Intermediate Microeconomics

Part I
CONSUMER THEORY
Laura Sochat
 Budget constraint I
Income is one of the factors affecting the quantity demanded by
consumers.
I like to spend money on food and on clothes. Assume they cost £5/g
and £10/unit respectively. Also assume that my weekly income is
£200.

 if I decide to only consume food.


 if I decide to only buy clothes.
 Budget constraint II
Food (g)
Given my income, I can afford
to buy 40g of food if I do not
40
buy any clothes.

Given my income, I can afford

to buy 20 units of clothes if I
do not buy any food.

20 Clothes (unit)
 Budget Constraint III
If instead, I want to balance my consumption between the two, it
must be true that I do not spend more than my income:

We know the respective prices, so we can re-write the budget

constraint such as:

We have drawn the budget constraint with food on the vertical axis.
Rewrite the budget constraint such as:
Food
The feasible set
40

Given my income, any bundle

below the budget constraint is
affordable. Any bundle on the
budget constrain is just
affordable

20 Clothes
Budget constraint- shifts and movement
We saw earlier that the slope of the budget constraint depends only
on relative prices:

A change in the price of one of the good will lead to a rotation of the
budget constraint
A change in the income of the consumer will lead to a shift of the
budget constraint
What if both prices change by the same proportion?
The effect of a change in the price of one good
Food (g)

40 Given the price of clothing, if

to £10

20
Given the price of food, if to
£20

10 20 Clothes (units)
 Budget constraint
Let’s go further… Suppose two goods, x (food) and y (coffee)
What would the budget constraint look like, if the consumer was to
be given:
– An in kind transfer of 40g of coffee?
What would the budget constraint look like if the government
imposes:
– A quantity tax (t) on coffee?
– A subsidy (s) on food?
 Preferences
Preferences will tell us more about a consumer’s choice.
Preference ordering; for any bundle :
– Strict preferences
– Weak preferences
– Indifference
– These are ordinal relations
While preferences will differ between individuals, there are some
properties we assume to be shared by all regarding preference
ordering. Some of those will ensure rationality of the choice made by
the consumers.
 Properties of preference ordering
Completeness
– The consumer can always rank between a choice of bundles. Either the consumer
prefers X to Y, Y to X, or is indifferent between the two.
Transitivity
– This assumption helps with the consistency of preference ordering.
Continuous
– If X is preferred to Y, and there is a third bundle Z which lies within a small radius of
Y, then X will be preferred to Z.
Non- satiation- More is better
– Suppose two bundles, X and Y such that X: (10,15) and Y: (12,15). It must be true
that B is preferred to A.
 Monotonicity and Convexity
Those two axioms are needed to define “well behaved preferences”

Monotonicity
– Consider two bundles x and y, if bundle y has at least as much of both goods, and
more of one, then it must be true that

Convexity
– Consider bundle x, comprising of a mixture of bundles x and y. It must be true that
that z is (at least weakly) preferred to x and y, for any
Food
Preference map
B

More is better tells us that B is

A preferred to A, and A is
15 preferred to D.

There must be a point C

C
equally likeable to A on [DB]

5 Clothes
 Indifference curve
Food

15
A
C

5 Clothes
 Indifference map
Food
What about point E?
E has more clothes
than C, but C has
more food than E,
B how can we tell
A whether E is preferred
15
to C?

E
D

5 Clothes
 Properties of indifference curves
Bundles on indifference curves further from the origin are preferred
to ones on indifference curves closer to the origin
– Follows from the monotonicity assumption.
Indifference curves are downward sloping
– Follows from the more is better- Every commodity is a good
Indifference curves cannot cross
– Follows from more is better and transitivity assumptions
Indifference curves are continuous
– Follows from the completeness assumption
Indifference curves are convex to the origin
– Preferences are convex
 Utility
Working with preference relations is not always convenient.
Economists like to work with Utility Functions, which are simple and
easy way of summarizing preferences.
If a preference relation is complete, transitive and (continuous) it can
be represented by a (continuous) utility function (sufficient condition
for the existence of a utility function).
– People are able to rank all possible situations from the least desirable to the most.
Economists call this ranking utility
– If x is preferred to y, then the utility assigned to x exceeds the utility assigned to y:
 Monotonic transformations of utility
functions
Consider a utility function , representing specific preferences. Then
we know that any monotonic transformations of this utility function
will represent the same preferences. Some examples of monotonic
transformations:
 Trade offs
We know that one is indifferent between two bundles on the same
indifference curve. The rate at which a consumer is willing to
substitute one good for another is represented by the slope of the
IC, and is called the Marginal rate of substitution.

It is the slope of the indifference curve at that point

 Marginal utility
𝑦

From point A to point B, the consumer loses

and gains . We also know that both A and B
give the consumer the same utility

Marginal utility lost from

∆ 𝑦A B less must be offset by marginal utility
gained from more
∆𝑥

𝑈 =𝑈 1
𝑥
 Marginal rate of substitution
To obtain the expression for the marginal rate of substitution,
consider implicit differentiation
Consider a change in and which keeps utility constant:

Consider a different representation of the utility function:

 Show that the marginal rate of substitution does not depend on the utility
representation
 Different preferences
Bread (piece) Bread (piece)

7
7
6 5

4 5 Pasta (kg) 4 5 Pasta (kg)

 Some utility functions examples
Perfect substitutes
– Consider the folder example above. All the consumer cares about is the overall
number of folders, not how many red/blue folders are in the mix. Considering the
one-to-one relationship from above, the utility function would take the form
– In general, the utility function will take the form
Perfect complements
– We looked above at the right earring/left earring where the relationship is one to
one. The right earring will not provide any utility without a left earring. Considering
this one-to-one relationship we obtain the following utility function .
– In general (not a one to one relationship), we would have
 Perfect complements/Perfect substitutes
Red folders
Right
earring MRS= if
MRS= if
MRS= if
Constant MRS

Blue folders Left earring

 Some utility functions examples
Cobb-Douglas preferences
– Very commonly used (also for production functions). Takes the general following
form: , where a and b represent the consumers preferences. We will assume that
and rewrite
𝑋 𝑋

1 1 1 4
𝑎= , 𝑏= 𝑎= , 𝑏=
2 2 5 5

𝑌 𝑌
Linking MRS to the slope of budget constraint
Slope of the budget constraint: For a given income (expenditure),
how much of one good does one have to give up to purchase an
extra unit of the other good
Slope of the indifference curve: How much of one good is one willing
to give up to obtain an extra unit of the other good, to be as well as
off as before.

The slope of the budget constraint give us the marginal cost of

clothes in terms of food. The slope of the indifference curve give us
the marginal benefit of clothes in terms of food.
Food (g) Optimal choice
40
Which point will be the
optimal choice for the
consumer?
Remember the assumptions
A C we made about preference
ordering, and the properties of
O indifference curves that follow
from those.
B

20
Clothes (unit)
 Optimal choice
The optimal choice for the consumer is the tangency point between
the budget constraint and an indifference curve.

If , the consumer gets less food (1) for giving up a unit of clothing than the amount of
food the consumer could buy by not buying any clothes (2)
 The consumer will clearly be better off buying more food, and less clothes.

Can you think of examples where the tangency condition might not
hold?
 The tangency condition is necessary, but not necessarily sufficient
 Corner solution
Food

At point A the marginal rate of

40 substitution is lower than the slope
of the budget constraint, with
diminishing marginal rate of
substitution, the two never reach
equality.

With MRS < slope of BC at every

point, the best the consumer can do
is to buy food only: For an extra unit
of clothing, the consumer will have
to give up more food than what he
could buy, by not buying clothes.

20
Clothes
 Revealed preferences
Use the consumer’s demand to discover his preferences-
we need to observe the consumer’s behaviour
– Assume behaviour doesn’t change over time; Economists use monthly, or
quarterly time spans
depicts the optimising bundle. What can we say about
bundle ?

Have we made any assumptions about preferences to

make this analysis easier?
 Weak Axiom of Revealed Preferences
Weak Axiom of Revealed Preferences
– If is directly revealed preferred to , and the two bundles are not
the same, then it cannot happen that is directly revealed
preferred to
Algebraically, we can say that if it is true that

Then, it cannot be true that

 Strong Axiom of Revealed Preferences
Looks at indirect revealed preferences as well

If if revealed preferred to , either directly or indirectly,

and if is different than , then cannot be directly, or
indirectly revealed preferred to .

Let’s look at how we can check SARP

 Homothetic tastes
A situation where the consumer’s preferences depend
solely on the ratio of good 1 to good 2
Homothetic tastes give rise to indifference maps where is
MRS is constant along any ray from the origin.

Can you say whether examples of preferences shown

above are homothetic preferences (perfect substitutes,
perfect complements, Cobb-Douglas)?
 Quasilinear tastes
Tastes are linear in one good, but may not be in the other
good:

With quasilinear tastes, indifference curves are vertical

translates of one another.
In this case, the MRS is constant along any vertical line
from the x-axis.