14.01SC | Fall 2011 | Undergraduate

Principles of Microeconomics

Unit 2: Consumer Theory

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The second unit of the course introduces you to the analysis of consumer behavior. The decisions that individuals make about what and how much to consume are among the most important factors that shape the evolution of the overall economy, and we can analyze these decisions in terms of their underlying preferences. You will learn how to model consumer preferences in a utility function, and use this utility function to make predictions about what consumers will do when they have a given income and can buy goods at a given price. You will also learn how to analyze the decision of whether and how much individuals choose to work.

  Preferences and Utility

  Image courtesy of William Jones on Flickr.

  Budget Constraints

  Image courtesy of allison.johnston on Flickr

  Deriving Demand Curves

  Image courtesy of Brian on Flickr.

  Applying Consumer Theory: Labor

  Image courtesy of Joi Ito on Flickr.

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Session Overview

Along with what to buy, another key decision that we make every day as economic agents is how much to work and how much to relax. The decision about supplying labor can be analyzed with the same tools used to analyze the market for pizza or movies, and we call this the analysis of the labor market. This lecture provides an overview of the economics of the labor market.

The decision to nap instead of work can be analyzed by economic tools. Image courtesy of Joi Ito on Flickr.

Keywords: Labor supply; Giffin good; leisure; consumer theory; labor economics; child labor.

Session Activities

Readings

Before watching the lecture video, read the course textbook for an introduction to the material covered in this session:

  • [R&T] Chapter 7, “The Analysis of Consumer Choice.” Sections 7.2.
  • [R&T] Chapter 12, “Wages and Employment in Perfect Competition.”
  • [Perloff] Chapter 5, “Applying Consumer Theory.” (optional)

Lecture Videos

The lecture video for this session consists of two parts.

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Resources

View video page

Resources

Check Yourself

Concept Quiz

This concept quiz covers key vocabulary terms and also tests your intuitive understanding of the material covered in this session. Complete this quiz before moving on to the next session to make sure you understand the concepts required to solve the mathematical and graphical problems that are the basis of this course.

Question 1

What is a Giffen good?

 

Consumption rising when income rises describes a normal good, and consumption rising when income falls describes an inferior good. Consumption falling when price increases is the most common case of own-price effect, where the substitution effect dominates the income effect. Consumption increasing when price increases is a Giffen good, where the income effect dominates the substitution effect.

Question 2

When we model the consumers trade-off between consumption and leisure, what is the slope of the budget constraint?

 

Just as in our previous analyses we used the ratio of prices of the two goods the consumer has the option to consume. In this case, we want the ratio of the price of income to the price of leisure. The price of income is one (it takes a dollar to buy a dollar), and the price of leisure is the wage rate. For every hour that you relax, you give up the hourly wage you could have earned by working that hour. You 'pay' your hourly wage for that hour of leisure.

Question 3

If the income effect dominates the substitution effect in the labor supply decision, what happens when the wage increases?

 

When the wage increases, there is both an income effect (each worker feels relatively richer) and a substitution effect (each hour of work has higher returns.) A richer worker will want to consume more leisure (since it is a normal good), and thus will work less. On the other hand, the fact that each hour of work has higher returns may impel a worker to work more. If the first (income) effect dominates, then workers will work less at a higher wage.

Question 4

If rural households in Vietnam begin to earn more money for their crops and become richer, what will happen to the supply curve for their children's labor? (Hint: assume that education is a normal good.)

 

If education for children is a normal good, families will consume more of it (i.e., school attendance will increase) when their income increases. Accordingly, the supply curve for child labor will shift left because children are spending more time in school.

Other OCW and OER Content

CONTENT PROVIDER NOTES
14.64 Labor Economics and Public Policy, Fall 2009. MIT OpenCourseWare An in-depth course on labor economics.

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Session Overview

Life would be easy if it was just a question of deciding what we would like most. The answer would probably be more of everything! Of course, economic decisions are not that simple, and the reason is that we are constrained in what we can choose: constrained by the amount of income, the amount of time, or any one of a number of factors. In this lecture we will analyze how consumers make choices when they face a budget constraint.

Our monetary income constrains our consumption. Image courtesy of allison.johnston on Flickr.

Keywords: Budget constraints; marginal rate of transformation; opportunity cost; constrained utility maximization; corner solutions.

Session Activities

Readings

Before watching the lecture video, read the course textbook for an introduction to the material covered in this session:

  • [R&T] Chapter 7, “The Analysis of Consumer Choice.” Sections 7.3.
  • [Perloff] Chapter 4, “Consumer Choice.” (optional)

Lecture Videos

View video page

Resources

Check Yourself

Concept Quiz

This concept quiz covers key vocabulary terms and also tests your intuitive understanding of the material covered in this session. Complete this quiz before moving on to the next session to make sure you understand the concepts required to solve the mathematical and graphical problems that are the basis of this course.

Question 1

Which of the following concepts is equivalent to the marginal rate of transformation between two goods?

 

These are all equivalent ways to express the concept of the marginal rate of transformation.

Question 2

What happens to a consumer when the price of a good she consumes increases, or her income decreases?

 

Her opportunity set has been restricted: choices that were available to her before are no longer available to her.

Question 3

How do we graphically represent the utility maximizing bundle that consumers can afford?

 

The point at which the indifference curve and the budget constraint cross is incorrect, because if the indifference curve is crossing the budget constraint the consumer could select another bundle on a higher indifference curve (where she or he obtains more utility) and still be within the budget set. The point where the budget constraint crosses the X or Y axis is incorrect, as this point is not relevant to the consumer's preferences. A point on the indifference curve that is to the right of the budget constraint is incorrect, as a point to the right of the budget constraint is not affordable.

Question 4

You are consuming two goods, pizzas and movies. At your current bundle, the marginal utility you would gain from spending an extra dollar on pizza is higher than the marginal utility you would gain from spending an extra dollar on movies. What should you do?

 

At the optimal consumer bundle, the marginal utility per dollar spent (bang for your buck) should be equal across all goods. If you can obtain more utility from spending an extra dollar on pizza, you should increase your pizza expenditure until the point where the marginal utility per dollar of the two goods is equalized.

Question 5

What is the definition of a corner solution?

 

Graphically, the optimal bundle lies on one of the axes, and thus is referred to as a corner solution. Note that 'an optimal bundle of two consumer goods in which the consumer does not spend all of his/her income' is a case that we rule out in our analysis by assuming that the consumer always spends all of his/her income on consumption, and does not save.

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Session Overview

Individuals make decisions about what to buy and when. But when we talk about the economy every day, we are often analyzing what millions of people are doing and deciding to do at different times. In order to think about this problem, we need to move from the micro to the macro and use our model of individual behavior to generate predictions about what will happen to total demand when the price changes.

Vintage food stamps. Image courtesy of Brian on Flickr.

Keywords: Constrained budget; price elasticity; Engel curves; income effect; substitution effect.

Session Activities

Readings

Read the recitation notes, which cover new content that adds to and supplements the material covered in lecture.

Before watching the lecture video, read the course textbook for an introduction to the material covered in this session:

  • [R&T] Chapter 7, “The Analysis of Consumer Choice.” Section 7.2.3.
  • [Perloff] Chapter 5, “Applying Consumer Theory.” (optional)

Lecture Videos

View video page

Resources

Check Yourself

Concept Quiz

This concept quiz covers key vocabulary terms and also tests your intuitive understanding of the material covered in this session. Complete this quiz before moving on to the next session to make sure you understand the concepts required to solve the mathematical and graphical problems that are the basis of this course.

Question 1

What is the definition of the income elasticity of demand?

 

Percentage change in quantity demanded for a given percentage change in price is the price elasticity of demand, and percentage change in quantity demanded for a given percentage change in the price of the other good is a cross-price elasticity.

Question 2

What is a plausible example of a good with negative income elasticity (i.e., an inferior good?)

 

Rice is a cheap staple food that is generally consumed by poor people; as they become richer, they will consume less rice and consume more of other types of foods. Sports cars, steak and jewelry are all luxury goods, which are generally not inferior goods.

Question 3

Assume you are consuming two goods, and the price of one increases. However, you are given extra income to ensure that your utility does not decrease. What happens to your consumption of the good with the higher price?

 

The question describes the substitution effect, and we know that the substitution effect has to be negative: an increase in prices causes you to substitute away from the good whose price is increasing, holding utility constant.

Question 4

In order to analyze the total effect of a change in price on the total consumption of a good, we decompose it into two components. What are the names of these two components?

 

'Normal' and 'inferior' are descriptive terms that can be used to describe whether the income effect is positive or negative, but they are not separate components of an overall price effect.

Other OCW and OER Content

CONTENT PROVIDER NOTES
“The Expenditure Function: An Application to the Economics of Food Stamps.”  Lec #5 in 14.03 Microeconomic Theory and Public Policy, Fall 2010. MIT OpenCourseWare Alternative notes with an advanced theoretical approach.

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Session Overview

Behind every supply and demand curve is an army of producers and consumers making their own decisions. For consumers, their decisions are driven, quite simply, by what they want! All consumers make decisions to maximize their utility. In this lecture, we will learn about utility, how to define it and how we represent it mathematically. 

How does each slice of pizza you consume impact your utility for the next? Image courtesy of William Jones on Flickr.

Keywords: Consumer theory; preference assumptions; indifference curves; utility functions; marginal utility.

Session Activities

Readings

Read the recitation notes, which cover new content that adds to and supplements the material covered in lecture.

Before watching the lecture video, read the course textbook for an introduction to the material covered in this session:

  • [R&T] Chapter 7, “The Analysis of Consumer Choice.” Sections 7.1, 7.2.1-2, and 7.3.2.
  • [Perloff] Chapter 4, “Consumer Choice.” (optional)

Lecture Videos

View video page

Resources

Check Yourself

Concept Quiz

This concept quiz covers key vocabulary terms and also tests your intuitive understanding of the material covered in this session. Complete this quiz before moving on to the next session to make sure you understand the concepts required to solve the mathematical and graphical problems that are the basis of this course.

Question 1

Which of the following is NOT an assumption that we make about consumer preferences?

 

This is a property of indifference curves (they are downward-sloping), not of the underlying preferences. Non-satiation, completeness and transitivity are the key assumptions made about consumer preferences.

Question 2

Why can't indifference curves be upward-sloping?

 

If an indifference curve is upward-sloping, it implies you are indifferent between a combination with a smaller amount of both good x and good y, and a combination with a larger amount of both good x and good y. The non-satiation principle tells us more is always better, and so the bundle with a larger amount of both good x and good y must be preferred.

Question 3

How is marginal utility defined?

 

Marginal utility captures how your utility changes when you consume more of a good.

Question 4

How does the marginal rate of substitution change as you move along a non-linear indifference curve?

 

A non-linear indifference curve is concave to the origin, and the marginal state of substitution is declining as you move along the indifference curve to the right. Assume pizza is on the y-axis and movies are on the x-axis. As you move to the right, you have more and more movies, and the marginal utility from each additional movie decreases. Accordingly, the marginal rate of substitution (the rate at which you are willing to trade movies for pizza) declines—you have too many movies, so you'd be happy to give some up for pizza, even if you don't get much pizza in exchange! (Note there is one exception to this rule; if you have a linear indifference curve, the marginal rate of substitution is constant. For this reason, the question specified non-linear indifference curves.)

Question 5

What is an appropriate intuitive explanation of the principle of diminishing marginal utility?

 

These are all appropriate ways to capture the intuition behind the principle of diminishing marginal utility.

Other OCW and OER Content

CONTENT PROVIDER NOTES
“Axioms of Consumer Preference and the Theory of Choice.”  Lec #3 in 14.03 Microeconomic Theory and Public Policy, Fall 2010. MIT OpenCourseWare Alternative notes with an advanced theoretical approach.

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Preparation

The problem set is comprised of challenging questions that test your understanding of the material covered in the course. Make sure you have mastered the concepts and problem solving techniques from the following sessions before attempting the problem set:

Problem Set and Solutions

Problem Solving Video

In the video below, a teaching assistant demonstrates his approach to the solution for problem 4 from the problem set. The teaching assistant notes common mistakes made by students and provides problem solving techniques for approaching similar questions on the problem set and exams.

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« Previous | Next »

Preparation

The problem set is comprised of challenging questions that test your understanding of the material covered in the course. Make sure you have mastered the concepts and problem solving techniques from the following sessions before attempting the problem set:

Problem Set and Solutions

Problem Solving Video

In the video below, a teaching assistant demonstrates his approach to the solution for problem 5 from the problem set. The teaching assistant notes common mistakes made by students and provides problem solving techniques for approaching similar questions on the problem set and exams.

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