Consumer Choice

1
Consumer Choice

• Unlimited Wants Limited Resources

2
Main Ideas

• The market demand is the outcome of decisions
  made by individual consumers about how to
  allocate income among competing alternatives.
  For normal goods, demand will slope down.
• Labor supply is outcome of decisions made by
  individuals about how to allocate time among
  competing alternatives. Labor supply may be
  backward bending.

3
Assumptions

• Consumer maximizes utility
• Utility depends on the quantity consumed of X and
  Y
• More is better
• Diminishing Marginal Utility
• Consumer is a price taker.
• Consumer income, I, is also predetermined.

4
Utility
5
Choice is Constrained
6
How Much X and How Much Y?

• Allocate Income Such That the Marginal Benefit of
  an Additional Dollar Spent on Good X Equals Its
  Marginal Cost.
• Marginal Cost is the Foregone Benefit of Spending
  Another Dollar on Y. (Opportunity Cost)
• Operate Within Budget

7
Optimal Consumption
8
Geometry of Consumers Choice

• Budget Line

• Utility
• Indifference Curves

9
The Budget Line
10
Budget Line Describes Consumption Opportunities.
This bundle is unattainable
This bundle does not use all income
11
INTERCEPTS
Quantity of Y Consumer Can Purchase If He Spends
All of His Money on Y Income/Py
Quantity of X Consumer Can Purchase If He Spends
All of His Money on X Income/Px
12
Slope of Budget Line
13
Changes in Income
An Increase in Income shifts budget line out.
Consumer can buy more stuff
14
Changes in Prices
Decrease in Price of X allows consumer to buy
more X with the same income
15
Utility Indifference Curve

• Describes bundles of X and Y that make the
  consumer equally happy.
• Each indifference curve represents a level of
  happiness. The further away from the origin, the
  greater the happiness
• Slope of indifference curve is the rate of
  marginal substitution

16
Indifference Curves Describe Tastes of Individual
Consumer
More is better. Consumer is happier at A than
at B
B
A
5,20
10,10
20,5
Willing to give up 3 Y for every X here
Give up only 1/3 Y for every X here
17
Consumers Optimal Bundle
A -- attainable, but yields less happiness than
B D -- attainable, but more is better C --
preferred to B, but not available
A
B
C
D
18
Derivation of Demand
19
Individual Demand

• P Q 2.5 40 5 20 10 10

20
Impact of Price Change

• Budget set shrinks showing a decrease in real
  purchasing power
• Slope of budget line changes showing a change in
  relative prices. As budget line gets steeper,
  Good X is more expensive relative to Good Y

21
Two Effects of Price Change

• Income Effect -- an increase in Price of X
  reduces purchasing power. (Shrinks budget set.)
  Consumer buys less of normal goods.
• Substitution Effect -- an Increase In Price of X
  Means X is More Expensive Relative to Y.
  (Change in slope) Consumer substitutes away from
  X towards Y.

22
Income and Substitution Effects
1. Price Increase shifts budget from green to
light blue
2. Dk. blue budget line represents income level
that allows consumer to return to old level of
happiness with new prices
X0-Xs - Substitution effect Xs-Xn -Income effect
X0
XN
Xs