Chương 1
Chương 1
Do Thi My Trang
1
Textbook,
Topic 1: Consumer behavior chapter 2,3,4
1.1. Budget Constraints
- Budget set (2.1)
- Budget lines and changes (2.3, 2.4, 2.6)
- The numeraire (2.5)
1.2. Preferences
- Preferences: Assumptions and types (3.1, 3.2)
- Indifference curves (3.3, 3.4, 3.5)
- Marginal rate of substitutions (MRS): Behaviour and interpretation (3.8)
1.3. Utility
- Ordinal utility (4.0)
- Utility functions (4.3)
- Cobb-Douglas preferences (4.3)
1.4. Discussions and practice exercise
- Discussion
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- Practice exercises
1.1. Budget Constraints
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1.1.1. Budget set
• The budget set is a set of consumptions which are affordable:
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Budget constraint
• Consider a simple 2-good economy
• Suppose a consumer has M to spend on goods 1 and 2
• Consumption bundle (x1, x2) be the amount that consumer chooses of
good 1 and good 2
• p1, p2: Price of two goods
• Consumer can afford all bundles (x1, x2) such: p1x1 + p2x2 = m
• consumer’s budget set
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Budget constraint graphically
x2
Not affordable
x1
m /p1
horizontal intercept
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Slope of Budget constraint
x2
Slope is -p1/p2
-p1/p2
+1
x1
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10
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12
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1.1.2. Budget line and changes
• When price and incomes change, the set of goods that a consumer can afford changes
as well.
• p1/p2 smaller (p2 increase more than p1) Budget line flatter
• p1/p2 larger (p1 increase more than p2) Budget line steeper
x2
Slope Flatter
From -2 to -3
Budget constraint pivots;
slope steeper from -p1/p2 to –p’1/p2
-p’1/p2 -p1/p2
Original budget set
x1
p2 increase p1 increase 15
1.1.2. Budget line and changes
• Income changes (example BC of pizza and cookies, income reduce from 70 to 62)
• Original and new budget constraints are parallel (same slope).
x2 x2
x1 x1
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Taxes
Quantity tax: Value tax (Valorem tax):
• Consumer has to pay a certain • Tax on value (the price) of a good
amount to the Government for instead of quantity of good.
each unit of product purchased • A value tax usually expressed in
• Assume that the government percentage term
imposes a quantity (or unit) tax: • Price change: to
t usd/unit Budget line steeper
• Price change: to
Budget line steeper
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Subsidy is opposite effect of a tax
Quantity Subsidy: Subsidy
• The Government gives an • Base the price of the good being
amount to consumer each unit subsidized (σ)
of good purchased • Actual price: (1- σ)
• Price change: : to Budget line flatter
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Lump-sum tax or subsidy
Lump-sum tax: Lump-sum subsidy:
• The Government take away some fixed • The Government give some fixed amount
amount of money, regardless of of money
consumer behavior • Amount of money has been increased
• Amount of money has been reduced • Budget line shift outward
• Budget line shift inward
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Rationing
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Taxes, subsidies, and rationing are
combined
• Consumer could consume good 1
at a price of up to level of
• They have to pay a tax t on all
consumption in excess of
• If:
Slope = -
Slope = - , budget line steeper
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Example: Food stamp program
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• In the first case, we have pegged p2 = 1, and in the second case m = 1.
Pegging the price of one of the goods or income to 1 and adjusting the
other price and income appropriately doesn’t change the budget set.
• When we set one of the prices to 1, we refer to that price as the
numeraire price. The numeraire price is the price relative to which we
are measuring the other price and income.
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REVIEW QUESTIONS
1. Originally the consumer faces the budget line . Then the
price of good 1 doubles, the price of good 2 becomes 8 times larger, and income
becomes 4 times larger. Write down an equation for the new budget line in terms
of the original prices and income.
2. What happens to the budget line if the price of good 2 increases, but the price
of good 1 and income remain constant?
3. If the price of good 1 doubles and the price of good 2 triples, does the budget
line become flatter or steeper?
4. Suppose that a budget equation is given by . The
government decides to impose a lump-sum tax of u, a quantity tax on good 1 of t,
and a quantity subsidy on good 2 of s. What is the formula for the new budget
line?
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• Problem 1: You have an income of $40 to spend on two commodities. Commodity 1 costs $10 per
unit, and commodity 2 costs $5 per unit.
(a) Write down your budget equation. .
(b) If you spent all your income on commodity 1, how much could you buy? .
(c) If you spent all of your income on commodity 2, how much could you buy?
(d) Suppose that the price of commodity 1 falls to $5 while everything else stays the same. Write
down your new budget equation
(e) Suppose that the amount you are allowed to spend falls to $30, while the prices of both
commodities remain at $5. Write down your budget equation.
(f ) Draw your budget line changes, show area representing commodity bundles that you can afiord
with the budget in Part (e) but could not afford to buy with the budget in Part (a). And the area
representing commodity bundles that you could afford with the budget in Part (a) but cannot afford
with the budget in Part (e).
• Problem 2. Murphy was consuming 100 units of X and 50 units of Y . The price of X rose from 2 to
3. The price of Y remained at 4.
How much would Murphy’s income have to rise so that he can still
exactly afford 100 units of X and 50 units of Y ?
• Problem 3. If Amy spent her entire allowance, she could afford 8 candy bars and 8 comic books a
week. She could also just afford 10 candy bars and 4 comic books a week. The price of a candy bar
is 50 cents. Draw her budget line in the box below. What is Amy’s weekly allowance. 28
Summary: Budget constraint
1. The budget set consists of all bundles of goods that the consumer can
afford at given prices and income. We will typically assume that there
are only two goods, but this assumption is more general than it seems.
2. The budget line is written as p1x1 +p2x2 = m. It has a slope of −p1/p2,
a vertical intercept of m/p2, and a horizontal intercept of m/p1.
3. Increasing income shifts the budget line outward. Increasing the price
of good 1 makes the budget line steeper. Increasing the price of good 2
makes the budget line flatter.
4. Taxes, subsidies, and rationing change the slope and position of the
budget line by changing the prices paid by the consumer.
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1.2. Preferences
- Preferences: Assumptions and types (3.1, 3.2)
- Indifference curves (3.3, 3.4, 3.5)
- Marginal rate of substitutions (MRS): Behaviour and interpretation (3.8)
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1.2. Preferences
• The economic model of consumer behavior: “people choose the best things they can
afford.”
• Call objects of consumer choice: “consumption bundles” (a complete list of the goods and
services).
• Analyzing consumer choice: simplify use two-dimensional diagram consumption bundle X
to consist of two goods:
• x1 denote the amount of one good
• x2 the amount of the other.
• The complete consumption bundle is therefore denoted by (, ).
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1.2.1. Consumer preferences
• Two consumer bundles: X (, ); Y (, ). The consumer can rank them as to
their desirability
• Idea of preference: based on consumer’s behaviour: a situation involving 2
bundles, observe consumer’s choice to know which consumer prefer.
• Comparing two different consumption bundles, x and y:
• strict preference: x is more preferred than y: X (, ) Y (, )
• weak preference: x is as at least as preferred as y: X (, ) Y (, )
• indifference: x is exactly as preferred as y (indifferent): X (, ) Y (, )
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Assumptions about Preferences
• Three assumption of consumer theory:
1. Completeness : assume any 2 different bundles can be compared.
X (, )Y (, ) or Y (, ) X (, ) or both (indifferent)
2. Transitivity: X (, )Y (, ) & Y (, ) Z (, ) X (, ) Z (, )
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1.2.2. Indifference Curves (IC)
• Indifferent Curves represents it all
combinations of consumption among
which you are indifferent
• 3 choices:
• A: 2 pizzas; 1 cookie
• B: 1 pizza; 2 cookies
• C: 2 pizza, 2 cookies
• Which choice do you like the most?
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x2
x2
WP(x), the set of SP(x), the set of
x bundles weakly x bundles strictly
preferred to x. preferred to x,
does not
WP(x) include
includes I(x).
I(x) I(x). I(x)
x1 x1
Weakly preferred set: The area consist of all bundles that are at least as good as the
bundles (x1, x2)
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4 properties of IC
1. Consumers prefer higher IC
2. IC are downward slopping
3. IC never cross
4. Only one IC through every bundle
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Why does that violate the principle of nonsatiation?
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• Why this violate the third property? –
IC crossing
B >C
B=A
C=A
violate transitivity
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1.2.3. Marginal rate of substitutions (MRS)
MRS = Δx2/Δx1 39
1.2.3. Marginal rate of substitutions (MRS)
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1.2.4. Shapes of indifferent curves
• Well-Behaved Preferences
• Monotonic
• Convex
z =(tx1+(1-t)y1, tx2+(1-t)y2)
x2+y2 x+y
z=
2
2
y2 y y
y2
x1 x1+y1 y1
2 x1 y1
z is preferred to x and y for all 0 < t < 1. 43
z is strictly preferred to both x and y.
x
x2 x’
z’
z
x
z
y y
y2 y’
x1 y1
Preferences are strictly convex Preferences are weakly convex if
when all mixtures z are strictly preferred to their at least one mixture z is equally
component bundles x and y. preferred to a component bundle. 44
Non-Convex Preferences
x2 B
et x2 B
te et
r te
r
z
z
y2 y2
x1 y1 x1 y1
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Perfect substitutes
• Two goods are perfect substitutes if the consumer is willing to substitute one good for the other at a
constant rate.
• The key characteristic is indifferent curves with a constant slope (straight line)
Indifference curves are straight
lines with a slope of -1
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Perfect complements
• Two goods are perfect complements if
consumers are always consumed together
in fixed proportions.
• IC are L-shaped where the vertex occurs
where the number of good 1 equals the
number of good 2.
• Increasing both quantities are the same
time moves the consumer to a higher
indifference curve
• The fixed proportion doesn’t need to be 1-
1, could be 2-1, 3-1, …
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Bad Neutral good
• A commodity is a bad if consumer • A good is a neutral good if consumer
doesn’t like it doesn’t care one way or the other
• IC have a positive slope • If x1 is a normal good, and x2 is neutral
• To put up with good x2 the consumer good then IC are veritcal
need to be given more x1
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Satiation
• Satiation occurs where there is an overall best
bundle for the consumer and the “closer” they are
to that best bundle the better off they are terms of
their own preferences
• Suppose () is most preferred bundle
• The further from this bundle, the worse off the
consumer is
• Then () is called a satiation point or bliss point
• IC
• Negative slope when consumer has too little or too much of both goods (too much of both
means both are bads)
• Positive slope when consumer has too much of one goods (it becomes a bad, reducing
consumption is better). 51
Summary: Preferences
1. Economists assume that a consumer can rank various consumption
possibilities. The way in which the consumer ranks the consumption
bundles describes the consumer’s preferences.
2. Indifference curves can be used to depict different kinds of
preferences.
3. Well-behaved preferences are monotonic (meaning more is better)
and convex (meaning averages are preferred to extremes).
4. The marginal rate of substitution (MRS) measures the slope of the
indifference curve. This can be interpreted as how much the consumer
is willing to give up of good 2 to acquire more of good 1.
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REVIEW QUESTIONS:
Problem 1. Assume you put $1 bill on vertical axis, what is your marginal rate
of substitution of $1 bills for $5 bills?
Problem 3. If both pepperoni and anchovies are bads, will the indifference
curve have a positive or a negative slope?
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Problem 4.
• In each of the following examples, the consumer consumes only two
goods, x and y. Based on the information given in each statement,
sketch a plausible set of indifference curves (draw at least two curves
on a set of labeled axes and indicate the direction of higher IC).
• 1. Alan likes wearing both right shoes (x) and left shoes (y). He always
needs to wear them as a pair, having a right shoe is useless without
the left one and viceversa.
• 2. Emma likes pizza (x) but hates vegetables (y). She is only willing to
eat an extra unit of vegetables if she gets to eat an extra unit of pizza.
• 3. Mary likes Coke (x) and Pepsi (y). She is indifferent between them as
she is unable to tell the difference between Coke and Pepsi
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1.3. Utility
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1.3. Utility Text book chapter 4
Point of views:
- Historically, Utility was thought as a numeric measure of a consumer’s happiness
Consumer try to maximize utility
- Questions: How do we measure?
How do we quantify utility from different choices
How do we compare utility between people
- Instead of above, start to think about utility as being constructive from preferences,
preferences describe choices
Utility is seen only as a way to describe preferences
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1.3.1. Utility function and ordinal utility
• Utility function: Takes consumption bundles and translates them into number
• More preferred bundles have higher utility than less preferred bundles:
(x1, x2) > (y1, y2) if and only if u(x1, x2) > u (y1, y2)
• Denote: u(.): utility function
• Ordinal utility: Absolute numbers do not matter, just the ranking of the
bundles
• Size of utility difference between bundles does not matter
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Examples
• order the bundles in the same way
• consumer prefers A to B and B to C
• All of the ways indicated are valid utility functions that describe the
same preferences
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1.3.2. Monotonic transformations
• Since only the ranking matter, no unique way to assign utility to
consumption bundles infinite number of way
• Ex: if u(x1, x2) present a way to assign utility numbers to the bundles (x1,
x2) then multiplying u(x1, x2) by 2 (or any positive number), that is an
other way to assign utility.
• (positive) Monotonic function: Transform a set of number into another
set that maintains the order of the numbers. If u1 > u2 f (u1) > f (u2)
• present a monotonic transformation by a function f(u)
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• Examples: Multiply by a positive number (f(u) = 3u), adding any number (f(u) = u
+ 7), raising u to an odd power (f(u) = , ….
• The rate of change of f(u) as u changes
• Always has a positive rate of change
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1.3.3. Utility Functions & Indifferent
curves
• Consider bundles (4,1), (2,3) and (2,2).
• Suppose (2,3) > (4,1) ~ (2,2).
• Assign to these bundles any numbers that preserve the preference ordering;
e.g. U(2,3) = 6 > U(4,1) = U(2,2) = 4.
• Call these numbers utility levels.
• Equal preference same IC, and same utility level.
• Therefore, all bundles in an indifference curve have the same utility level.
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Utility Functions & ICs
• So the bundles (4,1)
and (2,2) are in the IC x2
with utility level U=4.
• But the bundle (2,3) is
in the IC with utility
level U=6.
• On an IC diagram, this
preference
information looks like: Uº6
Uº4
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Utility Functions & ICs
• Comparing more bundles will
create a larger collection
x2 of all ICs
and a better description of the
consumer’s preferences.
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Some examples of utility functions
• Utility function:
• How do its difference curves look like?
45o
• Remind example of left shoe and right shoe
• Consumer care about the number of pairs of
shoe Choose the number of pairs of
shoes as the utility function min{x1,x2} = 8
8
• The number of complete pairs: minimum of
the number right shoes and the number of 5 min{x1,x2} = 5
left shoes, thus the utility function for
3 min{x1,x2} = 3
perfect complement: u(x1,x2) = min{x1,x2}
• Ex: take bundle min{10,10} = min{11,10} = x1
10 3 5 8
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• Second example: consumer always uses 2 teaspoons of sugar with
each cup of tea
• If x1 is the number of cups of tea available and x2 is the number of
teaspoons of sugar, utility function: u(x1,x2) = min{}.
• In general, a utility function that describes perfect-complement
preferences is given by:
u(x1, x2) = min{ }
• a and b are positive numbers that indicate the proportions in which the
goods are consumed
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Quasi-linear utility function
• Quasi-linear utility function : the preferences x2
are vertically shifted version: Each curve is a vertically
shifted copy of the others.
x2= k – v(x1)
• ie: The height of each difference curve is some
function of x1 plus a constant. There’s a
general form: U(x1,x2) = k = v(x1) + x2
• Quasi-linear (partly linear): The utility function
is linear in good 2, but (maybe) nonlinear in
good 1
• E.g.: u(x1,x2) = ln x1 + x2; x1
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Cobb-Douglas utility function
• Cobb-Douglas utility function:
• MU if x1 change:
• MU if x2 change:
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1.3.5. Marginal Utility and Marginal Rate of
Substitution (MU and MRS)
• Consider a change in the consumption of each good, (Δx1, Δx2), that keeps
utility constant—U(x1,x2) º k (k is a constant), that is, a change in consumption
that moves us along the indifference curve. Then we must have:
• Totally differentiating this identity gives:
MRS = = -
• Negative sign: If get more of good 1, have to get less of good 2 in order to keep
the same level of utility.
• However, MRS is normally refer by its absolute value – as a positive number
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Monotonic Transformations & MRS
• For U(x1,x2) = x1x2, the MRS = -x2/x1.
• Create V = U2; i.e. V(x1,x2) = x12x22.
• What is the MRS for V?
2
V / x1 2 x1 x 2 x2
MRS
V / x2 2
2 x1 x 2 x1
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Summary
1. A utility function is simply a way to represent or summarize
a preference ordering. The numerical magnitudes of utility
levels have no intrinsic meaning.
2. Thus, given any one utility function, any monotonic
transformation of it will represent the same preferences.
3. The marginal rate of substitution, MRS, can be calculated
from the utility function via the formula MRS = Δx2/Δx1 =
−MU1/MU2.
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Review questions
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