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1. 1

2. Aims:
1. To provide students with an understanding of
the standard theoretical analysis of consumer
and producer behaviour.
2. To provide students with an appreciation of
the economic efficiency and equity effects of
economic actions and policies.
3. To stress the relevance and application of
microeconomics for decision-making.
2

3. A short word about
microeconomics
 This course will provide you with an
understanding of neo-
classical/traditional microeconomic
theory. The course has this focus
because the traditional theory is:
 Currently very influential
 Currently the „dominant‟ view on
economic theory
 However, traditional microeconomics is
also very contentious
 You need to know this theory even if
you don‟t agree with it!
3

4. Traditional Microeconomics
 Focuses on individuals; that is, on consumers,
producers and workers, and their involvement in
markets
 Consumers – buy/demand goods and services
 Producers/firms
 Buy/demand labour and other inputs to produce goods
and services
 Sell/supply goods and services
 Workers – sell their labour
 Markets – are „places‟ where individuals interact to achieve
their needs and wants and negotiate prices
 Largely ignores social, inter-personal and cultural
factors and assigns government and multi-national
institutions a marginal role 4

5. Traditional Microeconomics
 Is optimistic about the ability of individuals
to achieve their needs and wants through
their involvement in market exchange
 Is optimistic about the ability of markets to
ensure an efficient allocation of resources
 Focuses on efficiency rather than equity
5

6. Traditional Microeconomics
 Consumer Theory focuses on the decisions
made by individuals about their purchases
of goods and services
 It relies on assumptions of rationality &
maximisation
 It studies how a rational consumer will
make decisions about using her income
 How she will respond to changing prices
(e.g. higher food prices)
 How her consumption patterns reflect
her preferences
 How her consumption pattern and level
will change when her income changes
6

7. Traditional Microeconomics
 Producer Theory focuses on the
decisions made by firms about
their levels of production and
production methods
•It relies on assumptions of rationality &
maximisation
•It studies how a rational producer will
make key decisions, such as
•How much to produce
•How many labour and other inputs to
hire
•How to respond to changes in wages
or new technologies
7

8. Traditional Microeconomics
 Rationality & Maximisation imply
individuals will attempt to make
the best use of their resources
•And before they make any decision they will
weigh up the opportunity costs and benefits
of alternative actions
•For example, before a consumer
decides to spend all her week‟s pay
on a new pair of shoes she will
consider the trade-offs (such as the
consequences of not paying the
rent)
8

9. Traditional Microeconomics
 Rationality& Maximisation also
imply that individuals will make
the decisions that they think are
best for them
 Thus, the theory generally
predicts negative consequences if,
for example, government policy
restricts or alters the choices
available to individuals
9

10. Traditional Microeconomics
 Is challenged by many
economists and non-economists
 Many question:
 i) The realism of the
theory‟s assumptions (e.g.
about rationality)
 ii) The accuracy of the theory‟s
predictions
 iii) The theory‟s focus (e.g. on
efficiency over equity) 10

11. Traditional Microeconomics
However, although it is far from
perfect, the theory is useful for
examining some important
issues.
For example, we can use the
theory to study some of the
effects of carbon taxes on:
- Consumers‟ budgets
- Consumers‟ choices
- Firms‟ cost of production
- Firms‟ input choices
11

12. This unit provides you with several key
resources to help you further your
knowledge of microeconomic theory and
its applications:
1. Text
2. Lectures and Tutorials
3. Challenges and Feedback
12

13. The Text
 Pindyck, R.S and
D. L. Rubinfeld
(2009),
Microeconomics,
7th edition,
Pearson Prentice
Hall, New
Jersey.
13

14. Other resources
 Blackboard
 Lecture slides posted before the lecture
 Unit outlines
 Tutorial questions
 Messages and announcements
14

15. Some final tips
 Keep reading
 Attempt the tutorial exercises each
week
 Practice and re-practice the
diagrams
 Listen carefully!
 Take many notes!!!
15

17. CONSUMER BEHAVIOUR
PART 1
Read Textbook Chapter 3.1 & 3.2
17

18. Introduction to Consumer Theory
This part of traditional microeconomic theory
is used to analyse and predict how
individuals make decisions about the
consumption of goods and services.
An important focus of the theory is on the
effects of changes in prices and incomes
on consumers’ demand for goods and
services.
18

19. The theory has 2 key components
 An individual‟s demand for different
goods & services is seen to depend
on
 1) her preferences (how she
values different commodities)
 2) her budget (what she can afford
given her income and the prices of
different goods and services)

20. Key Learning Outcomes
Part 1: Consumer preferences
Assumptions of consumer choice theory
Indifference curves
Indifference maps
Utility
Marginal Rate of Substitution (MRS)
Formula
Graphical representation
Special cases
20

21. Assumptions about
Preferences
The assumptions about preferences
need to be known.
The theory assumes consumers are
rational. This implies:
 1. Completeness
 2. Transitivity
 3. Greed
21

22. Consumer Preferences:
Assumptions
1. Preferences are complete
 Consumers can rank all available
consumption choices. That is, they can
say they
Prefer to
Or to
Or, they‟re indifferent between &

23. Consumer Preferences:
Assumptions
2. Preferences are transitive
Chocolate milk Tea Lemonade
If I prefer choc milk to tea,
AND I prefer tea to lemonade,
THEN I must prefer choc milk to lemonade.
This is a contentious assumption.
23

24. Consumer Preferences:
Assumptions
 3. Preferences are for more
goods than less
 = Assumption of GREED,
 (Except in the case of „bads‟
where less is preferred to more
e.g. pollution)
24

25. Consumer Preferences:
Showing Preferences on a Graph
The graphical presentation of these ideas about consumer
preferences focuses on how a rational consumer would rank
different baskets of goods and services
Market Units of Units of
Basket Food Clothing
A 20 30
B 10 50
D 40 20
E 30 40
G 10 20
HOW WOULD YOU RANK THESE BASKETS???
Are there any baskets you definitely prefer? 25

26. Step 1: Graph the market baskets
from the example
Clothing Market Units Units
(units) Basket of F of C
50 B A 20 30
B 10 50
40 E D 40 20
A E 30 40
30
G 10 20
20 D
G
10
Food (units)
10 20 30 40
26

27. Step 2: Identify all baskets that will
be preferred to A (green); and all the
baskets that are inferior to A (red).
B has less food but more
clothing than A.
Clothing
(units)
B
50 E has more
food & more
40 E clothing than
A.
A
30
D has more
G has less D
20 G food but less
food & less
clothing than
clothing
A.
than A. 10
Food (units)
10 20 30 40
27

28. This is REALLY
IMPORTANT
Indifference Curves
Clothing SUPPOSE the consumer
(units)
is indifferent between
50 B
points B, A, & D.
They will all be on the
40 E
SAME INDIFFERENCE
A CURVE.
30
D
20
G
U1
10
Food (units)
10 20 30 40
28

29. Indifference Curves, Satisfaction &
Utility
 An indifference curve represents
all combinations of market baskets
that the person is
_______________.
 Any basket located on the one
indifference curve will give a
consumer the same level of
satisfaction or ________.
29

30. Important: Indifference
Curves ARE NOT Demand
Curves
Clothing Price of
(units) food ($)
_______________ curve __________ curve
Food (units) Food (units)
30

31. Indifference Curves: Are used to
describe how consumers “feel” about
different commodities
Clothing If we take some clothing
(units) away from this consumer
50
We need to compensate
W him with more food
40
30
If the consumer
X needs a lot of
20 compensation
clothing must be
important to him
10 U1 and vice versa
10 20 30 40 Food (units)
31

32. Special Case: Indifference Curves
for “Bads”
Pollution
(units) If we take some pollution
R away from this consumer
We can reduce her level of
food and she would
maintain the same
satisfaction level
T
NB Indifference curves
slope upwards if one of
commodities is a “bad”.
Food If both commodities are
(units)goods the IC slopes
downward 32

33. Special Case: Indifference Curve
for a“Bad”
Risk
U0
Return
33

34. Special Case: Indifference Curves:
Neutrals
Clothing
(units) No matter how
much or how little
of a neutral
commodity– same
satisfaction level
Neutral
(units)
34

35. Indifference Curves: Neutrals
Neutral
(units)
Clothing
(units)
35

36. This is REALLY
IMPORTANT
Indifference Map
Clothing SUPPOSE the consumer
(units)
PREFERS point E to
50 B
points B, A, & D.
It will all be on a
40 E
HIGHER INDIFFERENCE
A CURVE.
30
D U2
20
G
U1
10
Food (units)
10 20 30 40
36

37. Indifference Map: Goods
Clothing
(units) Direction of
___________
satisfaction/utility
E Indifference maps:
A • Comprise a set of
U2 indifference curves
G
U1 E is preferred to A.
A is preferred to G.
U0
Food (units)
37

38. Special Case: Indifference Map
for “Bads”
Pollution
(units) S is preferred to T, which
is preferred to U
U
T
S
Food
(units)
38

39. Indifference Curves: Neutrals
Clothing Neutral commodity
(units) does not change utility
level.
Utility can only be
increased by
increasing clothing
(a ‘good’).
Neutral
(units)
39

40. Indifference Curves Maps
 Every commodity bundle must
be on an IC
 ICs cannot intersect
 Shape must reflect preferences
40

41. Question on the Indifference Maps
Good B Refer to the indifference curve
in the figure opposite. Which of
the following statements is
Increasing correct?
utility A. This individual will only
consume A and B in fixed
proportions.
B. This individual receives no
satisfaction from Good A.
C. This individual receives no
satisfaction from Good B.
Good A D. None of the above.
This question is from a past year test and
more than half of the students got it right.
How about U?
41

42. Marginal Rate of Substitution: Measuring
the Strength of Consumer’s Preferences
Clothing We’ve already learnt that
(units) if the consumer needs a
lot of compensation if we
50
reduce his clothing
W allowance, the good must
40 be important to him and
vice versa
30
The technical term used to
X
measure this trade-off and,
20 thus, to describe the
strength of consumer
10 preferences for different
U1
commodities is MRS
10 20 30 40 Food (units)
42

43. Marginal Rate of Substitution MRS
F = Food, C = Clothing
 Suppose Jo is willing to give up 3 units of C to
get 1 additional unit of F.
Give up 3 To get 1
units of C unit of F
 Jo‟s MRS of F for C is the maximum amount
of C she‟s willing to give up to obtain 1
additional unit of F.
MRS (F for C) = -C/F
 MRS (F for C) = –C/F
= –(–3)/1 = 3 43

44. MRS
General definition of MRS:
The maximum amount of a good
that a consumer is willing to give up
to get one additional unit of another good.
Need to know:
 Formula
 Use/Meaning
 Graphical representation
44

45. Meaning/Use of MRS
MRS describes the intensity of prefs
 Suppose BOB is willing to give up 2 units of C
to get 1 additional unit of F.
Give up 2 To get 1
units of C unit of F
Notice Bob will give up fewer C to get 1 extra F. This
implies C is more valuable and F is less valuable to
him, as compared to Jo
MRS (F for C) = –C/F
= –(–2)/1 = 2 45

46. MRS: What is being Substituted
for What?
 We say “MRS of F for C”, what is the
consumer giving up?
Answer: ____
 “MRS of F for C” – consumer is giving
up C.
 “MRS of C for F” – consumer is giving
up F.
46

47. MRS
MRS X for Y
Y
X
47

48. Marginal Rate of Substitution: Graphs
Clothing
(units) The SLOPE of the
5 Indifference Curve
measures MRS
W
4
BOB is willing to give up 2C
for 1F. His MRS (F for C)=2
3
X
2
1 U1
1 2 3 4 Food (units)
48

49. Marginal Rate of Substitution: Graphs
Clothing
(units) The SLOPE of the
5 Indifference Curve
measures MRS
W
4
Jo is willing to give up 3C
for 1F. Her MRS (F for C)=3
3
2 Her stronger preference for
F/weaker preference for C
X shows up in a steeper IC
1
1 2 3 4 Food (units)
49

50. MRS: Diminishing MRS
Notice that the slope of the IC changes along its
length. This shows that MRS isn’t constant for
Clothing (units) any individual SLOPE OF
A
16 INDIFFERENCE
MRSF for C CURVE
14 = - C/F
=6 MRS is diminishing
12 -6 (6  4  2  1)
making the slope
10 B convex.
1
8 MRSF for C
-4 = - C/F Why?
D
6 1
=2 If you have lots of clothing
-2 E you will be willing to trade
4 G
1 -1 lots of it to get an additional
2 1 unit of food and vice versa
1 2 3 4 5 Food (units)
50

51. Assumptions about
Preferences
 Our Assumptions about preferences
can now be expanded to:
 1. Completeness
 2. Transitivity
 3. Greed
 4. Diminishing MRS or “Convexity”
51

52. Special MRS Cases:
Perfect Substitutes
Apple Perfect substitutes:
Juice 4N This consumer will always trade
(glasses) N units of one good for 1 unit of another
3N MRS is constant:
Slope of indifference curve
does not change
2N
N
Orange Juice
0 1 2 3 4 (glasses)
52

53. Special MRS Cases:
Perfect Complements
Perfect complements:
Left An increase in one good must be
Shoes complemented by an increase in another
good to increase satisfaction
4
MRS is infinite:
Indifference curves have
3 right angles
2
1
0 1 2 3 4 Right Shoes
53

54. Question on Special MRS cases
Good Y
Alvin’s preferences for good X
and good Y are shown in the
diagram opposite. Which
assumption concerning
preferences do Alvin’s
indifference curves violate?
A. Diminishing marginal rates
of substitution
B. Transitivity of preferences
C. More is preferred to less
D. Completeness
Good X
This was a moderately difficult question in a
past year test. Did U get it right?
54

55. Recap:
Theory of Consumer Behavior
1. Different consumers prefer different
goods  Consumer preferences
2. Consumers have limited incomes to
spend  Budget constraint
3. Given their preferences and budget
constraints, rational consumers choose
combinations of goods that maximise
their satisfaction  Consumer choice
55

56. Key Learning Outcomes
 Part 2: Budget constraints
Budget line
Formula
Graphical representation
Effects of income changes on budget line
Effects of price changes on budget line
56

57. Budget Line (Constraint)
 The budget line shows all combinations
of two goods that can be purchased by
a given income level.
 Let I = income level
 Let F = units of food
 Let C = units of clothing
 PF = price per unit of food
 PC = price per unit of clothing
 The budget line formula is:
PFF + PCC = I
Total spend on food
Total spend on clothes
57

58. Note:
 Assume we draw the budget line
with C on the vertical axis...the
equation can be re-arranged as:
PF F  PC C  I
PF
C I  F
PC PC
PF
So the slope is 
PC
58

59. Budget Line Formula:
An Example
 Assume income of $80/week, price per unit
of food is $1 and price per unit of clothing
is $2
o I = $80
o PF = $1
o PC = $2
 Substituting the numbers into the budget
line formula
PFF + PCC = I
1F + 2C = 80
 F & C are unknown
59

60. Budget Line Formula:
An Example
Different choices of food and clothing that
use all the income of $80 can be identified
Basket Units of Units of Budget line
Food (F) Clothing (C) 1F + 2C = 80
A 0 40 1(0) + 2(40) = 80
B 20 30 1(20) + 2(30) = 80
D 40 20 1(40) + 2(20) = 80
E 60 10 1(60) + 2(10) = 80
G 80 0 1(80) + 2(0) = 80
60

61. Budget Line (Clothing on vertical axis):
Drawing the budget line 1F + 2C = 80
Clothing If I spent all my income (80) on
(Units) clothing at p=2, Findmany vertical intercept:
1. how the clothes
could I buy? (80/20=40)
I/PC = 80/2 = 40
40
2. Find the horizontal intercept:
30 I/PF = 80/1 = 80
If I spent all my income (80)
on food at3. Join the 2 intercepts
p=1 how much
20 food could I buy? a straight line to
in (80/1=80)
create the budget line
10
0 20 40 60 80 Units of Food (F)
61

62. Slope of the Budget Line
(Clothing on Vertical Axis)
Using the slope in the graph
= rise/run If Food is on the
= C/F vertical axis, the
formula is F/C
= –40/80
= –1/2
Using the price of the goods
(PF = $1; PC = $2)
= –PF/PC
If Food is on the
= –1/2 vertical axis, the
formula is -PC/PF
62

63. Question on Budget Lines
A consumer has $200 per day to spend on product
A, which has a unit price of $21, and product B,
which has a unit price of $7. What is the slope of
the budget line if good A is on the horizontal axis
and good B is on the vertical axis??
A. -7/21
B. 7/21 You’re given the price of the goods.
C. 21/7 Good B is on the vertical axis.
Formula is - PA/PB
D. -21/7
This question from a past year test was
supposed to be an EASY one !
Make sure you’re clear that the formula changes depending
on what’s on the vertical axis!
63

64. Budget Line:
Change in Income
Clothing
(units) Increase in income -
Parallel outward shift in
80 the budget line
60 Decrease in income -
Parallel inward shift in
the budget line
40
20
L1 L3
Food
0 40 80 120 160 (units)
64

65. Budget Line:
Change in Income – Example
 Assume price per unit of food is $1 and
price per unit of clothing is $2 but
income increases from $80 to $160.
 Using the budget line formula PFF + PCC
=I
L1 = 1F + 2C = 80
L2 = 1F + 2C = 160
 Using the steps in previous slides, graph
the budget lines L1 and L2.
65

66. Budget Line:
Change in Income - Example
Clothing
(units)
80
60
40
20
L1 L2
Food
0 40 80 120 160 (units)
66

67. Budget Line Policy Application:
Planned Compensation for Families
affected by Carbon Tax
LABOR is preparing a multibillion-
dollar carbon tax compensation
package that could leave up to 2.6
million low-income households better
off and a further 1.7 million middle-
income households no worse off.
67

68. Budget Line:
Change in Income - Example
Other goods
(units)
80
60
40
20
L1 L2
Electricity
0 40 80 120 160 (units)
68

69. Budget Line:
Change in Price
Decrease in price of food – >
Clothing Rotates budget line
(units) outward along food axis.
Increase in the price of food
–> Rotates budget line inward
40
along food axis.
L1 L2
L3
Food
40 80 120 160
(units)
69

70. Budget Line:
Change in Price – Example
 Assume income stays the same at $80, and
price per unit of clothing is $2 but price per
unit of food falls from $1 to $0.50.
 Using the budget line formula PFF + PCC = I
L1 = 1F + 2C = 80
L2 = 0.5F + 2C = 80
 Using the steps in previous slides, graph the
budget lines L1 and L2.
70

71. Budget Line:
Change in Price - Example
Clothing
(units)
40
L1 L2
Food
40 80 120 160
(units)
71

72. Budget Line Policy Application:
Change in Price of Electricity
“With a tax of $26 a tonne of carbon
dioxide, the opposition estimates the
annual additional cost of electricity at
$300 a household.
The cost to households estimated by the
opposition appears to be based on an
electricity bill of $1400 a year.”
72

73. Budget Line Policy Application:
Change in Price of Electricity
An increase in the
Other goods
(units) price of electricity by 20% in
rotates the budget line
inward.
L2
L1
Electricity
(units)
73

74. Question on Budget Lines
If the prices of two goods, X Good Y
and Y, increase by 50%, and
income rises by 100%,
A. The slope of the consumer’s
budget line will change,
becoming flatter to indicate
that X and Y are now
relatively less expensive.
B. The consumer’s budget line
will shift out from the original
and its slope will also change,
reflecting the lower prices for
X and Y.
Good X
C. The consumer’s budget line
will shift out from the origin Have to draw diagram for
with its slope unchanged. this one! If you know what
D. The consumer’s budget line happens when price and
will remain unchanged. income changes, you should
get this one right! 74

75. Key Learning Outcomes
 Consumer preferences
 Assumptions of consumer preferences
 Indifference curves
 Indifference maps
 Utility
 MRS
 Formula
 Graphical representation
 Special MRS cases
75

76. Key Learning Outcomes
 Budget constraints
 Budget line
 Formula
 Graphical representation
 Effects of income changes on budget line
 Effects of price changes on budget line
76

77. Assignments Prepared by
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