INTERMEDIATE

MICROECONOMICS
CHOICE CONSUMER
PREFERENCES AND
UTILITY FUNCTIONS

B.A. (HONOURS)
ECONOMICS

Group Members
1. Avinash kumar
- 7149
2. Pradeep kumar
- 7166
3. Sahil Agarwal
- 7165
4. B. Krishna Murti
- 7167
5. Aditya Mishra
- 7182
6. Dalip kumar
- 7189
7. Sanjay kumar Jha - 7191
8. Brojendro
- 7196
9. Neeraj kakkar
- 7199
Supervisor : MS. PROMILLA GUPTA

CHOICE
In this topic we will put together the budget set and
the theory of preferences in order to examine the
optimal choice of consumers. We said earlier that
the economic model of consumer choice is that
people choose the best bundle they can afford. We
can now rephrase this terms that sound more
professional by saying that consumers choose the
most preferred bundle from their budget sets.

Optimal Choice
The optimal choice of the consumer is that bundle
in the consumers budget set that lies on the highest
indifference curve. In the figure the choice (x1*,x2*) is
an optimal choice for the consumer. The set of
bundles that she prefers to (x1*,x2*) the set of
bundles above her indifference curve doesnt
intersect the bundle she can afford the bundles
beneath her budget line. Thus the bundle (x1*,x2*) is
the best bundle that the consumer can afford.

Consumer Demand
The optimal choice of good 1 and 2 at some set of prices and
income is called the consumers demanded bundle. In general
when prices and income change, the consumers 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.
We will write the demand functions are depending on both
prices and income : x1(p1,p2,m)and x2(p1,p2,m). For each different
set of prices and income, there will be a different combination of
goods that is the optimal choice of the consumers. Different
preferences will lead to different demand function.

Perfect Substitutes
The case of perfect substitutes is illustrated in figure. We have three
possible case:

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 good1.
If p1 > p2, then the consumer purchases only good 2.
Finally, if p1 = p2, there is a whole range of optimal choices any
amount of good 1 and 2 that satisfies the budget constraint is optimal
in this case. Thus the demand function for good 1 will be
x1 = m/p1
when p1 < p2
any number between 0 and m/p1
when p1 = p2
0
when p1 > p2

Perfect Complements
The case of perfect complements illustrated in figure. The optimal
choice must always lie on the diagonal, where the consumer is
purchasing equal amounts of both goods, no matter what the prices
are.
For example, let says that people with two feet buy shoes in pairs.
Let us solve for the optimal choice algebraically . We know that this
consumer is purchasing the same amount of good 1 and 2, no matter
what the prices. Let this amount be denoted by x. Then we have to
satisfy the budget constraint
p1x + p2x = m
Solving for x gives us the optimal choices of good 1 and 2.
x1 = x2 = x = m
p1 + p2

The demand function for the optimal choice here is quite intuitive. Since
the two goods are always consumed together, it is just as if the
consumer were spending all of her money on a single good that had a
price of p1 + p2.

Neutrals and Bads

In the case of a neutral good the consumer spends all of her money
on the good she likes and doesnt purchase any of the neutral good.
The same thing happens if one commodity is a bad. Thus, if
commodity 1 is a good and commodity 2 is a bad, then the demand
function will be
x1 = m
p1
x2 = 0

Discrete Goods
Let that good 1 is a discrete good that is available only in integer
units, while good 2 is money to be spent on everything else. If the
consumer chooses 1, 2, 3,. Units of good 1, she will implicitly
choose the consumption bundle (1, m p1), (2,m 2p1), (3, m3p1), and so on. We can simply compare the utility of each of
these bundles to see which has the highest utility.
As usual, the optimal bundle is the one on the highest
indifference curve. 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. Typically, as the price decreases further the consumer
will choose to consume more units of good 1.

Concave Preferences
The optimal choice for
these preferences is
always going to be a
boundary choice, like
bundle Z. If you have
money to purchase ice
cream and olives, and
you dont like to
consume
them
together, youll spend
all of your money on
one or the other.

Cobb-Douglas Preferences
Let the utility function of the Cobb-Douglas form, u(x1, x2) = Xc1 xd2 . The
optimal choices for this utility function. They turn out to be
x1 = c
m
c + d p1
x2 = d
m
c + d p2
The Cobb-Douglas preferences have a convenient property. The
fraction of his income that 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 x1
we have
p1x1 = p1 c
m = c
m
m c + d p1
c+d

Similarly the fraction of his income that the consumer spends on good 2
is
p2x2 = p1
c
m = c
m
m c + d p1
c+d
Thus the Cobb-Douglas consumer always spends a fixed fraction of his
income ob each good. The size of the fraction is determined by the
exponent in the Cobb- Douglas function.

Estimating Utility
Functions

For estimating utility function in real life we usually

have to determine what kind of preferences
generated the observed behavior.
We can use the observed choice behavior to value
the implications of proposed policy changes on
this consumer.
When given some observations on choice
behavior, we try to determine what, if anything , is
being maximized. Once if determined, we can use
this both to predict choice behavior in new
situations and to evaluate proposed changes in
the economic environment.

IMPLICATIONS OF THE MRS

CONDITION
1. 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.
2.The fact that prices are not arbitrary numbers
but reflect how people value things on the
margin is one of the most fundamental and
important ideas in economics.

3. 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.

Choosing Taxes
Choice between two types of taxes. We saw that a quantity tax is
a tax on the amount consumed of a good, like a gasoline tax of 15
percent per gallon. An income tax is just a tax on income.
First we analyze the imposition of a quantity tax. Suppose that
the original budget constraint is
p1x1 + p2x2 = m
If we tax the consumption of good 1 at a rate of t. From the
viewpoint of the consumer it is just as if the price of good 1 has
increased by an amount t. Thus the new budget constraint is
(p1 + t)x1 + p2x2 = m
Therefore a quantity tax on a good increases the price perceived
by the consumer. Figure gives an example of how that price
change might affect demand. At this stage, we dont know for
certain whether this tax will Increase or decrease the
consumption of good 1, although the presumption is that it will
decrease it.

Whichever is the case, we know that the optimal choice,

(x*1,x*2),must satisfy the budget constraint
(p1 + t) x*1 + p2x*2 = m
The revenue raised by this tax is R* = t X*1 .
Lets now consider an income tax that raises the same amount
of revenue . The form of this budget constraint would be
p1x1 + p2x2 = m - R*
or, substituting for R* ,
p1x1 + p2x2 = m - t X*1
It is easy to see that it has the same slope as the original budget
line,
p1/p2, but the problem is to determine its location. As it turns
out, the
budget line with the income tax must pass through the point
(X*1, X*2 ). The way to check this is to plug (X*1, X*2 ) into the
income-tax budget constraint and see if it is satisfied.

At (x*1,x*2) the MRS is (p1 +t)/p2 .But the income tax allows
us to trade at a rate of exchange of p1/p2. Thus the budget
line cuts the indifference curve at (x*1,x*2), which implies that
there will be some point on the budget line that will be
preferred to (x*1,x*2). Therefore the income tax is definitely
superior to the quantity tax in the sense that you can raise
the same amount of revenue from a consumer and still
leave him or her better off under the income tax than under
the quantity tax.

A QUESTION
FOR
PROBLEM SOLVING

Question: We begin with Charlie of the apples and

bananas. Charlie's utility function is U(xA, xB) = xA xB.
Suppose that the price of apples is 1, the price of
bananas is 2, and Charlie's income is 40.
(a) On the graph , draw Charlie's budget line. Plot a few
points on the indifference curve that gives Charlie a
utility of 150. Now plot a few points on the
indifference curve that gives Charlie a utility of 300.
Ans. Budget line p1 x1 + p2x2 = m
1 xA + 2xB = 40
which is drawn by blue line.
1st indifference curve gives utility of 150, which is drawn
by red line. Point satisfying the curve are
(30,5),(15,10),(10,15)&(5,30).
2nd indifference curve gives utility of 300, which is drawn
by black line. Point satisfying the curve are
(30,10),(20,15),(15,20) & (10,30).

(b) Can Charlie afford any bundles that give

him a utility of 150?

Ans. Yes. Charlie can afford bundles (30,5) &
(10,15) which gives him utility of 150. As
30x1 + 5x2 = 40 & 10x1 + 2x15 = 40.
(c) Can Charlie afford any bundles that give
him a utility of 300?
Ans. No. Charlie can not afford any bundles
that give him a utility of 300. As 20x1 +
15x2 = 50 & 15x1 + 20x2 = 55. Which he
could not afford as his income is 40.
(d) On your graph, mark a point that Charlie
can afford and that gives him a higher
utility than 150. Label that point A.
Ans. At point A, (20,10) is affordable and it
gives higher utility than 150. U(xA, xB) =
20.10 = 200.

(e) Neither of the indifference curves that you drew is tangent to

Charlie's budget line. Let's try to find one that is. At any point,
(xA,xB), Charlie's marginal rate of substitution is a function of xA
and xB. In fact, if you calculate the ratio of marginal utilities for
charlie's utility function, you will find that Charlie's marginal rate
of substitution is MRS(xA, xB) = xB / xA. This is the slope of his
indifference curve at (xA, xB). The slope of Charlie's budget line is
1/ 2 (give a numerical answer).
Ans. Since, we know that MRS(xA, xB) = slope of budget line
xB / xA = 1/ 2
xA = 2 xB ----------------(1)
Putting value of xA into the charlies budget line
2 xB + 2 xB = 40
xB = 10
Putting value of xB into equation (1).
xA = 20
The consumer optimal bundle is (20,10) which gives him higher
utility of 200. The indifference curve drawn by red dotted line
of utility 200 is tangent to Charlies budget line.