ESS, BRAC University; Fall 2012, THN

ECO 206: Intermediate Microeconomics I

Consumer Theory
1 Preference:
People dont just choose to buy goods arbitrarily (or blindly), they are usually guided by some form
of underlying preferences. Consumers do appear to make systematic choices, e.g., we probably buy
more or less of the same specic items every time we go to the grocery store. To start with, assume
that there are two goods, x and y, and that there are three bundles, A, B, and C. Each bundle has
a dierent combination of the two goods. Economists generally assume that consumers preferences
follow these properties:
(a) Completeness: Between two bundles, A and B, the consumer either prefers A to B or B to A
or is indierent between A and B. It is never possible that the consumer cannot decide between
two bundles, such as A and B.
(b) Transitivity: Consider a situation where it is true that the consumer prefers A to B and B
to C. Then the assumption of transitivity implies that the consumer prefers A to C. In other
words, the consumers preferences are consistent over a range of choices, also known as the
rationality assumption.
(c) Nonsatiation or more is better: Consumers always prefer more of a good than less of it.
In economics, a good is dened as a product for which more is preferred to less and a bad is a
product for which less is preferred than more (such as noise pollution).
(d) Continuity: Consider a situation where it is true that the consumer prefers A to B. Then
under this assumption, the consumer will prefer C to B if C is suciently close to A. In other
words, this assumption rules out the phenomenon of preference reversals.
(e) Strict convexity: Consider a situation where it is true that the consumer prefers both goods
A and B to C. Then, under this assumption, the consumer will prefer a weighted average of
the two goods A and B, such as A+ (1 )B, to good C; where 0 < 1.
1
(f) Reexivity: Each of the bundles, A or B or C, is as good as itself.
With these assumptions, a lot can be explained about a persons preferences. A preference map is
a graphical representation of peoples preferences. For simplicity, in most cases, we will consider a
world with only two goods, x and y ... will make the math easier ...
2 Indierence Curve:
It is the set of all the possible combinations of the two goods, x and y, that are deemed to be equally
desirable by the consumer. In other words, the consumer is indierent between any combinations
of goods x and y that lie along the same indierence curve. We can draw an entire indierence
map for a particular consumer purchasing combinations of the two goods, x and y. An indierence
map is then the set of all indierence curves that summarizes a persons tastes.
Indierence curves also have to display a set of properties:
(a) Bundles of goods on indierence curves that are further away from origin are preferred more
than those on indierence curves closer to the origin.
(b) There is an indierence curve through all possible combinations of goods and indierence curves
cannot cross.
(c) Indierence curves slope downward.
(d) Indierence curves cannot be thick.
2.1 Marginal Rate of Substitution (MRS):
The slope of an indierence curve has a special meaning it is the consumers marginal willingness
to substitute one good for an incremental change in the consumption of the other good. In a world
with two goods, x and y:
MRS
U=U
=
dy
dx
=
U
x
U
y
(1)
In equation (1), dy is the change in the amount consumed of good y due to a change in the amount
consumed of good x equal to dx. In most cases, indierence curves are convex to the origin we
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have what we call diminishing marginal rate of substitution. In simple words, convex indierence
curves mean that a consumer is willing to give up less of y (for x) as we move down along an
indierence curve. MRS tends to zero as we move towards the bottom right-hand corner of the
curve. In general, indierence curves can have various shapes:
(a) If x and y are perfect substitutes, indierence curves will be downward sloping with a slope
of exactly 1. In other words, MRS is equal to 1.
(b) If x and y are perfect complements, indierence curves will be L-shaped. In other words,
there is no substitution between the two goods.
(c) If x and y are imperfect substitutes (intermediate or between perfect substitutes and perfect
complements), indierence curves will have the standard downward sloping convex to the origin
shape. In other words, MRS is falling as we move down along the indierence curve.
3 Utility Function:
Underlying all the analysis so far we have assumed that individuals can actually assign numerical
values to the satisfaction derived from dierent combinations of the two goods and then compare
those numerical values. The term utility refers to such a set of numbers (or values) that represent
the relative rankings of the dierent combinations. Simply, it can be thought of as a measure of
satisfaction. Saying that John prefers x to y is the same as saying consuming x gives John more
utility or satisfaction than consuming y.
A unit of utility is referred to as a util. So a utility function is basically a function showing the
satisfaction values that are generated from dierent combinations of the two goods consumed. An
example of a utility function is given by:
U(x, y) =

x y = x
1
2
y
1
2
(2)
We can create a schedule of numerical utility values (or utils) for the various possible mixtures of
the two goods x and y. For example, calculate the utility or util value when (x, y) = (9, 16) and
(x, y) = (13, 13). Also remember that in this analysis, we are in the world of cardinal utility as
opposed to ordinal utility. Cardinal is when we can compute and compare numeric util values for
3
dierent (x, y) combinations. In an ordinal world, we can only say which is better between x and
y, but not how much better.
3.1 Marginal Utility and MRS:
Along one specic indierence curve, Joe receives a constant level of satisfaction (i.e. utility or
util) at all the points (or combinations of x and y). Let us hold Joes consumption of y constant
at 9 units and try to see what happens to Joes utility as he consumes more and more of the other
good, x. Substitute y = 9 in the utility function:
U(x|y = 9) = x
1
2
(9)
1
2
= 3x
1
2
(3)
The slope of the utility function is now given by:
dU
dx
= 3

1
2

(x)
1
2
1
=
3
2
x

1
2
=
3
2

x
(4)
This slope of the utility function,
dU
dx
, is known as the marginal utility of x. It is the gain in total
utility or satisfaction due to a marginal increase in the consumption of good x while we hold the
consumption of y constant at 10 units.
Note that the marginal utility of x,
dU
dx
, is a decreasing function of the consumption of x. This
negative slope of marginal utility refers to the phenomenon called diminishing marginal utility.
Each extra unit of x gives Joe more satisfaction, but the additional satisfaction becomes smaller
and smaller as x increases.
This slope of MU
x
can be computed as:
d
dx

dU
dx

=
3
2

d
dx

1
2

=
3
4
x

3
2
< 0 (5)
Now suppose Joe moves down along his indierence curve and lowers consumption of y and increases
consumption of x. So he gains marginal utility from the extra unit of x consumed and loses marginal
utility from the unit of y lost. The marginal rate of substitution or the slope of the indierence
curve (shown earlier) can be further specied as:
MRS
xy
=
dy
dx
=
MU
x
MU
y
(6)
4
4 Budget Constraint:
Utility functions and indierence curves constitute just one part of the consumers constrained op-
timization problem, the other part is the constraints faced by the consumer and the most important
constraint is the budget constraint. For simplicity, we exclude any savings or borrowing behavior
for the consumer. We say that each consumer has a xed (or constant) sum of money to spend
right now the consumers income. And again for graphical simplicity, we continue to use a two
good world.
Let I be the consumers money income, p
x
is the per unit price of good x, and p
y
is the per unit
price of good y. So the budget constraint can be written as:
I = xp
x
+yp
y
(7)
where xp
x
is the total share of income spent on consuming x and yp
y
is the total share of income
spent on consuming y. If we x the level of income at I = I, we can solve equation (7) to draw the
budget constraint in the (x, y)-plane. The equation of the budget line is:
y =
I
p
y

p
x
p
y

x (8)
where

px
py

is the slope of the budget line; this slope is also known as the relative price of
x in terms of the price of y. This ratio of the two prices is also known as the marginal rate
of transformation and the negative sign in the front illustrates the fact that budget line will be
negatively sloped. Buying more of good x will mean that less of good y can be aorded.
5 The Consumers Problem Utility Maximization:
So the consumer has a budget set (or opportunity set) and an indierence map that helps us
determine which combination of purchases gives him the highest amount of pleasure (utils of utility).
Consumer will try to maximize utility subject to his budget constraint (without a budget constraint
he/she will denitely want to consume innite amounts so the problem becomes unrealistic and
unbounded).
5
Mathematically, the consumers problem can be stated as:
Maximize:
{x,y}
U = U(x, y) (9)
s.t.: I = xp
x
+yp
y
(10)
In the above maximization problem, consumer is maximizing his/her utility function (given by
U(x, y)) by choosing the quantities of x and y to consume, keeping in mind that total expenditure
cannot go beyond I. This is the classic constrained utility maximization problem in consumer
theory.
At the optimum, the following condition has to be satised:
MRS =
MU
x
MU
y
=
p
x
p
y
= MRT (11)
Condition (11) above implies that the slope of the budget line must equal the slope of the indierence
curve at the optimum. In other words, the indierence curve has to be tangent to the budget line
at the optimum. Condition (11) can also be rearranged to:
MU
x
p
x
=
MU
y
p
y
(12)
which is the last dollar rule that was covered in the principles of microeconomics class. According
to condition (12), marginal utility per dollar spent must be equal for both goods, x and y. For
example, if
MUx
px
>
MUy
py
, consumer is getting more utility by spending the last dollar in buying x
than y and he/she will continue to buy more x. And, buying more x leads to lower MU
x
and higher
MU
y
(because of lower y being purchased); eventually,
MUx
px
will fall and will be equal to
MUy
py
.
In terms of second order conditions, utility will be maximized if the indierence curves are
strictly convex to the origin, that is, MRS is falling along the indierence curve. More discussion
on the second order conditions will be done in class. More formally, the Lagrange Multiplier
method is most often used in economics to solve constrained optimization problems. Recall that,
mathematically, the consumers problem can be stated as:
Maximize:
{x,y}
U = U(x, y) (13)
s.t.: I = xp
x
+yp
y
(14)
6
The Lagrange multiplier technique proceeds by, rst, writing down the Lagrange function:
L(x, y, ) = U(x, y) +[I xp
x
+yp
y
] (15)
where, is the Lagrange multiplier and is being added as an extra variable to be solved from
the optimization problem. According to Lagranges theorem, rst order necessary conditions for
optimization requires that the following three equations are satised:
L
x

=
L
x

: U
x
(x, y) p
x
= 0 (16)
L
y

=
L
y

: U
y
(x, y) p
y
= 0 (17)
L

=
L

: I xP
x
+yP
y
= 0 (18)
Now, the above rst order conditions can be solved simultaneously to obtain the solutions (x

, y

),
where, {x

, y

} are also knows as the Marshallian (or, uncompensated) demand functions

for the two goods. Also, divide equation (16) by (17) to obtain the tangency condition.
5.1 Marshallian Demand Curves:
Theoretically, the rst order conditions from the constrained utility maximization problem can
be solved to obtain closed-form solutions or the demand functions for each good. These optimal
quantities are the consumers quantity demanded of the various goods, in this case, {x

, y

}. In
general, the demand curves are given by:
x
m
= x

(p
x
, p
y
, I) (19)
y
m
= y

(p
x
, p
y
, I) (20)
where, the m denotes the fact that these are Marshallian demand functions. The above two demand
functions are the equations of demand curves that we have studied in principles classes. If we assume
specic forms for the utility function we will have a closed form solution for the demand curves
in equation (19) and (20). For example, if we assume a Cobb-Douglas utility function of the form
U = x

, the resultant demand equations will be as follows:

x
m
=
I
p
x
(21)
y
m
=
I
p
y
(22)
7
Some properties of these demand functions should be noted:
(a) The demand for each good depends only on its own price and income (only valid in case of this
Cobb-Douglas utility function). In this case, the two goods are independent because:
x
m
p
y
=
y
m
p
x
= 0
For certain utility functions, this property may not hold.
(b) In general, if:
x
m
p
y
> 0 goods x and y are gross substitutes
x
m
p
y
< 0 goods x and y are gross complements
(c) The demand curves are negatively sloped (conforms to the law of demand, we can check that
x

m
px
< 0 and
y
m
py
< 0). Later sections will elaborate more on this.
(d) The demand curves can be either positively or negatively related to the consumers income. In
case of the Cobb-Douglas utility function, it can be checked that
x
m
I
> 0 and
y
m
I
> 0). Later
sections will discuss this issue in further detail.
(e) The demand curves are homogeneous of degree zero in all prices and income.
(f) and are the income shares spent on x and y respectively.
5.2 Indirect Utility functions and Roys Identity:
For example, if = = 0.5, the demand functions are:
x

(p
x
, p
y
, I) =
I
2p
x
and y

(p
x
, p
y
, I) =
I
2p
y
(23)
Substitute the above demand functions into the objective function to obtain the maximized value
of the utility:
v(p
x
, p
y
, I) =

I
2p
x

0.5

I
2p
y

0.5
= I
0.5+0.5

1
2

0.5+0.5

1
p
0.5
x
p
0.5
y

=
I
2p
0.5
x
p
0.5
y
(24)
8
Equation (24) is the indirect utility function (IUF); it shows the maximum amount of utility
that can be achieved for any combination of the two prices (p
x
and p
y
) and income (m). Important
properties of the IUF has been discussed in class. In addition, using Roys Identity, one can
obtain the Marshallian demand functions directly from the IUF as follows:
x

(p
x
, p
y
, I) =
v
px
v
I
and y

(p
x
, p
y
, I) =
v
px
v
I
Obviously, the above trick is applicable only if you already know the IUF. You should check,
mathematically, that using Roys Identity, you can go from equation (2) to the two demand functions
in equation (1).
6 Expenditure Minimization and Hicksian Demand:
An alternative way to look at the consumers problem is to ask the question: given that the consumer
is facing a given set of prices, what is the minimum expenditure needed to achieve a target level
of utility? Look at the following two gures to understand the fundamental dierence between the
utility maximization and the expenditure minimization problems:

y
x x
y
e
0

A
(a) Utility Maximization (b) Expenditure Minimization
B
u
0

u
4

u
3

u
2

u
1

e
1
e
2

e
3

e
4

The gure on the left explains the utility maximization problem, where, the objective is to maximize
utility (or, reach the indierence curve furthest from the origin, u
4
> u
3
> u
2
> u
1
) given that the
9
consumer faces a xed level of income (or, one particular budget line given by e
0
). The one on the
right depicts the expenditure minimization problem, where, the objective is to minimize spending
(or, reach the budget line closest to the origin, e
4
> e
3
> e
2
> e
1
) given that the consumer achieves
a given level of utility (or, one particular indierence curve given by u
0
). Keep in mind that, in
each gure, the consumer is facing a given set of prices of the two goods (p
x
and p
y
). And in both
problems, the tangency condition remains the same, that is, optimality is achieved when the slope
of an indierence curve equals the slope of a budget line:
MRS =
MU
x
MU
y
=
p
x
p
y
= MRT
Formally, the expenditure minimization problem is:
Minimize:
{x,y}
e = I = xp
x
+yp
y
s.t.: u = u(x, y) = x

where, xp
x
+yp
y
= I is the budget constraint or the total spending for the consumer. Again, x and y
are the two choice variables (or, instruments) and p
x
, p
y
, u are the parameters (or, constants). This
problem is also solved using similar techniques as before, that is, forming the Lagrange function
and setting up the rst order conditions. But, the solutions for x and y will now be of the form
(again, assuming = = 0.5):
x
c
(p
x
, p
y
, u) = u

p
y
p
x

0.5
and y
c
(p
x
, p
y
, u) = u

p
x
p
y

0.5
(25)
where, x
c
and y
c
are the Hicksian or compensated demand curves. Along a compensated demand
curve, total spending is changing, but, utility is held constant. In other words, the consumer is
constantly being compensated such that utility remains the same and hence, the name compen-
sated. Substitute and complement goods can also be dened in terms of the Hicksian demand
functions. In general, if:
x
c
p
y
> 0 goods x and y are net substitutes
x
c
p
y
< 0 goods x and y are net complements
where, these denitions are only considering the substitution eects and hence the term net
(instead of gross). Substitute the Hicksian demand functions into the objective function (from the
10
minimization problem) to obtain the minimized value of spending:
e(p
x
, p
y
, u) = p
x
u

p
y
p
x

0.5
+p
y
u

p
x
p
y

0.5
= up
10.5
x
p
0.5
y
+up
0.5
x
p
10.5
y
= 2p
0.5
x
p
0.5
y
(26)
which is the expenditure function; it shows the minimum spending necessary to attain a par-
ticular level of utility given that the consumer faces the prices (p
x
and p
y
) and income (I). Using
Sheppards Lemma, one can obtain the Hicksian demand functions directly from the expenditure
function as well:
x
c
(p
x
, p
y
, u) =
e
p
x
and y
c
(p
x
, p
y
, u) =
e
p
y
Obviously, the above trick is applicable only if you already know the expenditure function. You
should check, mathematically, that using Sheppards Lemma, you can go from equation (4) to the
two demand functions in equation (3). Lastly, you should also note that the IUF (equation (2))
and the expenditure function (equation (4)) are inverses of each other.
7 Change in Income and Type of Goods:
We know that changes in the consumers income (while prices of both goods remain the same) shift
the demand curve for a good. But how does it happen? Consider there is an increase in income and
we know as a result the budget line will shift outward or to the right. When the budget line shifts to
the right we will have a new optimal bundle of goods at the same level of prices as before. This shift
in demand will continue if there is another subsequent increase in income and the demand curve
for both goods will continue to shift to the right. An income consumption curve traces all such
optimal consumption bundles as the consumers income changes. And an Engel curve shows the
relationship between quantity demanded of an individual good and income, holding prices constant.
For normal goods, Engel curve is positively sloped.
Superior vs. Inferior Good: Relationship between changes in income and changes in consump-
11
tion denes two types of goods:
(i) If
x
m
I
> 0, good x is a normal or superior good; and
(ii) if
x
m
I
< 0, good x is an inferior good
Another way of determining the type of goods is to calculate income elasticity values. Income
elasticities are generally used as a summary measure for the shapes of income consumption curves
and Engel curves. Recall that income elasticity is the percentage change in quantity demanded of
a good due to a given percentage change in income. The formula for income elasticity of good x is
given by:

I
=
x
m
I

I
x
m
(27)
Range of values for income elasticities denes the various types of goods.
(a) A good with negative income elasticity, i.e.,
I
< 0, is known as an inferior good. Inferior goods
are ones for which your demand falls as your income increase, e.g., junk/fast food, potatoes,
etc.
(b) Most other goods have positive income elasticities, i.e.,
I
> 0, these goods are known as normal
or superior goods. Normal goods are ones for which your demand increases as your income
increases, e.g., cars, wines, etc.
(c) Normal goods can also be distinguished into two further types: (i) necessities goods which
have income elasticity values between 0 and 1 and inclusive, that is 0
I
1, e.g., beer,
cigarettes, rice; and (ii) luxuries goods which have income elasticity values strictly greater
than 1, that is
I
> 1, e.g., the 2009 BMW 335xi Coupe.
(d) Keep in mind that the above denitions of all the goods are relevant for a representative rational
consumer whose underlying preferences always follow economic theory. Also, a good that is
luxury for on individual could be a necessity for another individual depending on their relative
perception of things and a host of other subjective factors.
12
8 Change in Price and the Slutsky Equation:
Remember we are still in the world with two goods (x and y). Price of good x is given by p
x
and
price of good y is given by p
y
. Now, consider a decrease in the price of good x (that is p
x
has fallen)
and the total eect consists of two smaller eects:
(a) Substitution eect: If utility is held constant, the consumer will now substitute more of good
x with the cheaper good y. Substitution eect is always negative, that is, the consumer will
always buy more of the cheaper product, good x in this case.
(b) Income eect: A decrease in p
x
means an increase in the consumers real income (that is
purchasing power), so he or she will buy more of at least one good (either x or y or both).
Income eect can be positive and negative depending on the type of the good.
The Slutsky equation is a mathematical equation that shows the decomposition of the total eect
of a price change into the above two eects. For a change in the price of x, the Slutsky equation is
given by:
x
m
p
x
=
x
c
p
x

x
m

x
m
m

(28)
where p
x
is the price of x, x
m
is the Marshallian demand, x
c
is the compensated demand, and I is
income. In the above Slutsky equation, the partial derivative on the left hand side is the total eect
of the change in p
x
. This is the slope of the Marshallian demand curve. The rst partial derivative
term on the right hand side is the substitution eect and this term is always negative; this term
is, basically, the slope of the compensated demand curve. The second term inside brackets on the
right hand side is the income eect and this can be either positive and negative:
(a) If x is a normal good, then, x
m
/I > 0, which means the overall income eect term is
negative. Therefore, together with the negative substitution eect, the total eect will be
negative. Hence, Marshallian demand curve will be negatively sloped.
(b) If x is an inferior good, then, x
m
/I < 0, which means the overall income eect term is
positive. But, the positive income eect is smaller than the negative substitution eect, so, the
total eect will still be negative. Hence, Marshallian demand curve will again be negatively
sloped.
13
(c) If x is an gien good, then, x
m
/I < 0, which means the overall income eect term is positive.
And, the positive income eect is bigger than the negative substitution eect, which means
the total eect will be positive. Therefore, Marshallian demand curve will be positively sloped.
Sometimes, this phenomenon is also referred to as the giens paradox.
8.1 Decrease in Price of x (Normal Good):
The following gure shows the income and substitution eects for a decrease in p
x
when x is a
normal good:
good y

good x
m/p
y
0

m/p
x
1
m/p
x
0

B
S
A
u
0

u
1

m
0
m
1

I
I
x
0
x
s
x
1

The consumer is initially at point A, where, the bundle (x
0
, y
0
) is bought at prices (p
0
x
, p
0
y
) and
income m
0
. When the price of x decreases to p
1
x
, the budget line rotates to the line m
1
. To nd the
substitution eect, draw a budget line (given by line II) parallel to the new budget line, but, tangent
to the old indierence curve (that is u
0
). So, substitution eect is the movement (or distance) from
x
0
to x
s
and this eect is always negative. And, since x is a normal good, the income eect will
further increase consumption from x
s
to x
1
. Remember, the decrease in p
x
results in a larger real
income (or purchasing power) and income eect is positive for a normal good. So, income eect is
the movement (or distance) from x
s
to x
1
.
14
8.2 Decrease in Price of x (Inferior Good):
The following gure shows the income and substitution eects for a decrease in p
x
when x is an
inferior good:














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The consumer is initially at point A, where, the bundle (x
0
, y
0
) is bought at prices (p
0
x
, p
0
y
) and
income m
0
. When the price of x decreases to p
1
x
, the budget line rotates to the line m
1
. To nd
the substitution eect, draw a budget line (given by line II) parallel to the new budget line, but,
tangent to the old indierence curve (u
0
). So, substitution eect is the movement (or distance)
from x
0
to x
s
and this eect is always negative. And, since x is an inferior good, the income eect
will decrease the consumption from x
s
to x
1
. Remember, the decrease in p
x
means larger real
income (or purchasing power), but, the consumer lowers consumption from x
s
, because, x is an
inferior good. So, income eect is the movement (or distance) from x
s
to x
1
. Lastly, note that the
decrease in x (income eect) is smaller than the initial increase in x (substitution eect) and hence,
the net (total) eect is still negative.
15
8.3 Decrease in Price of x (Gien Good):
The following gure shows the income and substitution eects for a decrease in p
x
when x is a
gien good:
good y

good x
m/p
y
0

m/p
x
1
m/p
x
0

B
S
A
u
0

u
1

m
0
m
1

I
I
x
0
x
s
x
1

The consumer is initially at point A, where, the bundle (x
0
, y
0
) is bought at prices (p
0
x
, p
0
y
) and
income m
0
. When the price of x decreases to p
1
x
, the budget line rotates to the line m
1
. To nd
the substitution eect, draw a budget line (given by line II) parallel to the new budget line, but,
tangent to the old indierence curve (u
0
). So, substitution eect is the movement (or distance)
from x
0
to x
s
and this eect is always negative. And, since x is now a gien good, the income
eect will decrease the consumption from x
s
to x
1
and this decrease will be greater than the initial
increase in consumption (due to substitution eect). Remember, the decrease in p
x
means larger
real income (or purchasing power), but, the consumer lowers consumption from x
s
, because, x is
a gien good. So, income eect is the movement (or distance) from x
s
to x
1
. Note that the net
(total) eect is now positive and the Marshallian demand curve will be positively sloped.
16
9 Revealed Preference:
So far, in consumer theory, we have derived demand curves from the consumers preferences (under
a certain set of assumptions guaranteeing the existence of a real valued utility function). In this
chapter, our objective is to understand whether we can identify the underlying preferences from
the consumers observed (or, revealed) behavior (or, demand). Keep in mind that, in most real life
situations, peoples behavior is directly observable, while the preferences are not. In the discussion
that follows, to keep things simple, assume that our consumer is living in a two good world (x
1
and
x
2
), where, prices are p
1
and p
2
. And, assume that the consumers current income is m. Then, the
Principle of Revealed Preference states that:
Let (x

1
, x

2
) be the chosen bundle when prices are (p
1
, p
2
), and let (x
0
1
, x
0
2
) be some other
bundle such that p
1
x

1
+ p
2
x

2
p
1
x
0
1
+ p
2
x
0
2
(which means that bundle (x
0
1
, x
0
2
) was also
aordable at p
1
, p
2
). Then, if the consumer is choosing the most preferred bundle she
can aord, it must be that (x

1
, x

2
) (x
0
1
, x
0
2
).
What does it all mean? Imagine that the consumer can aord to buy both the bundles, (x

1
, x

2
)
and (x
0
1
, x
0
2
), at the given prices and income; and, it has been observed that the consumer bought
the bundle (x

1
, x

2
). So, it is being observed through the consumers purchase decision that the
consumer revealed prefers bundle (x

1
, x

2
) over bundle (x
0
1
, x
0
2
). In other words, consumers
preference ordering is revealed through their buying decisions in the market. In earlier chapters,
we started with the fact that we know the consumers preferences (and, hence, a utility function)
and, then, derived the demand functions. Let us the understand the above in a simple gure:
17














"##$ %
&
"
#
#
$

%
'
(%
&
)* %
'
)+
(%
&
,
* %
'
,
+
(%
&
,
* %
'
,
+
A
B
C Budget line
The above gure shows a usual downward sloping budget line, where, the quantity of good x
1
is
on the horizontal axis and quantity of good x
2
is on the vertical axis. This budget line is drawn
for prices (p
1
, p
2
) and income m. It is observed in the market that, at these prices and income, the
consumer purchases the bundle (x

1
, x

2
) when bundle (x
0
1
, x
0
2
) was clearly aordable. Two possible
locations for this aordable bundle is shown all income is spent at B, while, there is excess income
at C. Mathematically:
p
1
x

1
+p
2
x

2
= p
1
x
0
1
+p
2
x
0
2
between A and B
p
1
x

1
+p
2
x

2
> p
1
x
0
1
+p
2
x
0
2
between A and C
The theory of revealed preference postulates that since the consumer is buying (x

1
, x

2
) when other
bundles were also aordable, it must be the case that bundle (x

1
, x

2
) is revealed preferred than
all the other aordable bundles. It is not important whether the other bundles exhaust all the
income (such as at point B) or leaves the consumer with some excess income (such as at point C).
18
9.1 Direct and Indirect Revealed Preference:
From the above analysis, bundle (x

1
, x

2
) is directly revealed preferred to bundle (x
0
1
, x
0
2
). To
understand indirect revealed preference, we need to introduce another set of prices and use the
idea of transitivity of preferences. Imagine that at a dierent set of prices, (p

1
, p

2
), the consumer
purchases the bundle (x
0
1
, x
0
2
) when bundle (x

1
, x

2
) was also aordable. This means that the con-
sumer directly revealed prefers bundle (x
0
1
, x
0
2
) over bundle (x

1
, x

2
). Based on the assumption
of transitivity, it must be that the consumer indirectly revealed prefers the bundle (x

1
, x

2
) over
the bundle (x

1
, x

2
).














"##$ %
&
"
#
#
$

%
'
(%
&
)* %
'
)+
(%
&
,
* %
'
,
+
(%
&
-* %
'
-+
A
C
B
BL
1
BL
2
In the above gure, two budget lines are shown. Budget line BL
1
is drawn for the prices (p
1
, p
2
) and
budget line BL
2
is drawn for the prices (p

1
, p

2
). For the situation depicted above, bundle (x

1
, x

2
)
is directly revealed preferred to bundle (x
0
1
, x
0
2
), and bundle (x
0
1
, x
0
2
) is directly revealed preferred
to bundle (x

1
, x

2
). Therefore, based on the assumption of transitivity, bundle (x

1
, x

2
) is indirectly
revealed preferred over the bundle (x

1
, x

2
). In addition, the chain of transitive preferences can be
much longer than just three bundles (as explained above). If, for example, bundle A is directly
revealed preferred to bundle B, B to C, C to D, , N to O, then, bundle A is still indirectly
19
revealed preferred to bundle O. Then, the theory of revealed preference states that if a bundle is
either directly or indirectly revealed preferred to another bundle, we will say that the rst bundle is
revealed preferred to the second bundle. And, if the consumer always chooses the best bundles
that he or she can aord, then revealed preference implies preference. In the presence of
certain additional assumptions, we may derive a consumers indierence curves from the theory
of revealed preference. We will cover this in appropriate detail in class, both graphically and
intuitively.
10 Weak Axiom of Revealed Preference:
The Weak Axiom of Revealed Preference (WARP) states that: if bundle (x

1
, x

2
) is directly
revealed preferred to bundle (x
0
1
, x
0
2
), and the two bundles are not the same, then, it cannot be that
(x
0
1
, x
0
2
) is directly revealed preferred to bundle (x

1
, x

2
).














"##$ %
&
"
#
#
$

%
'
(%
&
)* %
'
)+
(%
&
,
* %
'
,
+
A
B
BL
1
BL
2
It is easiest to understand the implications of WARP using a gure like the above. Two budget
lines are shown in the gure, BL
1
and BL
2
, for two dierent sets of prices. What can we conclude
20
from this gure? First, in case of BL
1
, the consumer is buying bundle (x

1
, x

2
) when bundle (x
0
1
, x
0
2
)
was aordable, which means (x

1
, x

2
) is preferred to (x
0
1
, x
0
2
). Second, in case of BL
2
, the consumer
is buying bundle (x
0
1
, x
0
2
) when bundle (x

1
, x

2
) was aordable, which means (x
0
1
, x
0
2
) is preferred to
(x

1
, x

2
). WARP simply implies than this type of cyclical preferences are inconsistent (not valid)
and this situation cannot occur for a utility maximizing consumer. In contrast, the following gure
shows a situation, where, WARP is satised:














"##$ %
&
"
#
#
$

%
'
(%
&
)* %
'
)+
(%
&
,
* %
'
,
+
A
B
BL
1
BL
2
Why is WARP satised in the above gure? In case of BL
1
, the consumer is buying bundle
(x

1
, x

2
) when bundle (x
0
1
, x
0
2
) was aordable, which means (x

1
, x

2
) is preferred to (x
0
1
, x
0
2
) (same
as before). But, now, in case of BL
2
, the consumer is buying (x
0
1
, x
0
2
) when the bundle (x

1
, x

2
) is
not aordable. So, we can still conclude that, in case of BL
2
, the consumer is simply buying the
cheapest bundle and, so, it is not the case that (x
0
1
, x
0
2
) is preferred to (x

1
, x

2
).
21
11 Exercises:
1. Calculate MU
x
, MU
y
, and MRS for each of the following utility functions; also, check whether
there is diminishing marginal utility for each good:
(a) U(x, y) = x
1
3
y
2
3
(b) U(x, y) = x +Ax

+y
(c) U(x, y) =

x
2
y
2
(d) U(x, y) =
x

+
y

, where 1 > , , > 0

2. Vasco consumes two goods: (i) pizza, q
1
; and (ii) burrito, q
2
. His utility function is given by
U(q
1
, q
2
) = 10q
1
q
2
2
. The price of pizza is p
1
= $5, the price of burritos is p
2
= $10, and his
income is Y = $150. Mathematically solve for Vascos optimal consumption bundle and show it
in a graph.
3. Anns utility function is given by U(x, y) =
xy
x+y
. Solve for her optimal values of x and y as a
function of P
x
, P
y
, and M.
4. Diego consumes two goods: (i) chewing gums, G ; and (ii) butter, B. His utility function is
given by U(G, B) = G
3
4
B
1
4
. The price of gums is P
G
= $1, the price of butter is P
B
= $2 , and
his income is Y = $100. Mathematically solve for Diegos optimal demand for chewing gums
and butter.
5. Suppose in a three good world that quantities and prices of the goods are labeled x
i
= (x
i
1
, x
i
2
, x
i
3
)
and p
i
= (p
i
1
, p
i
2
, p
i
3
) respectively, where, i = 1, 2, 3. Using the following information, check
whether the consumers preferences satisfy assumptions of WARP and transitivity:
p
1
= (4, 3, 2) x
1
= (2, 2, 2)
p
2
= (5, 3, 3) x
2
= (1, 3, 3)
p
3
= (5, 2, 3) x
3
= (1, 3, 2)
22