THE THEORY OF CONSUMER CHOICE

1
THE THEORY OF CONSUMER CHOICE

• Chapter 21

2
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?

3
The Budget Constraint

• The budget constraint depicts the consumption
  bundles that a consumer can afford.
• ä People consume less than they desire because
  their spending is constrained, or limited, by
  their income.

4
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.

5
The Budget Constraint
6
The Budget Constraint Line

• 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. If he buys no
  Pepsi, he can afford 100 pizzas.

7
The Budget Constraint Line
500
250
0
50
100
8
The Budget Constraint Line
B
500
250
A
0
50
100
9
The Budget Constraint Line
B
500
250
A
0
50
100
10
The Budget Constraint Line

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

11
The Budget Constraint Line
B
500
C
250
A
0
50
100
12
The Budget Constraint Line

• 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.

13
The Budget Constraint Line

• It measures the rate at which the consumer will
  trade one good for the other.

14
Preferences What the Consumer Wants

• A consumers preference among consumption bundles
  may be illustrated with indifference curves.

15
Preferences What the Consumer Wants

• An indifference curve shows bundles of goods that
  leave the consumer equally satisfied.

16
Indifference Curves
17
Indifference Curves

0
18
Indifference Curves

0
19
Indifference Curves

• 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.

20
Indifference Curves

0
21
Indifference Curves
C
B
A

0
22
The Marginal Rate of Substitution

• The slope at any point on an indifference curve
  is the marginal rate of substitution.
• ä It is the rate at which a consumer is
  willing to trade one good for another.
• ä It is the amount of one good that a
  consumer requires as compensation to give up
  one unit of the other good.

23
Indifference Curves

0
24
Indifference Curves
Slope

0
25
The Marginal Rate of Substitution

0
26
The Marginal Rate of Substitution
MRS
1

0
27
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.

28
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.

29
Indifference Curves

0
30
Indifference Curves
I2

0
31
Indifference Curves
C
B
I2
A

0
32
Indifference Curves
C
B
D
I2
A

0
33
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.
• If the quantity of one good is reduced, the
  quantity of the other good must increase.
• For this reason, most indifference curves slope
  downward.

34
Indifference curves are downward sloping.

0
35
Indifference curves do not cross.

• In order for preference rankings to be
  consistent, indifference curves cannot intersect
  or cross.
• If indifference curves were to cross the
  assumption that more is preferred to less would
  be violated.

36
Indifference curves do not cross.
C
A
B
0
37
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 causes his or her indifference
  curve to bow inward.

38
Indifference curves are bowed inward.
0
39
Indifference curves are bowed inward.
0
40
Indifference curves are bowed inward.
14
A
8
0
2
3
41
Indifference curves are bowed inward.
14
MRS 6
A
8
1
0
2
3
42
Indifference curves are bowed inward.
14
MRS 6
A
8
1
4
B
3
0
2
3
6
7
43
Indifference curves are bowed inward.
14
MRS 6
A
8
1
4
B
MRS 1
3
1
0
2
3
6
7
44
Extreme Indifference Curves

• Perfect substitutes
• Perfect complements

45
Perfect Substitutes

• Two goods with straight-line indifference curves
  are perfect substitutes.
• äThe marginal rate of substitution is constant.

46
Perfect Substitutes
47
Perfect Complements

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

48
Perfect Complements
I2
7
5
I1
7
5
Right Shoes
0
49
Quick Quiz!

• Draw some indifference curves for Pepsi and
  pizza.
• Explain the four properties of these indifference
  curves.

50
Optimization What the Consumer Chooses

• Consumers want to get the combination of goods on
  the highest possible indifference curve.
• ä However, the budget constraint may restrict
  or limit the consumer to a lower indifference
  curve.

51
Optimization What the Consumer Chooses

• Combining the indifference curve and the budget
  constraint determines the consumers optimal
  choice.

52
The Consumers Optimal Choice

• Consumer optimum occurs at the point where the
  highest indifference curve and the budget
  constraint are tangent.

53
The Consumers Optimal Choice

• The consumer chooses consumption of the two goods
  so that the marginal rate of substitution equals
  the relative price.

54
The Consumers Optimal Choice

• The consumers valuation of the two goods equals
  the markets valuation.

55
The Consumers Optimal Choice
56
The Consumers Optimal Choice
0
57
The Consumers Optimal Choice
I1
0
58
The Consumers Optimal Choice
I2
I1
0
59
The Consumers Optimal Choice
I3
I2
I1
0
60
The Consumers Optimal Choice
I3
I2
I1
Budget constraint
0
61
The Consumers Optimal Choice
Optimum
I3
I2
I1
Budget constraint
0
62
Changes in Income Affect Consumer Choices

• An increase in income shifts the budget
  constraint outward.
• ä The consumer is able to choose a better
  combination of goods on a higher
  indifference curve.

63
Changes in Income Affect Consumer Choices
64
Changes in Income Affect Consumer Choices
0
65
Changes in Income Affect Consumer Choices
I1
0
66
Changes in Income Affect Consumer Choices
I1
0
67
Changes in Income Affect Consumer Choices
New budget constraint
I1
0
68
Changes in Income Affect Consumer Choices
New budget constraint
I2
I1
0
69
Changes in Income Affect Consumer Choices
New budget constraint
New optimum
I2
I1
0
70
Changes in Income Affect Consumer Choices
New budget constraint
1. An increase in income shifts the budget
constraint outward
New optimum
I2
I1
0
71
Changes in Income Affect Consumer Choices
New budget constraint
1. An increase in income shifts the budget
constraint outward
New optimum
I2
I1
0
2. raising pizza consumption
72
Changes in Income Affect Consumer Choices
New budget constraint
1. An increase in income shifts the budget
constraint outward
New optimum
3. and Pepsi consumption.
I2
I1
0
2. raising pizza consumption
73
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.

74
An Inferior Good
75
An Inferior Good
Quantity
of Pepsi
Quantity
0
of Pizza
76
An Inferior Good
Quantity
of Pepsi
I1
Quantity
0
of Pizza
77
An Inferior Good
Quantity
of Pepsi
I1
Quantity
0
of Pizza
78
An Inferior Good
Quantity
of Pepsi
Initial
optimum
I1
Quantity
0
of Pizza
79
An Inferior Good
Quantity
of Pepsi
New budget constraint
Initial
optimum
I1
Quantity
0
of Pizza
80
An Inferior Good
Quantity
of Pepsi
New budget constraint
Initial
optimum
I2
I1
Quantity
0
of Pizza
81
An Inferior Good
Quantity
of Pepsi
New budget constraint
Initial
optimum
New optimum
I2
I1
Quantity
0
of Pizza
82
An Inferior Good
Quantity
of Pepsi
New budget constraint
1. When an increase in income shifts the budget
constraint outward...
Initial
optimum
New optimum
I2
I1
Quantity
0
of Pizza
83
An Inferior Good
Quantity
of Pepsi
New budget constraint
1. When an increase in income shifts the budget
constraint outward...
Initial
optimum
New optimum
I2
I1
Quantity
0
of Pizza
2. ... pizza consumption rises, making pizza a
normal good...
84
An Inferior Good
Quantity
of Pepsi
New budget constraint
3. ... but Pepsi consumption falls, making Pepsi
an inferior good.
1. When an increase in income shifts the budget
constraint outward...
Initial
optimum
New optimum
I2
I1
Quantity
0
of Pizza
2. ... pizza consumption rises, making pizza a
normal good...
85
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.

86
Changes in Prices Affect Consumer Choices
Quantity
of Pepsi
Quantity of Pizza
0
87
Changes in Prices Affect Consumer Choices
Quantity
of Pepsi
500
I1
Quantity of Pizza
100
0
88
Changes in Prices Affect Consumer Choices
Quantity
of Pepsi
500
I1
Initial budget constraint
Quantity of Pizza
100
0
89
Changes in Prices Affect Consumer Choices
Quantity
of Pepsi
500
Initial optimum
I1
Initial budget constraint
Quantity of Pizza
100
0
90
Changes in Prices Affect Consumer Choices
Quantity
of Pepsi
1. A fall in the price of Pepsi rotates the
budget constraint outward
500
I1
Initial budget constraint
Quantity of Pizza
100
0
91
Changes in Prices Affect Consumer Choices
Quantity
of Pepsi
New budget constraint
1,000
1. A fall in the price of Pepsi rotates the
budget constraint outward
500
I1
Initial budget constraint
Quantity of Pizza
100
0
92
Changes in Prices Affect Consumer Choices
Quantity
of Pepsi
New budget constraint
1,000
1. A fall in the price of Pepsi rotates the
budget constraint outward
500
I2
I1
Initial budget constraint
Quantity of Pizza
100
0
93
Changes in Prices Affect Consumer Choices
Quantity
of Pepsi
New budget constraint
1,000
New optimum
1. A fall in the price of Pepsi rotates the
budget constraint outward
500
I2
I1
Initial budget constraint
Quantity of Pizza
100
0
94
Changes in Prices Affect Consumer Choices
Quantity
of Pepsi
New budget constraint
1,000
New optimum
1. A fall in the price of Pepsi rotates the
budget constraint outward
500
I2
I1
Initial budget constraint
Quantity of Pizza
100
0
2. reducing pizza consumption
95
Changes in Prices Affect Consumer Choices
Quantity
of Pepsi
New budget constraint
1,000
New optimum
1. A fall in the price of Pepsi rotates the
budget constraint outward
500
3. and raising Pepsi consumption.
I2
I1
Initial budget constraint
Quantity of Pizza
100
0
2. reducing pizza consumption
96
Income and Substitution Effects

• A price change has two effects on consumption.
• ä An income effect
• ä A substitution effect

97
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 consumer is . . .
• . . . worse off when prices increase.
• . . . better off when prices decrease.

98
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.

99
The Substitution Effect

• When the price of a good increases, the amount of
  other goods that must be given up increases.

100
A Change in Price Substitution Effect

• A price change first causes the consumer to move
  from one point on a indifference curve to another
  on the same curve.
• ä Illustrated by movement from point A to point
  B.

101
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.
• ä Illustrated by movement from point B to point
  C.

102
Income and Substitution Effects
Quantity of Pizza
0
103
Income and Substitution Effects
Initial budget constraint
I1
Quantity of Pizza
0
104
Income and Substitution Effects
Initial optimum
A
Initial budget constraint
I1
Quantity of Pizza
0
105
Income and Substitution Effects
Initial optimum
A
Initial budget constraint
I1
Quantity of Pizza
0
106
Income and Substitution Effects
B
Initial optimum
A
Initial budget constraint
I1
Quantity of Pizza
0
107
Income and Substitution Effects
B
Initial optimum
Substitution effect
A
Initial budget constraint
I1
Quantity of Pizza
0
Substitution effect
108
Income and Substitution Effects
New budget constraint
B
Initial optimum
Substitution effect
A
Initial budget constraint
I1
Quantity of Pizza
0
Substitution effect
109
Income and Substitution Effects
New budget constraint
B
Initial optimum
Substitution effect
A
Initial budget constraint
I1
Quantity of Pizza
0
Substitution effect
110
Income and Substitution Effects
New budget constraint
B
Initial optimum
Substitution effect
A
I2
Initial budget constraint
I1
Quantity of Pizza
0
Substitution effect
111
Income and Substitution Effects
New budget constraint
C
New optimum
B
Initial optimum
Substitution effect
A
I2
Initial budget constraint
I1
Quantity of Pizza
0
Substitution effect
112
Income and Substitution Effects
New budget constraint
C
New optimum
Income effect
B
Initial optimum
Substitution effect
A
I2
Initial budget constraint
I1
Quantity of Pizza
0
Substitution effect
Income effect
113
Quick Quiz!

• Draw a budget constraint and indifference curves
  for Pepsi and pizza.

114
Quick Quiz!

• Show what happens to the budget constraint and
  the consumers optimum when the price of pizza
  rises.

115
Quick Quiz!

• Identify income and substitution effects.

116
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.

117
Deriving the Demand Curve
The Consumers Optimum
The Demand Curve for Pepsi
118
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.

119
Giffen Goods

• An increase in the price of a Giffen good raises
  the quantity demanded.
• Giffen goods are inferior goods for which the
  income effect dominates the substitution effect.
  
• They have demand curves that slope upwards.

120
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.

121
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.

122
How do interest rates affect household saving?

• Thus, an increase in the interest rate could
  either encourage or discourage saving.

123
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.

124
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.

125
Conclusion

• A consumers budget constraint shows the possible
  combinations of different goods he or she can buy
  given his or her income and the prices of the
  goods.
• Indifference curves represent a consumers
  combinations of preferences between two goods.

126
Conclusion

• Consumers prefer higher indifference curves to
  lower indifference curves.
• The consumer optimizes by choosing the point on
  his budget constraint that lies on the highest
  indifference curve.

127
Conclusion

• Income effect is the change in consumption that
  arises because a lower price makes the consumer
  better off.
• Substitution effect is the change in consumption
  that arises because a price change encourages
  greater consumption of the good that has become
  relatively cheaper.

128
Conclusion

• Income effect is reflected by the movement from a
  lower to a higher indifference curve.
• Substitution effect is reflected by a movement
  along an indifference curve to a point with a
  different slope.

129
Conclusion

• The theory of consumer choice can explain
• How wages affect labor supply
• How interest rates affect household saving
• Whether the poor prefer to receive cash or
  in-kind transfers

130
THE THEORY OF CONSUMER CHOICE

• End of Chapter 21

131
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132
Figure 21-1
133
Figure 21-2
134
Figure 21-3
135
Figure 21-4
136
(a) Perfect Substitutes
(b) Perfect Complements
Nickels
6
4
I
2
7
5
I
1
2
I
I
I
1
2
3
Dimes
1
2
3
0
7
5
Right Shoes
0
Figure 21-5
137
Figure 21-6
138
Figure 21-7
139
Figure 21-8
140
Figure 21-9
141
Figure 21-10
142
Figure 21-11
143
Quantity of
Potatoes
Initial budget constraint
B
Optimum with high
price of potatoes
Optimum with low
D
price of potatoes
E
2.
...
which
1. An increase in the price of
C
increases
potatoes rotates the budget
potato
consumption
if potatoes
I
1
I
New budget
are a Giffen
2
constraint
good.
Quantity
0
A
of Meat
Figure 21-12
144
Consumption
5,000
Optimum
I
3
2,000
I
2
I
1
Hours of Leisure
0
60
100
Figure 21-13
145
(a) For a person with these preferences
. . . the labor supply curve slopes upward.
Wage
Consumption
1. When the wage rises
BC
1
I
2
BC
2
I
1
0
Hours of Labor
0
Hour of Leisure
2. hours of leisure decrease
Supplied
3.
and hours of labor increase.
Figure 21-14a
146
. . . the labor supply curve slopes backward.
(a) For a person with these preferences
Wage
Consumption
1. When the wage rises
BC
1
I
2
BC
2
I
1
Hours of Labor
0
Hours of
0
2. hours of leisure increase
Supplied
Leisure
3.
and hours of labor decrease.
Figure 21-14b
147
Consumption
when Old
Budget
constraint
110,000
Optimum
55,000
I
3
I
2
I
1
Consumption
0
50,000
100,000
when Young
Figure 21-15
148
(a) Higher Interest Rate Raises Saving
(b) Higher Interest Rate Lowers Saving
Consumption
Consumption
when Old
when Old
BC
BC
2
2
1. A higher interest rate rotates
the budget constraint outward . . .

1. A higher interest rate rotates the budget
constraint outward . . .
BC
1
BC
1
I
2
I
I
2
1
1
I
0
0
Consumption
when Young
2. . . . resulting in lower consumption when
young and, thus, higher saving.
2. . . . resulting in lower consumption when
young and, thus, higher saving.
Figure 21-16
149
(a) The Constraint Is Not Binding
Cash Transfer
In-Kind Transfer
Food
Food
BC
(with 1,000 cash)
BC
(with 1,000 food stamps)
2
2
BC
BC
1
1
B
B
I
2
I 2
1,000
1,000
A
A
I
I
1
1
Nonfood
0
0
Nonfood
Consumption
Consumption
Figure 21-17a
150
(b) The Constraint Is Binding
Cash Transfer
In-Kind Transfer
Food
Food
BC
(with 1,000 cash)
BC
(with 1,000 food stamps)
2
2
BC
BC
1
1
C
1,000
1,000
B
B
A
A
I
I
2
I
2
I
I
1
1
3
Nonfood
0
0
Nonfood
Consumption
Consumption
Figure 21-17b