1. Chapter Four
Consumer Choice

2. Chapter Outline Preferences. Utility. Budget Constraint.
Constrained Consumer Choice.
Behavioral Economics.
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3. 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.
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4. Utility Theories Cardinal Utility Theory Ordinal Utility Theory
Measurable
Jeremy Bentham
Ordinal Utility Theory
Only requires ordering of preferences
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5. Ordinal Utility Theory
Preference assumptions
Completeness
Transitivity
More is Better
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6. 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.
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7. 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.
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8. 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
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9. Are these statements consistent with the pervious assumptions?
I like a scoop of chocolate ice cream the same as a scoop of vanilla ice cream.
I am indifferent between having a scoop of chocolate ice cream or a scoop of vanilla ice cream. However, I prefer a scoop of vanilla ice cream to a scoop of strawberry ice cream and I prefer a scoop of strawberry ice cream to chocolate ice cream.
I prefer an ice cream cone with one scoop of ice cream over one with two scoops.
I don’t know whether I want to spend another 50 cents for another scoop of ice cream. I can’t decide.
I am indifferent between the small serving size and the medium serving size.
I don’t know whether I really like rocky road ice cream. I have never tasted it.
I like ice cream flavored with real vanilla beans more than ice cream flavored with an artificial vanilla flavoring, but I don’t think it is worth the extra cost.
I can’t look at another plate of ice cream. I am willing to pay someone to get it out of my sight.
I am indifferent between a plate of ice cream containing one scoop of chocolate and two scoops of vanilla and a plate containing one scoop of vanilla and two scoops of chocolate. However, I prefer a plate containing one scoop of chocolate and three scoops of vanilla to a plate containing one scoop of vanilla and three scoops of chocolate. 
I hate ice cream.
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10. 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
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11. Figure 4.1 Bundles of Pizzas and Burritos Lisa Might Consume
Which of these two bundles would be preferred by Lisa?
Lisa prefers any bundle in area A over e
Which of these two bundles would be preferred by Lisa?
(a)
(b) c A c 25 25
itos per semester
itos per semester f 20
Lisa prefers bundle f over bundle e, since f has more of both goods: Pizza and Burritos
Lisa prefers bundle e over bundle d, since e has more of both goods: Pizza and Burritos 20 r r e
, Bur 15
, Bur 15 e B a B a d 10 b 10 I 1 b 5 B 15 25 30 15 25 30 Z
, Pizzas per semester Z
, Pizzas per semester
If Lisa is indifferent between bundles e, a, and c …..
Lisa prefers bundle e to any bundle in area B
we can draw an indifferent curve over those three points
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12. Figure 4.1 Bundles of Pizzas and Burritos Lisa Might Consume25 25
itos per semester f f 20
itos per semester 20 I2 e r 15 e r 15
, Bur a
, Bur a d B d 10 B b 10 1 b I 5 I0 B 15 25 30 15 25 30 Z
, Pizzas per semester Z
, Pizzas per semester
we can draw an indifferent curve over those three points
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13. Properties of Indifference Maps
Bundles on indifference curves farther from the origin are preferred to those on indifference curves closer to the origin.
There is an indifference curve through every possible bundle.
Indifference curves cannot cross.
Indifference curves slope downward.
QUESTION: Can you tell which of the assumptions of consumer preferences determine each of the 4 properties?
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14. Impossible Indifference Curves
Lisa is indifferent between e and a, and also between e and b…
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.
itos per semester r
, Bur B e b I 1 a I Z
, Pizzas per semester
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15. Impossible Indifference Curves
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.
itos per semester b r
, Bur B a I Z
, Pizzas per semester
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16. Figure 4.2 Impossible Indifference Curves
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17. 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
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18. Solved Problem 4.1
Consumer is indifferent between b and a since both points are in the same indifference curve…
But this contradicts the “more is better” assumption since b has more of both and hence it should be preferred over a.
itos per semester r b
, Bur B a I Z
, Pizzas per semester
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19. 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.
The slope of the indifference curve!
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20. Figure 4.3 (a) MRS along an Indifference curve
Indifference Curve Convex to the Origin
The MRS from bundle a to bundle b is -3.
This is the same as the slope of the indifference curve between those two points.
From b to c,
MRS = -2.
From bundle a to bundle b, Lisa is willing to give up 3 Burritos in exchange for 1 more Pizza… a 8
itos per semester –3 r b
From bundle b to bundle c, Lisa is willing to give up 2 Burritos in exchange for 1 more Pizza…
From bundle c to bundle d, Lisa is willing to give up 1 Burritos in exchange for 1 more Pizza…
, Bur 5 1 B -2 c 3 1 -1 d 2 1 I 3 4 5 6 Z
, Pizzas per semester
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21. Figure 4.3 (b) Marginal Rate of Substitution
(b) Indif f
erence Cu r v
e Conc a v
e to the O r
igin
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
Could you think why?
itos per semester a 7 – 2 r b
, Bur 5 1 B – 3 c 2 1 I 3 4 5 6 Z
, Pizzas per semester
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22. 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?
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23. 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
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24. Figure 4.4a Perfect Substitutes
Bill views Coke and Pepsi as perfect substitutes: can you tell how his indifference curves would look like?
Straight, parallel lines with an MRS (slope) of −1.
Bill is willing to exchange one can of Coke for one can of Pepsi.
eek 4 w 3
, Cans per e 2 k Co 1 I 1 I 2 I 3 I 4 1 2 3 4 P
epsi, Cans per w
eek
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25. Figure 4.4b Perfect Complements
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.
eek w e c 3 I 3 d b
Ice cream, Scoops per 2 I 2 a 1 I 1 1 2 3 Pi e
, Slices per w
eek
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26. Figure 4.4c Imperfect Substitutes
The standard-shaped, convex indifference curve in panel lies between these two extreme examples.
Convex indifference curves show that a consumer views two goods as imperfect substitutes. f
itos per semester r
, Bur B I Z
, Pizzas per semester
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27. Application: Indifference Curves Between Food and Clothing
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28. Problems: constructing indifference curves
Don is altruistic. Show the possible shape of his indifference curves between charity and all other goods.
Miguel considers tickets to the Houston Grand Opera and to Houston Astros baseball games to be perfect substitutes. Show his preference map.
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?
Question # 2, 4 and 6 of the end of chapter problems.
Solution:
In this case, charity is considered a good. Increases in charity increase his utility, but with diminishing returns, similar to most goods. Thus, indifference curves would have the typical convex shape, with quantity of charity giving on one axis and all other goods on the other.
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29. 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)
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30. Utility Function: Example
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.
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31. 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:
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32. Figure 4.5 Utility and Marginal Utility
(a) Utility
350
, Utils
Utility function, U
(10, Z ) U
250
DU = 20
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).
Marginal utility is the slope of the utility function as we hold the quantity of the other good constant.
230
DZ = 1 1 2 3 4 5 6 7 8 9 10 Z
, Pizzas per semester
(b) Marginal Utility
130
, Marginal utility of pizza Z MU 20 MU Z 1 2 3 4 5 6 7 8 9 10 Z
, Pizzas per semester
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33. 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,
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34. Movement along an indifference curve
Trade off B for Z so as to leave utility constant
As B declines MUB increases
As Z increases MUZ decreases
(MUZ /MUB) decreases
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35. Derive MRS of Burritos for Pizza
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36. 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
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37. 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.
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38. Budget Constraint (cont).
How many burritos can Lisa buy?
To answer solve budget constraint for B (quantity of burritos):
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39. Budget Constraint (cont).
From previous slide we have:
If pZ = $1, pB = $2, and Y = $50, then:
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40. Figure 4.6 Budget Constraint
Amount of Burritos consumed if all income is allocated for Burritos.
From previous slide we have that if:
pZ = $1, pB = $2, and Y = $50, then the budget constraint, L1, is: a 25 = Y / p
itos per semester B b 20 L 1 r
Amount of Pizza consumed if all income is allocated for Pizza.
, Bur c B 10
Opportunity set d 10 30 50 = Y / p Z Z
, Pizzas per semester
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41. The Slope of the Budget Constraint
We have seen that the budget constraint for Lisa is given by the following equation:
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
Slope = DB/DZ = MRT
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42. Table 4.1 Allocations of a $50 Budget Between Burritos and Pizza
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43. Budget Constraint
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44. Figure 4.7(a) Changes in the Budget Constraint: An increase in the Price of Pizzas.
PZ = $1 $2 Y
Slope = -$1/$2 = -0.5
B = - Z PB PB
If the price of Pizza doubles, (increases from $1 to $2) the slope of the budget line increases 25
itos per semester L 1 ( p
= $1) Z r
, Bur B
Loss
This area represents the bundles she can no longer afford!!!
L2 (pZ = $2) 25 50
Slope = -$2/$2 = -1 Z
, Pizzas per semester
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45. Figure 4.7(b) Changes in the Budget Constraint: Increase in Income (Y)
$100 PZ
$50
B = - Z PB PB
If Lisa’s income increases by $50 the budget line shifts to the right (with the same slope!) 50 L 3 ( Y =
$100)
B, Burritos per semester 25
This area represents the new consumption bundles she can now afford!!!
Gain L 1 ( Y =
$50) 50
100 Z
, Pizzas per semester
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46. Changes in Budget Constraint
Change in relative prices
Rotates the budget constraint
Change in income
Parallel shift in budget constraint
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47. 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?
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48. Solved Problem 4.2
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49. Figure 4.8(a) Consumer Maximization: Interior Solution
Would Lisa be able to consume any bundle along I3 (i.e. bundle f)?
No! Lisa does not have enough income to afford any bundle along I3
Would Lisa be able to consume any bundle along I1?
Yes; she could afford bundles d, c, and a.
Nevertheless, there are other affordable bundles that should be preferred and affordable.
For instance bundle e
Bundle e is called a consumer’s optimum.
If Lisa is consuming this bundle, she has no incentive to change her behavior by substituting one good for another.
itos per semester r
, Bur 25 B c f 20 B e 10 I 3 d A a I2 I1 10 30 50 Z
, Pizzas per semester
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50. Maximize Utility Given a Budget Constraint
Two possible solutions
Interior solution
Some of both goods are consumed
Corner solution
Only one of two goods is consumed
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51. 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:
itos per semester r
, Bur 25 B
Slope of I2
Slope of BL e I2 50 Z
, Pizzas per semester
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52. Constrained Utility Maximization
MRS<MRT 50 A • I • E
III • D IV 45
Quantity of pizzas C • B II R T 40
MRS>MRT 30 20 15 10 10 20 30 40 50 60 70 80 90
100
Quantity of burgers

53. Consumer Equilibrium (recap)
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54. Consumer Equilibrium (recap)
Holding utility constant along an indifference curve
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55. Consumer Equilibrium
Individuals that face identical prices have the same MRS
For each individual the last dollar spent on each and every good at the same amount to utility
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56. Consumer Equilibrium
When the indifference curve is steeper than the budget constraint
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57. Figure 4.8(b) Consumer Maximization: Corner Solution
For the first dollar spent on Z the MUz/Pz < MUb/Pb
itos per semester r e
, Bur 25 B I 3 I 2
Budget line I 1 50 Z
, Pizzas per semester
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58. 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.
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59. Solved Problem 4.3
With perfect substitutes a corner solution maximizes utility
Only consume the good that is relatively cheaper
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60. Figure 4.9 Optimal Bundles on Convex Sections of Indifference Curves
Interior solution minimizes welfare
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61. 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?
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62. Solved Problem 4.4 Bundle “a” maximizes welfare in U.S.
Price of U.S. food higher in France
Employer increases his income so that he can consume the same bundle in France
Is he better off?
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63. 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.
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64. 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.
Questions:
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?
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65. Figure 4.10 Food Stamps Versus Cash
Budget line with cash Y
+ 100 f C e Y I 3
All other goods per month d I 2 I 1 B
Budget line with f
ood stamps A O r
iginal b
udget line
100 Y Y
+ 100 F
ood per month
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66. 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
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