Chap - 21 The Theory of Consumer Choice

The Theory of Consumer Choice
Chapter 21
IN THIS CHAPTER YOU WILL . . .
1.See how a budget constraint represents the choices a consumer can afford 2. Learn how indifference curves can be used to represent a consumers preferences 3. Analyze how consumers optimal choices are determined
IN THIS CHAPTER YOU WILL . . . 4.See how a consumer responds to changes in income and changes in prices 5. Decompose the impact of a price change into an income effect and a substitution effect 6. Apply the theory of consumer choice to four questions about household behavior
The theory of consumer choice addresses the following questions:

Do
all demand curves slope downward? How do wages affect labor supply? How do interest rates affect household saving? Do the poor prefer to receive cash or in-kind transfers?
The Budget Constraint

The
budget constraint depicts the consumption bundles that a consumer can afford.
People
consume less than they desire because their spending is constrained, or limited, by their income.
The Budget Constraint
It shows the various combinations of goods the consumer can afford given his or her income and the prices of the two goods.
The Consumers Opportunities

Pints of Pepsi Number of Pizzas Spending on Pepsi Spending on Pizza Total Spending
0 50 100 150 200 250 300 350 400 450 500
100 90 80 70 60 50 40 30 20 10 0
$ 0 100 200 300 400 500 600 700 800 900 1,000
$1,000 900 800 700 600 500 400 300 200 100 0
$1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000
The Consumers Budget Constraint

Any
point on the budget constraint line indicates the consumers combination or tradeoff between two goods. For example, if the consumer buys no pizzas, he can afford 500 pints of Pepsi (point B). If he buys no Pepsi, he can afford 100 pizzas (point A).
The Consumers Budget Constraint...

Quantity of Pepsi 500 B
Consumers budget constraint

A 100
Quantity of Pizza
Alternately,
the consumer can buy 50 pizzas and 250 pints of Pepsi.

Quantity of Pepsi 500
250

A 100
50
Quantity of Pizza

The
slope of the budget constraint line equals the relative price of the two goods, that is, the price of one good compared to the price of the other. It measures the rate at which the consumer will trade one good for the other.
Preferences: What the Consumer Wants A consumers preference among consumption bundles may be illustrated with indifference curves.
Representing Preferences with Indifference Curves
An indifference curve shows bundles of goods that make the consumer equally happy.
The Consumers Preferences...

Quantity of Pepsi C
I2
A 0 Indifference curve, I1 Quantity of Pizza
The Consumers Preferences

The
consumer is indifferent, or equally happy, with the combinations shown at points A, B, and C because they are all on the same curve.
The Marginal Rate of Substitution

The
It
slope at any point on an indifference curve is the marginal rate of substitution.

is the rate at which a consumer is willing to substitute one good for another. It is the amount of one good that a consumer requires as compensation to give up one unit of the other good.

Quantity of Pepsi C
B
MRS
D 1 A
I2
Indifference curve, I1 Quantity of Pizza
Properties of Indifference Curves

Higher indifference curves are
preferred to lower ones. Indifference curves are downward sloping. Indifference curves do not cross. Indifference curves are bowed inward.
Property 1: Higher indifference curves are preferred to lower ones.

Consumers
usually prefer more of something to less of it. Higher indifference curves represent larger quantities of goods than do lower indifference curves.

Quantity of Pepsi C
I2
Property 2: Indifference curves are downward sloping.

A
consumer is willing to give up one good only if he or she gets more of the other good in order to remain equally happy. If the quantity of one good is reduced, the quantity of the other good must increase. For this reason, most indifference curves slope downward.

Quantity of Pepsi
Indifference curve, I1 0 Quantity of Pizza
Property 3: Indifference curves do not cross.

Points
A and B should make the consumer equally happy. Points B and C should make the consumer equally happy. This implies that A and C would make the consumer equally happy. But C has more of both goods compared to A.

Quantity of Pepsi C
A
B
Quantity of Pizza
Property 4: Indifference curves are bowed inward.

People
are more willing to trade away goods that they have in abundance and less willing to trade away goods of which they have little. These differences in a consumers marginal substitution rates cause his or her indifference curve to bow inward.

MRS = 6
8 1 A
4 3 0 2 3
MRS = 1
1
6
Indifference curve Quantity of Pizza
Two Extreme Examples of Indifference Curves
Perfect
substitutes Perfect complements
Perfect Substitutes
Two
goods with straight-line indifference curves are perfect substitutes.

The
marginal rate of substitution is a fixed number.
Perfect Substitutes
Nickels
6 4
I1
I2
2
I3
3 Dimes
Perfect Complements
Two goods with right-angle indifference curves are perfect complements.
Perfect Complements
Left Shoes
7 5
I2 I1
Right Shoes
Optimization: What the Consumer Chooses

Consumers
want to get the combination of goods on the highest possible indifference curve. However, the consumer must also end up on or below his budget constraint.
Optimization: What the Consumer Chooses

Combining
the indifference curve and the budget constraint determines the consumers optimal choice. Consumer optimum occurs at the point where the highest indifference curve and the budget constraint are tangent.
The Consumers Optimal Choice
The consumer chooses consumption of the two goods so that the marginal rate of substitution equals the relative price.
The Consumers Optimal Choice At the consumers optimum, the consumers valuation of the two goods equals the markets valuation.
The Consumers Optimum...

Quantity of Pepsi
Optimum B A
I3
I1
Budget constraint 0
I2
Quantity of Pizza
How Changes in Income Affect the Consumers Choices

An
increase in income shifts the budget constraint outward.

The
consumer is able to choose a better combination of goods on a higher indifference curve.
An Increase in Income...
Quantity of Pepsi New budget constraint 1. An increase in income shifts the budget constraint outward New optimum 3. and Pepsi consumption.
Initial budget constraint
Initial optimum
I2 I1
2. raising pizza consumption Quantity of Pizza
Normal versus Inferior Goods

If
a consumer buys more of a good when his or her income rises, the good is called a normal good. If a consumer buys less of a good when his or her income rises, the good is called an inferior good.
An Inferior Good...
Quantity of Pepsi New budget constraint
3. ... but Pepsi consumption falls, making Pepsi an inferior good.

Initial optimum
1. When an increase in income shifts the budget constraint outward...
New optimum
I1
I2
Quantity of Pizza
2. ... pizza consumption rises, making pizza a normal good...
How Changes in Prices Affect Consumer Choices

A fall in the price of any good rotates the budget constraint outward and changes the slope of the budget constraint.
A Change in Price...
Quantity of Pepsi 1,000
New budget constraint
3. and raising Pepsi consumption.
500
New optimum 1. A fall in the price of Pepsi rotates the budget constraint outward
I2
I1
100 Quantity of Pizza 2. reducing pizza consumption
Initial budget constraint 0
Income and Substitution Effects

A
price change has two effects on consumption.

An
income effect A substitution effect
The Income Effect

The income effect is the change in consumption that results when a price change moves the consumer to a higher or lower indifference curve.
The Substitution Effect

The substitution effect is the change in consumption that results when a price change moves the consumer along an indifference curve to a point with a different marginal rate of substitution.
A Change in Price: Substitution Effect

A price change first causes the consumer to move from one point on an indifference curve to another on the same curve.
Illustrated
by movement from point A to point B.
A Change in Price: Income Effect

After moving from one point to another on the same curve, the consumer will move to another indifference curve.
Illustrated by movement from point B to point C.
Income and Substitution Effects...

Quantity of Pepsi
C New optimum Income effect Substitution effect B Initial optimum
I2 I1
Quantity of Pizza
Substitution effect Income effect
Income and Substitution Effects When the Price of Pepsi Falls

Good Pepsi Income Effect Consumer is richer, so he buys more Pepsi. Substitution Effect Pepsi is relatively cheaper, so consumer buys more Pepsi. Total Effect Income and substitution effects act in same direction, so consumer buys more Pepsi. Income and substitution effects act in opposite directions, so the total effect on pizza consumption is ambiguous.
Pizza
Consumer is richer, so he buys more pizza.
Pizza is relatively more expensive, so consumer buys less pizza.
Deriving the Demand Curve

A consumers demand curve can be viewed as a summary of the optimal decisions that arise from his or her budget constraint and indifference curves.
Deriving the Demand Curve...

(a) The Consumers Optimum Quantity of Pepsi
(b) The Demand Curve for Pepsi Price of Pepsi
150
$2
I2
1 50 0
I1
Quantity of Pizza 0 50 150 Quantity of Pepsi
Do all demand curves slope downward?

Demand
curves can sometimes slope
upward. This happens when a consumer buys more of a good when its price rises.
Giffen Goods
Economists
use the term Giffen good to describe a good that violates the law of demand. Giffen goods are inferior goods for which the income effect dominates the substitution effect. They have demand curves that slope upwards.
Quantity of Potatoes B
A Giffen Good...
2...which D increases potato consumption if potatoes are a Giffen good. 0
Optimum with high price of potatoes Optimum with low price of potatoes C 1. An increase in the price of potatoes rotates the budget...

A
I2
I1
Quantity of Meat
How do wages affect labor supply?

If
the substitution effect is greater than the income effect for the worker, he or she works more. If income effect is greater than the substitution effect, he or she works less.
The Work-Leisure Decision...

Consumption $5,000
Optimum 2,000
I3
I2 I1
60
100
Hours of Leisure
An Increase in the Wage...

Consumption
(a) For a person with these preferences . . . the labor supply curve slopes upward.
Wage
1. When the wage rises
I2 BC1 BC2 I1
Hours of Leisure 2. hours of leisure decrease 0
Hours of Labor Supplied 3. ...and hours of labor increase.

Consumption
(b) For a person with these preferences . . . the labor supply curve slopes backward.
BC2
Wage
BC1 I1
0
I2
Hours of Leisure 2. hours of leisure increase
Hours of Labor Supplied 3. ...and hours of labor decrease.
How do interest rates affect household saving?

If
the substitution effect of a higher interest rate is greater than the income effect, households save more. If the income effect of a higher interest rate is greater than the substitution effect, households save less.
The Consumption-Saving Decision...

Consumption when Old Budget constraint $110,000
55,000
Optimum
I3 I2 I1
0 $50,000 100,000 Consumption when Young
An Increase in the Interest Rate...

BC2
Consumption when Old (a) Higher Interest Rate Raises Saving (b) Higher Interest Rate Lowers Saving
Consumption when Old
BC2
1. A higher interest rate rotates the budget constraint outward...
BC1
I2
BC1 I1 I1
0 Consumption 2. resulting in lower when Young consumption when young and, thus, higher saving. 0
I2
2. resulting in higher consumption when young and, thus, lower saving.
Hours of Leisure
How do interest rates affect household saving? Thus, an increase in the interest rate could either encourage or discourage saving.
Do the poor prefer to receive cash or in-kind transfers?

If an in-kind transfer of a good forces the recipient to consume more of the good than he would on his own, then the recipient prefers the cash transfer.
Do the poor prefer to receive cash or in-kind transfers?

If the recipient does not consume more of the good than he would on his own, then the cash and in-kind transfer have exactly the same effect on his consumption and welfare.
Cash versus In-Kind Transfers...

(a) The Constraint Is Not Binding
Food Cash Transfer Food In-Kind Transfer
BC2 (with $1,000 cash)
BC2 (with $1,000 food stamps)
BC1
BC1
B
$1,000
I2
A
$1,000
I2
A
I1
0 Nonfood Consumption
I1
Nonfood Consumption

(b) The Constraint Is Binding
BC1
BC1
$1,000
B A
$1,000
C B
I1
I2
I1
I2 I3
Nonfood Consumption
Summary
A
consumers budget constraint shows the possible combinations of different goods he can buy given his income and the prices of the goods. The slope of the budget constraint equals the relative price of the goods. The consumers indifference curves represent his preferences.
Summary
Points
on higher indifference curves are preferred to points on lower indifference curves. The slope of an indifference curve at any point is the consumers marginal rate of substitution. The consumer optimizes by choosing the point on his budget constraint that lies on the highest indifference curve.
Summary
When
the price of a good falls, the impact on the consumers choices can be broken down into an income effect and a substitution effect. The income effect is the change in consumption that arises because a lower price makes the consumer better off. The income effect is reflected by the movement from a lower to a higher indifference curve.
Summary
The
substitution effect is the change in consumption that arises because a price change encourages greater consumption of the good that has become relatively cheaper. The substitution effect is reflected by a movement along an indifference curve to a point with a different slope.
Summary
The
theory of consumer choice can explain:

Why
demand curves can potentially slope upward. How wages affect labor supply. How interest rates affect household saving. Whether the poor prefer to receive cash or inkind transfers.
Graphical Review

Quantity of Pepsi 500 B

A 100
Quantity of Pizza

250

A 100
50
Quantity of Pizza

Quantity of Pepsi C
I2

Quantity of Pepsi C
B
MRS
D 1 A
I2
Indifference curve, I1 Quantity of Pizza

Quantity of Pepsi C
I2

Quantity of Pepsi
Indifference curve, I1 0 Quantity of Pizza

Quantity of Pepsi C
A
B
Quantity of Pizza

MRS = 6
8 1 A
4 3 0 2 3
MRS = 1
1
6
Indifference curve Quantity of Pizza
Perfect Substitutes
Nickels
6 4
I1
I2
2
I3
3 Dimes
Perfect Complements
Left Shoes
7 5
I2 I1
Right Shoes
The Consumers Optimum...

Quantity of Pepsi
Optimum B A
I3
I1
Budget constraint 0
I2
Quantity of Pizza
Harcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
An Increase in Income...
Quantity of Pepsi New budget constraint 1. An increase in income shifts the budget constraint outward New optimum 3. and Pepsi consumption.
Initial optimum
I2 I1
2. raising pizza consumption Quantity of Pizza
An Inferior Good...
Quantity of Pepsi New budget constraint
3. ... but Pepsi consumption falls, making Pepsi an inferior good.

Initial optimum
1. When an increase in income shifts the budget constraint outward...
New optimum
I1
I2
Quantity of Pizza
2. ... pizza consumption rises, making pizza a normal good...
A Change in Price...
Quantity of Pepsi 1,000
3. and raising Pepsi consumption.
500
New optimum 1. A fall in the price of Pepsi rotates the budget constraint outward
I2
I1
100 Quantity of Pizza 2. reducing pizza consumption
Income and Substitution Effects...

Quantity of Pepsi
C New optimum Income effect Substitution effect B Initial optimum
I2 I1
Quantity of Pizza
Substitution effect Income effect
Deriving the Demand Curve...

(a) The Consumers Optimum Quantity of Pepsi
(b) The Demand Curve for Pepsi Price of Pepsi
150
$2
I2
1 50 0
I1
Quantity of Pizza 0 50 150 Quantity of Pepsi
Quantity of Potatoes B
A Giffen Good...
2...which D increases potato consumption if potatoes are a Giffen good. 0
Optimum with high price of potatoes Optimum with low price of potatoes C 1. An increase in the price of potatoes rotates the budget...

A
I2
I1
Quantity of Meat
The Work-Leisure Decision...

Consumption $5,000
Optimum 2,000
I3
I2 I1
60
100
Hours of Leisure

Consumption (a) For a person with these preferences . . . the labor supply curve slopes upward.
Wage
I2 BC1 BC2 I1
Hours of Leisure 2. hours of leisure decrease 0
Hours of Labor Supplied 3. ...and hours of labor increase.

Consumption (b) For a person with these preferences . . . the labor supply curve slopes backward.
BC2
Wage
BC1 I1
0
I2
Hours of Leisure 2. hours of leisure increase
Hours of Labor Supplied 3. ...and hours of labor decrease.
The Consumption-Saving Decision...

Consumption when Old Budget constraint $110,000
55,000
Optimum
I3 I2 I1
0 $50,000 100,000 Consumption when Young
An Increase in the Interest Rate...

BC2
Consumption when Old (a) Higher Interest Rate Raises Saving (b) Higher Interest Rate Lowers Saving
Consumption when Old
BC2
BC1
I2
BC1 I1 I1
0 Consumption 2. resulting in lower when Young consumption when young and, thus, higher saving. 0
I2
2. resulting in higher consumption when young and, thus, lower saving.
Hours of Leisure

(a) The Constraint Is Not Binding
BC1
BC1
B
$1,000
I2
A
$1,000
I2
A
I1
I1
Nonfood Consumption

(b) The Constraint Is Binding
BC1
BC1
$1,000
B A
$1,000
C B
I1
I2
I1
I2 I3
Nonfood Consumption

Chap - 21 The Theory of Consumer Choice

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Chap - 21 The Theory of Consumer Choice

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The Theory of Consumer Choice

IN THIS CHAPTER YOU WILL . . .

The theory of consumer choice addresses the following questions:

The Budget Constraint

The Budget Constraint

The Consumers Opportunities

0 50 100 150 200 250 300 350 400 450 500

The Consumers Budget Constraint

The Consumers Budget Constraint...

Consumers budget constraint

The Consumers Budget Constraint

the consumer can buy 50 pizzas and 250 pints of Pepsi.

The Consumers Budget Constraint...

Consumers budget constraint

The Consumers Budget Constraint

Representing Preferences with Indifference Curves

The Consumers Preferences...

The Consumers Preferences

The Marginal Rate of Substitution

slope at any point on an indifference curve is the marginal rate of substitution.

The Consumers Preferences...

Properties of Indifference Curves

Property 1: Higher indifference curves are preferred to lower ones.

Property 1: Higher indifference curves are preferred to lower ones.

Property 2: Indifference curves are downward sloping.

Property 2: Indifference curves are downward sloping.

Indifference curve, I1 0 Quantity of Pizza

Property 3: Indifference curves do not cross.

Property 3: Indifference curves do not cross.

Property 4: Indifference curves are bowed inward.

Property 4: Indifference curves are bowed inward.

Indifference curve Quantity of Pizza

Two Extreme Examples of Indifference Curves

substitutes Perfect complements

goods with straight-line indifference curves are perfect substitutes.

marginal rate of substitution is a fixed number.

Two goods with right-angle indifference curves are perfect complements.

Optimization: What the Consumer Chooses

Optimization: What the Consumer Chooses

The Consumers Optimal Choice

The Consumers Optimum...

How Changes in Income Affect the Consumers Choices

increase in income shifts the budget constraint outward.

consumer is able to choose a better combination of goods on a higher indifference curve.

Normal versus Inferior Goods

3. ... but Pepsi consumption falls, making Pepsi an inferior good.

1. When an increase in income shifts the budget constraint outward...

2. ... pizza consumption rises, making pizza a normal good...

How Changes in Prices Affect Consumer Choices

New budget constraint

3. and raising Pepsi consumption.

Initial budget constraint 0

Income and Substitution Effects

price change has two effects on consumption.

income effect A substitution effect

The Income Effect

The Substitution Effect

A Change in Price: Substitution Effect

by movement from point A to point B.

A Change in Price: Income Effect

Illustrated by movement from point B to point C.

Income and Substitution Effects...

New budget constraint