The Theory of Consumer Choice

The Theory of
Consumer Choice
Chapter 21
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?
The Budget Constraint

The
budget constraint depicts the consumption

bundles that a consumer can afford.
People consume less than they desire because their

spending is constrained, or limited, by their income.
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.
Copyright 2001 by Harcourt, Inc. All rights reserved
The Consumers Opportunities

Pints of
Pepsi
0
50
100
150
200
250
300
350
400
450
500
Number of
Pizzas
100
90
80
70
60
50
40
30
20
10
0
Spending
on Pepsi
$ 0
100
200
300
400
500
600
700
800
900
1,000
Spending
on Pizza
Total
Spending
$1,000
900
800
700
600
500
400
300
200
100
0
$1,000
1,000
1,000
1,000
1,000
1,000
1,000
1,000
1,000
1,000
1,000
The Consumers Budget

Constraint
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
(point B). If he buys no Pepsi, he can
afford 100 pizzas (point A).

Constraint...
Quantity
of Pepsi
500 B
Consumers
budget constraint
A
100
Quantity
of Pizza

Constraint
Alternately, the
consumer can buy

50 pizzas and 250 pints of Pepsi.

Constraint...
Quantity
of Pepsi
500
250
C
Consumers
budget constraint
50
A
100
Quantity
of Pizza

Constraint
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.
It measures the rate at which the
consumer will trade one good for the
other.
Preferences:
What the Consumer Wants
A consumers preference among
consumption bundles may be
illustrated with indifference curves.
Representing Preferences with

Indifference Curves
An indifference curve shows
bundles of goods that make the
consumer equally happy.
The Consumers Preferences...

Quantity
of Pepsi
C
D
I2
A
Indifference
curve, I1
Quantity
of Pizza
The Consumers Preferences

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.
The Marginal Rate of Substitution

The
slope at any point on an indifference curve is the marginal rate of

substitution.
It is the rate at which a consumer is willing to substitute one good for another.
It is the amount of one good that a consumer requires as compensation to give up one
unit of the other good.

Quantity
of Pepsi
C
D
I2
MRS 1
A
0
Indifference
curve, I1
Quantity
of Pizza
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.
Property 1: 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.

Quantity
of Pepsi
C
D
I2
A
Indifference
curve, I1
Quantity
of Pizza
Property 2: 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 in order to remain equally happy.
If the quantity of one good is reduced, the
quantity of the other good must increase.
For this reason, most indifference curves
slope downward.

downward sloping.
Quantity
of Pepsi
Indifference
curve, I1
0
Quantity
of Pizza
Property 3: Indifference curves do not

cross.
Points A and B should make the
Points B and C should make the
This implies that A and C would make
the consumer equally happy.
But C has more of both goods compared
to A.

cross.
Quantity
of Pepsi
C
A
B
Quantity
of Pizza

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 cause his or
her indifference curve to bow inward.

bowed inward.
Quantity
of Pepsi
14
MRS = 6
8
4
3
0
MRS = 1
B
1
7
Indifference
curve
Quantity
of Pizza
Two Extreme Examples of

Indifference Curves
Perfect
substitutes
Perfect complements
Perfect Substitutes
Two
goods with straight-line indifference

curves are perfect substitutes.
The marginal rate of substitution is a fixed number.
Perfect Substitutes
Nickels
6
4
2
I1
1
I2
I3
Dimes
Perfect Complements
Two goods with right-angle
indifference curves are perfect
complements.
Perfect Complements
Left
Shoes
I2
I1
Right Shoes
Optimization: What the Consumer

Chooses
Consumers want to get the
combination of goods on the highest
possible indifference curve.
However, the consumer must also end
up on or below his budget constraint.
Optimization: What the Consumer

Chooses
Combining the indifference curve and
the budget constraint determines the
consumers optimal choice.
Consumer optimum occurs at the point
where the highest indifference curve and
the budget constraint are tangent.
The Consumers Optimal Choice

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

At the consumers optimum, the
consumers valuation of the two goods
equals the markets valuation.
The Consumers Optimum...

Quantity
of Pepsi
Optimum
B
A
I3
I1
I2
Budget constraint
0
Quantity
of Pizza
How Changes in Income Affect the

Consumers Choices
An
increase in income shifts the budget constraint outward.
The consumer is able to choose a better

higher indifference curve.
combination of goods on a
An Increase in Income...
Quantity
of Pepsi
New budget constraint

1. An increase in income shifts
the budget constraint outward
New optimum
3. and Pepsi
consumption.
Initial
optimum
I2
Initial
budget
constraint
I1
0
2. raising pizza
Quantity
of Pizza
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.
An Inferior Good...
Quantity
of Pepsi
3. ... but
Pepsi
consumption
falls, making
Pepsi an
inferior
good.
Initial
optimum
1. When an increase in income

shifts the budget constraint
outward...
New optimum
Initial
budget
constraint
I1
I2
Quantity
2. ... pizza consumption rises, of Pizza
making pizza a normal good...
How 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.
A Change in Price...
Quantity
of Pepsi
1,000
3. and
raising Pepsi
consumptio
n.
500
Initial budget
constraint
0
New optimum
1. A fall in the price of
Pepsi rotates the budget
constraint outward
I2
I1
100
2. reducing pizza
Quantity of Pizza
Income and Substitution Effects

A price
change has two effects on consumption.
An income effect
A substitution effect
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 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.
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.
Illustrated by movement from

point A to point B.
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.
Illustrated by movement from

point B to point C.
Income and Substitution Effects...

Quantity
of Pepsi
C New optimum
Income effect
Initial optimum
Substitutio
n effect
Initial
budget
constraint 0
I2
I1
Substitution effect
Income effect
Quantity of Pizza
Income and Substitution Effects When

the Price of Pepsi Falls
Good
I ncome Effect
Substitution Effect
Total Effect
Pepsi
Consumer is richer,
so he buys more Pepsi.
Pepsi is relatively
cheaper, so consumer
buys more Pepsi.
Income and
substitution
effects act in
same direction,
so consumer buys
more Pepsi.
Pizza
Consumer is richer,
so he buys more pizza.
Pizza is relatively
more expensive,
so consumer buys
less pizza.
Income and
substitution
effects act in
opposite directions,
so the total effect
on pizza consumption
is ambiguous.
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.
Deriving the Demand Curve...

(a) The Consumers Optimum
Quantity
of Pepsi
New budget
constraint
150
(b) The Demand Curve for Pepsi

Price of
Pepsi
$2
I2
B
1
50
A
I1
0
Initial budget
constraint
Quantity
of Pizza
50
150 Quantity
of Pepsi
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.
Giffen Goods
Economists use the term Giffen good to
describe a good that violates the law of
demand.
Giffen goods are inferior goods for which
the income effect dominates the
substitution effect.
They have demand curves that slope
upwards.
Quantity of
Potatoes
A Giffen Good...
Initial budget constraint
2...which
D
increases
potato
consumptio
n if
potatoes
are a Giffen
good.
0
Optimum with high

price of potatoes
Optimum with low
price of potatoes
1. An increase in the price
of potatoes rotates the
budget...
New budget
constraint
I2
A
I1
Quantity
of Meat
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.
The Work-Leisure Decision...

Consumption
$5,000
Optimum
I3
2,000
I2
I1
0
60
100
Hours of
Leisure
Consumption
An Increase in the Wage...

(a) For a person with these
preferences
. . . the labor supply curve slop

upward.
Wage
1. When the
wage rises
I2
BC1
BC2
I1
Hours of 0
Hours of
Labor
2. hours of leisure Leisure
3. ...and hours of labor
increase.
Supplied
decrease
Consumption

(b) For a person with these
preferences

backward.
Wage
BC2
1. When the
wage rises
I2
BC1
I1
0
Hours of 0
Hours of
Leisure
Labor
2. hours of leisure
decrease.
Supplied
increase
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.
The Consumption-Saving Decision...

Consumption
when Old Budget
constraint
$110,000
55,000
Optimum
I3
I2
I1
0
$50,000
100,000
Consumption
when Young
BC2
BC1
(a) Higher Interest

Rate Raises Saving
I2
Consumption
when Old
Consumption
when Old
An Increase in the Interest Rate...

(b) Higher Interest Rate
Lowers Saving
BC2
1. A higher
interest rate
rotates the
budget constraint
outward...
1. A higher
interest rate
rotates the
budget constraint
outward...
I2
BC1
I1
I1
0
0
Consumption
2. resulting in lower
when Young
consumption when young
and, thus, higher saving.
Hours of
2. resulting in higher Leisure
and, thus, lower saving.
How do interest rates affect

household saving?
Thus, an increase in the interest
rate could either encourage or
discourage saving.
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.
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.
Cash versus In-Kind Transfers...

(a) The Constraint Is Not Binding
Cash Transfer
Food
In-Kind Transfer
Food
BC (with $1,000 cash)
BC (with $1,000 food stamps)
BC1
BC1
B
$1,000
B
I2
I2
$1,000
I1
0
Nonfood
Consumption
I1
Nonfood
Consumption

(b) The Constraint Is Binding
Cash Transfer
Food
BC1
BC1
$1,000
B
A
In-Kind Transfer
Food
I1
$1,000
I2
0
Nonfood
Consumption
B
A
I1
I2
I3
Nonfood
Consumption
Summary
A consumers budget constraint shows the
possible combinations of different goods he can
buy given his income and the prices of the goods.
The slope of the budget constraint equals the
relative price of the goods.
The consumers indifference curves represent
his preferences.
Summary
Points on higher indifference curves are
preferred to points on lower indifference curves.
The slope of an indifference curve at any point
is the consumers marginal rate of substitution.
The consumer optimizes by choosing the point
on his budget constraint that lies on the highest
indifference curve.
Summary
When the price of a good falls, the impact on
the consumers choices can be broken down
into an income effect and a substitution effect.
The income effect is the change in
consumption that arises because a lower price
makes the consumer better off.
The income effect is reflected by the movement
from a lower to a higher indifference curve.
Summary
The substitution effect is the change in consumption that
arises because a price change encourages greater
consumption of the good that has become relatively cheaper.
The substitution effect is reflected by a movement along an
indifference curve to a point with a different slope.
Summary
The
theory of consumer choice can explain:
Why demand curves can potentially slope upward.

How wages affect labor supply.
How interest rates affect household saving.
Whether the poor prefer to receive cash or in-kind transfers.
Graphical
Review

Constraint...
Quantity
of Pepsi
500 B
Consumers
budget constraint
A
100
Quantity
of Pizza

Constraint...
Quantity
of Pepsi
500
250
C
Consumers
budget constraint
50
A
100
Quantity
of Pizza

Quantity
of Pepsi
C
D
I2
A
Indifference
curve, I1
Quantity
of Pizza

Quantity
of Pepsi
C
D
I2
MRS 1
A
0
Indifference
curve, I1
Quantity
of Pizza

Quantity
of Pepsi
C
D
I2
A
Indifference
curve, I1
Quantity
of Pizza

downward sloping.
Quantity
of Pepsi
Indifference
curve, I1
0
Quantity
of Pizza

cross.
Quantity
of Pepsi
C
A
B
Quantity
of Pizza

bowed inward.
Quantity
of Pepsi
14
MRS = 6
8
4
3
0
MRS = 1
B
1
7
Indifference
curve
Quantity
of Pizza
Perfect Substitutes
Nickels
6
4
2
I1
1
I2
I3
Dimes
Perfect Complements
Left
Shoes
I2
I1
Right Shoes
The Consumers Optimum...

Quantity
of Pepsi
Optimum
B
A
I3
I1
I2
Budget constraint
0
Quantity
of Pizza
An Increase in Income...
Quantity
of Pepsi

1. An increase in income shifts
the budget constraint outward
New optimum
3. and Pepsi
consumption.
Initial
optimum
I2
Initial
budget
constraint
I1
0
2. raising pizza
Quantity
of Pizza
An Inferior Good...
Quantity
of Pepsi
3. ... but
Pepsi
consumption
falls, making
Pepsi an
inferior
good.
Initial
optimum
1. When an increase in income

shifts the budget constraint
outward...
New optimum
Initial
budget
constraint
I1
I2
Quantity
2. ... pizza consumption rises, of Pizza
making pizza a normal good...
A Change in Price...
Quantity
of Pepsi
1,000
3. and
raising Pepsi
consumptio
n.
500
Initial budget
constraint
0
New optimum
1. A fall in the price of
Pepsi rotates the budget
constraint outward
I2
I1
100
2. reducing pizza
Quantity of Pizza
Income and Substitution Effects...

Quantity
of Pepsi
C New optimum
Income effect
Initial optimum
Substitutio
n effect
Initial
budget
constraint 0
I2
I1
Substitution effect
Income effect
Quantity of Pizza
Deriving the Demand Curve...

(a) The Consumers Optimum
Quantity
of Pepsi
New budget
constraint
150
(b) The Demand Curve for Pepsi

Price of
Pepsi
$2
I2
B
1
50
A
I1
0
Initial budget
constraint
Quantity
of Pizza
50
150 Quantity
of Pepsi
Quantity of
Potatoes
A Giffen Good...
Initial budget constraint
2...which
D
increases
potato
consumptio
n if
potatoes
are a Giffen
good.
0
Optimum with high

price of potatoes
Optimum with low
price of potatoes
1. An increase in the price
of potatoes rotates the
budget...
New budget
constraint
I2
A
I1
Quantity
of Meat
The Work-Leisure Decision...

Consumption
$5,000
Optimum
I3
2,000
I2
I1
0
60
100
Hours of
Leisure
Consumption

(a) For a person with these
preferences

upward.
Wage
1. When the
wage rises
I2
BC1
BC2
I1
Hours of 0
Hours of
Labor
2. hours of leisure Leisure
increase.
Supplied
decrease
Consumption

(b) For a person with these
preferences

backward.
Wage
BC2
1. When the
wage rises
I2
BC1
I1
0
Hours of 0
Hours of
Leisure
Labor
2. hours of leisure
decrease.
Supplied
increase
The Consumption-Saving Decision...

Consumption
when Old Budget
constraint
$110,000
55,000
Optimum
I3
I2
I1
0
$50,000
100,000
Consumption
when Young
BC2
BC1
(a) Higher Interest

Rate Raises Saving
I2
Consumption
when Old
Consumption
when Old
An Increase in the Interest Rate...

(b) Higher Interest Rate
Lowers Saving
BC2
1. A higher
interest rate
rotates the
budget constraint
outward...
1. A higher
interest rate
rotates the
budget constraint
outward...
I2
BC1
I1
I1
0
0
Consumption
2. resulting in lower
when Young
and, thus, higher saving.
Hours of
2. resulting in higher Leisure
and, thus, lower saving.

(a) The Constraint Is Not Binding
Cash Transfer
Food
In-Kind Transfer
Food
BC1
BC1
B
$1,000
B
I2
I2
$1,000
I1
0
Nonfood
Consumption
I1
Nonfood
Consumption

(b) The Constraint Is Binding
Cash Transfer
Food
BC1
BC1
$1,000
B
A
In-Kind Transfer
Food
I1
$1,000
I2
0
Nonfood
Consumption
B
A
I1
I2
I3
Nonfood
Consumption

The Theory of Consumer Choice

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The Theory of Consumer Choice

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Formats disponibles

The Theory of

The theory of consumer choice

Do all demand curves slope

The Budget Constraint

budget constraint depicts the consumption

People consume less than they desire because their

The Budget Constraint

It shows the various combinations of

Copyright 2001 by Harcourt, Inc. All rights reserved

The Consumers Opportunities

The Consumers Budget

The Consumers Budget

The Consumers Budget

consumer can buy

The Consumers Budget

The Consumers Budget

Representing Preferences with

The Consumers Preferences...

The Consumers Preferences

consumer is indifferent, or equally

The Marginal Rate of Substitution

slope at any point on an indifference curve is the marginal rate of

The Consumers Preferences...

Properties of Indifference Curves

preferred to lower ones.

Property 1: Higher indifference curves

Consumers usually prefer more of

Property 1: Higher indifference curves

Property 2: Indifference curves are

Property 2: Indifference curves are

Property 3: Indifference curves do not

Property 3: Indifference curves do not

Property 4: Indifference curves are

Property 4: Indifference curves are

Two Extreme Examples of

goods with straight-line indifference

The marginal rate of substitution is a fixed number.

Optimization: What the Consumer

Optimization: What the Consumer

The Consumers Optimal Choice

The Consumers Optimal Choice

The Consumers Optimum...

How Changes in Income Affect the

increase in income shifts the budget constraint outward.

The consumer is able to choose a better

New budget constraint

Normal versus Inferior Goods

New budget constraint

1. When an increase in income

How Changes in Prices Affect

New budget constraint

Income and Substitution Effects

change has two effects on consumption.

The Income Effect

The Substitution Effect

Illustrated by movement from

Illustrated by movement from

Income and Substitution Effects...

Income and Substitution Effects When

Deriving the Demand Curve

Deriving the Demand Curve...

(b) The Demand Curve for Pepsi

Do all demand curves slope

curves can sometimes slope