The Theory of Consumer Choice

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PowerPoint Slides prepared by:

Andreea CHIRITESCU

Eastern Illinois University

Budget Constraint

• Budget constraint
• Limit on the consumption bundles that a consumer can afford
• Slope of the budget constraint
• Rate at which the consumer can trade one good for the other
• Relative price of the two goods

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Figure 1

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Consumer’s Budget Constraint

The budget constraint shows the various bundles of goods that the consumer can buy for a given income. Here the consumer buys bundles of pizza and Pepsi. The table and graph show what the consumer can afford if his income is $1,000, the price of pizza is $10, and the price of Pepsi is $2.

Figure 1

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Consumer’s Budget Constraint

The budget constraint shows the various bundles of goods that the consumer can buy for a given income. Here the consumer buys bundles of pizza and Pepsi. The table and graph show what the consumer can afford if his income is $1,000, the price of pizza is $10, and the price of Pepsi is $2.

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Preferences

• Indifference curve
• Shows consumption bundles that give the consumer the same level of satisfaction
• Slope of indifference curve
• Marginal rate of substitution
• Rate at which a consumer is willing to trade one good for another
• Not the same at all points

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Figure 2

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The Consumer’s Preferences

The consumer’s preferences are represented with indifference curves, which show the combinations of pizza and Pepsi that make the consumer equally satisfied. Because the consumer prefers more of a good, points on a higher indifference curve (I₂ here) are preferred to points on a lower indifference curve (I₁). The marginal rate of substitution (MRS) shows the rate at which the consumer is willing to trade Pepsi for pizza. It measures the quantity of Pepsi the consumer must be given in exchange for 1 pizza.

Preferences

• Four properties of indifference curves
1. Higher indifference curves are preferred to lower ones
• Higher indifference curves – more goods
2. Indifference curves are downward sloping
3. Indifference curves do not cross
4. Indifference curves are bowed inward

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Bowed Indifference Curves

Indifference curves are usually bowed inward. This shape implies that the marginal rate of substitution (MRS) depends on the quantity of the two goods the consumer is consuming. At point A, the consumer has little pizza and much Pepsi, so he requires a lot of extra Pepsi to induce him to give up one of the pizzas: The marginal rate of substitution is 6 pints of Pepsi per pizza. At point B, the consumer has much pizza and little Pepsi, so he requires only a little extra Pepsi to induce him to give up one of the pizzas: The marginal rate of substitution is 1 pint of Pepsi per pizza.

Preferences

• Extreme examples of indifference curves
• Perfect substitutes
• Two goods with straight-line indifference curves
• Marginal rate of substitution – constant
• Perfect complements
• Two goods with right-angle indifference curves

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Perfect Substitutes and Perfect Complements

When two goods are easily substitutable, such as nickels and dimes, the indifference curves are straight lines, as shown in panel (a). When two goods are strongly complementary, such as left shoes and right shoes, the indifference curves are right angles, as shown in panel (b).

(a) Perfect Substitutes

(b) Perfect Complements

Optimization

• Optimum
• Point where indifference curve and budget constraint touch
• Best combination of goods available to the consumer
• Marginal rate of substitution

= Relative price

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Consumer’s Optimum

The consumer chooses the point on his budget constraint that lies on the highest indifference curve. At this point, called the optimum, the marginal rate of substitution equals the relative price of the two goods. Here the highest indifference curve the consumer can reach is I₂. The consumer prefers point A, which lies on indifference curve I₃, but the consumer cannot afford this bundle of pizza and Pepsi. By contrast, point B is affordable, but because it lies on a lower indifference curve, the consumer does not prefer it.

Optimization

• Higher income
• Consumer can afford more of both goods
• Shifts the budget constraint outward
• New optimum
• Normal good
• Good for which an increase in income raises the quantity demanded

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An Increase in Income

When the consumer’s income rises, the budget constraint shifts out. If both goods are normal goods, the consumer responds to the increase in income by buying more of both of them. Here the consumer buys more pizza and more Pepsi.

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A Change in Price

When the price of Pepsi falls, the consumer’s budget constraint shifts outward and changes slope. The consumer moves from the initial optimum to the new optimum, which changes his purchases of both pizza and Pepsi. In this case, the quantity of Pepsi consumed rises, and the quantity of pizza consumed falls.

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Income and Substitution Effects

The effect of a change in price can be broken down into an income effect and a substitution effect. The substitution effect—the movement along an indifference curve to a point with a different marginal rate of substitution—is shown here as the change from point A to point B along indifference curve I₁. The income effect—the shift to a higher indifference curve—is shown here as the change from point B on indifference curve I₁ to point C on indifference curve I₂.

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The Work-Leisure Decision

This figure shows Sally’s budget constraint for deciding how much to work, her indifference curves for consumption and leisure, and her optimum.

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An Increase in the Wage (a)

The two panels of this figure show how a person might respond to an increase in the wage. The graphs on the left show the consumer’s initial budget constraint, BC₁, and new budget constraint, BC₂, as well as the consumer’s optimal choices over consumption and leisure. The graphs on the right show the resulting labor-supply curve. Because hours worked equal total hours available minus hours of leisure, any change in leisure implies an opposite change in the quantity of labor supplied. In panel (a), when the wage rises, consumption rises and leisure falls, resulting in a labor-supply curve that slopes upward.

(a) For a person with these preferences . . .

. . . the labor supply curve slopes upward.

Income effects on labor supply

• Andrew Carnegie, 19^th century
• “The parent who leaves his son enormous wealth generally deadens the talents and energies of the son, and tempts him to lead a less useful and less worthy life than he otherwise would”
• Income effect on labor supply – substantial

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.