Intermediate Microeconomic Theory

Lecture IV:
Consumer Choice, Demand Curves,
and Applications
Fall 2024
Instructor: Prof. SHI, Ce “Matthew”

The Chinese University of Hong Kong

1
Consumer Choice

Assume:
 Only non-negative quantities
 "Rational” choice: The consumer chooses the
basket that maximizes his satisfaction given the
constraint that his budget imposes.

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Consumer’s
Consumer’sProblem:
Problem:

Max
MaxU(X,Y)
U(X,Y)

Subject
Subjectto:
to:PPxxXX++PPyyYY<<II

Chapter Four 2
Chapter Four
Interior Consumer Optimum

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Optimality Condition

PxX + PyY = I

One spends all her income.

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If PxX + PyY < I, what happens?

Chapter Four 4
Optimality Condition

MUx/Px = MUy/Py

“At the optimal basket, each good gives

equal ‘bang for the buck’ (the worth of

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money) ”
If MUx/Px < MUy/Py, what happens?
What should anyone do?

Chapter Four 5
Contained Optimization

What
What are are the
the equations
equations that
that the
the
optimal
optimal consumption
consumption basket
basket must
must
fulfill
fulfill ifif we
we want
want to
to represent
represent the
the
consumer’s
consumer’s choice choice among
among three
three
goods?
goods?

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• MU
X / XP = MUY / P
Y is an example of “marginal reasoning” to maximize

• XP X + PY Y = I reflects the “constraint”

Chapter Four 6
Interior Consumer Optimum

• U (X,Y) = XY and MUx = Y while MUy = X

• I = $1,000
• X P = $50 andY P = $200

• Basket A contains (X=4, Y=4)

• Basket B contains (X=10, Y=2.5)
• Question:

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• Is either basket the optimal choice for the consumer?

Basket A: MRSx,y = MUx/MUy = Y/X = 4/4 = 1

Slope of budget line = -Px/Py = -1/4

Basket B: MRSx,y = MUx/MUy = Y/X = 1/4

Chapter Four 7
Special Functional Forms
I. Cobb-Douglas: U = Axy
Optimally, a consumer choose to consume:
x* =
y* =

1. dx*/dPx =

2. dx*/dI =
i.e., x is …
3. dx*/dPy =

Chapter Three 8
Special Functional Forms
II.
II. Leontiff:
Leontiff: UU == Amin(αx,βy)
Amin(αx,βy)
where:
where:A,
A,α,
α,ββare
arepositive
positiveconstants.
constants.

Condition 1 given by the Lagrange Multiplier Method may

not work (why?)

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We reason that, optimally,
Why?
We still have Condition 2:

=> x* =
and y* =

Chapter Three 9
Special Functional Forms
II. Leontiff: U = Amin(αx,βy)
Optimally, a consumer choose to consume:
x* =
y* =

1. dx*/dPx =

2. dx*/dI =
i.e., x is …
3. dx*/dPy =

Chapter Three 10
Special Functional Forms
III.
III. Linear:
Linear: UU == Ax
Ax ++ By
By
where:
where:A,
A,BBare
arepositive
positiveconstants.
constants.

Condition 1 given by the Lagrange Multiplier Method may

not always work (why?)

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We compare the slopes of BL and ICs
If Px / Py > A / B

If Px / Py < A / B,

If Px / Py = A / B,

Chapter Three 11
Some Concepts
Corner Points: One good is not being
consumed at all – Optimal basket lies on
the axis

Composite Goods: A good that

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represents the collective expenditure on
every other good except the commodity
being considered

Chapter Four 12
 Some Concepts

Chapter Four
13

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Revealed Preference

Suppose
Suppose that
that preferences
preferences are
are not
not
known
known (i.e.,
(i.e., no
no indifference
indifference curve).
curve).
Can
Can we
we infer
infer them
them from
from purchasing
purchasing
behavior?

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behavior?

Chapter Four 14
Reveal Preference
Y A, B: optimal consumption bundles for BC1 and BC2, respectively.

Can we infer the ranking of A and B?

A
•
B
•
X
BC1 BC2
Chapter Four 15
Reveal Preference
Y A, B: optimal consumption bundles for BC1 and BC2, respectively.

Can we infer the ranking of A and B?

Answer: We look at a point C

• C

• B
A
•

X
BC1 BC2
Chapter Four 16
Reveal Preference
Y A, B: optimal consumption bundles for BC1 and BC2, respectively.

Can we infer the ranking of A and B?

• A

B
• X
BC1 BC2
Chapter Four 17
Reveal Preference
Y A, B: optimal consumption bundles for BC1 and BC2, respectively.

Can we infer the ranking of A and B?

Answer: We look at a point C

B
• C
A •• X
BC1 BC2
Chapter Four 18
 Application I

Chapter Four
19

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 Application I

Chapter Four
20

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 Application I

Chapter Four
21

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Chapter Four
Application II: Savings

22

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 Price Consumption Curves
Y (units)
PPYY==$4
$4
II==$40
$40

10

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Price Consumption Curve
•
• •
PX = 1

PX = 4 PX = 2
0 XA=2 XB=10 XC=16 20 X (units)
Chapter Five 23
Individual Demand Curves
ThePrice
The Price Consumption
Consumption Curve
Curve of
ofGood
GoodX:
X:

Is the set of optimal baskets for

every possible price of good x,
holding all other prices and
income constant.

The price consumption curve for good x

can be written as the quantity consumed
of good x for any price of x. This is the
individual’s demand curve for good x.

Chapter Five 24
Individual Demand Curve
PX

Individual
Individual
Demand
DemandCurve
Curve
For
ForXX

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PX = 4
•
PX = 2 • U increasing
PX = 1 •
X
XA XB XC
Chapter Five 25
Individual Demand Curve
 The consumer is maximizing utility at every point along the
demand curve

 The marginal rate of substitution falls along the demand curve

as the price of x falls (if there was an interior solution). (why?)

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 As the price of x falls, it causes the consumer to move down
and to the right along the demand curve as utility increases in
that direction.

The demand curve is also the “willingness to pay” curve – and

willingness to pay for an additional unit of X falls as more X is
consumed.
Chapter Five 26
Change in Income & Demand

The
The income
income consumption
consumption curve
curve of
of good
good xx
isis the
the set
set of
of optimal
optimal baskets
baskets for
for every
every
possible
possible level
level of
of income.
income.

We
We can
can graph
graph the
the points
points on
on the
the income
income
consumption
consumption curve
curve as
as points
points on
on aa shifting
shifting
demand
demand curve.
curve.

Chapter Five 27
Income Consumption Curve

Chapter Five 28
Engel Curves

The income consumption curve for good x also can

be written as the quantity consumed of good x for
any income level. This is the individual’s Engel
Curve for good x. When the income consumption

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curve is positively sloped, the slope of the Engel
Curve is positive.

Chapter Five 29
Engel Curves
I ($)

Engel Curve
“X
“Xisisaanormal
normalgood”
good”
92

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68

40

0 X (units)
10 18 24
Chapter Five 30
Definitions of Goods
• If the income consumption curve shows that the consumer
purchases more of good x as her income rises, good x is a normal
good.

• Equivalently, if the slope of the Engel curve is positive, the

good is a normal good.

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• If the income consumption curve shows that the consumer
purchases less of good x as her income rises, good x is an inferior
good.

• Equivalently, if the slope of the Engel curve is negative, the

good is an inferior good.
Chapter Five 31
Optimality Condition

1. PxX + PyY = I
What does it mean in words?

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2. MUx/Px = MUy/Py
What does it mean in words?

Chapter Four 32
Impact of Change in the Price of a Good

• Substitution Effect: Relative change in price

affects the amount of good that is bought as
consumer tries to achieve the same level of
utility

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• Income Effect: Consumer’s purchasing
power changes and affects the consumer in
a way similar to effect of a change in income

Chapter Five 33
The Substitution Effect

• As the price of x falls, all else constant, good x

becomes cheaper relative to good y.
• This change in relative prices alone causes the
consumer to adjust his/ her consumption

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basket.
• This effect is called the substitution effect.
• The substitution effect always is negative.
• Usually, a move along a demand curve will be
composed of both effects.
Chapter Five 34
Impact of Change in the Price of a Good

Definition: As the price of x falls, all else

constant, purchasing power rises. As the price
of x rises, all else constant, purchasing power
falls.

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This is called the income effect of a change in
price.

The income effect may be positive

(normal good) or negative (inferior
good). Chapter Five 35
Impact of Change in the Price of a Good

• If price of a good falls – consumer

substitutes into the good to achieve the
same level of utility

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• When price falls – purchasing power
increases the consumer can buy the same
amount and still have money left

Chapter Five 36
The Substitution and Income Effects

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Chapter Five 37
The Substitution and Income Effects

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Chapter Five 38
Example – Income and Substitution Effects

Suppose U(x,y) = xy
Px1 = $9, Py = $1, I = $72

 MUx = y, MUy = x

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Tangency Condition: MUx/MUy = Px/Py 
Constraint: Pxx + Pyy = I 

Solving:

What is the level of utility at the optimum?

U1 = XY =
Chapter Five 39
Example – Income and Substitution Effects

Suppose U(x,y) = xy
Py = $1 and I = $72

Price of x falls and Px2 = $4.

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What is the (final) optimal consumption basket?

Tangency Condition: MUx/MUy = Px/Py 

Constraint: Pxx + Pyy = I 

Solving:

Chapter Five 40
Example – Income and Substitution Effects

Find the decomposition basket B.

1. It must lie on the original indifference curve U1 along with
basket A  U1 = ?
2. It must lie at the point where the decomposition budget
line is tangent to the indifference curve.

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3. Price of X (PX) on the decomposition budget line is final
price of $4.
MUx/MUy = Px/Py 

Substitution Effect:
Income Effect:

Chapter Five 41
Giffen Goods

If a good is so inferior that the net effect of a price

decrease of good x, all else constant, is a decrease in
consumption of good x, good x is a Giffen good.

For Giffen goods, demand does not slope down.

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When might an income effect be large enough to
offset the substitution effect? The good would have
to represent a very large proportion of the budget.

Chapter Five 42
Giffen Goods – Income and Substitution Effects

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Chapter Five 43