REVIEW OF CONSUMER THEORY

CHAPTER 1
 Review of Consumer Theory

UTILITY FUNCTIONS
 Describe how much “happiness” or “satisfaction” an individual
experiences from “consuming” goods – the benefit of consumption

 Marginal Utility
 The extra total utility resulting from consumption of a
small/incremental extra unit of a good
 Mathematically, the (partial) slope of utility with respect to that good

2
 Review of Consumer Theory

UTILITY FUNCTIONS
 Describe how much “happiness” or “satisfaction” an individual
experiences from “consuming” goods – the benefit of consumption

 Marginal Utility
 The extra total utility resulting from consumption of a
small/incremental extra unit of a good
 Mathematically, the (partial) slope of utility with respect to that good

 One-good case: u(c), with du/dc > 0 and d2u/dc2 < 0

 Recall interpretation: strictly increasing at a strictly decreasing rate
 Diminishing marginal utility

3
 Review of Consumer Theory

UTILITY FUNCTIONS
 Describe how much “happiness” or “satisfaction” an individual
experiences from “consuming” goods – the benefit of consumption

 Marginal Utility
 The extra total utility resulting from consumption of a
small/incremental extra unit of a good
 Mathematically, the (partial) slope of utility with respect to that good
Alternative notation: du/dc OR u’(c) OR uc(c) OR u1(c)

 One-good case: u(c), with du/dc > 0 and d2u/dc2 < 0

 Recall interpretation: strictly increasing at a strictly decreasing rate
 Diminishing marginal utility

4
 Review of Consumer Theory

UTILITY FUNCTIONS
 Describe how much “happiness” or “satisfaction” an individual
experiences from “consuming” goods – the benefit of consumption

 Marginal Utility
 The extra total utility resulting from consumption of a
small/incremental extra unit of a good
 Mathematically, the (partial) slope of utility with respect to that good
Alternative notation: du/dc OR u’(c) OR uc(c) OR u1(c)

 One-good case: u(c), with du/dc > 0 and d2u/dc2 < 0

 Recall interpretation: strictly increasing at a strictly decreasing rate
 Diminishing marginal utility

 Two-good case: u(c1, c2), with ui(c1, c2) > 0 and uii(c1, c2) < 0 for
each of i = 1,2
 Utility strictly increasing in each good individually (partial)
 Diminishing marginal utility in each good individually

5
 Review of Consumer Theory

UTILITY FUNCTIONS
 Describe how much “happiness” or “satisfaction” an individual
experiences from “consuming” goods – the benefit of consumption

 Marginal Utility
 The extra total utility resulting from consumption of a
small/incremental extra unit of a good
 Mathematically, the (partial) slope of utility with respect to that good
Alternative notation: du/dc OR u’(c) OR uc(c) OR u1(c)

 One-good case: u(c), with du/dc > 0 and d2u/dc2 < 0

 Recall interpretation: strictly increasing at a strictly decreasing rate
 Diminishing marginal utility

 Two-good case: u(c1, c2), with ui(c1, c2) > 0 and uii(c1, c2) < 0 for
each of i = 1,2
 Utility strictly increasing in each good individually (partial)
 Diminishing marginal utility in each good individually

 Easily extends to N-good case: u(c1, c2, c3, c4,…, cN)

6
 Review of Consumer Theory

UTILITY FUNCTIONS
u(c)
 One-good case
Slope (marginal utility) asymptotes to (but never
reaches…) zero

Example: u(c) = ln c or u(c) = sqrt(c)

7
 Review of Consumer Theory

UTILITY FUNCTIONS
u(c)
 One-good case
Slope (marginal utility) asymptotes to (but never
reaches…) zero

Example: u(c) = ln c or u(c) = sqrt(c)

c
 Two-good case
u(c1,c2)

Example: u(c1, c2) = ln c1 + ln c2 or

u(c1, c2) = sqrt(c1) + sqrt(c2)

8
 Review of Consumer Theory

UTILITY FUNCTIONS
u(c)
 One-good case
Slope (marginal utility) asymptotes to (but never
reaches…) zero

Example: u(c) = ln c or u(c) = sqrt(c)

c
 Two-good case
u(c1,c2)

Example: u(c1, c2) = ln c1 + ln c2 or

u(c1, c2) = sqrt(c1) + sqrt(c2)

u(c1,c2)

Viewed in
good-by-
good space

c1

9
 Review of Consumer Theory

UTILITY FUNCTIONS
u(c)
 One-good case
Slope (marginal utility) asymptotes to (but never
reaches…) zero

Example: u(c) = ln c or u(c) = sqrt(c)

c
 Two-good case
u(c1,c2)

Example: u(c1, c2) = ln c1 + ln c2 or

u(c1, c2) = sqrt(c1) + sqrt(c2)

u(c1,c2) u(c1,c2)

Viewed in
good-by-
good space

c1 c2

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 Review of Consumer Theory

UTILITY FUNCTIONS
Alternative views

Emphasizing
the contours Indifference Curve: the
set of all consumption
bundles that deliver a
particular level of
utility/happiness

11
 Review of Consumer Theory

UTILITY FUNCTIONS
Alternative views

Emphasizing Viewing only

the contours Indifference Curve: the the contours
set of all consumption
bundles that deliver a
particular level of
utility/happiness

12
 Review of Consumer Theory

UTILITY FUNCTIONS
 Marginal Rate of Substitution (MRS)
 Maximum quantity of one good consumer is willing to give up to obtain
one extra unit of the other good

 Graphically, the (negative of the) slope of c2

an indifference curve

 MRS is itself a function of c1 and c2

(i.e., MRS(c1, c2))
c1

13
 Review of Consumer Theory

UTILITY FUNCTIONS
 Marginal Rate of Substitution (MRS)
 Maximum quantity of one good consumer is willing to give up to obtain
one extra unit of the other good

 Graphically, the (negative of the) slope of c2

an indifference curve

 MRS is itself a function of c1 and c2

(i.e., MRS(c1, c2))
c1
 MRS equals ratio of marginal utilities
u1 (c1 , c2 )
 MRS (c1 , c2 ) 
u2 (c1 , c2 )

 Using Implicit Function Theorem (see Practice Problem Set 1)

14
 Review of Consumer Theory

UTILITY FUNCTIONS
 Marginal Rate of Substitution (MRS)
 Maximum quantity of one good consumer is willing to give up to obtain
one extra unit of the other good

 Graphically, the (negative of the) slope of c2

an indifference curve

 MRS is itself a function of c1 and c2

(i.e., MRS(c1, c2))
c1
 MRS equals ratio of marginal utilities
u1 (c1 , c2 )
 MRS (c1 , c2 ) 
u2 (c1 , c2 )

 Using Implicit Function Theorem

 Summary: whether graphically- or mathematically-formulated,

utility functions describe the benefit side of consumer optimization
15
 The Graphics of Consumer Theory

BUDGET CONSTRAINTS
 Describe the cost side of consumption

 One-good case (trivial): Pc = Y

 Assume income Y is taken as given by consumer for now…

16
 The Graphics of Consumer Theory

BUDGET CONSTRAINTS
 Describe the cost side of consumption

 One-good case (trivial): Pc = Y

 Assume income Y is taken as given by consumer for now…

 Two-good case (interesting): P1c1 + P2c2 = Y

 Assume income Y is taken as given by consumer for now…

17
 The Graphics of Consumer Theory

BUDGET CONSTRAINTS
 Describe the cost side of consumption

 One-good case (trivial): Pc = Y

 Assume income Y is taken as given by consumer for now…

 Two-good case (interesting): P1c1 + P2c2 = Y

 Assume income Y is taken as given by consumer for now…

Plotted in 2D-consumption-space

c2

c1

18
 The Graphics of Consumer Theory

BUDGET CONSTRAINTS
 Describe the cost side of consumption

 One-good case (trivial): Pc = Y

 Assume income Y is taken as given by consumer for now…

 Two-good case (interesting): P1c1 + P2c2 = Y

 Assume income Y is taken as given by consumer for now…

P1c1  P2c2  Y Plotted in 2D-consumption-space

c2

Isolate c2 to
graph the budget P2c2   P1c1  Y
constraint

P1 Y
c2   c1 
P2 P2 c1

19
 The Graphics of Consumer Theory

BUDGET CONSTRAINTS
 Describe the cost side of consumption

 One-good case (trivial): Pc = Y

 Assume income Y is taken as given by consumer for now…

 Two-good case (interesting): P1c1 + P2c2 = Y

 Assume income Y is taken as given by consumer for now…

P1c1  P2c2  Y Plotted in 2D-consumption-space

c2
Slope = -P1/P2
Isolate c2 to
graph the budget P2c2   P1c1  Y
constraint

P1 Y
c2   c1 
P2 P2 c1

20
 The Graphics of Consumer Theory

BUDGET CONSTRAINTS
 Describe the cost side of consumption

 One-good case (trivial): Pc = Y

 Assume income Y is taken as given by consumer for now…

 Two-good case (interesting): P1c1 + P2c2 = Y

 Assume income Y is taken as given by consumer for now…

Plotted in 3D-consumption-space Plotted in 2D-consumption-space

c2
Slope = -P1/P2

c1

21
 The Graphics of Consumer Theory

BUDGET CONSTRAINTS
 Describe the cost side of consumption

 One-good case (trivial): Pc = Y

 Assume income Y is taken as given by consumer for now…

 Two-good case (interesting): P1c1 + P2c2 = Y

 Assume income Y is taken as given by consumer for now…

Plotted in 3D-consumption-space Plotted in 2D-consumption-space

c2
Slope = -P1/P2

c1

22
 The Graphics of Consumer Theory

CONSUMER OPTIMIZATION
 Consumer’s decision problem: maximize utility subject to budget
constraint – bring together both cost side and benefit side

23
 The Graphics of Consumer Theory

CONSUMER OPTIMIZATION
 Consumer’s decision problem: maximize utility subject to budget
constraint – bring together both cost side and benefit side
u(c)
 One-good case

Y/P c

24
 The Graphics of Consumer Theory

CONSUMER OPTIMIZATION
 Consumer’s decision problem: maximize utility subject to budget
constraint – bring together both cost side and benefit side
u(c)
 One-good case
 Trivially, choose c = Y/P

Y/P c

25
 The Graphics of Consumer Theory

CONSUMER OPTIMIZATION
 Consumer’s decision problem: maximize utility subject to budget
constraint – bring together both cost side and benefit side
u(c)
 One-good case
 Trivially, choose c = Y/P
 No decision to make here…

Y/P c

26
 The Graphics of Consumer Theory

CONSUMER OPTIMIZATION
 Consumer’s decision problem: maximize utility subject to budget
constraint – bring together both cost side and benefit side
u(c)
 One-good case
 Trivially, choose c = Y/P
 No decision to make here…

 Two-good case Y/P c

 How to optimally allocate Y across the two goods c1 and c2?

 A non-trivial decision problem…

c2 Utility increasing
in the northeast
direction

c1

27
 The Graphics of Consumer Theory

CONSUMER OPTIMIZATION
 Consumer’s decision problem: maximize utility subject to budget
constraint – bring together both cost side and benefit side
u(c)
 One-good case
 Trivially, choose c = Y/P
 No decision to make here…

 Two-good case Y/P c

 How to optimally allocate Y across the two goods c1 and c2?

 A non-trivial decision problem…

c2 Utility increasing
in the northeast
direction

c1

28
 The Graphics of Consumer Theory

CONSUMER OPTIMIZATION
 Consumer’s decision problem: maximize utility subject to budget
constraint – bring together both cost side and benefit side
u(c)
 One-good case
 Trivially, choose c = Y/P
 No decision to make here…

 Two-good case Y/P c

 How to optimally allocate Y across the two goods c1 and c2?

 A non-trivial decision problem…

c2 Utility increasing
in the northeast
direction
Optimal choice
occurs at point of
tangency between
budget line and an
indifference curve Highest attainable
indifference curve
c1

29
 The Graphics of Consumer Theory

CONSUMER OPTIMIZATION
 Consumer’s decision problem: maximize utility subject to budget
constraint – bring together both cost side and benefit side
u(c)
 One-good case
 Trivially, choose c = Y/P
 No decision to make here…

 Two-good case Y/P c

 How to optimally allocate Y across the two goods c1 and c2?

 A non-trivial decision problem…
OPTIMALITY CONDITION:
At the optimal choice,
c2 Utility increasing
in the northeast MRS = slope of budget line
direction
Optimal choice
occurs at point of
tangency between
budget line and an
indifference curve Highest attainable
indifference curve
c1

30
 The Graphics of Consumer Theory

CONSUMER OPTIMIZATION
 Consumer’s decision problem: maximize utility subject to budget
constraint – bring together both cost side and benefit side
u(c)
 One-good case
 Trivially, choose c = Y/P
 No decision to make here…

 Two-good case Y/P c

 How to optimally allocate Y across the two goods c1 and c2?

 A non-trivial decision problem…
OPTIMALITY CONDITION:
At the optimal choice,
c2 Utility increasing
in the northeast MRS = slope of budget line
direction
Optimal choice
occurs at point of ratio of marginal utilities = price ratio
tangency between
budget line and an
indifference curve Highest attainable
indifference curve
c1

31
 The Mathematics of Consumer Theory

LAGRANGE ANALYSIS
 Consumer optimization a constrained optimization problem
 Maximize some function (economic application: utility function)…
 …taking into account some restriction on the objects to be maximized
over (economic application: budget constraint)

 Lagrange Method: mathematical tool to solve constrained

optimization problems

32
 The Mathematics of Consumer Theory

LAGRANGE ANALYSIS
 Consumer optimization a constrained optimization problem
 Maximize some function (economic application: utility function)…
 …taking into account some restriction on the objects to be maximized
over (economic application: budget constraint)

 Lagrange Method: mathematical tool to solve constrained

optimization problems

 General mathematical formulation

 Choose (x, y) to maximize a given objective function f(x,y)…
 …subject to the constraint g(x,y) = 0 (Note formulation of constraint)

33
 The Mathematics of Consumer Theory

LAGRANGE ANALYSIS
 Consumer optimization a constrained optimization problem
 Maximize some function (economic application: utility function)…
 …taking into account some restriction on the objects to be maximized
over (economic application: budget constraint)

 Lagrange Method: mathematical tool to solve constrained

optimization problems

 General mathematical formulation

 Choose (x, y) to maximize a given objective function f(x,y)…
 …subject to the constraint g(x,y) = 0 (Note formulation of constraint)
 Step 1: Construct Lagrange function Lagrange multiplier

L ( x , y ,  )  f ( x, y )   g ( x, y )

34
 The Mathematics of Consumer Theory

LAGRANGE ANALYSIS
 Consumer optimization a constrained optimization problem
 Maximize some function (economic application: utility function)…
 …taking into account some restriction on the objects to be maximized
over (economic application: budget constraint)

 Lagrange Method: mathematical tool to solve constrained

optimization problems

 General mathematical formulation

 Choose (x, y) to maximize a given objective function f(x,y)…
 …subject to the constraint g(x,y) = 0 (Note formulation of constraint)
 Step 1: Construct Lagrange function Lagrange multiplier

L ( x , y ,  )  f ( x, y )   g ( x, y )
 Step 2: Compute first-order conditions with respect to x, y, and λ
f x ( x, y )   g x ( x, y )  0
f y ( x, y )   g y ( x, y )  0
g ( x, y )  0
35
 The Mathematics of Consumer Theory

LAGRANGE ANALYSIS
 Consumer optimization a constrained optimization problem
 Maximize some function (economic application: utility function)…
 …taking into account some restriction on the objects to be maximized
over (economic application: budget constraint)

 Lagrange Method: mathematical tool to solve constrained

optimization problems

 General mathematical formulation

 Choose (x, y) to maximize a given objective function f(x,y)…
 …subject to the constraint g(x,y) = 0 (Note formulation of constraint)
 Step 1: Construct Lagrange function Lagrange multiplier

L ( x , y ,  )  f ( x, y )   g ( x, y )
 Step 2: Compute first-order conditions with respect to x, y, and λ
1) f x ( x, y )   g x ( x, y )  0
f y ( x, y )   g y ( x, y )  0
g ( x, y )  0
36
 The Mathematics of Consumer Theory

LAGRANGE ANALYSIS
 Consumer optimization a constrained optimization problem
 Maximize some function (economic application: utility function)…
 …taking into account some restriction on the objects to be maximized
over (economic application: budget constraint)

 Lagrange Method: mathematical tool to solve constrained

optimization problems

 General mathematical formulation

 Choose (x, y) to maximize a given objective function f(x,y)…
 …subject to the constraint g(x,y) = 0 (Note formulation of constraint)
 Step 1: Construct Lagrange function Lagrange multiplier

L ( x , y ,  )  f ( x, y )   g ( x, y )
 Step 2: Compute first-order conditions with respect to x, y, and λ
1) f x ( x, y )   g x ( x, y )  0
2) f y ( x, y )   g y ( x, y )  0
g ( x, y )  0
37
 The Mathematics of Consumer Theory

LAGRANGE ANALYSIS
 Consumer optimization a constrained optimization problem
 Maximize some function (economic application: utility function)…
 …taking into account some restriction on the objects to be maximized
over (economic application: budget constraint)

 Lagrange Method: mathematical tool to solve constrained

optimization problems

 General mathematical formulation

 Choose (x, y) to maximize a given objective function f(x,y)…
 …subject to the constraint g(x,y) = 0 (Note formulation of constraint)
 Step 1: Construct Lagrange function Lagrange multiplier

L ( x , y ,  )  f ( x, y )   g ( x, y )
 Step 2: Compute first-order conditions with respect to x, y, and λ
1) f x ( x, y )   g x ( x, y )  0 Rationale: setting first derivatives to zero
2) f y ( x, y )   g y ( x, y )  0 isolates maxima (or minima…technically,
need to check second-order condition…)
3) g ( x, y )  0
38
 The Mathematics of Consumer Theory

LAGRANGE ANALYSIS
 Step 3: Solve the system of first-order conditions for x, y, and λ
 Often most interested in simply eliminating the multiplier…

39
 The Mathematics of Consumer Theory

LAGRANGE ANALYSIS
 Step 3: Solve the system of first-order conditions for x, y, and λ
 Often most interested in simply eliminating the multiplier…

f x ( x, y )
 From eqn 1), isolate λ: 
g x ( x, y )

40
 The Mathematics of Consumer Theory

LAGRANGE ANALYSIS
 Step 3: Solve the system of first-order conditions for x, y, and λ
 Often most interested in simply eliminating the multiplier…

f x ( x, y )
 From eqn 1), isolate λ: 
g x ( x, y )
f x ( x, y )
 Insert expression for λ in eqn 2): f y ( x, y )  g y ( x, y )  0
g x ( x, y )

41
 The Mathematics of Consumer Theory

LAGRANGE ANALYSIS
 Step 3: Solve the system of first-order conditions for x, y, and λ
 Often most interested in simply eliminating the multiplier…

f x ( x, y )
 From eqn 1), isolate λ: 
g x ( x, y )
f x ( x, y )
 Insert expression for λ in eqn 2): f y ( x, y )  g y ( x, y )  0
g x ( x, y )
 Rearrange

 Optimality condition: at the optimum (x*, y*)

f x ( x*, y*) g x ( x*, y*)

f y ( x*, y*) g y ( x*, y*)

42
 The Mathematics of Consumer Theory

LAGRANGE ANALYSIS
 Step 3: Solve the system of first-order conditions for x, y, and λ
 Often most interested in simply eliminating the multiplier…

f x ( x, y )
 From eqn 1), isolate λ: 
g x ( x, y )
f x ( x, y )
 Insert expression for λ in eqn 2): f y ( x, y )  g y ( x, y )  0
g x ( x, y )
 Rearrange

 Optimality condition: at the optimum (x*, y*)

f x ( x*, y*) g x ( x*, y*) Graphical interpretation: at the
 constrained optimum, the function f(.)
is tangent to the function g(.)
f y ( x*, y*) g y ( x*, y*)
y

f(x,y)
The constrained optimum (x*, y*)

g(x,y)

43
 The Mathematics of Consumer Theory

LAGRANGE ANALYSIS
 Apply Lagrange tools to consumer optimization
 Objective function: u(c1,c2)
 Constraint: g(c1,c2) = Y – P1c1 – P2c2 = 0

44
 The Mathematics of Consumer Theory

LAGRANGE ANALYSIS
 Apply Lagrange tools to consumer optimization
 Objective function: u(c1,c2)
 Constraint: g(c1,c2) = Y – P1c1 – P2c2 = 0

 Step 1: Construct Lagrange function

L(c1 , c2 ,  )  u(c1 , c2 )   Y  Pc
1 1  P2c2 

 Step 2: Compute first-order conditions with respect to c1, c2, λ

45
 The Mathematics of Consumer Theory

LAGRANGE ANALYSIS
 Apply Lagrange tools to consumer optimization
 Objective function: u(c1,c2)
 Constraint: g(c1,c2) = Y – P1c1 – P2c2 = 0

 Step 1: Construct Lagrange function

L(c1 , c2 ,  )  u(c1 , c2 )   Y  Pc
1 1  P2c2 

 Step 2: Compute first-order conditions with respect to c1, c2, λ

u1 (c1 , c2 )   P1  0
u2 (c1 , c2 )   P2  0
Y  Pc
1 1  P2 c2  0

46
 The Mathematics of Consumer Theory

LAGRANGE ANALYSIS
 Apply Lagrange tools to consumer optimization
 Objective function: u(c1,c2)
 Constraint: g(c1,c2) = Y – P1c1 – P2c2 = 0

 Step 1: Construct Lagrange function

L(c1 , c2 ,  )  u(c1 , c2 )   Y  Pc
1 1  P2c2 

 Step 2: Compute first-order conditions with respect to c1, c2, λ

u1 (c1 , c2 )   P1  0
u2 (c1 , c2 )   P2  0
Y  P1c1  P2c2  0

47
 The Mathematics of Consumer Theory

LAGRANGE ANALYSIS
 Apply Lagrange tools to consumer optimization
 Objective function: u(c1,c2)
 Constraint: g(c1,c2) = Y – P1c1 – P2c2 = 0

 Step 1: Construct Lagrange function

L(c1 , c2 ,  )  u(c1 , c2 )   Y  Pc
1 1  P2c2 

 Step 2: Compute first-order conditions with respect to c1, c2, λ

1) u1 (c1 , c2 )   P1  0
2) u2 (c1 , c2 )   P2  0
3) Y  Pc
1 1  P2 c2  0

48
 The Mathematics of Consumer Theory

LAGRANGE ANALYSIS
 Apply Lagrange tools to consumer optimization
 Objective function: u(c1,c2)
 Constraint: g(c1,c2) = Y – P1c1 – P2c2 = 0

 Step 1: Construct Lagrange function

L(c1 , c2 ,  )  u(c1 , c2 )   Y  Pc
1 1  P2c2 

 Step 2: Compute first-order conditions with respect to c1, c2, λ

1) u1 (c1 , c2 )   P1  0
2) u2 (c1 , c2 )   P2  0
3) Y  Pc
1 1  P2 c2  0

 Step 3: Solve (focus on eliminating multiplier from eqns 1 & 2)

u1 (c1* , c2* ) P1
* *
 OPTIMALITY CONDITION
u2 (c1 , c2 ) P2
i.e., MRS = price ratio

49
 The Road Ahead

THE THREE MACRO (AGGREGATE) MARKETS

 Goods Markets P

wage
 Labor Markets

labor
interest
rate
 Financial/Capital/Savings/Asset
Markets

 Will put micro-foundations under all three

capital

50