LECTURE NOTES FOR INTERMEDIATE MICROECONOMICS

PROF. REGINA TREVINO

The Basis of Economics is Choice.

Lecture Two:
Consumer Choice, Derivation of Individual Demand and Market
Aggregation

2.1. CONSUMER CHOICE

In this part of the course, we will analyze the consumer choice problem. In the process,

we will derive a typical consumer’s demand curve, and ultimately, the industry demand

curve for a product.

The Consumer’s Problem:

To derive a consumer’s demand curve, we must first solve for the consumer’s optimal

consumption decision. This involves three steps. First, we must characterize the

consumer’s preferences over various bundles of goods. Second, we must determine

which bundles of goods are feasible. And finally, we must determine which of the

feasible bundles the consumer most prefers.

We must know three things to understand the consumer’s choice:

1. Preferences. What does the consumer prefer?

2. Constraints. What set of choices can the consumer choose from?

3. Optimality. How do preferences and constraints interact in the consumer’s choices?

2.1.1 Preferences and Tastes

Consumer preferences are defined axiomatically, this means, we set forth a few

meaningful and distinct assumptions to characterize the structure and properties of

preferences. The axioms of consumer choice are intended to give a formal mathematical

expression to fundamental aspects of consumer behavior. The rest of the theory then

builds logically from these axioms.

AXIOM 1. Completeness. When confronted with any two bundles, the consumer

can tell us which one is preferred, or whether she is indifferent between them.

AXIOM 2. Consistency (or stability). Preferences are stable. If x is preferred to y, it

remains so.

AXIOM 3. Transitivity. If bundle A = ( x1 , y1 ) is preferred to B = ( x 2 , y 2 ) , and B

is preferred to C=(x3, y3) then, the consumer also prefers A to C.

AXIOM 4. Monotonicity (or nonsatiation). More is better. More precisely, if

A = ( x1 , y1 ) is a bundle of goods and B = ( x 2 , y 2 ) is a bundle of goods with at

least as much of both goods and more of one, then B is preferred to A.

The essence of rational behavior is contained in two assumptions:

1. Each consumer has an ordered set of preferences

2. She chooses the most preferred position available to her.

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2.1.2 Deriving the Consumer’s Indifference Curves

An indifference curve represents all combinations of goods that provide identical level of

satisfaction to the consumer.

Let’s examine a representative consumer’s preferences over pizza and/or CDs over a

one-year period. Consider the graph in Figure 2.1. The indifference curve U1 is generated

by connecting up bundles of food and music among which the consumer is indifferent.

Music

Δy

Δx
U1

Pizza
FIGURE 2.1
A Consumer’s typical indifference curve between pizza and music

The slope of an indifference curve tells us about tradeoffs that leave consumers

neither worse nor better off. Note that the slope of U1 is negative, this is a consequence of

nonsatiation. To see this consider Figure 2.2. If we start at bundle (x1, y2) and move

anywhere up and to the right, we must be moving to a preferred position. If we move

down and to the left we must be moving to a worse position. So, if we are moving to an

indifferent position we must be moving either left and up or right and down.

We refer to the negative of the slope of an indifference curve at a particular point as

the marginal rate of substitution (MRS). The name comes from the fact that the MRS

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measures the rate at which the consumer is willing to substitute one good from another.

Mathematically it is given by,

∆y
MRS x , y = − .
∆x

y
Indifference curve

∆y
Slope = − = MRS
∆x

Δy Better bundles

Δx

(x1, y1)

Worse bundles

x
The marginal rate of substitution (MRS). The MRS measures the slope of FIGURE 2.2
the indifference curve at a particular point.

Note that the way we have drawn the indifference curve for this consumer, the

marginal rate of substitution declines as we move down the curve. This is referred to as a

diminishing rate of marginal substitution. Such an indifference curve is bowed inward;

i.e., it is convex to the origin.

2.1.3 Deriving an Indifference Map

We have drawn an indifference curve through some given point. But since we can do this

for all possible points (remember the assumption of completeness), we can create a

family of indifference curves. A collection of all such indifference curves represents an

indifference map.

Properties of Indifference Maps:

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• Indifference curves for “goods” have negative slope.

• An indifference curve passes through each and every point in the commodity space

(by completeness).

• The higher and further to the right the indifference curve lies, the higher the level

of satisfaction associated with bundles on the curve. That is, more preferred

bundles lie to the northeast of less preferred bundles.

• Indifference curves cannot intersect (by transitivity).

• Indifference curves are convex if there is diminishing marginal rate of substitution.

• Indifference curves need not be parallel, since lines have no width and can get

arbitrarily close to one another without intersecting.

• Since consumers have different tastes and preferences, the shape, slope, and

location of indifference curves will vary across consumers.

y
Indifference
curves

x
Indifference Curve Map. Indifference curves have negative slope and satisfaction FIGURE 2.3
increases the higher and further to the right that the curve is.

2.1.4 Goods that are “Bads”

Some goods are undesirable to have: pollution, hours of work, risk in a financial

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investment, etc. The analysis, nonetheless, is similar. We can talk about the

corresponding “goods” for each “bad” (i.e., analyze preferences over clean air, hours of

leisure, etc.) and proceed as before, or we can draw our indifference maps with positive

slopes. For example, consider the tradeoff between steel production and the pollution

such process generates.

Steel
Production

U3

U2
U1

Pollution

Goods that are “Bads”. The indifference curves in this case have a positive slope. FIGURE 2.4

2.1.5 The Consumer’s Utility Function

The theory outlined above only required the consumer to rank the various consumption

choices; it did not require that the consumer assign a measure of happiness or “utility” to

her consumption. Nonetheless, it seems plausible that we could characterize preferences

with a numerical representation of utility.

By this, we mean that there exists a utility function, U(x, y), which converts a

bundle of goods (x, y) into a numerical measure of utility, such that if a consumer prefers

bundle (x, y) to bundle (x’, y’), then

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U(x, y) > U(x’, y’),

and the reverse is also true.

The utility function serves to order potential consumption baskets in terms of their

desirability to the consumer. What is important about the utility function is the way it

orders the baskets of goods and not the specific number attached to particular baskets.

2.1.6 Constraints on Consumption

Consumers have finite resources and can’t purchase unlimited quantities of everything.

Given that tastes are insatiable, eventually, their budget constraints must bind.

Price-Taking Consumers

We assume that the consumer is a price taker. That is, the consumer recognizes that her

purchases are so small that they cannot affect the market’s equilibrium price. She takes

prices as given.

Now, suppose that the world consists of only two goods, good x1 and good x2 , and

the consumer must decide the amount of each good to consume. A consumption bundle,

( x1, x2 ) , indicates then, the consumer’s chosen amount of each good. Also, assume that

the consumer has certain amount of money, I , to spend in these goods and that the prices

of the goods are p1 and p2 respectively.

The market baskets that the consumer can afford (the budget set) are those inside and

along her budget constraint:

p1x1 + p2 x2 ≤ I

Here p1x1 is the consumer’s expenditure on good x1 and p2 x2 the expenditure on good

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x2 . The consumer’s budget constraint requires that the amount of money spent on the

two goods be no more than the total amount the consumer has to spend. The affordable

consumption bundles―those that do not cost more than I ―constitute the consumer’s

budget set.

Figure 2.5 depicts the budget constraint graphically. In this case, the intercepts with

the axes represent the maximum amount of each good that the consumer could have if

she devoted her entire income to that good only.

x2
Vertical
intercept:
I /p2

Budget line;
slope =−p1 /p2

Budget set

Horizontal intercept: I /p1

The Budget Set. The budget set consist of all bundles that are affordable at FIGURE 2.5
the given prices and income.

Note the following:

(i) The horizontal and vertical intercepts have economic content. At x1 = 0 for example,

the vertical intercept indicates the maximum number of units of good x2 that the

consumer could have if she spends all her income in good x2.

p1
(ii) The slope of the budget line is the (negative) of the ratio of prices (i.e., slope= − ).
p2

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Changes in Prices and Income

When income changes, but relative prices do not, a parallel shift in the budget constraint

occurs. If income decreases, the constraint shifts inward, and vice versa.

Units of good y

I/py

I’/py slope=−px/py

I’/px I/px
Units of good x
FIGURE 2.6
Decrease in Income. A decrease in income is a parallel shift of the budget line.

When the price of one of the good changes and other things stay the same, the budget

line rotates along the axis of the good whose price changes. If the price increases, the line

pivots inward, and vice versa.

Units of good y

I/py

slope=−px/py

slope=−px’/py

I/px’ I/px
Units of good x FIGURE 2.7

Increase in Price. If the price of good x increases the budget line rotates inwards.

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2.1.7 Consumer’s Optimal Decision

We now consider the consumer’s optimal choice. We have two equations which

determine the optimal choice for the case of an interior solution:

1. The tangency condition (for interior solutions):

px
MRS x, y =
py

2. All income is spent. This means that at the optimal consumption bundle (x*, y*)

the budget condition binds with equality, that is,

p x × x * + p y × y* = I

Graphically this means that in the two-good case the consumer will choose a point at

which the budget line is tangent to a curve in the indifference map. This is depicted in

Figure 2.8.

Units of good y

MRSx,y=px/py

y*

U(x,y)

x* Units of good x
FIGURE 2.8
Consumer’s Optimal Choice. The optimal basket (x*, y*) is determined by the tangency
condition: the indifference curve is tangent to the budget line.

2.2 CONSTRUCTING (INDIVIDUAL) DEMAND CURVES

We now examine how the household’s optimal decision changes in the face of changes in

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the economy. Specifically, we proceed in three steps: (1) compute the optimal bundle

before the change, (2) compute the new optimal bundle after the change, (3) compare.

This is called an exercise in comparative statics (i.e., comparing one static equilibrium to

another).

First, we consider what happens to the optimal choice for a particular good of the

household’s basket as we vary the price of that good, holding everything else constant.

Consider the example of a price change depicted in Figure 2.9. A decrease in the price of

good x leads to an outward rotation of the budget constraint along the x-axis.

Δy

Δx x

Price Changes. Example of a price change of good x and its effect on consumption FIGURE 2.9

Here, a decrease in the price of x leads to an increase in the consumption of both x

and y (this is not always the case and depends upon the nature of consumer preferences as

we will see later on). Graphically, we can derive the individual consumer’s demand curve

by tracing out the changes in consumption as price changes. Such a curve is called a

price-consumption curve (PCC) and is illustrated in Figure 2.10 Panel A.

The graph immediately below the PCC gives us the individual consumer’s demand

curve for x. Figure 2.10 Panel B depicts the individual consumer’s demand for good x.

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Price
Consumption
Curve

px x1 x2 x3 x

px1
px2

B px3

Demand curve

x 1 x2 x3 x

Price Consumption Curve and the Demand for Good x.

The individual demand curve of Figure 2.10 Panel B will be of the form

q x = d ( p x , p y , I ) , likewise we are able to construct the individual demand for good y:

q y = d ( p y , p x , I ) . The demand equations give the consumer’s optimal choices of x and y

as functions of the corresponding prices px and py and the income I. These demand

functions are in essence a summary of the behavioral content of the consumer’s

utility function.

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2.3 THE ENGEL CURVE

Remember that an increase in income leads to a parallel shift outward in the budget

constraint. If an increase in income increases the consumption of a good, that good is said

to be normal. If, on the other hand, higher income leads to less consumption of a good,

the good is considered to be an inferior good.

We can derive the income consumption curve (ICC) by graphing the relationship

between demand for good x and income (assuming that y is a normal good). The

relationship between demand and income is called an Engel curve. If the good is normal,

the ICC and the Engel curve will be upward sloping. If the good is inferior, the ICC and

Engel curve will have a negative slope.

NORMAL GOOD INFERIOR GOOD

y
y Income
Consumption
Curve
Income
Consumption
Curve

Income x
Income x
Engel curve

I3 I3
I2 I2
I1
I1

Engel curve

x
x

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A few additional remarks on consumer choice:

Rationality and Money Illusion: Note that rational decision-making depends on relative

prices and incomes, not absolute levels. When all prices and incomes increase or decrease

in the same proportion, our model predicts that there is no effect on the bundles chosen

by consumers. There is no money illusion.

Optimal choice with Composite Commodities: So far, we have analyzed two-good

decisions by consumers. Subject to some technical caveats, we can proceed in any

environment by considering the choice between one good and “all other goods”; the latter

is sometimes abbreviated AOG. For simplicity, we will always assume that pAOG = 1.

2.4 PRICE-CHANGE COMPENSATION

Now we want to analyze how a change in relative prices affects the consumer’s choices.

It is very important, however, to analyze a pure change in relative prices, that is, one that

does not also change real income (or purchasing power).

We will add to the analysis in the following way:

1. Assume that the consumer is initially consuming the optimal basket (x*, y*).

2. Change relative prices in a way that permits, yet does not require, the selection of

(x*, y*). That is, we change the relative prices in a way that keeps the consumer’s

purchasing power constant.

If the original optimal basket is to remain available, an increase in Px0 has to be

accompanied by a decrease in Py0 or by an increase in the money income. Graphically,

this means that the new and the old budget constraint intersect exactly at the original

optimal basket (x*, y*), which means that the consumer can still consume (x*, y*) if she

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wants to.

The following is a simple and widely used type of price-change compensation.

Suppose a consumer’s income (e.g., a worker’s wage) is adjusted for changes in prices in

the following way. We start with an initial prices Px0, and Py0, and income level I0, and

derive the optimal consumption levels x* and y*. Now, suppose prices change to Px1 and

Py1. The compensation consists of adjusting income towards a new level I1 such that the

old optimal bundle (x*, y*) is exactly affordable under the new prices. That is,

I 1 = Px1 x * + Py1 y *

Will this be a fair compensation?

It turns out that whenever the price change involves a change in relative prices, i.e.,

whenever Px1/ Py1 is different to Px0/ Py0, then such a price compensation will

overcompensate the consumer, since it allows her to reach a higher indifference curve

than before (as depicted in Figure 2.11 below). In summary, if the consumer’s

preferences are smooth and convex, the compensation will leave the consumer strictly

better off.

original consumption
basket

new (compensated)
budget constraint

x
FIGURE 2.11
A Compensated Price Change

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2.5 DERIVING MARKET DEMAND FROM CONSUMER DEMANDS

So far, we have derived individual household demand curves. We can obtain the market

demand curve by horizontally summing the demand curves across households as

illustrated in the figure below. Mathematically, if you are given several demand curves to

“add” up, you first solve for q, then add over q, and then simplify.

px Household 1 Household 2 px Market Demand

12 16 4 10 16 26
x1 x2 xM

2.6 CONSUMER SURPLUS

The consumer surplus tells us how much value a market creates for a consumer. It is the

analogue of profit for the firm. One simple way to measure the consumers’ surplus from

market purchases is by calculating the area under the demand curve and above the current

market price.

The intuition behind this can be best understood by thinking of the market demand

curve as being composed of many simple individual consumers’ unit-demand curves.

Each point on the curve represents a particular consumer’s reservation price, which is the

highest price that a given consumer will accept and still purchase the good. The fact that

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this reservation price is above the market price, p * , implies that the consumer gets some

surplus from the transaction. Adding up all of these rectangles, as illustrated in Figure

2.12, gives us the area that represents the aggregate gains from trade.

Consumer
Surplus

height

p*

Demand curve

Qd Q
base
Consumer Surplus. The consumer surplus is the area under the FIGURE 2.12
demand curve and above the market price.

If we have a linear demand curve of the form

p = a − bQ (2.1)

the consumers’ surplus is a triangular area. In particular, if the market price is p * , then
the distance (a − p*) gives the height of the triangle and the quantity demanded at the
current market price, Q * , gives the base. The consumer surplus is then calculated as
follows
1
CS = [Q * ×(a − p*)]
2
Figure 2.13 illustrates the consumers’ surplus with the linear demand of equation (2.1).

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a Supply curve

Consumer
Surplus
p*

Demand curve

Q* Q

Consumer Surplus with a Linear Demand Curve. If the demand curve is given by FIGURE 2.13
p = a – bQ, then the consumer surplus is calculated as CS = ½ [Q*×(a - p*)].

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