Econ 301 - Week 2

Chapter 3: Consumer Choice Theory

-Economics is a theory of choice- how individuals make choices under different constraints.

-When we model consumer choice we look at preferences and constraints (usually budget
constraints)

I. Preferences
Preferences represent an individual’s relative valuation of different goods. Preferences may be
Weak: an individual prefers good x at least as much as good y (xy)

Strict: an individual strictly prefers good x to y (xy)

Indifferent: an individual prefers good x at least as much as y, and prefers good y at least as
much as x (xy and yx, or xy)

Preferences are assumed to be:

Complete: an individual can compare any two goods or basket of goods. For any two goods, x
and y, either xy or yx or both (xy)

Transitive: if xy, and yz, then xz

Example:

1. When Jim went to dinner last night he had a choice of chicken, beef or pasta, and he chose
chicken. At a picnic this afternoon there was beef, pasta, and fish, and Jim ate the fish. A week
ago Sally brought fish and beef for lunch, and Jim had some beef. Assuming Jim’s preferences
are complete and transitive, and constant across time, what can we say about

a. his preference relation between beef and chicken?

b. his preference relation for fish and chicken?

c. his total preference relation among all of the foods offered to him?

d. If you were going to prepare Jim tonight, what would you prepare?
Usually preferences are assumed to be nonsatiated, meaning more is better. The book gives an
example of when this may not be so: if you like hot dogs, eating two hot dogs is probably better
than eating fifty. However, if we assume free disposal, this is not as much of a problem. Also,
what’s more important for the theory is that some good exists that the consumer wants more
of, which seems like a reasonable assumption.

II. Utility and Indifference Curves

Utility Functions assign real numbers (utility) to different bundles, to represent preferences. If
an individual prefers x to y, then the utility function assigns a higher number to x than y.

Example:
1
1. Let Jane’s utility function be given by: u  2 x 2  y .

a. What’s Janes utility from the bundle (4,2)?

b. Does Jane prefer 8 of x and zero y, or 8 of y and zero x?

c. What is Jane’s marginal utility for good x?

Indifference Curves show all the market baskets that give the consumer the same level of
utility.

Example:
1 1
2. If a consumer’s utility is given by u  x 2 y 2 , find the expression for and graph her
indifference curve that passes through (4,4). What is the marginal rate of substitution at (4,4)?

3. If two goods are perfect substitutes, what does the graph of the indifference curves look like?
What if the two goods are perfect complements?
III. Budget Constraints
Budget Constraints are the ways that market prices and the consumer’s income limit choices.

Example:

1. Water costs $2/gallon, and bread costs $3/loaf. If Bill only consumes bread and water, and
he has an income of $50, graph his budget set.

IV. Choice
Individuals’ optimal choice maximizes utility with respect to their budget constraints.

Example:
1 1
1. If u  2 x y , income m=100, and the prices of x and y are $2 and $4 respectively, what is
2 2

the optimal choice?