Chapter 21 The Theory of Consumer Choice

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Chapter 21 The Theory of Consumer Choice

• Outline of Topics
• T1 The budget constraint What the consumer can
  afford
• T2 Preference What the consumer wants
• T3 Optimization What the consumer chooses
• T4 Four Applications

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• T1, The budget constraint What the consumer can
  afford
• Budget constraint the limit on the consumption
  bundles that a consumer can afford
• People consume less than they desire because
  their spending is constrained, or limited, by
  their income.
• See Table 21-1 and Figure 21-1 on page 469
• All the points on the line from A to B are
  possible. This line, called budget constraint,
  shows the consumption bundles that the consumer
  can afford.
• It also shows the tradeoff between two goods that
  the consumer faces. The slope of the budget
  constraint measures the rate at which the
  consumer can trade one good for the other.
• The slope of the budget constraint equals the
  relative price of the two goods-the price of one
  good compared with the price of the other.

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• T2 Preference What the consumer wants
• Indifference curve a curve that shows the
  consumption bundles that give the consumer the
  same level of satisfaction
• If the two bundles suit his tastes equally well,
  we say that the consumer is indifferent between
  the two bundles.
• The consumer is equally happy at all points on
  any given indifference curve, but he prefers some
  indifference curves to others. Because he prefers
  more consumption to less, higher indifference
  curves are preferred to lower ones.
• See Figure 21-2 on page 471
• The slope at any point on an indifference curve
  equals the rate at which the consumer is willing
  to substitute one good for the other. This rate
  is called the marginal rate of substitution (MRS).

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• MRS the rate at which a consumer is willing to
  trade one good for another.
• Four Properties of Indifference Curves
• Property 1 Higher indifference curves are
  preferred to lower ones.
• Property 2 Indifference curves are downward
  sloping.
• Property 3 Indifference curves do not cross.
• See Figure 21-3
• Property 4 Indifference curves are bowed inward.
• See Figure 21-4
• The bowed shape of the indifference curve
  reflects the consumers greater willingness to
  give up a good that he already has in large
  quantity

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• Two extreme examples of Indifference Curves
• Perfect Substitute Two goods with straight-line
  indifference curves eg, nickels and dimes
• Perfect complements Two goods with right-angle
  indifference curves eg, left shoes and right
  shoes.
• See Figure 21-5 on page 474
• T3 Optimization What the consumer chooses
• The consumers optimal choices The consumer
  chooses the point on his budget constraint that
  lies on the highest indifference curve.
• We say that the indifference curve is tangent to
  the budget constraint.
• At this point,called the optimum, the marginal
  rate of substitution equals the relative price of
  the two goods.

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• Thus, the consumer chooses consumption of the two
  goods so that the marginal rate of substitution
  equals the relative price.
• See Figure 21-6 on page 476
• How changes in income affect the consumers
  choices When the consumers income raises, 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.
• See Figure 21-7 on page 477
• If an increase in income induces the consumer to
  buy more of Good 1 but less of Good 2, then
  economists call Good 2, an inferior good.
• See Figure 21-8 on page 478

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• How changes in prices affect the consumers
  choices
• When the price of Pepsi falls, the consumers
  budget constraint shifts outward and changes
  slope. The consumer moves from the initial
  optimum to the new optimum, which changes his
  purchases of both Pepsi and pizza.
• See Figure 21-9 on page 479.
• Income and Substitution Effects
• The impact of a change in the price of a good on
  consumption can be decomposed into two effects
  an income effect and a substitution effect.
• Income effect the change in consumption that
  results when a price change moves the consumer to
  a higher or lower indifference curve

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• Substitution effect the change in consumption
  that results when a price change moves the
  consumer along a given indifference curve to a
  point with a new marginal rate of substitution
• Now consider the end result of these two effects.
  In our example, we assume that Pepsi is cheaper
  and pizza is still the same price. See Figure
  21-10 on page 480.
• The consumer certainly buys more Pepsi, because
  the income and substitution effects both act to
  raise purchases of Pepsi.
• But it is ambiguous whether the consumer buys
  more pizza because the income and substitution
  effects work in opposite directions.

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• See Table 21-2 on page 480 for conclusion also
  page 481 regarding to two steps of change, A-B
  B-C.
• Deriving the demand curve
• Recall that a demand curve shows the quantity
  demanded of a good for any given price. We can
  view a consumers demand curve as a summary of
  the optimal decision that arise from his or her
  budget constraint and indifference curves.
• See Figure 21-11 on page 482.

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• T4 Four Applications
• 1, Do all demand curves slope downward?
• Demand curves can sometimes slope upward. In
  other words, consumers can sometimes violate the
  law of demand and buy more of a good when the
  price rises.
• Giffen good a good for which an increase in the
  price raises the quantity demanded
• See Figure 21-12. Notice that a rise in the price
  of potatoes has led the consumer to buy a larger
  quantity of potatoes. The reason is that potatoes
  here are a strongly inferior good. When the price
  of potatoes rises, the consumer is poorer. The
  income effect makes the consumer want to buy less
  meat and more potatoes.
• But, Giffen goods are very rare.

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• 2, How do wages affect labour supply?
• See Figure 21-13 on page 484 for the Work-Leisure
  Decision.
• Now consider what happens when the wage
  increases. See Figure 21-14 on page 485.
• Two possible outcomes
• labour supply curve has an upward slope Agent
  responds to the higher wage by working harder and
  enjoying less leisure.
• labour supply curve has a backward slope Agent
  responds to the higher wage by enjoying more
  leisure.
• Why would a person respond to a higher wage by
  working less? Because of income and substitution
  effects of a higher wage.

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• SE When the wage rises, leisure becomes more
  costly relative to consumption, and this
  encourage the agent to substitute consumption for
  leisure.
• In other words, the SE induces the agent to work
  harder in response to higher wages.
• IE When the wage rises, the agent moves to a
  higher indifference curve. She is now better off
  than she was. As long as consumption and leisure
  are both normal goods, she tends to use this
  increase in well-being to enjoy higher
  consumption and greater leisure.
• In other words, the IE induces the agent to work
  less, which tends to make the labour supply curve
  slope backward.

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• 3, How do interest rates affect household saving?
• See Figure 21-15 on page 488, the
  consumption-saving decision
• Now, consider what happens when the interest rate
  increases. See Figure 21-16 on page 489.
• Two possible outcomes because of different
  preferences
• However, in both cases, the budget constraint
  shifts outward and becomes steeper. Besides,
  consumption when old rises in both cases.
• In panel (a), Rohan responds to the higher
  interest rate by consuming less when young.
• In panel (b), Rohan responds by consuming more
  when young.
• 4, Do the poor prefer to receive cash or in-kind
  transfers?

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• The government wants to help Paula because of her
  low income. The government can either give Paula
  1000 worth of food or simply give her 1000 in
  cash. What does the theory of consumer choice
  have to say about the comparison between these
  two policy options?
• See Figure 21-17 on page 490.
• The theory of consumer choice teaches a simple
  lesson about cash vs. in-kind transfers.
• If an in-kind transfer of a good forces the
  recipient to consume more of the good than he or
  she would on his or her own, then the recipient
  prefers the cash transfer.
• If an in-kind transfer of a good does not forces
  the recipient to consume more of the good than he
  or she would on his or her own, then the cash and
  in-kind transfer have exactly the same effect on
  the consumption and welfare of the recipient.