A presentation on Theory

of consumer choice.
Sidharth Yadav
Roll no. 531
Section I

Introduction
The theory of consumer choice examines the
trade-offs that people face in their role as
consumers. It examines how consumers facing
these trade-offs make decisions and how they
respond to changes in their environment.
Three basic questions concerning household
decisions are
Do all demand curves slope downward?
How do wages affect labor supply?
How do interest rates affect household saving?

Budget Constraint : What the

consumer can afford?
People consume less than they desire because

their spending is constrained, or limited, by their

income. We begin the study of consumer choice
by examining the link between income and
spending.
Budget constraint is the limit on the consumption
bundles that a consumer can afford. When
represented graphically, it is called a budget line.

1. Budget line of a
consumer consuming 2

Preferences : What the consumer wants?

The budget constraint in the previous slide
shows the trade off that the consumer faces
between good X&Y.
But, the consumers choices depend not only on
the constraints and also his preferences.
A consumers preferences lets him choose
amongst different bundles of the same good.
A curve which shows the bundles which
provide equal satisfaction to the consumer is
called an indifference curve. Different
indifference curves depict different levels of

Indifference Curve
2. IC showing bundles (A,B) of
goods X&Y.

Properties of an IC :
Higher ICs represent higher satisfaction.
ICs are always downward sloping.
2 ICs never intersect.
ICs are always convex.

Optimization : What the consumer

chooses?

4. Figure showing different ICs along with the budget line of a

consumer consuming 2 goods X&Y. BC is the budget line.

With reference to the previous slide,

The consumer chooses the point on his budget
constraint that lies on the highest IC. At this point
slope of the IC = slope of the budget line.
Here, the highest IC that the consumer can reach is
IC3. The consumer prefers IC4 and IC5 but the
consumer cannot afford any bundle on these ICs as
they are above the budget line.
By contrast, IC1 and IC2 are affordable but the
consumer would not prefer them as they offer a lower
level of satisfaction as compared to IC3.
Therefore, the optimum point of consumption for this
consumer is the point of tangency (A) of IC3 and
budget line BC.

Change in Prices.
The impact of change in the price of a good

on its consumption can be decomposed into

two effects1. Income effect
2. Substitution Effect

Income Effect
It is the change in
consumption that results
when a price change moves
the consumer to a higher or a
lower IC.
Here due to a fall in the price
of Good X, the budget line
shifts rightward which
enables the consumer to buy
more of Good X and thus the
consumer shifts to a higher
IC(2).

5. Income effect when price

of good X falls.

Substitution Effect
Substitution effect is the
change in consumption that
results when a price change
moves a consumer along the
same IC to a point with a
different marginal rate of
substitution ( Slope of the IC)
Here, the price of Good Y falls
which leads shifting of budget
line BC1 outwards to BC2. The
consumer now thinks that since
Good X is relatively more
expensive, he should buy less
of Good X and more of Good Y.

6. Substitution effect when

price of Good Y falls.

Price Effect
Price Effect = Income
Effect + Substitution
Effect.
Theprice effectis the
impact on the market
based on how the
consumer is spending
money as a result of the
incomeeffect.
For a normal good, income
effect overpowers
substitution effect.

7. Figure showing both

income and substitution
effecs.

The Three Applications

Do all demand curves slope

downward?
How do wages affect labor supply?
How do interest rates affect

household saving?

Do all demand curves slope downward?

As a matter of economic theory, demand curves
can sometimes slope upwards also. In this
case, the consumers violate the law of
demand.
This happens in case of a giffen good.
Economists use the term giffen good to
describe a good that violates the law of
demand. Giffen goods are inferior goods for
which income effect dominates the
substitution effect. Therefore, they have
demand curves that slope upward.

How do wages affect labor supply?

People spend some of their time enjoying

leisure and some of it working so they can

afford to buy goods. The essence of the timeallocation problem is the trade-off between
leisure and consumption.
The work-leisure decision shows a persons

budget constraint for deciding how much to

work, his ICs for consumption and leisure, and
his optimum.

An increase in the wages

Panel A

8. In panel A, a higher wage induces the person to enjoy less

leisure and work more, so the labor supply curve slopes upward.

An increase in the wages

Panel B

9. In panel B, a higher wage induces the person to enjoy more

leisure and work less, so the labor supply curve slopes backward.

Panel A vs. B
In panel A, when wages rise, leisure becomes more

costly relative to consumption and this encourages him

to substitute away from leisure and towards
consumption. Labor supply curve slopes upward.
In panel B, when wages rise, he moves to a higher IC.
As long as consumption and leisure are both normal
goods, he tends to want to use this increase in wellbeing to enjoy both higher consumption and greater
leisure. Labor supply curve slopes backward.
If the substitution effect is greater than income effect,
he works more. If income effect is greater than
substitution, he works less. The labor supply curve,
therefore, could be either upward or backward sloping.

How do interest rates affect

household saving?
An important decision that every person faces

is how much income to consume today and

how much to save for the future.

10. This figure shows the

budget constraint for a
person deciding how
much to consume in the
two periods of his life,
the ICs representing his
preferences, and the
optimum.

When the interest rate increases

11. In both panels, an increase in the interest rate shifts the

budget constraint outward. In the panel on the left, consumption
when young falls. The result is an increase in saving when young.
In the panel on the right, consumption in both period rises, result
is decrease in saving when young.

Thank You!