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Intermediate Microeconomics
Nguyen Thi Hao
[email protected]
0949230527

Textbook,
chapter 5, 6, 10
Topic 2: Optimal choice
2.1. Choice
- Optimal choice (5.1)
- Consumer demand (5.2, 5.3)
- Implication of MRS condition (5.5)
2.2. Demand
- Income offer curve and Engel curve (6.2, 6.3, 6.4)
- Price offer curve and demand curve (6.5, 6.6)
2.3. Intertemporal choice
- Budget constraint (10.1)
- Preferences for consumption (10.2, 10.3)
- Present value (10.6, 10.7)
*) Discussion

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2.1.1. Optimal choice

• Budget determines what I can buy.
• Utility function (preferences) determine how I value those affordable
alternatives.
• Which bundle do I buy?

2.1.1. Optimal choice

Typical case
• The bundle with the highest utility
among the affordable.
• We call this bundle the Rational
Constrained Choice.

• When x1* > 0 and x2* > 0, the

demanded bundle is interior.
• If buying (x1*,x2*) costs $m then the
budget is exhausted.

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(x1*,x2*) – optimal choice if satisfies x2

two conditions:

• the budget is exhausted:

p1x1* + p2x2* = m
(x1*,x2*)
x2 *
• the slope of the budget constraint,
and the slope of the IC containing
(x1*,x2*) are equal: MRS = -p1/p2
x1
x1 *

what would happen if the MRS were different from the price ratio?
(economic meaning of the condition MRS = slop of budget line at an
interior optimum)

• Suppose, for example, that the MRS is Δx2/Δx1 = −1/2 and the price ratio is 1/1.
• Then this means the consumer is just willing to give up 2 units of good 1 in order to
get 1 unit of good 2—but the market is willing to exchange them on a one-to-one
basis.
• Thus the consumer would certainly be willing to give up some of good 1 in order to
purchase a little more of good 2.
• Whenever the MRS is different from the price ratio, the consumer cannot be at his or
her optimal choice.

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Some exceptions “not crossing” still imply tangent?

1. The indifference curve might not

have a tangent line:
• Indifference curve has a kink at the
optimal choice
• a tangent just isn’t defined
(mathematical definition of a tangent
requires that there be a unique
tangent line at each point)
• This case doesn’t have much
economic significance—it is more of a
nuisance than anything else.
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Some exceptions “not crossing” still imply tangent?

2. Boundary optimum: The optimal

point occurs where the consumption of
some good is zero
the slope of the indifference curve and
the slope of the budget line are
different, but the indifference curve still
doesn’t cross the budget line.

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Some exceptions “not crossing” still imply tangent?

3. More than 1 tangency:
• Three bundles where the tangency
condition is satisfied, all of them
interior, but only two of them are
optimal
• The tangency condition: necessary
condition for optimality, not a
sufficient condition
• But for convex preference: it is
sufficient: “any point that satisfies the
tangency condition must be an
optimal point”
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2.1.2. Consumer demand

• The optimal choice of goods 1 and 2 (x1*,x2*) at some set of prices and income
is called the consumer’s demanded bundle
 when prices and income change, the consumer’s optimal choice will change

• The demand function is the function that relates the optimal choice—the
quantities demanded—to the different values of prices and incomes.

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2.1.2. Consumer demand

Demand functions depending on both prices and income:

x1(p1, p2, m) and x2(p1, p2, m)

• Each different set of prices and income  a different combination of goods

that is the optimal choice of the consumer.
• Different preferences will lead to different demand functions;

 study the behavior of these demand functions—how the optimal

choices change as prices and income change

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Perfect substitutes
m/p1 when p1<p2
x1 = any number between 0 and m/p1 when p1=p2
0 when p1>p2

Optimal choice with perfect substitutes. If the

goods are perfect substitutes, the optimal
choice will usually be on the boundary.

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• Ex: Suppose that indifference curves are described by straight lines

with a slope of −b. Given arbitrary prices and money income p1, p2,
and m, what will the consumer's optimal choices look like?

The optimal choices will be:

• x1 = m/p1 and x2 = 0 if p1/p2 < b,
• x1 = 0 and x2 = m/p2 if p1/p2 > b,
• and any amount on the budget line if p1/p2 = b.

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Perfect complement
• the optimal choice must always lie on the
diagonal, where the consumer is
purchasing equal amounts of both goods,
no matter what the prices are
• p1, p2 price of x1, x2
• x – amount of good 1, good 2
• Budget constraint: p1x + p2x = m
x1=x2=x=
( )
two goods are always consumed together,
it is just as if the consumer were spending
all money on a single good that had a price
of p1 +p2

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Ex: Suppose that a consumer always consumes 2 spoons of sugar

with each cup of coffee. If the price of sugar is p1 per spoonful and
the price of coffee is p2 per cup and the consumer has m dollars to
spend on coffee and sugar, how much will he or she want to
purchase?

• Let z be the number of cups of coffee the consumer buys. Then we

know that 2z is the number of teaspoons of sugar he or she buys.
We must satisfy the budget constraint: 2p1z + p2z = m.
• Solving for z we have z = m/(2p1 + p2)

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• Ann insist on consuming 2 cookies with every cup of coffee. If the

price of cookies is $3 and the price of coffee is $5. If her income is m,
what is her demand for coffee?
• X1, x2: Cookies and coffee  x1 = 2x2
• BL: 3x1+ 5x2=m  6x2+ 5x2=m  x2 = m/11

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Neutrals and bads

• In the case of a neutral good the consumer spends all of her money on
the good she likes and doesn’t purchase any of the neutral good.
• The same thing happens if one commodity is a bad. Thus, if commodity 1
is a good and commodity 2 is a bad, then the demand functions will be:
x1 = m/p1
x2 = 0

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Discrete goods
• Good 1: Discrete goods (integer unit),
• Good 2: money to be spent on everything else
• If consumer chooses 1,2,3 … unit of good 1
• Consumption bundle: (1, m - p1), (2, m - 2p1), (3, m - 3p1), ...
• Compare the utility of each of these bundles to see which has the highest utility.

• If the p1 is very high, then the

consumer will choose zero units
of consumption;
• p1 decreases the consumer will
find it optimal to consume 1 unit
of the good.
• p1 decreases further the
consumer will choose to consume
more units of good 1.
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Concave
convex preference Concave preference
Combination Specialization

Lobster Cheese
(0,2)
(0,10)

(5,5) (1,1)

(10,0) Steak (2,0) Ice cream

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Concave

• The optimal choice for these

preferences is always going to
be a boundary choice, like
bundle Z.
• Concave preference: don’t like
to consume them together,
spend all of money on one or
the other.

Which point is optimal choice: X or Z ?

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Cobb-Douglas preferences
• Cobb-Douglas Utility function: u(x1, x2) =𝑥 𝑥 .
• Appendix (page 93-94), proved to derive the optimal

𝒄 𝒎
𝒙𝟏 =
𝒄 + 𝒅 𝒑𝟏
𝒅 𝒎
𝒙𝟐 =
𝒄 + 𝒅 𝒑𝟐

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Cobb-Douglas preferences
Fraction spent on x1 x2

• p1,p2 price of x1, x2  expenditure x1: p1x1

𝒄
• Fraction spent on x1 in total income = = =
( ) 𝒄 𝒅
𝒅
• Fraction spent on x2 in total income =
𝒄 𝒅

• Cobb-Douglas consumer always spends a fixed fraction on their income on each

good. The size of fraction is determined by the exponent in the C-D function
• If u(x1,x2) = 𝑥 𝑥  interpret a fraction of income spent on good 1
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• Ex1: Suppose that you have highly nonconvex preferences for ice cream
and olives, like those given in the text, and that you face prices p1, p2
and have m dollars to spend. List the choices for the optimal
consumption bundles.

• Ex2. If a consumer has a utility function u(x1, x2) = 𝑥 𝑥 , what fraction

of her income will she spend on good 1 and good 2?

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Summary
1. The optimal choice of the consumer is that bundle in the consumer’s budget
set that lies on the highest indifference curve.
2. Typically the optimal bundle will be characterized by the condition that the
slope of the indifference curve (the MRS) will equal the slope of the budget
line.
3. If we observe several consumption choices it may be possible to estimate a
utility function that would generate that sort of choice behavior. Such a utility
function can be used to predict future choices and to estimate the utility to
consumers of new economic policies.
4. If everyone faces the same prices for the two goods, then everyone will have
the same marginal rate of substitution, and will thus be willing to trade off the
two goods in the same way.

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Review questions
1. If two goods are perfect substitutes, what is the demand function for good 2?
2. Suppose that indifference curves are described by straight lines with a slope of
-b. Given arbitrary prices and money income p1, p2, and m, what will the
consumer’s optimal choices look like?
3. Suppose that a consumer always consumes 2 spoons of sugar with each cup of
coffee. If the price of sugar is p1 per spoonful and the price of coffee is p2 per
cup and the consumer has m dollars to spend on coffee and sugar, how much
will he or she want to purchase?
4. Suppose that you have highly nonconvex preferences for ice cream and olives,
like those given in the text, and that you face prices p1, p2 and have m dollars
to spend. List the choices for the optimal consumption bundles.
5. If a consumer has a utility function u(x1, x2) = x1x4 2, what fraction of her
income will she spend on good 2?
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2.1.3. Implication of the MRS condition

• Read page 85-86

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2.2. Demand
Remind last lectures
- Optimal choice: We present the basic model of consumer choice: How maximizing
utility subject to a budget constraint to get optimal choice
- Demand function: give optimal amount of each good as the function of price, income
x1=x1(p1,p2,m), x2 = x2(p1,p2,m)

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2.2. Demand
- Income offer curve and Engel curve (6.2, 6.3, 6.4)
- Price offer curve and demand curve (6.5, 6.6)

2.3. Intertemporal choice

- Budget constraint (10.1)
- Preferences for consumption (10.2, 10.3)
- Present value (10.6, 10.7)

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2.2.1. Income offer curve and Engel curve

• Changes in Income: A rise in income shifts the budget line out.

• Normal good: increase in income increases demand:  >0

• Inferior good: increase in income decreases demand:  <0
• Nearly any kind low quality good like gruel, bologna, shacks.

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2.2.1. Income offer curve and Engel curve

Normal goods An inferior good (Good 1):

Income increases  Demand for both normal income increases  demand for inferior
goods increases good decreases 30

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2.2.1. Income offer curve and Engel curve

• As income changes, the optimal choice moves along the income offer curve or
income expansion path. (function: 𝑥 (𝑥 )
• The relationship between the optimal choice and income, with prices fixed, is
called the Engel curve. (function: m(𝑥 ))

prices fixed

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Income offer curve and Engel curve: Perfect substitutes

• Suppose that p1 < p2: Consumer is specializing in consuming good 1  horizontal
income offer curve.
• Demand for good 1 is 𝑥 = m/ 𝑝
• Engel curve is a straight line: m = 𝑝 𝑥 , slope p1

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Income offer curve and Engel curve: Perfect complements

• Demand for good 1 is 𝑥 = m/(𝑝 + 𝑝 ).
• Engel curve is a straight line: m = (𝑝 + 𝑝 ) 𝑥 ; slope = 𝑝 + 𝑝

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Income offer curve and Engel curve: Cobb-Douglas preferences

Cobb Douglas: 𝑢 𝑥 , 𝑥 =𝑥 𝑥
• Demand x1 =
If p1: fixed  a linear function of m
Eg: Double m  demand double
( )
• Demand x2 =  linear

( )
 The income offer curve is a straight line: x2= 𝑥
 Engel curve is a straight line: m = ; slop =
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Income offer curve and Engel curve: Homothetic preferences

• Income rises, the impact on demand can be less or more rapid than income increases.
• Luxury Good: Increase in demand by greater proportion than income rise
• Necessary good: increase demand by lesser proportion than income

• Suppose that the consumer’s preferences only depend on the ratio of good 1 to good 2
• If the consumer prefers (x1, x2) to (y1, y2),  automatically prefers (2x1, 2x2) to (2y1, 2y2), (3x1, 3x2)
to (3y1, 3y2),…, since the ratio of good 1 to good 2 is the same for all of these bundles.
•  the consumer prefers (tx1, tx2) to (ty1, ty2) for any positive value of t. Preferences that have this
property are known as homothetic preferences.
• If the consumer has homothetic preferences, the income offer curves and Engel curves are straight
lines. Thus perfect substitutes, perfect complements and Cobb-Douglas are homothetic preferences.

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Income offer curve and Engel curve: Homothetic preferences

• Consumer has homothetic

preferences:
 income offer curves are all straight
lines through the origin
 income is scaled up or down by any
amount t > 0, the demanded bundle
scales up or down by the same
amount.
 Engel curve straight line as well
(double income, double demand eg.)

Engel curves are straight lines if the consumer’s preferences are homothetic.
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A non-homothetic example: Quasi-linear preferences

• Function: u(𝑥 , 𝑥 ) = v(𝑥 )+ 𝑥
• The indifference curves shift in a parallel way. It is tangent to the budget line at a bundle
(𝑥 ∗ , 𝑥 ∗ ), then another indifference curve must be tangent at (𝑥 ∗ , 𝑥 ∗ +k) for any constant k.
• Increasing income increase doesn’t change the demand for good 1.
• Extra income  consume good2  Engel curve for good 1: Vertical line

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2.2.2. The price offer curve and Demand curve: price changes
Ordinary goods and Giffen goods
• Changes in price lead to a tilts or pivots of the budget line.

• Ordinary good: decrease in price increases demand: <0


• Giffen good: decrease in price decreases demand: >0


Eg: Suppose you consume a little of meat

and a lot of potatoes. A reduction of price of
potatoes gives you extra money for meat.
Then you might need less potatoes.

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Ordinary goods and Giffen goods

Ordinary: Quantity demanded of good 1 should Giffen: decrease in the price of good
increase when its price decreases. 1 leads to a reduction in the
• How does budget line, vertical and Horizontal demand for good 1
intercept move?

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2.2.2. The price offer curve and Demand curve: price changes
• As price changes the optimal choice moves along the price offer curve.
• The relationship between the optimal choice and a price, with income and the other
price fixed, is called the demand curve
𝒑𝟏 - change; m, 𝒑𝟐 fixed

• Price offer curve: Connecting • Demand curve: optimal level of x1 by p1

optimal point (graph: x1 and x2) changes (graph: x1 and p1) 40

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Example of Perfect substitutes

To find out demand curve:

x1=0 • Fix p
• Graph demand x vs p
p2<p1

p1=p2

x1=
p2>p1

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Example of Perfect compliment

• Consumed in fixed proportions  price offer curve is a straight line
• If consumed in 1:1 proportion, the demand for good 1 is given by 𝑥 =

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Example of Discrete Goods

• Reservation price 𝑟 : price where consumer is just indifferent between consuming
and not consuming unit n of good.

• For the price 𝑟 the utility from

0 and 1 units is the same:
u(0; m) = u(1; m - 𝑟 )
• For the price 𝑟 :
u(1; m - 𝑟 ) = u(2; m - 2 𝑟 )

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Example of quasilinear preferences

Special case: quasilinear preferences u(𝒙𝟏 ; 𝒙𝟐 ) = v(𝒙𝟏 ) + 𝒙𝟐 (1)
• At r : 𝑥 =1, 𝑥 = m- r , replace to function (1):
u(0; m) = u(1; m - r )  v(0) + m = v(1) + m - r
 r = v(1) (because v(0)=0)
• At r : 𝑥 = 2, 𝑥 = m-2r , replace to function (1):
u(1; m - r ) = u(2; m - 2r ) v(1) + m - r = v(2) + m - 2r
 r = v(2) - v(1) (cancel m both sides)
 r = v(3) – v(2) and so on
• Reservation prices measure marginal utilities associated with different levels of
consumption of good1.

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Review question
1. If the consumer is consuming exactly two goods, and she is always spending
all of her money, can both of them be inferior goods?
2. Show that perfect substitutes are an example of homothetic preferences.
3. Show that Cobb-Douglas preferences are homothetic preferences.
4. The income offer curve is to the Engel curve as the price offer curve is to . . .?
5. If the preferences are concave will the consumer ever consume both of the
goods together?
6. Are hamburgers and buns complements or substitutes?
7. What is the form of the inverse demand function for good 1 in the case of
perfect complements?
8. True or false? If the demand func on is x1 = −p1, then the inverse demand
func on is x = −1/p1. 45

2.3. Intertemporal choice

• Exam of consumer behavior by considering the choices involved in
saving and consuming over time.

• Choices of consumption over time are known as intertemporal choices.

- Budget constraint (10.1)
- Preferences for consumption (10.2, 10.3)
- Present value (10.6, 10.7)

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2.3.1. Budget constraint

• Intertemporal choice: Making consumption choices over time
• Assume 2 time periods:
𝑐 𝑐 Amount of consumption in each period Price
𝑚 𝑚 income in period 1 and period 2
𝑝 𝑝 price of consumptions, assume = k =1
r the rate of interest for borrowing a or lending

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2.3.1. Budget constraint

First case: Saving (consume less than income)
• Period 1: Budget constraint when a consumer saves
Savings = 𝑚 - 𝑐  interest earned = r(𝑚 - 𝑐 )
• In period 2: If 𝑐 = 𝑚 (income period 2 + saving period 1 + interest on saving)
𝑐 = 𝑚 + (𝑚 - 𝑐 ) + r(𝑚 - 𝑐 )
𝑐 = 𝑚 + (1+r)(𝑚 - 𝑐 ) (1)

Second case: borrowing (consume more than income)

• Period 1: Budget constraint when a consumer borrows
Borrowing = 𝑐 - 𝑚  interest paid = r(𝑐 - 𝑚 )
• In period 2: expenditure on consumption:
𝑐 = 𝑚 - (𝑐 - 𝑚 ) - r(𝑐 - 𝑚 ) = 𝑚 - (1+r)(𝑐 - 𝑚 )
𝑐 = 𝑚 + (1+r)(𝑚 - 𝑐 ) (2) 48

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2.3.1. Budget constraint

First case: Saving (consume less than income)
𝑐 = 𝑚 + (1+r)(𝑚 - 𝑐 ) (1)
Second case: borrowing (consume more than income)
𝑐 = 𝑚 + (1+r)(𝑚 - 𝑐 ) (2)

(1) = (2) Both constraints are same for saving and borrowing
• If m1 − c1 is posi ve, then the consumer earns interest on this savings = r(m - c )
• if m1 − c1 is nega ve, then the consumer pays interest on his borrowings. = r(c - m )
• If c1 = m1, then necessarily c2 = m2, and the consumer is neither a borrower nor a
lender. We might say that this consumption position is the “Polonius point.”

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Present and future value from of Budget constraint

• Rearrange budget constraint function: c = m + (1+r)(m - c ) to get:
(1+r) c + c = (1+r) m + m (3)
c + =m + (4)

• Both (3) & (4) have the form: 𝐩𝟏 𝐱 𝟏 + 𝐩𝟐 𝐱 𝟐 = 𝐩𝟏 𝐦𝟏 + 𝐩𝟐 𝐦𝟐

In equation (3)  p = 1+r; p =1  Future value (makes the price of
future consumption equal to 1)
In equation (4)  p = 1; p =  Present value (makes the price of
present consumption equal to 1)

We say: equation (3) expresses the budget constraint in terms of future value,
equation (4) expresses the budget constraint in terms of present value.
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Budget constraint, r=0 Present and future value from

of Budget constraint

C1
C1

Budget constraint when the rate of interest is zero Present and future values: The vertical intercept
and no borrowing is allowed. The less the of the budget line measures future value. The
individual consumes in period 1, the more he can horizontal intercept measures the present value
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consume in period 2.

Present and future value from

of Budget constraint
• Horizontal intercept: Maximum amount of
period 1 consumption possible (m2=0)
𝑚2
𝑐1 = 𝑚1 +
1+𝑟
• Vertical intercept: Maximum amount of
period 2 consumption possible (m1=0)
𝑐2 = (1 + 𝑟)𝑚1 + 𝑚2

• Slope = -(1+r)

Every dollar saved in period 1 increase the amount of composite good that can be purchased in
period 2 by (1+r) 52

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2.3.2. Preferences for consumption

• Consumer’s preferences represented by the indifference curves. The shape
of the indifference curves indicates the consumer’s tastes for consumption
at different times.
Example:
• indifference curves has a slope = −1  consumer who didn’t care whether
he consumed today or tomorrow. MRS between today and tomorrow is −1.
• Perfect complements preference: IC indicate that the consumer wanted to
consume equal amounts today and tomorrow. Such a consumer would be
unwilling to substitute consumption from one time period to the other, no
matter what it might be worth to him to do so.
• Well-behaved preferences: Convexity of preferences: consumer would rather
have an “average” amount of consumption each period rather than have a
lot today and nothing tomorrow or vice versa  Consumer always is willing
to substitute some amount of consumption today for consumption
tomorrow. How much he is willing to substitute depends on the particular
pattern of consumption
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Consumer react to Interest rate change

Borrower Lender
Consume more today c1>m1 Consumer less today c1<m1

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Interest rate increase

c = m + (1+r)(m - c )
Borrower (c1>m1) Lender (c1<m1)

C1 C1

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2.3.3. Present value (10.6, 10.7)

Forms of Budget constraint:

(1+r)c1 + c2 = (1+r)m1 + m2 (3) value of the endowment in terms of future value
c1 + = m1 + (4) value of the endowment in terms of present value
(3): If we can borrow/lend at an interest rate of r, what is the future equivalent of $1 today?
(4): How much is a dollar next period worth in terms of a dollar today?

Answer : (1 + r) dollars (3) and 1/(1 + r) dollars (4)

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2.3.3. Present value

• a consumption plan is affordable if the present value of consumption equals the
present value of income.
• if the consumer can freely buy and sell goods at constant prices, then the
consumer would always prefer a highervalued endowment to a lower-valued one.
• In the case of intertemporal decisions: a consumer can freely borrow and lend at
a constant interest rate, then the consumer would always prefer a pattern of
income with a higher present value to a pattern with a lower present value.
• an endowment with a higher value gives rise to a budget line that is farther out.
The new budget set contains the old budget set, which means that the consumer
would have all the consumption opportunities she had with the old budget set
plus some more.
• the present value is a more convenient way to measure the purchasing power of
an endowment of money over time, and it is the measure to which we will devote
the most attention.

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Present value for several periods

Period 1 Period 2 Period 3
• Three-period model:
Present value $1 $ $
• Interest rate each period: r ( ) ( )
Future value $(1 + 𝑟) $(1+r) $1
• Budget constraint form:
𝑐 + + =𝑚 + +
( ) ( )
• Price of period-n consumption in term of today’s consumption is given by:
𝑝 =
( )
• Interest earned on savings from period 1 to 2 is r1, while savings from period 2 to 3 earn r2

𝑐 + + =𝑚 + +
( ) ( )

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Example
• The present value of $1 t years in the future at different interest rates.
• The notable fact about this table is how quickly the present value goes
down for “reasonable” interest rates.
• For example, at an interest rate of 10 percent, the value of $1 20 years
from now is only 15 cents

The present value of $1 t years in the future

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Review questions
1. How much is $1 million to be delivered 20 years in the future worth today
if the interest rate is 20 percent?
2. As the interest rate rises, does the intertemporal budget constraint become
steeper or flatter?
3. Would the assumption that goods are perfect substitutes be valid in a study
of intertemporal food purchases?
4. A consumer, who is initially a lender, remains a lender even after a decline
in interest rates. Is this consumer better off or worse off after the change in
interest rates? If the consumer becomes a borrower after the change is he
better off or worse off?
5. What is the present value of $100 one year from now if the interest rate is
10%? What is the present value if the interest rate is 5%?

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