Week 2 – Lecture 2

Consumer Choice

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Chapter Four Overview

1. The Budget Constraint

2. Consumer Choice

3. Duality

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4. Some Applications

5. Revealed Preference

Chapter Four 2
Key Definitions
Budget Set:
• The set of baskets that are affordable

Budget Constraint:
• The set of baskets that the consumer may
purchase given the limits of the available income.

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Budget Line:
• The set of baskets that one can purchase when
spending all available income.

PxX + PyY = I
Y = I/Py – (Px/Py)X

Chapter Four 3
The Budget Constraint

Assume only two goods available: X and Y

• Price of x: Px ; Price of y: Py
• Income: I
Total expenditure on basket (X,Y): PxX + PyY

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The Basket is Affordable if total expenditure
does not exceed total Income:

PXX + PYY ≤ I

Chapter Four 4
A Budget Constraint Example

Two goods available: X and Y

I = $10
Px = $1
Py = $2

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All income spent on X → I/Px Budget Line 1:
units of X bought 1X + 2Y = 10
Or
All income spent on Y → I/Py
units of X bought Y = 5 – X/2
Slope of Budget Line = -Px/Py = -1/2

Chapter Four 5
 A Budget Constraint Example
Y

Budget line = BL1

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I/PY= 5 A
•
-PX/PY = -1/2
•C B

•
I/PX = 10 X
Chapter Four 6
Budget Constraint

• Location of budget line shows what the

income level is.
• Increase in Income will shift the budget line
to the right.

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– More of each product becomes affordable
• Decrease in Income will shift the budget line
to the left.
– less of each product becomes affordable

Chapter Four 7
 A Budget Constraint Example
Y Shift of a budget line
I = $12
PX = $1
PY = $2 If income rises, the budget line shifts parallel
to the right (shifts out)

6 Y = 6 - X/2 …. BL2 If income falls, the budget line shifts parallel

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5 to the left (shifts in)

BL2

BL1

10 12 X
Chapter Four 8
Budget Constraint

• Location of budget line shows what the

income level is.
• Increase in Income will shift the budget line
to the right.

Copyright (c)2014 John Wiley & Sons, Inc.

– More of each product becomes affordable
• Decrease in Income will shift the budget line
to the left.
– less of each product becomes affordable

Chapter Four 9
A Budget Constraint Example
Y Rotation of a budget line

If the price of X rises, the budget

line gets steeper and the
horizontal intercept shifts in
I = $10
If the price of X falls, the budget

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6 PX = $1 line gets flatter and the
5 BL1 PY = $3 horizontal intercept shifts out

Y = 3.33 - X/3 …. BL2

3.3
3
BL2
10
Chapter Four
X 10
A Budget Constraint Example

Two goods available: X and Y

I = $800
Px = $20
Py = $40

Copyright (c)2014 John Wiley & Sons, Inc.

All income spent on X → I/Px Budget Line 1:
units of X bought 20X + 40Y = 800
Or
All income spent on Y → I/Py
units of X bought Y = 20 – X/2
Slope of Budget Line = -Px/Py = -1/2

Chapter Four 11
A Budget Constraint Example

Copyright (c)2014 John Wiley & Sons, Inc.

Chapter Four 12
Consumer Choice

Assume:
 Only non-negative quantities
 "Rational” choice: The consumer chooses the
basket that maximizes his satisfaction given the
constraint that his budget imposes.

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Consumer’s Problem:

Max U(X,Y)

Subject to: PxX + PyY < I

Chapter Four 13
Interior Optimum
Interior Optimum: The optimal consumption basket is
at a point where the indifference curve is just tangent
to the budget line.

A tangent: to a function is a straight line that has the

same slope as the function…therefore….

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MRSx,y = MUx/MUy = Px/Py

“The rate at which the consumer would be willing to

exchange X for Y is the same as the rate at which they
are exchanged in the marketplace.”
Chapter Four 14
Interior Consumer Optimum
Y
B
•
Preference Direction

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Optimal Choice (interior solution)
•
IC
•C BL
0 X
Chapter Four 15
Chapter Four
Interior Consumer Optimum

16

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Interior Consumer Optimum

• U (X,Y) = XY and MUx = Y while MUy = X

• I = $1,000
• PX = $50 and PY = $200
• Basket A contains (X=4, Y=4)
• Basket B contains (X=10, Y=2.5)
• Question:

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• Is either basket the optimal choice for the consumer?

Basket A: MRSx,y = MUx/MUy = Y/X = 4/4 = 1

Slope of budget line = -Px/Py = -1/4

Basket B: MRSx,y = MUx/MUy = Y/X = 1/4

Chapter Four 17
 Interior Consumer Optimum
Y

50X + 200Y = I

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2.5 • U = 25

0 10 X
Chapter Four 18
Equal Slope Condition

MUx/Px = MUy/Py

“At the optimal basket, each good gives

equal bang for the buck”

Copyright (c)2014 John Wiley & Sons, Inc.

Now, we have two equations to solve for two unknowns
(quantities of X and Y in the optimal basket):

1. MUx/Px = MUY/PY
2. PxX + PyY = I

Chapter Four 19
Contained Optimization

What are the equations that the

optimal consumption basket must
fulfill if we want to represent the
consumer’s choice among three
goods?

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• MUX / PX = MU Y / P Y is an example of “marginal reasoning” to maximize
• P X + P Y = I reflects the “constraint”
X Y

Chapter Four 20
 Contained Optimization

U(F,C) = FC
PF = $1/unit
PC = $2/unit
I = $12

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Solve for optimal choice of food
and clothing

Chapter Four 21
Some Concepts
Corner Points: One good is not being
consumed at all – Optimal basket lies on
the axis

Composite Goods: A good that

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represents the collective expenditure on
every other good except the commodity
being considered

Chapter Four 22
 Some Concepts

Chapter Four
23

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 Some Concepts

Chapter Four
24

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 Some Concepts

Chapter Four
25

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 Some Concepts

Chapter Four
26

Copyright (c)2014 John Wiley & Sons, Inc.

 Some Concepts

Chapter Four
27

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Duality
The mirror image of the original (primal) constrained
optimization problem is called the dual problem.
Min PxX + PyY
(X,Y) subject to: U(X,Y) = U*

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where: U* is a target level of utility.

If U* is the level of utility that solves the

primal problem, then an interior
optimum, if it exists, of the dual
problem also solves the primal problem.

Chapter Four 28
Optimal Choice
Y

Example: Expenditure Minimization

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Optimal Choice (interior solution)
•
U = U*
Decreases in
expenditure level PXX + PYY = E*
0 X

Chapter Four 29
Optimal Choice
Y
Example: Expenditure Minimization

50X + 200Y = E

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25 = XY (constraint)
Y/X = 1/4 (tangency condition)

2.5 • U = 25

0 X
10
Chapter Four 30
Revealed Preference

Suppose that preferences are not

known. Can we infer them from
purchasing behavior?

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If A purchased, it must be preferred
to all other affordable bundles

Chapter Four 31
Revealed Preference

Suppose that preferences are “standard” – then:

All baskets to the Northeast of A must be

preferred to A.

Copyright (c)2014 John Wiley & Sons, Inc.

This gives us a narrower range over which
indifference curve must lie

This type of analysis is called revealed preference

analysis.

Chapter Four 32