Principles of Microeconomics

SS 3-4
LUMS
Fall-18
 Overview-Consumer Theory
• The objective of this module is to study the (neoclassical)
economic theory of consumer behavior i.e. understand
how consumers optimally choose their consumption
bundles:
– Develop an economic (bottom-up) model to convert an abstract
consumer choice problem into a mathematically tractable
constrained optimization problem.
– Derive the law of demand from the solution to consumer‘s utility
maximization problem.
– Apply consumer theory to understand societal outcomes in
different contexts.
 Overview-Consumer Theory
• The fundamental building blocks of the economic theory of
consumer behavior are:
– Preferences: Tastes/likes of an individual.
– Budget: Resources available to satisfy preferences.
• Simplifying assumptions in our consumer behavior model:
– Two good model. Easily extendable to include multiple goods.
– Static model with no savings i.e. all budget/resources spend on
current period consumption. Possible to extend to include savings
and multiple periods.
– Consumers are price takers in goods markets. Consistent with
facts but can be relaxed.
 Roadmap-Consumer Theory
1. Describe key assumptions about consumer preferences.
2. Derive properties of indifference curves from the
assumptions on preferences.
3. Introduce the concept of utility functions i.e.
mathematical functions representing indifference curves.
4. Model the consumer’s budget constraints.
5. Solve the consumer’s optimization problem to derive the
law of demand:
a) Describe the graphical conditions characterizing the optimal
consumption bundle.
b) Describe the mathematical conditions characterizing the optimal
consumption bundle.
 1-Preferences
• Preferences play an important role in consumer choice but
cannot be directly observed.
• Therefore, economists developed some assumptions about
the underlying nature of preferences to systematically study
consumer behavior:
– Each assumption is reasonable and imposes a certain degree of
rationality on consumers’ preferences.
• These assumptions are necessary to translate an abstract
consumer choice problem into a concrete, mathematically
tractable constrained optimization problem.
 1-Preferences
• Assumptions about preferences:
– Completeness: Consumers can rank any set of bundles in order of
preference i.e. have preferences over all possible consumption
bundles.
– Transitivity: Consumers preferences are not inconsistent i.e. if x is
preferred over y, and y is preferred over z then x must be preferred
over z.
– Non-satiation: All else equal, consumer prefer consumption
bundles with more quantity of goods over consumption bundles
with less quantity of goods.
– Convexity: Consumers prefer balanced consumption bundles over
unbalanced consumption bundles.
• Note: No assumption mentions prices or budget constraints.
 2-Indifference Curves
• Indifference curves are a graphical depiction of preferences:
– Consumption bundles over which a consumer is indifferent i.e.
combinations of good from which consumers derive the same level
of satisfaction.
• Properties of indifference curves can be derived from our
assumptions about consumer preferences:
– Every possible consumption bundle lies on some indifference curve
i.e. indifference curves are continuous (completeness)
– Consumers prefer consumption bundles on indifference curves
further away from the origin (non-satiation)
– Indifference curves are downward sloping (non-satiation)
– Indifference curves cannot intersect (transitivity)
• A Preference map comprises of infinite indifference curves.
 2-Indifference Curves
• Shape of indifferences curves is effected by the nature of the
underlying goods in the model:
– Perfect Substitutes (blue and black pens): negatively sloped line.
– Perfect Complements (pair of shoes): L-Shaped line with a vertex.
– Everything Else: Smooth downward sloping curves.
• Marginal rate of substitution (MRS) is the slope of an
indifference curve:
– Denotes the rate at which a consumer is willing to tradeoff good-2
(y-axis) with 1 unit of good-1 (x-axis), given that the consumer stays
on the same indifference curve i.e. same level of happiness.
– MRS negatively related to the quantity of good consumed (law of
diminishing marginal utility).
– MRS is purely a preference concept and is unrelated to prices.
 3-Utility Functions
• Utility function: A mathematical function representing
indifference curves:
– Utility functions assign numbers to consumption bundles such
that more preferred bundles are assigned larger numbers.
– Simply a way of labeling indifference curves such that no
property of indifference curves is violated i.e. downward
sloping, no intersection and increasing away from the origin.
– Magnitude of utility function is important in so far as it ranks
different consumption bundles i.e. “size” of differences
between consumption bundles is not important i.e. utility is an
ordinal concept.
3-Utility Functions
 3-Utility Functions
• Marginal utility: how utility changes with the
consumption of an additional unit of a given good.
– Mathematically equal to the derivative of the utility function
with respect to the given good.
• The marginal utility of consuming additional goods is
diminishing, but always positive.
– Intuitively, consumption of each additional slice of pizza gives us
less happiness/gratification compared to the previous slice.
• Marginal utility determines how much consumers are
willing to pay for an additional unit of a good.
• Slope of indifference curve (MRS) equal to ratio of
marginal utilities (can you prove this)
 4-Budget Constraints
• Consumer behavior also effected by resource constraints.
• Budget constraint simply represents the total expenditure on
different consumption bundles, given prices and wealth.
– Mathematical representation: 𝑊 = 𝑝1 𝑥 1 + 𝑝2 𝑥 2 . Total
expenditure on RHS and income on LHS.
– Graphical representation: Downward sloping straight line, all
bundles below the line are feasible i.e. affordable
• Budget constraint always binds due to non-satiation and the
assumption of no savings in our model.
• Note: Budget constraint is independent of preferences.
 4-Budget Constraints
• The slope of the budget constraint is called the marginal
rate of transformation (MRTS):
– The exchange rate between the two goods in the market.
• How does a budget constraint change with wealth:
– Wealth increase: outward shift increasing set of affordable
consumption bundles.
– Wealth decrease: inward shift decreasing set of affordable
consumption bundles.
• How does a budget constraint change with prices:
– Price increase: inward rotation, reducing set of affordable
consumption bundles.
– Price decrease: outward rotation, increasing set of affordable
bundles.
5-Deriving Optimal Consumption Bundle
• Preferences and budget constraints fully characterize the
solution to the consumer choice problem.
• We can easily determine the optimal consumption bundle
graphically given a consumers indifference curve and
budget constraint:
– Question: What is the highest indifference curve that a
consumer can reach given his budget constraint?
– Answer: Consumption bundle that makes consumer happiest is
the point where the indifference curve is tangent to the budget
constraint.
5-Deriving Optimal Consumption Bundle
• Mathematically, at the optimal consumption bundle MRS=
MRTS.
– MRS: determined by preferences i.e. the rate at which consumer is
willing to substitute good y for 1 unit of good x.
– MRTS: determined by market dynamics independent of consumer
preferences i.e. ratio of each good’s market price.
• Intuition for this mathematical result:
– MRS can be viewed as the marginal benefit from consuming an
additional unit of good x in terms of the quantity of good y.
– MRTS can be viewed as the marginal cost of buying an additional
unit of good x in terms of quantity of good y.
– Remember the optimality condition in economics i.e. marginal
benefit = marginal cost!
• Usually, easier to work with algebra then graphs in practice.