshouldNOTCROI

NOThave a toeslope this ABA D
Bytransitivity B D
violatesstrictmonotonicity Violatesmonotonicity

A B can'tbeB A f contradiction blarz B D

bystrictmonotonicity
 Marginalrate ofsubstitution DX Pory Theauntof'ythatis givenup
foran additional x

Clothing DONOTMIXTHEMUP
go A Inverse rel

40 i Convex diminishing MRS

30 1B
I MRS
20 t C yy DX
t D
lo Duetoconvexity axiom
n
I l l 1 Food
10 20 30 40

Clothing
A IP curve is convexthenbasket It is
preferred to U
kt x4 CKzYz
YitzI
Yi A
v I
k l
p i
l
I l l 1 Food
X k 4 Xz

2polarcases of interest
Perfectsubstitute indiebtw 2goods Perfectcomplements
Adrily Wsthoe
y
3 z M

z z a

l i B

l l l l l l l l
l 2 3 Yibuprofen l z z 4 Rightshoe
curvesshaped as right angles
constant MRS

Mrs 4 dbTpwpen GD I Mrs 0

Right Leftwillnotgiveupy'formore'x
SUREN will
kept Right giveup
 5 Numerical scorerepresentingthesatisfaction that a consumergetsfrom a
givenbasket

Utilityfunction represents preferencesthatsatisfy theaxioms

Ex UlfC s Ft2C
Lb UffC s F t 2C
Utility preferences
combinations Market basket
more
qd clothing futility
Higherutility preferred Aq
Sameutility indifferent 4 4 12

bOrdinalin nature generates a rankingofmarketbaskets

Doesn'tshowhowmuchonebasketispreferredtoanother

Utility d MRS calculate MRS IxylPromtheequationattheindifference curve

Marginalutility NU afgood X extrautilityfromconsumingoneadditionalunitat X

Diminishing marginalutility asmoreofagoodisconsumed Xwillyield

consumingmore
smalleradditionsto
utility
Nothing
Additionalconsumption at F generate Mile MUeDE
Yi Reducedconsumption ofC lowerMuc Muck
y
f B MUeDF MUeDL

y µµy Mrsw porc

I MRS MUI
MUC
l I i r i l
X X2 Food

When consumers maximizetheir MRS W F PorC

utility Pig
MRS MU µy PI
Pc
dollarofexpenditure issameforeachgood
MpU
Mtg MarginalUtilityper
ly
Maximumutilityachieved

Equalmarginalprinciple

i Mrssunfish 9 Mp
 Example _VxI findMRS
Utility

MUN 2 44 impliuil differentiation

MUysfugl.filJADoritmixitupw

Mui
L't t mrs.MN

s4 lq.ytk.x
MUys2gUy
Examples
CobbDouglas Perfect Substitutes Perfect comlements

UHH x4B UH4l xXtpY ulx.yt.mnaXpY

x Baretrewnstants y
y
MRS
MRS xY B
BX Uz
U
uh X
oPxp
Relativity shows X NOMRS
relativeimportanceWXandY
MRSisconstant Utilityiuc.bychoosing
indiPPcurveslinear motealth2goods
together
 allcombinationsofgoodsforwhichthetotalamount ofmoneyspent
isequaltoincome

Pe Ft RCs I lineome
Ege
Igogig b b
ooo Max ve oftheratioofthepricesof 2goods
amutofC

Example Ft 20 80 c 40 IF
nothing
slope DI Pt
IF Pc
140
P
ro

O
80 Food
T

Effectsafchanges inIncome Prices

1 Increasein income clothing

Increase shiftoutwards
Budgetlineshiftoutwards
slopeisthesame
consumercan
buymoregoods Decrease shiftinwards
Budgetsetis
tag At
b
Isyo 1 80 Is160 Food

clothing
2 Increase inpriceofonegood
Increase rotate IN
Budgetrotates inonaxisatthe
good
Decrease rotateOUT
Budgetsetis smaller

Pedk
pass 2 pest
Assumption consumer is rational maximize
utilitysubject tothebudget
constraint

Utilitymaximization indiecuretangenttothebudgetconstraint
MRS PI wst
MarginalbenefitsMarginal
Py
Reasonwhy

clothing 6Cannotafford D
seAtB MRS1 1 Priceratio1112 Utilitynotmaximized
I iB B AtA MRS Priceratio nohighersatisfaction canbeattaines
D

ys
Food

I Toteachconstrained maximum
spend allincome
choosethebundlesuchthat MRS priceratio

Algebraicsolution solveoptimalconsumptionvalues X
dy
Use2equations CobbDouglas function
1MRS Priceratio
2Budgetconstraint Is pXtpyYl UHyl X yB
UHg s X y pet Py t 1 60
f
Process MRS
FindMRS
MRS Priceratio
Mrs
ME I IT
g g I x

setMRSPriceratio Usebudgetconstraint
y
Tx 4 Is PxX tp Y
y I g x
Usebudgetconstraints at

Xy
60 20
y 10
Y Iff r s
X
Ktp pi
special cases

cornersolutions MRS f Priceratio

Consumermaximizes utility
byconsumingonly 1 ofthe2goods
IndiewerreNOTtangenttothebudgetlinetwotangencypoint

2situations
MRS3 PI y
Py gHighestlevelofutility
slopeofindivPcurve slopeofthebudgetline

More x k less
y
MRSS
Hy X
Less X dmore
y
Corner solutions are COMMON

Perfect substitutes MRS PriceRatio

GivenMRS 1 consumerchoosescheapergood
Y UHy Xty pigs2 pal Is20
MRS MUI t PxLPy X is preferred
Ui NIUy e
y
U
Uz Priceratio
t
B X
learnabtanindividual's utilityProm observeddecisions
Usethesamelogicto
verify if
choicesare

rational ornot