Principles of Microeconomics: Ch. 21 First Canadian Edition Overview u The budget constraint u Indifference curves u The consumer’s optimal choice u Income and substitution effects on choice u Deriving the demand curve

Principles of Microeconomics: Ch. 21 First Canadian Edition The Budget Constraint: What Consumers Can Afford “The budget constraint depicts the consumption possibilities available to the individual.” u People consume less than they desire because their spending is constrained, or limited, by their income.

Principles of Microeconomics: Ch. 21 First Canadian Edition The Budget Constraint Pepsi Pizza Pepsi ($2) Pizza ($10)

Principles of Microeconomics: Ch. 21 First Canadian Edition The Budget Constraint Pepsi ($2) Pizza ($10) B C A Any point on the constraint line equals $1,000, the income available to spend on the two products.

Principles of Microeconomics: Ch. 21 First Canadian Edition The Budget Constraint u The slope of the budget constraint measures the rate at which the consumer can trade one good for the other. u The slope equals the relative price of the two goods, i.e. the price of one good compared to the price of the other.

Principles of Microeconomics: Ch. 21 First Canadian Edition Indifference Curves Pepsi Pizza C B A I1I1 I2I2...

Principles of Microeconomics: Ch. 21 First Canadian Edition Indifference Curves u The consumer is indifferent among combinations A, B, and C, because they are all on the same curve. u 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.

Principles of Microeconomics: Ch. 21 First Canadian Edition Indifference Curves Pepsi Pizza C B A I1I1 I2I2... Slope between points A and B. Tradeoff between the two bundles. D.

Principles of Microeconomics: Ch. 21 First Canadian Edition The Marginal Rate of Substitution u The slope is called the marginal rate of substitution. – The rate at which consumers are willing to trade one good for another. – The amount that the consumer must receive as compensation in order to give up something else that he/she desires.

Principles of Microeconomics: Ch. 21 First Canadian Edition 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.

Principles of Microeconomics: Ch. 21 First Canadian Edition Optimization: What the Consumer Chooses u Consumers would like to obtain the combination of goods on the highest possible indifference curve. However, the budget constraint may restrict or limit the consumer to a lower indifference curve. u Combining the indifference curve and budget constraint determines the optimum choice.

Principles of Microeconomics: Ch. 21 First Canadian Edition The Consumer’s Optimal Choice Pepsi Pizza I1I1 I2I2 Consumer’s indifference curves, based on personal preferences. I3I3

Principles of Microeconomics: Ch. 21 First Canadian Edition The Consumer’s Optimal Choice Pepsi Pizza I1I1 I2I2 Consumer’s budget constraint. I3I3

Principles of Microeconomics: Ch. 21 First Canadian Edition The Consumer’s Optimal Choice u The point at which the indifference curve and the budget constraint touch (i.e. its tangent) is called the optimum. u The consumer chooses consumption of the two goods so that the marginal rate of substitution equals the relative price.

Principles of Microeconomics: Ch. 21 First Canadian Edition A Change in Income Affects Choices Pepsi Pizza I1I1 I2I2 I3I3. Q Pepsi Q Pizza An Increase in income shifts the budget constraint.

Principles of Microeconomics: Ch. 21 First Canadian Edition A Change in Income Affects Choices Pepsi Pizza I1I1 I2I2 I3I3 Q Pepsi Q Pizza A new optimum. Q New

Principles of Microeconomics: Ch. 21 First Canadian Edition Changes in Prices Affect Consumer’s Choices u A fall in the price of any good will shift the budget constraint outward and will change the slope of the budget constraint.

Principles of Microeconomics: Ch. 21 First Canadian Edition Deriving the Demand Curve A consumer’s demand curve is a summary of the optimal decisions that arise from his budget constraint and indifference curves.

Principles of Microeconomics: Ch. 21 First Canadian Edition Conclusion u Indifference curve analysis describes how individuals make decisions. It has many relevant applications. u If people behave AS IF they followed the model, then the model will yield accurate and useful predictions and results.