CHAPTER 2:

CONSUMER’S BEHAVIOR AND

OPTIMAL CHOICE
BY: PHD. TRẦN AN QUÂN
MAIN CONTENT
1) Utility
2) Utility function
3) Cobb-Douglas preferences
4) Marginal Utility
5) Optimal choice
6) Consumer demand
7) Implication of MRS condition
 UTILITY

• Utility is seen as a way to describe consumer’s preferences

• A utility function is a way of assigning a number to every possible
consumption bundle such that more-preferred bundles get assigned
larger numbers than less-preferred bundle
• Bundle (x1, x2) is preferred to a bundle (y1, y2) if and only if the utility of
(x1, x2) is larger than the utility of (y1, y2):
(x1, x2) (y1, y2) if and only if u(x1, x2) > u(y1, y2).
 UTILITY

• The magnitude of the utility function is only important when it ranks

the different consumption bundles; the size of the utility difference
between any two consumption bundles doesn’t matter. Because of
this emphasis on ordering bundles of goods, this kind of utility is
referred to as ordinal utility
 UTILITY
• We have illustrated several different ways of assigning utilities to three
bundles of goods, all of which order the bundles in the same way. In
this example, the consumer prefers A to B and B to C. Valid utility
functions describe the same preference; they all have the property
that A is assigned a higher number than B, which in turn is assigned a
higher number than C
 UTILITY
• If u(x1, x2) represents a way to assign utility numbers to the bundles
(x1, x2), then multiplying u(x1, x2) by 2 (or any other positive number)
is just as good a way to assign utilities
• Multiplication by 2 is an example of a monotonic transformation.
Monotonic transformation is a way of transforming one set of numbers
into another set of numbers in a way that preserves the order of the
numbers.
 UTILITY
• In a way that preserves the order of the numbers in the sense that u 1 > u2
implies f(u1) > f(u2).

• For a monotonic transformation, f(u2)−f(u1) always has the same sign as u2 −

u1. Thus a monotonic function always has a positive rate of change. This
means that the graph of a monotonic function will always have a positive slope
 UTILITY

Panel A illustrates a positive monotonic function—one that is always

increasing. Panel B illustrates a function that is not monotonic, since
it sometimes increases and sometimes decreases
 UTILITY

• If f(u) is any monotonic transformation of a utility function that

represents some particular preferences, then f(u(x1, x2)) is also a utility
function that represents those same preferences.
• Monotonic transformation of a utility function is a utility function that
represents the same preferences as the original utility function.
 UTILITY FUNCTION
• If preferences are monotonic then the line through the origin must
intersect every indifference curve exactly once. Thus every bundle is
getting a label, and those bundles on higher indifference curves are
getting larger labels— and that’s all it takes to be a utility function.
 UTILITY FUNCTION

Constructing a utility function from indifference curves. Draw a

diagonal line and label each indifference curve with how far it is
from the origin measured along the line.
 UTILITY FUNCTION
• Some example of utility function:
Suppose that the utility function is given by: u(x1, x2) = x1x2
x2 = k/ x1 , for k = 1, 2, 3…

The indifference curves k = x1x2 for different values of k

 UTILITY FUNCTION- PERFECT
SUBSTITUTES
• The utility function u(x1, x2) = x1+x2. We can measure utility by the total number of
goods
• We could also use the square of the number of goods:

also represent the perfect substitutes preferences, as would any other monotonic
transformation of u(x1, x2), as would any other monotonic transformation of u(x1, x2).
In general, preferences for perfect substitutes can be represented by a utility
function of the form u(x1, x2) = ax1 + bx2
With a and b are some positive numbers measuring the “value” of goods 1 and 2 to
the consumer. And the slope of a typical indifference curve is given by −a/b
 UTILITY FUNCTION- PERFECT
COMPLEMENTS
• Pick a bundle of goods such as (10, 10). If we add one more unit of
good 1 we get (11, 10)
min{10,10} = min{11,10} = 10
• In general, a utility function that describes perfect-complement
preferences is given by u(x1, x2) = min{ax1, bx2}
 UTILITY FUNCTION- QUASILINEAR
PREFERENCES

• Suppose that a consumer has indifference curves that are vertical

translates of one another. This means that all of the indifference
curves are just vertically “shifted” versions of one indifference curve.
• The equation for an indifference curve takes the form x2 = k −v(x1).
Higher values of k give higher indifference curves.
UTILITY FUNCTION- QUASILINEAR
PREFERENCES

Each indifference curve is a vertically shifted version

of a single indifference curve
 COBB-DOUGLAS PREFERENCES
• Utility function in term of the Cobb-Douglas utility function has type:

where c and d are positive numbers that describe the preferences of the consumer

• Cobb-Douglas indifference curves look just like the nice convex

monotonic indifference curves that we referred to as “well-behaved”
indifference curves
 COBB-DOUGLAS PREFERENCES

Cobb-Douglas indifference curve: Panel A shows the case where

c = 1/2, d = 1/2 and panel B shows the case where c = 1/5, d =
4/5
 MARGINAL UTILITY
Marginal utility: The change of this consumer’s utility when he consumes a little
more of one good
Marginal utility with respect to good 1:

This measures the rate of change in utility (ΔU) associated with a small change in
the amount of good 1 (Δx1). Note that the amount of good 2 is held fixed in this
calculation.
=>
 MARGINAL UTILITY AND MRS

• Consider a change in the consumption of each good, (Δx1, Δx2), that keeps
utility constant—that is, a change in consumption that moves us along the
indifference curve. Then we must have:

• Solving for the slope of indifference curve:

 OPTIMAL CHOICE

• In the diagram, the bundle of goods that is associated with the highest
indifference curve that just touches the budget line is labeled (x1*, x2*). The
choice (x1*, x2*) is an optimal choice for the consumer.
• The indifference curve that intersects or lies above the budget line cannot
represents the optimal choice.
 OPTIMAL CHOICE

Optimal choice: The optimal consumption position is where

the indifference curve is tangent to the budget line
OPTIMAL CHOICE- EXCEPTIONAL CASES

Kinky tastes: An optimal consumption bundle where the

indifference curve doesn’t have a tangent
OPTIMAL CHOICE- EXCEPTIONAL CASES

Boundary optimum: The optimal consumption involves consuming zero units

of good 2. The indifference curve is not tangent to the budget line
OPTIMAL CHOICE- EXCEPTIONAL CASES

More than one tangency: In this case, there are three tangencies, but only two
optimal points, so the tangency condition is necessary but not sufficient
 CONSUMER DEMAND

• The optimal choice of goods 1 and 2 at some set of prices and income
is called the consumer’s demanded bundle. In general when prices
and income change, the consumer’s optimal choice will change.
• The demand function is the function that relates the optimal choice-
the quantities demanded- to the different values of prices and
incomes.
 CONSUMER DEMAND- PERFECT
SUBSTITUTES

• If p2 > p1, then the slope of the budget line is flatter than the slope of the
indifference curves. In this case, the optimal bundle is where the consumer
spends all of his or her money on good 1.
• If p1 > p2, then the consumer purchases only good 2.
• If p1 = p2, there is a whole range of optimal choices- any amount of goods 1
and 2 that satisfies the budget constraint is optimal in this case.
CONSUMER DEMAND- PERFECT
SUBSTITUTES

Optimal choice with perfect substitutes. If the goods are perfect

substitutes, the optimal choice will usually be on the boundary.
 CONSUMER DEMAND- PERFECT
COMPLEMENTS
• Optimal choice must always lie on the diagonal, where the consumer
is purchasing equal amounts of both goods, no matter what the prices
are
• We know that this consumer is purchasing the same amount of good
1 and good 2, no matter what the prices
p1x + p2x = m.
Solving for optimal choice:
x1 = x2 = x =
 CONSUMER DEMAND- PERFECT
COMPLEMENTS

Optimal choice with perfect complements. If the goods are perfect

complements, the quantities demanded will always lie on the
diagonal since the optimal choice occurs where x1 equals x2
 CONSUMER DEMAND- NEUTRALS AND
BADS

• In the case of a neutral good the consumer spends all of her money
on the good she likes and doesn’t purchase any of the neutral good.
The same thing happens if one commodity is a bad.
• If commodity 1 is a good and commodity 2 is a bad:
x1= m/p1
x2 = 0
 CONSUMER DEMAND- DISCRETE GOODS

• Discrete goods: In panel A the demand for good 1 is zero, while in panel B one
unit will be demanded.
• If the price of good 1 is very high, then the consumer will choose zero units of
consumption; as the price decreases the consumer will find it optimal to consume
1 unit of the good
 CONSUMER DEMAND- CONCAVE
PREFERENCES

Optimal choice with concave preferences: The optimal choice is the

boundary point, Z, not the interior tangency point, X, because Z lies on a
higher indifference curve
CONSUMER DEMAND: COBB-DOUGLAS
PREFERENCES
• Suppose that the utility function is of the Cobb-Douglas form
• Consider the fraction of his income that a Cobb-Douglas consumer spends on good 1.
If he consumes x1 units of good 1, this costs him p1x1, so this represents a fraction
p1x1/m of total income. Substituting the demand function for x 1:

• Similarly, the fraction of his income that the consumer spends on good 2 is d/(c +
d).
 IMPLICATIONS OF MRS CONDITION
• Price ratios measure marginal rates of substitution is very important, it means that we
have a way to value possible changes in consumption bundles.
• Since prices measure the rate at which people are just willing to substitute one good
for another, they can be used to value policy proposals that involve making changes
in consumption.
• If we observe one choice at one set of prices we get the MRS at one consumption
point. If the prices change and we observe another choice we get another MRS. As
we observe more and more choices we learn more and more about the shape of the
underlying preferences that may have generated the observed choice behavior.