Lecture 6
CONSUMER CHOICE

Key concepts

• Preferences
• Utility
• Indifference curves
• Budget constraint
• Marginal utility
• Marginal rate of substitution
• Optimal bundle

1. Consumer's preferences

• The liking for different goods

Utility

• Measure of satisfaction from consuming bundles of goods
• Subjective notion

Measures of utility

• Ordinal utility: Ranking of bundles by preference
• Cardinal utility: Magnitude assigned to each bundle

Properties of the utility function

• Utility increases with amount consumed:
  "More is better"

Marginal utility of a good

• Increase in utility due to additional unit of consumption of a good
• Law of diminishing marginal utility

Indifference curves

• Graphical representation of consumer's preferences
• Negative slope (why?)
• A "higher" indifference curve represents a higher level of utility (why?)
• Marginal rate of substitution (MRS):
  
  How much is the consumer willing to give up of Good 2 to gain an additional unit of Good 1 (and maintain the same level of utility)?
• Link between MRS and slope of an indifference curve?

2. Budget constraint

• Feasible set of choices determined by prices and income
• Equation of the budget constraint is obtained from the condition:
  
  Expenditure = Income
• Link between slope of budget constraint and ratio of prices?

Shift or rotation of the budget constraint

• Increase in the price of a good causes the budget constraint to rotate inwards (why?)
• Increase in income causes the budget constraint to shift outwards (why?)

3. Optimal bundle

• What is the consumer's objective?
  
  To maximize utility

Tangency condition

• Consumer's utility is maximized at the point where the indifference curve is tangential to the budget constraint
• At optimal point: MRS = Ratio of prices (why?)

Optimal rule

• Marginal utility per dollar is the same for all goods: MU₁/P₁ = MU₂/P₂