Consumer Choice

Cardinal Utility Analysis

Ordinal Utility Analysis
Utility Function: assigning a level of utility to each market basket; C=
u (F + C); 8 units of F and 2 units of C 8 + 2(3) =14,; 6 + 4(2) = 14
Consumer Preferencesfinding the practical way of knowing the
reasons people might prefer one good to another
Budget Constraintslimited incomes restricted the quantities
purchased
Consumer Choicescombination of goods chosen by consumers at
given prices
Market Basketslist with specific quantities of one or more goods, also
called bundle. Consumers will select a market basket that will make
him well off as much as possible
Completenessconsumer will prefer A to B or B to A, he is indifferent
between the two
Transitivityconsumer will prefer A to B and B to C, and hence A to C
More is Betterconsumer will prefer more of any good to less (bads
are ignored here)
Indifference Curverepresents all combinations of market baskets that
provide a consumer with the same level of satisfaction
Properties of IC
Indifference Map
Marginal Rate of Substitutionthe MRS of F for C is the maximum
amount of clothing that a person is willing to give up to obtain an
additional unit of food. For e.g., if MRS is 3, a consumer is willing to
forego 3 units of C for 1 additional unit of F (Fig. 3.5)
MRS-- -C/F. We add the minus sign to make MRS a positive
number(C is always negative; the consumer gives up clothing to
obtain additional food)
Convexityan IC is convex if the MRS diminishes along the curve. The
MRS of food for clothing is -C/F = - (-6)/1. As food consumption
increases, the slope of IC falls in magnitude. Thus the MRS also falls
Perfect SubstitutesMRS of apple juice for orange juice is 1. Raman is
willing to trade 1 glass of one for 1 glass of the other. The slope of IC
need not be -1 in the case of perfect substitutes (e.g. memory chip in
pg. 70, MRS = -2)
Perfect ComplimentsMRS of left shoes for right shoes is zero when
there are more right shoes than left shoes; Sita will not give up any left

shoes to get additional right shoes. MRS is infinite when there are more
left shoes than right shoes because Sita will give up all except one of
her excess left shoes to obtain an additional right shoe ( right angles
ICs)
Budget Lineall combinations of goods for which the total amount
spent is equal to income; PfF + PcC = 1 (price of food times quantity +
price of cloth times quantity) See table 3.2 and Fig 3.10. The vertical
intercept (1/Pc) represents the maximum amount of C that can be
purchased with income I; the horizontal intercept (1/Pf) gives us the
maximum of food. The slope of the line measured between B and D is
Pf/Pc = - 10/20 = -1/2. The slope of the line C/F = -1/2, measures the
relative cost of food and clothing
Effects of Changes in Incomea change in income changes the vertical
intercept of the budget line but does not change the slope. Fig. 3.11
shows if income increases doubled, the Budget Line shifts to the right
and vice versa
Effects of Changes in Pricea change in the price of one good causes
the BL to rotate about one intercept. When the price of food falls, the
BL rotates outward from L1 to L2 and vice versa (Fig. 3.12)
Maximizing market must satisfy 2 conditions: must be located on the
budget line, and must give the consumer the most preferred basket.
Marginal benefit = Marginal Cost. In Fig. 3.13, at point At A, MRS
between the two goods equals the price ratio. At B, MRS = -10/10 = 1
is greater than the price ratio (1/2), satisfaction is not maximized
Corner Solutionsa consumer is purchasing only one commodity. The
MRS is not equal to price ratio for all levels of consumption. Fig. 3.15.
A small decrease in price of yogurt will not alter the consumers choice, but if
the price of yogurt falls big enough, the consumer could shift from ice cream
to yogurt

Revealed Preferenceit helps us to understand the implications of

choices that consumers must make in particular situations
Marginal Utility and Consumer Choice
Cost- - of Living Indexes:
Ideal Cost of Living Index: Cost of attaining a given level of
utility of current prices relative to the cost of attaining the same
utility of basic year price.
Laspeyres Index: Amount of money at current year price that an
individual requires to purchase a bundle of goods and services
chosen in a base year divides by the cost of purchasing the same
basket at base year prices.

 Comparing 1 and 2: The LI is far better than the IC. It over

compensates Rachel for the higher cost of living by overstating
the true cost of living.
Paasche Index: Amount of money of current year prices that an
individual requires to purchase a current basket of goods and
services divided by the cost of purchasing the same basket in a
base year.
Chain Weighted Index: Obtaining an estimate of real GDP after
adjusting inflation. It was introduced to overcome problems that
arose when long term comparisons of real GDP were made using
fixed weigh price index (Paasche & Laspeyeres) though prices
were rapidly changing.