Chapter 21 The Theory of Consumer Choice Outline of Topics T1 The budget constraint: What the consumer can afford

d T2 Preference: What the consumer wants T3 Optimization: What the consumer chooses T4 Four Applications

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 2 with the price of the other.

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. 5

 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. 6 See Figure 21-8 on page 478

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 7

 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.

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. 10

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. 11

 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. 13 4, Do the poor prefer to receive cash or in-kind transfers?

 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 14 same effect on the consumption and welfare of the recipient.