CONSUMER THEORY

CONSUMER THEORY
 The agent: individual (consumer)
 The activity: consume the whole set of commodities (goods and
services) we focus on L commodities I= 1, 2 ……… I.
 The frame work: consumption feasible set
XR
where x  X is a consumption bundle which species the amounts of
the different commodities;
 Time and Location: are included in the definition of a commodity.
CONSUMPTION FEASIBLE SET
Let X be the set of commodity bundles that the individual can
conceivably
consume given the physical constraints imposed by the
environment.
Example of physical constraints: Impossibility to have negative
amounts of
bread, water,. . . , indivisibility.
Constraints may be physical but also institutional (legal
requirements).
Example: non-negative orthant.
X= {x  RL| xI ≥0, I = 1, ………., L} = RL+
PROPERTIES OF THE CONSUMPTION FEASIBLE SET
 Non negativity:
 Closed set: it includes its own boundary;
 Convexity: if xX and y  X than for every α  [0; 1]: X’’= α x + (1-
α )y  X
PREFERENCE RELATIONSHIP
 Each consumer is endowed with a preference relation on the
consumption feasible set X.
 These preferences represent the primitive of our analysis.
 The expression:
x y
means that “x is at least as good as y".
 From this weak preference relation two relevant binary relations
may be derived:
STRONG PREFERENCE AND INDIFFERENCE
RELATIONS
 The strong preference relation defined as follows.
x y iff x y and not y x;
 The indifference relation ~ defined as follows.
x ~ y iff x y and y x:
AXIOMS OF CHOICE
 Completeness: for every x; yX either x y or y x, or both.
 Transitivity: for every x; y; z 2 X if x y and y z then x z:
 Reflexivity: for every x  X:
x x:
 A preference relation satisfying completeness, transitivity and
reflexivity is termed rational.
AXIOMS OF CHOICE (2)
 Continuity: the preference relation in X is continuous if it is
preserved under the limit operation.
 In other words, for every converging sequence of pairs of
commodity
Bundles {(Xn, yn)}∞n=0 such that
Xn yn n
where
X=
Then
x y:
UTILITY FUNCTION
 utility function is a mapping
u:X→:
This mapping summarizes and represents the preference of a
consumer in an ordinal fashion.
One of the key results of consumer theory is: the Representation
Theorem.
REPRESENTATION THEOREM
If preferences are rational (complete, reflexive and transitive) and
continuous;
then there exists a continuous utility function that represents such
preferences.
A utility function represents a preference relation if the following
holds:
x y iff u(x) > u(y)
PREFERENCES WITHOUT UTILITY REPRESENTATION
 Notice that there exists preferences that have no utility
representation.
 Consider for example the following lexicographic preferences:
(x1; x2) (y1; y2)
 if and only if either x1 > y1 or if x1 = y1 then x2 > y2.
 Discontinuity follows from the fact that the upper contour set and
the lower contour set are both neither closed nor open.
LEXICOGRAPHIC PREFERENCE

{X|X X }
(X1, X2)

{X|X X }
LOCAL NON-SATIATION
 Consider a weaker assumption than strong monotonicity, but
enough for a Representation Theorem:

for every x  X and every " ε > 0, there exists y  X such that:
 Local non-satiation: A preference relation is locally non-satiated if

< ε and y x
 where denotes the Euclidean distance between points x and
y in an L-dimensional vector space:
=
CONTINUOUS UTILITY FUNCTION
From now on we shall assume that:
 the consumer's preference relation is continuous
 the consumer's preferences satisfy strong monotonicity (local non-
satiation),
 Hence preferences are representable by a continuous utility
function.
INDIFFERENCE CURVES
 A relevant feature of a utility function is its map of indifference
curves
PROPERTIES OF INDIFFERENCE CURVES
 Downward sloping (implied by strict monotonicity).
 Each consumption bundle is part of an indifference curve (implied
by the completeness of preferences).
 Two indifference curves cannot cross (it violates transitivity):
INDIFFERENCE CURVES CANNOT CROSS

Strong Monotonicity: w y
w~z~z y~w~y
a contradiction.

Z
y
CONVEXITY OF INDIFFERENCE CURVES
 Convexity (to the origin), implied by the convexity of the
preference
relation .
Definition (Convex Preferences)
The preference relation is convex if for every x  X the upper
contour
Set {y X|Y x} is convex.
The convexity property of the indifference curves can be restated in
the following manner.
MARGINAL RATE OF SUBSTITUTION
 To obtain the expression for the marginal rate of substitution,
consider implicit differentiation
Consider a change in and which keeps utility constant:

 Consider a different representation of the utility function:

 Show that the marginal rate of substitution does not depend on

the utility representation
MARGINAL UTILITY

𝑦
From point A to point B, the
consumer loses and gains . We
also know that both A and B
give the consumer the same
A
utility
∆ 𝑦 B

∆𝑥 Marginal utility lost

𝑈 =𝑈 1from less must be offset by
marginal
𝑥 utility gained from
more
 DIFFERENT PREFERENCES

Bread Bread
(piece) (piece)

7
7
6 5

4 5 4 5 Pasta
Pasta
(kg) (kg)
SOME UTILITY FUNCTIONS EXAMPLES
Perfect substitutes
 Consider the folder example above. All the consumer cares about is
the overall number of folders, not how many red/blue folders are in the
mix. Considering the one-to-one relationship from above, the utility
function would take the form
 In general, the utility function will take the form
Perfect complements
 We looked above at the right earring/left earring where the relationship
is one to one. The right earring will not provide any utility without a left
earring. Considering this one-to-one relationship we obtain the
following utility function .
 In general (not a one to one relationship), we would have
PERFECT COMPLEMENTS/PERFECT
SUBSTITUTES
Red
folders Right MRS= if
earrin MRS= if
Constant MRS g
MRS= if

Blue Left
folders earring
SOME UTILITY FUNCTIONS EXAMPLES
Cobb-Douglas preferences
 Very commonly used (also for production functions). Takes the general
following form: , where a and b represent the consumers preferences.
We will assume that and rewrite
𝑋 𝑋

1 1 1 4
𝑎= , 𝑏= 𝑎= , 𝑏=
2 2 5 5

𝑌 𝑌
LINKING MRS TO THE SLOPE OF BUDGET
CONSTRAINT
 Slope of the budget constraint: For a given income (expenditure),
how much of one good does one have to give up to purchase an
extra unit of the other good
Slope of the indifference curve: How much of one good is one
willing to give up to obtain an extra unit of the other good, to be as
well as off as before.
 The slope of the budget constraint give us the marginal cost of
clothes in terms of food.
The slope of the indifference curve give us the marginal benefit of
clothes in terms of food.
OPTIMAL CHOICE
Food (g)

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Which point will be the
optimal choice for the
consumer?
Remember the
A C assumptions we made
about preference
O ordering, and the
properties of indifference
curves that follow from
B
those.

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Clothes (unit)
OPTIMAL CHOICE
The optimal choice for the consumer is the tangency point between
the budget constraint and an indifference curve.

If , the consumer gets less food (1) for giving up a unit of

clothing than the amount of food the consumer could buy by
not buying any clothes (2)
The consumer will clearly be better off buying more food, and less
clothes.

Can you think of examples where the tangency condition might not
hold?
The tangency condition is necessary, but not necessarily
sufficient
 CORNER SOLUTION
Food
At point A the marginal rate
40 of substitution is lower than
the slope of the budget
constraint, with diminishing
marginal rate of substitution,
the two never reach equality.

With MRS < slope of BC at

every point, the best the
consumer can do is to buy
food only: For an extra unit of
clothing, the consumer will
have to give up more food
than what he could buy, by
not buying clothes.

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Clothes
REVEALED PREFERENCES
Use the consumer’s demand to discover his preferences- we need
to observe the consumer’s behaviour
 Assume behaviour doesn’t change over time; Economists use
monthly, or quarterly time spans
depicts the optimising bundle. What can we say about bundle ?

Have we made any assumptions about preferences to make this

analysis easier?
WEAK AXIOM OF REVEALED PREFERENCES
Weak Axiom of Revealed Preferences
 If is directly revealed preferred to , and the two bundles are not
the same, then it cannot happen that is directly revealed
preferred to
Algebraically, we can say that if it is true that

Then, it cannot be true that

STRONG AXIOM OF REVEALED PREFERENCES
Looks at indirect revealed preferences as well

If if revealed preferred to , either directly or indirectly, and if is

different than , then cannot be directly, or indirectly revealed
preferred to .

Let’s look at how we can check SARP

HOMOTHETIC TASTES
A situation where the consumer’s preferences depend solely on the
ratio of good 1 to good 2
Homothetic tastes give rise to indifference maps where is MRS is
constant along any ray from the origin.

Can you say whether examples of preferences shown above are

homothetic preferences (perfect substitutes, perfect complements,
Cobb-Douglas)?
QUASILINEAR TASTES
Tastes are linear in one good, but may not be in the other good:

With quasilinear tastes, indifference curves are vertical translates

of one another.
In this case, the MRS is constant along any vertical line from the x-
axis.
CHANGES IN INCOME
Since px/py does not change, the MRS will stay constant
An increase in income will cause the budget constraint out in
a parallel fashion (MRS stays constant)

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WHAT IS A NORMAL GOOD?
A good xi for which xi/I  0 over some range of income is a
normal good in that range

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NORMAL GOODS
If both x and y increase as income rises, x and y are normal
goods

Quantity of y
As income rises, the individual chooses
to consume more x and y

C
B

A U3
U2
U1
Quantity of x
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WHAT IS AN INFERIOR GOOD?

A good xi for which xi/I < 0 over some range of income is an

inferior good in that range

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INFERIOR GOOD

If x decreases as income rises, x is an inferior good

As income rises, the individual chooses

to consume less x and more y
Quantity of y

B U3

U2
A
U1
Quantity of x
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CHANGES IN A GOOD’S PRICE

A change in the price of a good alters the slope of the

budget constraint (px/py)
 Consequently, it changes the MRS at the consumer’s
utility-maximizing choices

When a price changes, we can decompose consumer’s

reaction in two effects:
 substitution effect
 income effect

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SUBSTITUTION AND INCOME EFFECTS

Even if the individual remained on the same indifference

curve when the price changes, his optimal choice will
change because the MRS must equal the new price ratio
 the substitution effect

The price change alters the individual’s real income and

therefore he must move to a new indifference curve
 the income effect

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SIGN OF SUBSTITUTION EFFECT (SE)

SE is always negative, that is, if price increases, the substitution

effect makes quantity to decrease and conversely. See why:
1) Assume px decreases, so: px1< px0
2) MRS(x0,y0)= px0/ py0 & MRS(x1,y1)= px1/ py0

1 and 2 implies that:

MRS(x1,y1)<MRS(x0,y0)

As the MRS is decreasing in x, this means that x has increased,

that is: x1>x0

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CHANGES IN THE OPTIMAL CHOICE WHEN A PRICE
DECREASES

Quantity of y Suppose the consumer is maximizing

utility at point A.

If the price of good x falls, the consumer

will maximize utility at point B.

A
U2

U1

Quantity of x
Total increase in x
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SUBSTITUTION EFFECT WHEN A PRICE DECREASES
To isolate the substitution effect, we hold
Quantity of y utility constant but allow the
relative price of good x to change.
Purple is parallel to the new one

The substitution effect is the movement

from point A to point C

A C The individual substitutes

good x for good y
because it is now
U1
relatively cheaper
Quantity of x

Substitution effect

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INCOME EFFECT WHEN THE PRICE
DECREASES

Quantity of y The income effect occurs because the

individual’s “real” income changes
(hence utility changes) when
the price of good x changes
The income effect is the movement
from point C to point B
B

A C
If x is a normal good,
U2 the individual will buy
more because “real”
U1 income increased
Quantity of x

Income effect

How would the graph change if the good was inferior?

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SUBS AND INCOME EFFECTS WHEN A
PRICE INCREASES
Quantity of y
An increase in the price of good x means that
the budget constraint gets steeper

The substitution effect is the

C movement from point A to point C
A

B
The income effect is the
U1 movement from point C
to point B
U2

Quantity of x
Substitution effect
Income effect

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How would the graph change if the good was inferior?
PRICE CHANGES FOR
NORMAL GOODS
If a good is normal, substitution and income effects
reinforce one another
 when price falls, both effects lead to a rise in quantity
demanded
 when price rises, both effects lead to a drop in quantity
demanded

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PRICE CHANGES FOR
INFERIOR GOODS
If a good is inferior, substitution and income effects
move in opposite directions
The combined effect is indeterminate
 when price rises, the substitution effect leads to a drop in quantity
demanded, but the income effect is opposite
 when price falls, the substitution effect leads to a rise in quantity
demanded, but the income effect is opposite

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GIFFEN’S PARADOX
If the income effect of a price change is strong enough,
there could be a positive relationship between price and
quantity demanded
 an increase in price leads to a drop in real income
 since the good is inferior, a drop in income causes
quantity demanded to rise

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A SUMMARY
Utility maximization implies that (for normal
goods) a fall in price leads to an increase in
quantity demanded
 the substitution effect causes more to be purchased
as the individual moves along an indifference curve
 the income effect causes more to be purchased
because the resulting rise in purchasing power
allows the individual to move to a higher indifference
curve
Obvious relation hold for a rise in price…

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A SUMMARY
Utility maximization implies that (for inferior goods) no
definite prediction can be made for changes in price
 the substitution effect and income effect move in opposite directions
 if the income effect outweighs the substitution effect, we have a
case of Giffen’s paradox

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