Consumer Behavior Ch. 7

The Budget Line The budget line 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. 3

The Consumer’s Budget Line... Quantity of Pepsi B 500 C 250 50 Consumer’s Budget line A 100 Quantity of Pizza

The Consumer’s Budget Line The slope of the budget 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. 10

Preferences: What the Consumer Wants A consumer’s preference among consumption bundles may be illustrated with indifference curves. An indifference curve shows bundles of goods that make the consumer equally happy. 11

The Consumer’s Preferences... Quantity of Pepsi D I2 C B A Indifference curve, I1 Quantity of Pizza

The Consumer’s 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. 14

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. 17

The Consumer’s Preferences... Quantity of Pepsi C B D 1 MRS I2 A 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.

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. 22

Property 3: Indifference curves do not cross. Quantity of Pepsi C A B Quantity of Pizza

Property 4: 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. Quantity of Pepsi 8 3 Indifference curve A 14 2 1 MRS = 6 4 6 3 7 B 1 MRS = 1 Quantity of Pizza

Perfect Substitutes Nickels 2 1 4 I1 I2 6 3 I3 Dimes

Perfect Complements Left Shoes 7 5 I1 I2 Right Shoes

The Consumer’s Optimum... Quantity of Pepsi I3 I2 Budget constraint I1 Optimum A B Quantity of Pizza

How Changes in Income Affect the Consumer’s Choices An increase in income shifts the budget line outward. The consumer is able to choose a better combination of goods on a higher indifference curve. 35

An Increase in Income... Quantity New budget line of Pepsi 1. An increase in income shifts the budget line outward… New optimum 3. …and Pepsi consumption. Initial optimum Initial budget line I1 2. …raising pizza consumption… Quantity of Pizza

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 line. 41

Initial budget constraint Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. A Change in Price... Quantity of Pepsi New optimum I2 1,000 I1 New budget constraint 1. A fall in the price of Pepsi rotates the budget constraint outward… 3. …and raising Pepsi consumption. 500 Initial budget constraint 2. …reducing pizza consumption… 100 Quantity of Pizza

Income and Substitution Effects A price change has two effects on consumption. An income effect A substitution 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 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. 44

X2 X1 The new optimum is Eb on I2. The Total Price Effect is xa to xb Ea I2 I1 xa xb X1

Draw a line parallel to the new budget line and tangent to the old indifference curve X2 Eb Ea I2 I1 xa xb X1

The new optimum on I1 is at Ec The new optimum on I1 is at Ec. The movement from Ea to Ec (the increase in quantity demanded from Xa to Xc) is solely in response to a change in relative prices X2 Eb Ea I2 Ec I1 xa xc xb X1

Xa Xc X2 X1 This is the substitution effect. Eb Ea I2 Ec I1

A Change in Price: Substitution Effect The substituiton effect increases the quantity demanded of a good whose price has fallen and reduces the quantity demanded of a good whose price has risen. 51

A Change in Price: Income Effect The income effect leads consumers to buy more of a product whose price has fallen, if it is a normal good.

Because of the combined operation of the income and substitution effects, the demand curve for any normal good will be negatively sloped.