Chapter Four
Consumer
Choice
Chapter Outline
1. Preferences.
2. Utility.
3. Budget Constraint.
4. Constrained Consumer Choice.
5. Behavioral Economics.
© 2009 Pearson Addison-Wesley. All rights reserved.
4-2
Premises of Consumer Behavior
 Individual preferences determine the
amount of pleasure people derive from
the goods and services they consume.
 Consumers face constraints or limits
on their choices.
 Consumers maximize their well-being
or pleasure from consumption, subject
to the constraints they face.
© 2009 Pearson Addison-Wesley. All rights reserved.
4-3
Properties of Consumer Preferences
 Completeness - when facing a choice
between any two bundles of goods, a
consumer can rank them so that one
and only one of the following
relationships is true: The consumer
prefers the first bundle to the second,
prefers the second to the first, or is
indifferent between them.
© 2009 Pearson Addison-Wesley. All rights reserved.
4-4
Properties of Consumer Preferences
 Transitivity - a consumer’s preferences
over bundles is consistent in the sense
that, if the consumer weakly prefers
Bundle z to Bundle y (likes z at least as
much as y) and weakly prefers Bundle y
to Bundle x, the consumer also weakly
prefers Bundle z to Bundle x.
© 2009 Pearson Addison-Wesley. All rights reserved.
4-5
Properties of Consumer Preferences
 More Is Better - all else being the
same, more of a commodity is better
than less of it (always wanting more is
known as nonsatiation).
 Good - a commodity for which more is
preferred to less, at least at some levels of
consumption
 Bad - something for which less is preferred
to more, such as pollution
© 2009 Pearson Addison-Wesley. All rights reserved.
4-6
Preference Maps
 Indifference curve - the set of all
bundles of goods that a consumer views
as being equally desirable.
 Indifference map - a complete set of
indifference curves that summarize a
consumer’s tastes or preferences
© 2009 Pearson Addison-Wesley. All rights reserved.
4-7
Figure 4.1 Bundles of Pizzas and
Burritos Lisa Might Consume
25
Lisa prefers any
bundle in area A
(b)
over e
A
f
20
15
e
a
d
10
b
5
B
15
25
30
Z, Pizzas per semester
If Lisa
Lisa
prefers
is indifferent
bundle e bundles
between
to any e, a,
bundle
and
c …..
in area B
© 2009 Pearson Addison-Wesley. All rights reserved.
B, Burritos per semester
B, Burritos per semester
(a)
Which
Which of
of these
these
two
two bundles
bundles
would
would be
be
preferred
c
preferred by
by
Lisa?
Lisa?
c
25
20
Lisa prefers
bundle
feover
over
15
bundle e,
d, since fe
has more
of both
10
goods: Pizza and
Burritos
e
a
b
15
25
I1
30
Z, Pizzas per semester
we can draw an
indifferent curve over
those three points
4-8
Figure 4.1 Bundles of Pizzas and
Burritos Lisa Might Consume
(c)
A
c
25
f
20
15
e
a
d
10
b
B, Burritos per semester
B, Burritos per semester
(a)
25
c
f
20
I2
e
15
a
10
d
I1
5
I0
B
15
25
30
Z, Pizzas per semester
15
25
30
Z, Pizzas per semester
we can draw an
indifferent curve over
those three points
© 2009 Pearson Addison-Wesley. All rights reserved.
4-9
Properties of Indifference Maps
1. Bundles on indifference curves farther
from the origin are preferred to those
on indifference curves closer to the
origin.
2. There is an indifference curve through
every possible bundle.
3. Indifference curves cannot cross.
4. Indifference curves slope downward.
© 2009 Pearson Addison-Wesley. All rights reserved.
4-10
Impossible Indifference Curves
B, Burritos per semester
 Lisa is indifferent
between e and a, and
also between e and
b…
e
b
a
I1
I0
Z, Pizzas per semester
© 2009 Pearson Addison-Wesley. All rights reserved.
 so by transitivity she
should also be
indifferent between a
and b…
 but this is impossible,
since b must be
preferred to a given it
has more of both goods.
4-11
 Lisa is indifferent
between b and a
since both points
are in the same
indifference curve…
 But this contradicts
the “more is better”
assumption. Can
you tell why?
 Yes, b has more of
both and hence it
should be preferred
over a.
B, Burritos per semester
Impossible Indifference Curves
b
a
I
Z, Pizzas per semester
© 2009 Pearson Addison-Wesley. All rights reserved.
4-12
Figure 4.2 Impossible Indifference
Curves
© 2009 Pearson Addison-Wesley. All rights reserved.
4-13
Solved Problem 4.1
 Can indifference curves be thick?
 Answer:
 Draw an indifference curve that is at least
two bundles thick, and show that a
preference property is violated
© 2009 Pearson Addison-Wesley. All rights reserved.
4-14
B, Burritos per semester
Solved Problem 4.1
 Consumer is
indifferent between b
and a since both
points are in the same
indifference curve…
b
a
I
 But this contradicts the
“more is better”
assumption since b
has more of both and
hence it should be
preferred over a.
Z, Pizzas per semester
© 2009 Pearson Addison-Wesley. All rights reserved.
4-15
Willingness to Substitute Between
Goods
 marginal rate of substitution (MRS) - the
maximum amount of one good a consumer will
sacrifice to obtain one more unit of another
good.
B
MRS 
Z
 The slope of the indifference curve!
© 2009 Pearson Addison-Wesley. All rights reserved.
4-16
Figure 4.3 (a) MRS along an
Indifference curve
B, Burritos per semester
Indifference Curve Convex to the Origin
From bundle a to bundle
b, Lisa
 This
is the same as the
slopeinof the indifference
is willing to give up 3 Burritos
curve between those
exchange for 1 more Pizza…
two points.
a
8
–3
b
5
1
-2
c
3
1
-1
2
0
d
1
3
 The MRS from bundle
a to bundle b is -3.
4
5
6
From bundle c
b to bundle d,
c,
From
Lisa is willing to give
up 1
2b to c,
 for
MRS
Burritos in exchange
1 = -2.
more Pizza…
 This is the same as the
slope of the indifference
I
curve between those
two points.
Z, Pizzas per semester
© 2009 Pearson Addison-Wesley. All rights reserved.
4-17
Figure 4.3 (b) Marginal Rate of
Substitution
B, Burritos per semester
(b) Indifference Curve Concave to the Origin
a
7
–2
 From bundle a to
bundle b, Lisa is
willing to give up 2
Pizzas for 1
Burrito.
 Nevertheless, from
b to c she is willing
to give up 3 Pizzas
for 1 burrito.
 This is very unlikely
b
5
1
–3
c
2
1
I
0
3
4
5
6
Z, Pizzas per semester
© 2009 Pearson Addison-Wesley. All rights reserved.
 Could you think
why?
4-18
Diminishing marginal rate of
substitution
 The marginal rate of substitution
approaches zero as we move down and
to the right along an indifference curve.
 Discussion: could you imagine a good
that does not exhibit this property?
© 2009 Pearson Addison-Wesley. All rights reserved.
4-19
Curvature of Indifference Curves.
 Casual observation suggests that most
people’s indifference curves are convex.
 Exceptions:
 Perfect substitutes - goods that a consumer is
completely indifferent as to which to consume.
 Perfect complements - goods that a consumer is
interested in consuming only in fixed proportions
© 2009 Pearson Addison-Wesley. All rights reserved.
4-20
Coke, Cans per week
Figure 4.4a Perfect Substitutes
 Bill views Coke and
Pepsi as perfect
substitutes: can you
tell how his
indifference curves
would look like?
4
3
2
1
I1
0
1
I2
I3
I4
2
3
4
Pepsi, Cans per week
© 2009 Pearson Addison-Wesley. All rights reserved.
 Straight, parallel lines
with an MRS (slope)
of −1.
 Bill is willing to
exchange one can of
Coke for one can of
Pepsi.
4-21
Ice cream, Scoops perweek
Figure 4.4b Perfect Complements
d
2
b
a
1
0
c
e
3
1
I3
I2
I1
2
3
Pie, Slices per week
© 2009 Pearson Addison-Wesley. All rights reserved.
 If she has only one
piece of pie, she
gets as much
pleasure from it
and one scoop of
ice cream, a,
 as from it and two
scoops, d,
 or as from it and
three scoops, e.
4-22
Figure 4.4c Imperfect Substitutes
 The standardshaped, convex
indifference curve
in panel lies
between these two
extreme examples.
B, Burritos per semester
f
I
 Convex indifference
curves show that a
consumer views
two goods as
imperfect
substitutes.
Z, Pizzas per semester
© 2009 Pearson Addison-Wesley. All rights reserved.
4-23
Application: Indifference Curves
Between Food and Clothing
© 2009 Pearson Addison-Wesley. All rights reserved.
4-24
Problems: constructing indifference
curves
1. Don is altruistic. Show the possible shape of
his indifference curves between charity and
all other goods.
2. Miguel considers tickets to the Houston
Grand Opera and to Houston Astros baseball
games to be perfect substitutes. Show his
preference map.
3. If Joe views two candy bars and one piece of
cake as perfect substitutes, what is his
marginal rate of substitution between candy
bars and cake?
© 2009 Pearson Addison-Wesley. All rights reserved.
4-25
Utility
 Utility - a set of numerical values that
reflect the relative rankings of various
bundles of goods.
 utility function - the relationship
between utility values and every
possible bundle of goods.
U(B, Z)
© 2009 Pearson Addison-Wesley. All rights reserved.
4-26
Utility Function: Example
u  BZ
 Question: Can determine whether Lisa would be
happier if she had Bundle x with 9 burritos and 16
pizzas or Bundle y with 13 of each?
 Answer: The utility she gets from x is 12utils. The
utility she gets from y is 13utils. Therefore, she
prefers y to x.U= BZ.
© 2009 Pearson Addison-Wesley. All rights reserved.
4-27
Marginal utility
 marginal utility - the extra utility that a
consumer gets from consuming the last unit of
a good.
 the slope of the utility function as we hold the
quantity of the other good constant.
 Marginal Utility of good Z is:
U
MU Z 
Z
© 2009 Pearson Addison-Wesley. All rights reserved.
4-28
(a) Utility
U, Utils
Figure 4.5
Utility and
Marginal Utility
0
U = 20
MU Z 
Z = 1
1
2
3
4
5
6
7
8
9
U
Z
10
Z, Pizzas per semester
(b) Marginal Utility
MU Z, Marginal utility of pizza
 Marginal utility is the
slope of the utility
function as we hold
the quantity of the
other good constant.
Utility function, U (10, Z )
250
230
 As Lisa consumes
more pizza, holding
her consumption of
burritos constant at
10, her total utility, U,
increases…
 and her marginal
utility of pizza, MUZ,
decreases (though it
remains positive).
350
130
20
0
MU Z
1
2
3
4
5
6
7
8
9
10
Z, Pizzas per semester
© 2009 Pearson Addison-Wesley. All rights reserved.
4-29
Utility and Marginal Rates of
Substitution
 The MRS is the negative of the ratio of the
marginal utility of another pizza to the
marginal utility of another burrito.
 Formally,
B
MU Z
MRS 

Z
MU B
© 2009 Pearson Addison-Wesley. All rights reserved.
4-30
Budget Constraint
 budget line (or budget constraint) - the
bundles of goods that can be bought if
the entire budget is spent on those
goods at given prices.
 opportunity set - all the bundles a
consumer can buy, including all the
bundles inside the budget constraint and
on the budget constraint
© 2009 Pearson Addison-Wesley. All rights reserved.
4-31
Budget Constraint
 If Lisa spends all her budget, Y, on pizza and
burritos, then
pBB + pZZ = Y
 where pBB is the amount she spends on burritos
and pZZ is the amount she spends on pizzas.
 This equation is her budget constraint.
 It shows that her expenditures on burritos and pizza use
up her entire budget.
© 2009 Pearson Addison-Wesley. All rights reserved.
4-32
Budget Constraint (cont).
 How many burritos can Lisa buy?
 To answer solve budget constraint for B (quantity of
burritos):
PB B  PZ Z  Y
PB B  Y  PZ Z
Y  PZ Z
B
PB
© 2009 Pearson Addison-Wesley. All rights reserved.
4-33
Budget Constraint (cont).
 From previous slide we have:
Y  PZ Z
B
PB
 If pZ = $1, pB = $2, and Y = $50, then:
$50  ($1 Z )
B
 25  0.25Z
$2
© 2009 Pearson Addison-Wesley. All rights reserved.
4-34
B, Burritos per semester
Figure 4.6 Budget Constraint
25 = Y/pB
20
a
Amount of Burritos
 From previous slide we have
consumed if all income
that if:
is allocated for
– pZ = $1, pB = $2, and Y = $50,
Burritos.
then the budget constraint,
L1, is:
B
b
L1
c
10
$50  ($1 Z )
 25  0.25Z
$2
Amount of Pizza
consumed if all income
is allocated for Pizza.
Opportunity set
d
0
10
© 2009 Pearson Addison-Wesley. All rights reserved.
30
50 = Y /pZ
Z, Pizzas per semester
4-35
The Slope of the Budget Constraint
 We have seen that the budget constraint for Lisa is
given by the following equation:
Y PZ
B  Z
PB PB
Slope = B/Z = MRT
 The slope of the budget line is also called the marginal rate of
transformation (MRT)
 rate at which Lisa can trade burritos for pizza in the marketplace
© 2009 Pearson Addison-Wesley. All rights reserved.
4-36
Table 4.1 Allocations of a $50 Budget
Between Burritos and Pizza
© 2009 Pearson Addison-Wesley. All rights reserved.
4-37
B, Burritos per semester
Figure 4.7(a) Changes in the Budget
Constraint: An increase in the Price of
Pizzas.
Slope = -$1/$2 = -0.5
25
L1 (pZ = $1)
$2
Y - PZ = $1
PB
PB
B=
If the price of Pizza
doubles, (increases
from $1 to $2) the
slope of the budget
line increases
Loss
L2
(pZ = $2)
0
Slope = -$2/$2 = -1
Z
This area represents
the bundles she can
no longer afford!!!
25
50
Z, Pizzas per semester
© 2009 Pearson Addison-Wesley. All rights reserved.
4-38
Figure 4.7(b) Changes in the Budget
Constraint: Increase in Income (Y)
B, Burritos per semester
$100
$50
B= P B
50
L3 (Y = $100)
25
If Lisa’s income
increases by $50 the
budget line shifts to
the right (with the
same slope!)
Gain
L1 (Y = $50)
0
PZ
Z
PB
This area represents
the new consumption
bundles she can now
afford!!!
50
100
Z, Pizzas per semester
© 2009 Pearson Addison-Wesley. All rights reserved.
4-39
Solved Problem 4.2
 A government rations water, setting a
quota on how much a consumer can
purchase. If a consumer can afford to
buy 12 thousand gallons a month but
the government restricts purchases to
no more than 10 thousand gallons a
month, how does the consumer’s
opportunity set change?
© 2009 Pearson Addison-Wesley. All rights reserved.
4-40
Solved Problem 4.2
© 2009 Pearson Addison-Wesley. All rights reserved.
4-41
B, Burritos per semester
Figure 4.8(a) Consumer Maximization:
Interior Solution
Would
BundleLisa
e isbe
called
ato to
Would
Lisa
beable
able
consume
consumer’s
any
bundle
optimum.
along
consume
any
bundle
I1? If Lisa
3 (i.e.
is consuming
this
along
I
bundle
f)?
 Yes; she could afford bundles
bundle, she has no
d, c, Lisa
and a.does not have
 No!
incentive
to
change
her
 enough
Nevertheless,
there
other
income
toare
afford
behaviorbundles
by substituting
affordable
any bundle alongthat
I3 should
be
preferred
andanother.
affordable.
one
good for
25
c
20
B
10
e
d
A
0
f
10
 For instance bundle e
a
30
© 2009 Pearson Addison-Wesley. All rights reserved.
I3
I2
I1
50
Z, Pizzas per semester
4-42
B, Burritos per semester
Figure 4.8(a) Consumer Maximization:
Interior Solution
 The budget constraint and the indifference curve
have the same slope at the point e where they
touch.
 Therefore, at point e:
MU Z
PZ
MRS  
   MRT
MU B
PB
25
Slope of I2
Slope of BL
e
I2
0
© 2009 Pearson Addison-Wesley. All rights reserved.
50
Z, Pizzas per semester
4-43
B, Burritos per semester
Figure 4.8(b) Consumer
Maximization: Corner Solution
25
e
I3
I2
Budget line
I1
50
Z, Pizzas per semester
© 2009 Pearson Addison-Wesley. All rights reserved.
4-44
Solved Problem 4.3
 Nigel, a Brit, and Bob, a Yank, have the same
tastes, and both are indifferent between a
sports utility vehicle (SUV) and a luxury
sedan. Each has a budget that will allow him
to buy and operate one vehicle for a decade.
For Nigel, the price of owning and operating
an SUV is greater than that for the car. For
Bob, an SUV is a relative bargain because he
benefits from lower gas prices and can qualify
for an SUV tax break. Use an indifference
curve–budget line analysis to explain why
Nigel buys and operates a car while Bob
chooses an SUV.
© 2009 Pearson Addison-Wesley. All rights reserved.
4-45
Solved Problem 4.3
© 2009 Pearson Addison-Wesley. All rights reserved.
4-46
Figure 4.9 Optimal Bundles on Convex
Sections of Indifference Curves
© 2009 Pearson Addison-Wesley. All rights reserved.
4-47
Solved Problem 4.4
 Alexx doesn’t care about where he lives, but
he does care about what he eats. Alexx
spends all his money on restaurant meals at
either American or French restaurants. His
firm offers to transfer him from its Miami office
to its Paris office, where he will face different
prices. The firm will pay him a salary in euros
such that he can buy the same bundle of
goods in Paris that he is currently buying in
Miami.11 Will Alexx benefit by moving to
Paris?
© 2009 Pearson Addison-Wesley. All rights reserved.
4-48
Solved Problem 4.4
© 2009 Pearson Addison-Wesley. All rights reserved.
4-49
Food Stamps
 Nearly 11% of U.S. households worry
about having enough money to buy food
and 3.3% report that they suffer from
inadequate food (Sullivan and Choi,
2002).
 Households that meet income, asset, and
employment eligibility requirements
receive coupons that can be used to
purchase food from retail stores.
© 2009 Pearson Addison-Wesley. All rights reserved.
4-50
Food Stamps (cont).
 The Food Stamps Program is one of the
nation’s largest social welfare programs
with expenditures of $33.1 billion for
nearly 29.1 million people in 2006.
 Would a switch to a comparable cash
subsidy increase the well-being of food
stamp recipients?
 Would the recipients spend less on food and
more on other goods?
© 2009 Pearson Addison-Wesley. All rights reserved.
4-51
All other goods per month
Figure 4.10 Food Stamps Versus Cash
Budget line with cash
Y + 100
f
Y
C
e
I3
d
I2
I1
B
Budget line with
food stamps
A
0
Original
budget line
100
© 2009 Pearson Addison-Wesley. All rights reserved.
Y
Y + 100
Food per month
4-52
Behavioral Economics
 behavioral economics - by adding
insights from psychology and empirical
research on human cognition and
emotional biases to the rational
economic model, economists try to
better predict economic decision making
© 2009 Pearson Addison-Wesley. All rights reserved.
4-53