Chapter 5: Choice (Excluding Subchapters 5.4 and 5.
5)
5.1 Optimal Choice
1. Concept of Optimal Choice:
o Optimal Bundle: The combination of goods providing the highest utility within the
consumer’s budget.
o Condition for Optimality:
The optimal bundle lies on the budget line.
The indifference curve at the optimal bundle is tangent to the budget line.
2. Mathematical Condition:
o Marginal Rate of Substitution (MRS) = Price Ratio:
MRS represents the consumer's willingness to trade one good for another.
3. Diagrams:
o Tangency Condition:
The point of tangency between the indifference curve and the budget line is the
optimal choice.
o Exceptions:
Kinked Preferences: Indifference curves may not have tangents (e.g., perfect
complements)
Boundary Optima: The consumer consumes zero of one good.
4. Convexity and Multiple Tangencies:
o If preferences are strictly convex, there is only one tangency point that is optimal.
5.2 Consumer Demand
1. Demand Functions:
o Express the quantities of goods demanded as functions of prices and income:
o Interpretation: Shows how optimal consumption changes with variations in prices and
income.
2. Income and Price Effects:
o Higher income shifts the budget line outward, potentially increasing demand.
o Changes in prices pivot the budget line, altering the consumer's choices.
5.3 Examples of Demand
1. Perfect Substitutes:
o Indifference curves are straight lines (constant MRS).
o Consumer spends all their income on the cheaper good:
If p1 < p2, consume only x 1.
If p1= p2 , any combination is optimal.
If p1 > p2, consume only x 2.
2. Perfect Complements:
o Indifference curves are L-shaped.
o Optimal choice lies on the diagonal:
o Example: Right and left shoes must be consumed in pairs.
3. Neutrals and Bads:
o Neutrals: Consumer’s utility is unaffected by one good.
o Bads: Consumer minimizes consumption of the bad.
4. Discrete Goods:
o Goods only available in integer units.
o Demand depends on reservation prices at which a consumer is indifferent between
purchasing or not.
5. Cobb-Douglas Preferences:
o Utility function:
o Demand functions:
5.6 The Slutsky Equation
1. Purpose:
o Analyses how a price change impacts consumption.
o Splits the effect into:
Substitution Effect: Change due to relative price adjustment.
Income Effect: Change due to altered purchasing power.
2. Equation:
Where:
o h1 : Hicksian (compensated) demand.
∂ x1
o : Income effect term.
∂m
3. Graphical Representation:
o Diagram shows:
Initial and final bundles.
Budget line shifts due to price change.
Decomposition of movement along the indifference curve (substitution effect)
and shift to new utility level (income effect).
4. Special Cases:
o Normal Goods: Income and substitution effects reinforce each other.
o Inferior Goods: Income and substitution effects work in opposite directions.
o Giffen Goods: Income effect dominates, leading to an upward-sloping demand curve.
Key Terms
Optimal Bundle: The most preferred affordable combination of goods.
Indifference Curve: Represents combinations of goods providing the same utility.
Budget Line: Depicts all possible combinations of goods a consumer can afford.
Marginal Rate of Substitution (MRS): The rate at which a consumer substitutes one good for
another.
Convex Preferences: Consumers prefer averages over extremes, leading to smooth, bowed-out
indifference curves.