Microeconomics: Lecture 5

Utility Maximization and Individual Demand- Part III

Consumer Theory: Roadmap

Building blocks Preferences and Axioms of Rationality (Part I) Part II Representation of Rational Preferences: Utility Affordable Bundles: Budget Set Today: Part III A model of Consumer Choice: Utility Maximization: Derivation of Individual Demand Last Part Derivation of Market Demand Two Levels of Rationality: In Preferences and in Choices

A model of consumer theory

The model of consumer theory we

study is called utility

maximization

Consumers choose bundles with

the highest utility they can afford

Utility maximization model (1)

Agents: 1 consumer Resources: $ Preferences:

Complete Transitive Satisfies strict monotonicity & is continuous
Can be represented by a utility function

Utility maximization model (2)

Objective: allocate $ Income (I) in 2 goods Behavioral Assumption: consumer is rational and wants to choose the bundle of goods that (1) Is affordable (2) Maximizes her utility Markets: There is a GIVEN market price for each good Remember assumption: individual purchase does not affect the price in the market

Utility maximization: graphical analysis in two goods

Quantity of y
A C B
U3
U2 U1

Quantity of x

Utility maximization: graphical analysis in two goods Utility is maximized where the indifference
curve is tangent to the budget constraint
Quantity of y

U2

Quantity of x

Utility maximization: analytically

The individuals objective is to maximize

utility = U(x,y)

subject to the budget constraint

I = pxx + pyy

MRS and Utility and Marginal Utility

Suppose that an individual has a utility

function of the form U(x,y)

The total differential of U is

Along any indifference curve, utility is

constant (dU = 0)

MRS using marginal utility

MRS is the ratio of the marginal utility

of x to the marginal utility of y

utility maximization: analytically 2-goods

For two goods, This implies that at the optimal allocation of
income

Example : Cobb-Douglas utility function

Cobb-Douglas utility function:
U(x,y) = xy

1. MRS=price ratio: 2.
U / x U / y

Budget Expended:

I = p xx + p y y

Example : Cobb-Douglas utility function

Solving for x yields

Solving for y yields The individual will allocate percent of his
income to good x and percent of his income to good y

Marshallian Demands

It is often possible to manipulate firstorder conditions to solve for optimal values of x,y These optimal values will depend on the prices of all goods and income x* = x(px,py,I) y* = y(px,py,I)

Summary

To reach a constrained maximum, an individual should:

spend all available income choose a commodity bundle such that the MRS
between any two goods is equal to the ratio of the goods prices

the individual will equate the ratios of the marginal utility to price for every good that is actually consumed

Effects of Changes in Income &Prices

Study how utility maximizing choice of a good varies as:

Income Changes: Obtain Engel Curves Price of good itself changes: obtain individual demand
curve.

Prices of Other Goods Change

Introduce Income Consumption Curve (ICC)

Introduce Price Consumption Curve (PCC)

Engel curve

Effects of Changes in Income &Prices

how does demand for a good change -if income and prices are doubled? -if income increases, all else equal?

(normal vs inferior goods)

-the price of the good changes?

-the price of another good changes?

(complements vs substitutes)

Effects of Changes in Income &Prices

As incomes and prices change, they

affect consumer choices, because they affect the budget lines

We can show the effects of these

changes on budget lines and consumer choices

Suppose the Prices and Incomes Double

Px=$4, Py=$10, I=$20

Versus

Px=$8, Py=$20, I=$40 (because of

inflation say, nominal prices are rising)

Both Income &All Prices Change by Same Factor

Budget line remains the same! Conclusion: NO CHANGE IN CHOICES
Quantity of y

I PX Y X PY PY

px py

Quantity of x

I. Income Changes

Budget line moves in a parallel way. Choices Change Accordingly Picture Follows

Effects of Income Changes

Clothing (units per month)
Assume: Pf = $1, Pc = $2 I = $10, $20, $30

7 5 3
A B
U1 U2

U3

An increase in income, with the prices fixed, causes consumers to alter their choice of market basket.

10

16

Food (units per month)

Income Consumption Curve (ICC)

Clothing (units per month)
The Income Consumption Curve traces out the utility maximizing market basket for each income level
Income Consumption Curve

7 5 3
A B
U1 U2

U3

10

16

Food (units per month)

Normal Goods
When the income-consumption curve has a positive slope: The quantity demanded increases with
income

The income elasticity of demand is positive The good is a normal good

Inferior Goods
When the income-consumption curve has
a negative slope:

The quantity demanded decreases with

income

The income elasticity of demand is negative The good is an inferior good

An Inferior Good
Steak (units per month) 10
U3 but hamburger becomes an inferior good when the income consumption curve bends backward between B and C. Income-Consumption Curve C Both hamburger and steak behave as a normal good, between A and B...

5
A

U2
U1

10

20

30

Hamburger (units per month)

Engel Curves

Engel curves relate the quantity of good consumed to income If the good is a normal good, the Engel curve is upward sloping If the good is an inferior good, the Engel curve is downward sloping

Engel Curves
Income 30 ($ per month) 20

10

12

16

Food (units per month)

Engel Curves
Income 30 ($ per month) 20

10

12

16

Food (units per month)

II. Price Change

Slope of the budget line changes Consumer Choices Change Picture Follows

Effect of a Price Change

Clothing

10

Assume: I = $20 PC = $2 PF = $2, $1, $0.50

A
U1

6
5 4

D B

Each price leads to different amounts of food purchased

U3

U2
Food (units per month)

12

20

Price Consumption Curve (PCC)

Clothing

10

6
5 4

A
U1

The PriceConsumption Curve traces out the utility maximizing market basket for each price of food
D B

U3

U2
Food (units per month)

12

20

Individual Demand Curve

Price of Food

Food (units per month)

Effect of a Price Change

Price of Food
$2.00 E

G $1.00

$.50

Demand Curve
Food (units per month)

12

20

Individual Demand Curve

Recall that:
Demand Curve graphs:
where py,I are FIXED

x* = x(px,py,I)

x* = x(px,py,I) the relationship of x* and px

Graphical deriving demand curve!

Individual Demand Curve

Quantity of y

As the price of x falls...

px

px px px

quantity of x demanded rises.

U1

U2

U3

x1 I = px + py

x2

x3

Quantity of x
I = px + py

Quantity of x

I = px + py

Price Changes More Closely

A change in the price of a good has

two effects:

Substitution Effect Income Effect

Substitution Effect

Substitution Effect
The substitution effect is the change in an
items consumption associated with a change in the price of the item, with the level of utility held constant

When the price of an item declines, the

substitution effect always leads to an increase in the quantity demanded of the good

Income Effect

Income Effect
The income effect is the change in an
items consumption brought about by the increase in purchasing power, with the price of the item held constant

When a persons income increases, the

quantity demanded for the product may increase or decrease

Income Effect

Income Effect
Even with inferior goods, the income
effect is rarely large enough to outweigh the substitution effect

Income and Substitution Effects: Normal Good

Clothing (units per month) R
When the price of food falls, consumption increases by F1F2 as the consumer moves from A to B.

C1

C2

U2 U1
O F1 S F2 T
Food (units per month)

Income and Substitution Effects: Inferior Good

Clothing (units per month) R
Since food is an inferior good, the income effect is negative. However, the substitution effect is larger than the income effect.

A B

U2

Substitution Effect

U1
E S F2 T
Food (units per month)
Income Effect

F1
Total Effect

Giffen Good: upward sloping demand!!!

The income effect may theoretically be
large enough to cause the demand curve for a good to slope upward

This rarely occurs and is of little practical

interest

Cross Price Effects

So far model showed us that

When the price of good x changes, this

typically affects both x*,y*

The effect of a change in price of x on y*, is

called cross-price effect.

The SIGN of cross-price effect depends on

whether x and y are substitutes or complements.

Substitutes

Two goods are considered substitutes

if an increase (decrease) in the price of one leads to an increase (decrease) in the quantity demanded of the other

Example: movie tickets and video rentals Example: DVD rental versus DVD sale

Complements

Two goods are considered

complements if an increase (decrease) in the price of one leads to a decrease (increase) in the quantity demanded of the other

Ex: gasoline and cars Ex: cake frosting and cake mix

Much of empirical work in microeconomics IO

Estimate models of demand by gathering data where (p, q, characteristics) is observed
Finding out what (estimated) OWN and CROSS price elasticities are

Important for firms producing multiple products when setting optimal prices

Summary

Utility maximization implies that (for

normal goods) a fall in price leads to an increase in quantity demanded

But this is not always true: Giffen Goods Normal versus inferior goods Engel Curves

Required Reading
The required for Lecture 5 is: Pindyck and Rubinfeld,
Microeconomics, 7th edition, Chapter 3, pp. 86-92, pp. 95-100)

Pindyck and Rubinfeld, 7th edition,

Chapter 4, pp. 111-125.

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