LECTURE 2

Chapter 4

CONSUMER BEHAVIOR

I. The representative consumer

- Representative of consumers’ preference focus on
+ Consumption goods
+ Leisure (any time spent not working on the market)
Example: Sleep, cooking, yard work...

- Assume that all consumers are identical (representative consumer)

II. Consumer behavior

• Static model (one-period model) ⇒ no savings: Decision made by consumer for only one period
• A representative consumer (present lots of consumers)
+ values consumption
+ values leisure
+ works and receives a wage
+ pays taxes
+ receives dividends (all the profit that firm makes go to dividend)
 Question: How does the consumer decide how much to work? How much to consume?
III. Preferences
• Utility function: U(C, L)
+ U is utility function
+ C is an aggregated consumer good (consumption)
+ L is any time spent not working in the market (leisure)
+ (C1, L1) is a consumption bundle.
 U (C1, L1) > U (C2, L2) ⇒ individual strictly prefers U (C1, L1).
 U (C1, L1) = U (C2, L2) ⇒ individual indifferent between both consumption bundles.
=> The utility function captures how an individual consumer ranks consumption
bundle.
• Bundles
+ The more, the better
+ Diversity is preferred (2 A and 3 B is more preferred to 5 C)
+ Consumption and leisure are normal goods
• Indifference curve:
+ Quantity of bundle A > B and D => better
+ All bundles that give the same utility are on the same IC
Example: Consumer is indifferent between B and D
+ Downward sloping: ↑ l ⇒↓ c in order to stay on the same indifference curve
+ Convex: diminishing MRSl,c (bow toward the origin)
IV. Marginal rate of substitution (MRS)
• The rate which consumer is willing to substitute leisure for consumption
goods.
 ∂U(c,l)
• = the marginal utility of consumption = MUc = Uc(c,l)
∂c
∂U(c.l)
• = the marginal utility of leisure = MUl = Ul (c,l)
∂I
• MRSl,c at point (c0,l0)
∂U(c,l)
∂I 𝑀𝑈 𝑜𝑓 𝑙𝑒𝑖𝑠𝑢𝑟𝑒
MRSl,c = ∂U(c,l) =
𝑀𝑈 𝑜𝑓 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛
∂c
=>
MRS =

• The MRSl,c is the negative of the slope of the indifference curve at a particular
consumption bundle (c0,l0).
• The property of diminishing marginal rate of substitution follows from the property that the indifference curve
is bowed in toward the origin.
V. Budget constraints
• Assume that representative consumer behaves competitively
=> The consumer is price taker (price is given, and their action has no effect on the price)
• Assume that there is no government, no supplied currency (money) and no banks
• Barter economy (economy without monetary exchange)
=> People exchange goods for goods (consumption goods and time)

•Time constrain h= L + NS
+ h is time available
+ L is leisure
+ NS is time working = h - L
• Disposal income C = wNs + 𝜋 – T
+ Income: wNs
+ w is the real wage per unit of time (consumption goods)
+ 𝜋 is dividend income
+ T is tax (by the government)
+ 𝜋 − 𝑇 doesn’t depend on w

Summary:
• Budget constrain:
C = w(h-L) + 𝜋 – T
+ w, 𝜋, T and h is given
+ C + wL is real expenditure on consumption good and leisure
𝑑𝑐
+ The slope of budget line: =-w
𝑑𝐿
+ When leisure increase, constraint decrease
+ When leisure decrease, constrain increase
a. When (T- 𝜋) > 0 : More tax than dividend ( T > 𝜋 )
C = -wL + wh + (𝜋 – T )
𝝅−𝐓
• c = 0 => wh + 𝜋 – T = wL => L = h + ( ) (horizontal intercept)
𝒘
=> Consumer work h hour and no leisure
• L = 0 => c = wh + 𝝅 – T (vertical intercept)
=> Max leisure that consumer can take and still be able to pay lump sum tax
 b. When (T- 𝜋) < 0 -> (T < 𝜋 )
C = - wL + wh + 𝜋 – T
• Budget constraint is kinked
=> Because leisure is limited by the number of available hours.
• At point B, L = h => numbers of hours work (Ns) by consumer is 0
=> C = 𝜋 – T > 0
• Point along BD is consumer working 0 hours and consuming
=> C ≤ 𝜋 – T
• Other bundles outside the shaded blue are not feasible

VI. Consumers optimization

- Only consider T < 𝜋 in this case
- > Put preference constraint together
• Consumer is rational
• The optimal consumption bundle is the point representing a consumption–leisure pair that is:
+ on the highest possible indifference curve
+ on or inside the consumer’s budget constraint
• Never choose consumption bundle inside budget constraint (blue shade) because people prefer more to
less (not optimal)
• Where indifferent curve cuts budget constraint line ( E and F ) is also not optimal
• Where indifferent curve is tangent to budget constraint is optimal (H)

a) Graphical approach
1. Point J: inside the budget set ⇒ cannot be optimal
2. Point F: MRSL, c > w (wage) (e.g., suppose that MRSl,c = 2 and w = 1)
-> Too much consumption with too little leisure
-> Better off moving ti the right
3. Point E: MRSL, c < w (e.g., suppose that MRSl,c = 0.5 and w = 1)
-> Too little consumption with too much leisure
-> Better of moving to the left
4. Point H: MRSL, C = W => Optimal
-> MRS equal slope of the constraint
-> Cannot make the trade of leisure and consumption because this
is the highest point (optimal)
• Consumer optimization in competitive markets implies that the consumer sets the marginal rate of
substitution of any good x for any other good y = to the relative price of x in terms of y
• Get 1 hour of leisure, give up double consumption
• Increase consumption by give up leisure => budget constraint
b) Mathematical approach
=> A General Constrained Optimization Problem:
 Example: Max f (x1, x2) =x1x2 with constraint: x1+4x2 ≤ 16
x1, x2
-> constraint: x1 + 4x2 – 16 ≤ 0
=> Construct and maximize a single function (called the Lagrangian)
Max L = (x1x2) - 𝛌 (x1 +4x2-16)
x1,x2, 𝛌
p/s: λ is the Langrange multiplier.
𝜕𝑙 𝜕𝑙 𝜕𝑙
=> = 0, = 0, =0
∂x1 ∂x2 ∂λ
𝜕𝑙
+ = x2 – λ= 0 (derivative on x1, ignore other factors) => λ=x2
∂x1
𝜕𝑙 𝑥1
+ = x1 – 4λ = 0 (derivative on x2) => λ=
∂x2 4
𝜕𝑙
+ = -(x1 + 4x2 – 16) = 0 (derivative on λ)
∂λ
𝜕𝑙 𝑥1
=> = -(x1 + 4 λ – 16) = 0 => -(x1 + 4 – 16) = 0 => -(2x1 – 16) = 0 => x1 = 8
∂λ 4
 8
Conclusion: x1 = 8, λ = = 2, x2=2
4

 Example: Max u(c,L) =c1/2 L1/2 with constraints c ≤ w(h−L) +π−T

Assume that w=1, h=24, and π−T=0
-> constraint: c – w(h-L) – π + T ≤ 0
-> c – 1(24-L) – (0) = c – 24 + L
=> Max L = c1/2L1/2 – λ(c-24+L)
C, L, λ
𝜕𝑙 1
+ = c (-1/2) L1/2 – λ = 0 (derivative on c) (1)
∂c 2
𝜕𝑙 1
+ = L (-1/2) c1/2 – λ = 0 (derivative on L) (2)
∂L 2
𝜕𝑙
+ = - (c-24+L) = 0
∂λ
=> Both (1) and (2) = λ
=> c = L
𝜕𝑙
=> = - (L-24+L) -> -(2L-24) = 0 -> L = 12 => c=12
∂λ
1
Conclusion: L = 12, c=12, λ =
2
=> From both examples, the final answer is the optimal result: MRSL, C = w
c. Normal goods vs inferior goods
- Normal Good: if the quantity demanded increases as income increases
- Inferior Good: if the quantity demanded decreases as income increases

=> We are assuming that C and L are both normal goods

d. In a competitive market
- MRSx,y equal the relative price of X in terms of y
VII. Situation questions
1. Change in Real Dividends (𝝅) or Taxes (T)?
 Change in consumers real dividend income minus taxes, 𝝅 – T
- Causes by
+ Change in 𝜋: increase in 𝜋 is caused by an increase in the productivity of firms ->
increase in the dividends that are paid to the consumer
+ Change in T: decreases in T represents a tax cut for the consumer, and disposable
income
- When 𝜋 -T increases, from point H, consumers would
instead choose point K

 Consider an increase in π (or a decrease in T)

=> wNs + 𝝅 – T increases
- Income increases => more money
- The slope of the budget line remains unchanged at w
=> Doesn’t affected by real wage (w)
- More is available at I=H (point J) ????
- Move from I1 to I2 => More consumption for both
=> Move from point H to point K
- Both C and L increase (as expected since both are normal
goods).
Change in price -> Income and substitution effects

2. Changes in the Real Wage: Income and Substitution Effects

=> Change in real wage (W) faced by the representative consumer, holding everything else
constant. (ex: If W increases)
- Initially, we are at point F
- The relative price of leisure is W
 - The price of consumption is 1
=> Give up 1 consumption for 1 leisure
-> The quantity of consumption goods chosen by the consumer increases when the real wage
increases
-> Labor supply (Ns), may rise or fall when the real wage (W) rises.
- If 𝜋, T is constant:
-> initially the budget constraint is ABD
-> An increase in the real wage w causes the budget constraint to shift out to EBD.
-> Consumers choose H
- Given that consumption and leisure are normal goods
=> consumption must increase but leisure may increase or decrease in response to an
increase in the real wage.
a. Substitution effect
- change relative prices but keep individuals at the same utility
level.
- The budget line rotates from AB to JK
=> The slope of budget constraint changes while staying in
the same indifference curve
- When real wage increases, leisure is more expensive relative
to consumption goods
=>consumer choose cheaper goods (consumption) than
expensive one (leisure)
⇒substitute L for c
⇒↓L and ↑ C
- Consumer is indifferent between the consumption bundle
chosen (point O) and the initial consumption bundle (F).
- Move from F to O
Conclusion: Consumption increase, leisure decrease, and
substitution effect for labor supply (Ns = h – l ) increase

b. Income effect
- Move from O to H
- real wage stays the same as the budget constraint shifts out from JKD to EBD
- nonwage income increases.
-> when the real wage increases, individuals become wealthier
=> the consumer can consume more consumptions and more leisure, as the budget
constraint has shifted out.
-> ↑L and ↑ C
 Both Substitute and income effect (when w increase):
-> consumption (C) increase
-> The effect on L is ambiguous (up and down)
-> increase or a decrease in labor supply Ns.

VIII. Perfect complements

- If consumption and leisure are perfect complements for the consumer, an increase in dividend income has no
effect on the ratio of consumption to leisure.
- Optimal bundle: on the line of C = al
IX. Perfect substitute

- Solve for slope of budget constraint and indifference curve

- If w>MRS => choose N (Y)

- w< MRS => choose M (X)
- w=MRS => choose any point on the indifference curve that touches the budget line.

TUTORIAL

1) Use a diagram to show that if the consumer prefers more to less, then indifference curves cannot
cross.
 - When the indifference curve cut each other, it means that the bundles
give equal satisfaction as it lies on the same indifference curve.
 Point A is on both indifference curves, I1 and I2
=> The consumer is indifferent between A and B, as both points
are on I2.
=> the consumer is indifferent between A and C, as both points
are on I1.
 However, based on the assumption of consumers prefer more to
less, point C provide more leisure and consumption and is more
preferred compares to A and B
=> Consumers must strictly prefer C to A.
=> Contradict
=> Two indifference curves can’t cross.
2) Suppose that leisure and consumption goods are perfect substitutes. In this case, an indifference
curve is described by the equation u=aL+bC, where a and b are positive constants, and u is the level
of utility. That is, a given indifference curve has a value for u, with higher indifference curves having
higher values for u.
(a) Show what the consumer’s indifference curves look like when consumption and leisure are
perfect substitutes and determine graphically and algebraically what consumption bundle the
consumer will choose. Show that the consumption bundles the consumer chooses depends on the
𝒂
relationship between and w and explain why.
𝒃
- Perfect substitute: Linear Indifferent curve

+
+ We have u = al + bC
𝑢−𝑎𝑙 𝑢 𝑎
=> Indifference Curve: C = or C= − 𝑙
𝑏 𝑏 𝑏
𝑎
=> Slope = -
𝑏
+ Budget constraint: C = W(h-L) + (π -T) (given above during lecture)
=> Slope of constraint = -W (slope of budget line is negative)
p/s: To find slope, y=mx + y, m is slope
𝑎
 w>MRS ( ) -> slope of Budget Constraint > slope of Indifference Curve => choose N (Y)
𝑏

C
I4
I3
I2
C I1

L L

 w< MRS -> slope of Budget Constraint < slope of Indifference Curve => choose M (X)
 w=MRS -> slope of BC = slope of IC => choose any point on the indifference curve that
touches the budget line.
 (b) Do you think it likely that any consumer would treat consumption goods and leisure as perfect
substitutes?
- No. As people prefer the diversity of the goods. So even though good x and good y are similar,
consumer will want more good y than good x if they have lots of good y in hand
- The utility function in this problem does not obey the property that the consumer prefers
diversity, and is therefore not a likely possibility.

(c) Given perfect substitutes, is more preferred to less? Do preferences satisfy the diminishing-
marginal-rate-of-substitution property?
- yes. More is still preferred to less => consumers still choose the highest possible indifference curve
that touches the budget line.
- No. Preferences do not satisfy diminishing MRS as MRS is constant along the indifference curve (MRS
= 0)
3) Suppose that the government imposes a proportional income tax on the representative consumer’s
wage income. That is, the consumer’s wage income is W(1−t) (h−L), where t is the tax rate. What
effect does the income tax have on consumption and labor supply? Explain your results in terms of
income and substitution effects.
- Original budget line: C ≤ W(h-L) + (π -T)
- As the wage income is now w(1-t) (h-L)
=> C ≤ W (1-t) (h-L)
Note: t is tax imposes by the government on income.
m is -w(1-t)
- The original budget constraint when tax hasn’t imposed (t=0) is FGH
=> When t > 0, the budget constraint is EGH.
- The slope of the original budget line is –w
The slope of the new budget line is –w(1–t).
- Originally, consumers would pick optimal point (budget line = indifference
curve)
After the tax has been imposed, the consumer picks point B.
 The substitution effect: Leisure is more expensive, consumers
choose consumption
=> reduce in C Increase in L
=> Indifferent in moving from point A to point D
 Income effect: moves the consumer to point B
=> Reduce in C and decrease in L
=> C decrease, L is vague

=> Conclusion, consumption increases, leisure ambiguous

4) Consider a representative consumer with the following preferences

U(c,l) = ln c + σ ln l
Where c is consumption, l is leisure, and 0< σ <1 is a constant. The individual receives a real wage
of w for every unit of labor supplied, receives no dividends from firms, and pays no taxes. The
maximum amount of time available to the individual in this period is h. Find the optimal amount of
consumption and leisure desired by the individual (as a function of σ,h, or w). Find the labor supply
curve. Does labor supply depend on the wage rate w? Interpret your result.
=> The Lagrange (budget constraint) is given by L = ln c + σ ln l− λ(c−wh+wl).
=>
∂𝐿 1 1
= – λ = 0 => λ = (1)
∂c 𝑐 𝑐
∂𝐿 σ σ
= – λw = 0 => λ = (2)
∂𝑙 𝑙 𝑙𝑤
∂𝐿
= - c +wh -wl = 0 (3)
∂λ
=> From 1 and 2
 𝑙𝑤
=> c =
σ
∂𝐿 𝑙𝑤
=> Substitute into (3) -> = - +wh -wl = 0
∂λ σ
ℎσ
=> 𝑙 =
1+σ
ℎw
=> c =
1+σ

ℎσ ℎ
=> Labour supply equation: Ns(w) =h−L(w) -> Ns = h - = (which is different from c)
1+σ 1+σ
=> Does not depend on w
=> This happens because the income effect (which tells individuals to work less when w increases) is
exactly offset by the substitution effect (which tells individuals to work more when w increases)