Lecture 12 slide 1

A primer on

Consumer Choice

Finding the optimal choice

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Constrained consumer choice

The consumer will want to choose the best bundle within her opportunity set

Nothing lying beyond the budget constraint is reachable

We can always find something better that what lies inside the budget constraint...

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Figure 4.08a Consumer Maximization

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Constrained consumer choice

We want to choose a bundle that lies at the tangency of the budget constraint and the indifference curve

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MRS and MRTMarginal Rate of Substitution between pizzas and burritos:

telling us how many burritos we are willing to give up for an extra bit of pizza

and the Marginal Rate of Transformation was the ratio of prices, the slope of the budget constraint ? pZ

pB

MRS = ABAZ

=? MUZ

MUB

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Interior solution

The MRS = MRT between pizzas and burritos if we have an interior solution

You will make yourself best-off when you choose your bundle by making equal your, subjective, relative valuation of the goods (MRS) and the, objective, relative valuation of the goods made in the market (MRT)

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Interior solution

To understand this remember that we have decreasing MRS

This means that the more pizzas we have relative to burritos, the less we value pizzas relative to burritos

By sliding along our indifference curves or along our budget constraint we would be changing our MRS

When are we going to stop?

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Interior solution

Remember the ratio of prices is given (regardless of how much you slide along your indifference curves/budget constraint)

Now imagine you are currently consuming a bundle that makes your MRS pizza-burrito very high

What does it mean?

Well it must mean that according to your own taste you have relative few pizzas if compared to burritos, that makes the MRS high: you would be willing to give away many burritos for a slice of pizza!

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Interior solution

So perhaps you are going to choose a bundle with more pizza and less burritos, right?

Because you seem to have now too little pizza and too many burritos to be happy, right?

Go to hidden slide Go to hidden slide

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Corner solution

But we can have a corner solution too

This happens when we try to follow our rule of sliding until MRS = MRT but we are stopped by one of the axes

This is because we cannot consume less than 0 pizza nor less than 0 burritos!!!

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Figure 4.08b Consumer Maximization

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An example

Steven is indifferent between buying books on-line or in a shop: they are the same price and quality

But then the government taxes books in the shop

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Solved Problem 4.3

Initially ANY point on I2 will be the best for him

After the tax, he will obviously choose to shop only on-line!…as suggested by the new budget constraint L*

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Figure 4.09a Optimal Bundles on Convex Sections of Indifference Curves

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Figure 4.09b Optimal Bundles on Convex Sections of Indifference Curves

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Next

Deriving Demand Curves

The price-consumption curve

The income-consumption curve

The Engel curve

The effects of a price change