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    Microeconomics: Lecture 4: Consumer Behavior (Part II)

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    blackhawk31
    This document summarizes key concepts from a lecture on consumer theory and microeconomics. It introduces the concept of utility functions to represent rational preferences over different bundles of goods. Specific utility functions are discussed, including Cobb-Douglas, perfect substitutes, and perfect complements. The budget set is also introduced, which contains all affordable combinations of goods given a consumer's income and prices. Marginal utility and the marginal rate of substitution are defined in terms of utility functions.

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    Microeconomics: Lecture 4: Consumer Behavior (Part II)

    Uploaded by

    blackhawk31
    10 views29 pages
    This document summarizes key concepts from a lecture on consumer theory and microeconomics. It introduces the concept of utility functions to represent rational preferences over different bundles of goods. Specific utility functions are discussed, including Cobb-Douglas, perfect substitutes, and perfect complements. The budget set is also introduced, which contains all affordable combinations of goods given a consumer's income and prices. Marginal utility and the marginal rate of substitution are defined in terms of utility functions.

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    Lecture 4 _to Annotate

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    This document summarizes key concepts from a lecture on consumer theory and microeconomics. It introduces the concept of utility functions to represent rational preferences over different bundles of goods. Specific utility functions are discussed, including Cobb-Douglas, perfect substitutes, and perfect complements. The budget set is also introduced, which contains all affordable combinations of goods given a consumer's income and prices. Marginal utility and the marginal rate of substitution are defined in terms of utility functions.

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    © All Rights Reserved
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    Download as ppt, pdf, or txt
    10 views29 pages

    Microeconomics: Lecture 4: Consumer Behavior (Part II)

    Uploaded by

    blackhawk31
    This document summarizes key concepts from a lecture on consumer theory and microeconomics. It introduces the concept of utility functions to represent rational preferences over different bundles of goods. Specific utility functions are discussed, including Cobb-Douglas, perfect substitutes, and perfect complements. The budget set is also introduced, which contains all affordable combinations of goods given a consumer's income and prices. Marginal utility and the marginal rate of substitution are defined in terms of utility functions.

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    Microeconomics: Lecture 4

    Consumer Behavior (Part II)

    Consumer Theory: Roadmap


    Building blocks Preferences and Axioms of Rationality (Part I) Today: (Part II) Representation of Rational Preferences: Utility Affordable Bundles: Budget Set Third Part: A model of Consumer Choice: Utility Maximization: Derivation of Individual Demand Last Part Derivation of Market Demand Two Levels of Rationality: In Preferences and in Choices

    Consumer Theory: Part II

    Representation of Rational
    Preferences: Utility

    Affordable Bundles: Budget Set

    Introducing Utility
    Utility function Formula that assigns a level of utility to individual market
    baskets

    If the utility function is

    A market basket with 8 units of food and 3 units of clothing gives a utility of

    Utility Representation
    Utility rankings are ordinal in nature: they record the
    relative desirability of commodity bundles

    This means that if U represents my preferences and


    U(icecream)=100 and U(cake)=10, then someone can deduce that I prefer ice cream to cake but NOT that I like ice cream 10 times more than I like cake.

    This representation is unique only up to an ORDERpreserving transformation and it does not have any meaning of intensity.

    Utility

    Utility is affected by the consumption of physical commodities psychological attitudes general cultural environment
    Economists generally devote attention to quantifiable options while holding constant the other things that affect utility or ceteris paribus assumption

    Utility

    Because utility measures are not unique, it makes no sense to consider how much more utility is gained from A than from B
    It is also impossible to compare utilities between people

    Utility - Example
    Market Basket Food Clothing Utility

    Utility - Example

    Baskets for each level of utility can be plotted to get an indifference curve

    To find the indifference curve for a utility of 14, we can


    change the combinations of food and clothing that give us a utility of 14

    Utility - Example

    Utility and the MRS

    Suppose an individuals preferences for hamburgers (Y) and soft drinks (X) can be represented by

    Solving for Y, we get

    Solving for MRS =

    Utility and the MRS

    Note that as X rises, MRS falls

    Marginal Utility
    Suppose that an individual has a utility function
    of the form

    We can define the marginal utility of good X1 by The marginal utility is the extra utility obtained
    from slightly more X1 (all else constant)

    Marginal Utility

    The total differential of U is

    The extra utility obtainable from slightly more X1, X2,, Xn is the sum of the additional utility provided by each of these increments

    Deriving the MRS

    Suppose we change X and Y but keep utility constant (dU = 0)

    Rearranging, we get:

    MRS is the ratio of the marginal utility of X to the marginal utility of Y

    Marginal Utility and the MRS

    Again, we will use the utility function

    The marginal utility of a soft drink is

    The marginal utility of a hamburger is

    Examples of Utility Functions

    Cobb-Douglas Utility
    where and are positive constants

    The relative sizes of and indicate the


    relative importance of the goods

    Examples of Utility Functions

    Perfect Substitutes
    Quantity of Y The indifference curves will be linear. The MRS will be constant along the indifference curve.

    U3 U1 U2 Quantity of X

    Perfect Complements
    Quantity of Y

    Examples of Utility Functions

    The indifference curves will be L-shaped. Only by choosing more of the two goods together can utility be increased.
    U3 U2 U1 Quantity of X

    Affordable bundles: budget set

    Bundle: a combination of goods What does it mean for a bundle to be


    affordable?

    It costs less than the amount of money the


    consumer has to spend.

    Affordable bundles belong in the budget


    set

    The Budget Line


    Different choices of food and clothing can be calculated that use all income These choices can be graphed as the budget line

    Example: Assume income of $80/week, PF = $1 and PC = $2

    The budget line then can be written:

    Assumption: All income is allocated to food (F) and/or clothing (C)

    21

    The Budget Line


    Clothing

    (I/PC) = 40 30

    A B
    10 D 20 E

    20 10

    G
    0
    4/22/2014

    20

    40

    60

    80 = (I/PF)

    Food
    22

    The Budget Line - Changes

    The Effects of Changes in Income


    An increase in income causes the budget
    line to shift outward, parallel to the original line (holding prices constant)

    Can buy more of both goods with more


    income

    4/22/2014

    23

    The Budget Line Changes


    Clothing (units per week)

    80 60 40 20
    0
    L3 (I = $40)
    4/22/2014

    An increase in income shifts the budget line outward

    A decrease in income shifts the budget line inward


    L1 (I = $80) L2 (I = $160)

    40

    80

    120

    160

    Food

    (units per week)


    24

    The Budget Line Changes: Price change


    Clothing (units per week) A decrease in the price of food to $.50 changes the slope of the budget line and rotates it outward

    40

    L3
    (PF = 2)
    4/22/2014

    L1
    (PF = 1)
    80

    L2
    120 160

    An increase in the price of food to $2.00 changes the slope of the budget line and rotates it inward

    (PF = 1/2)
    Food
    (units per week) 25

    40

    The Budget Line

    The slope indicates the rate at which the two goods can be substituted without changing the amount of money spent
    We can rearrange the budget line equation to make this more clear

    4/22/2014

    26

    budget set (1)

    Assume that an individual has I dollars


    to allocate between good x and good y
    Quantity of y
    I py

    pxx + pyy I
    If all income is spent on y, this is the amount of y that can be purchased

    The individual can afford to choose only combinations of x and y in the shaded triangle

    If all income is spent on x, this is the amount of x that can be purchased

    4/22/2014

    I px

    Quantity of x
    27

    Summary
    Rational Preferences can be represented by utility functions A few simple functional forms can capture important
    differences in individuals preferences for two (or more) goods

    Cobb-Douglas function linear function (perfect substitutes) fixed proportions function (perfect complements) The Budget Set contains all affordable bundles for a
    consumer

    Required Reading

    Pindyck and Rubinfeld,


    Microeconomics, 8th edition, Chapter 3, pp. 78-86.

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