Chapter 5 Consumer Choice ECONOMICS: Principles and Applications, 4e HALL & LIEBERMAN, © 2008 Thomson South-Western

2 Consumer Choice You are constantly making economic decisions Constraints –Too little income or wealth –Too little time to enjoy it all Consumer theory –The theory of individual decision making

3 The Budget Constraint Two facts of economic life –Pay for goods and services bought –Limited funds to spend A consumer’s budget constraint identifies combinations of goods and services the consumer can afford with a limited budget

4 The Budget Constraint Budget line –Graphical representation of a budget constraint Slope of the budget line –Trade-off between one good and another –Amount of one good that must be sacrificed in order to buy more of another good

5 The Budget Constraint Number of Concerts per Month Number of Movies per Month A With $150 per month, Max can afford 15 movies and no concerts,... H But not points above the line. F G Points below the line are also affordable. Figure 1 The Budget Constraint B 12 movies and 1 concert or any other combination on the budget line. C D E

6 Changes in the Budget Line Changes in income - shift the budget line –Income increase - upward-rightward shift –Income decrease - downward-leftward shift –Do not affect the budget line’s slope Changes in price – rotate the budget line –The slope changes –One of the intercepts changes

7 Changes in the Budget Line 1.An increase in income shifts the budget line rightward, with no change in slope. Number of Concerts per Month 5 15 Number of Movies per Month Figure 2 Changes in the Budget Line (a)

8 Changes in the Budget Line 2.A decrease in the price of movies rotates the budget line upward. Number of Concerts per Month 5 15 Number of Movies per Month 30 Figure 2 Changes in the Budget Line (b)

9 Changes in the Budget Line 3.while a decrease in the price of concerts rotates it rightward. Number of Concerts per Month 5 15 Number of Movies per Month 30 Figure 2 Changes in the Budget Line (c)

10 Preferences Rational preferences –Any two alternatives can be compared one is preferred or the two are valued equally –The comparisons are logically consistent (transitive) –How you make choices More is Better –Choose a point on the budget line rather than a point below it

11 Consumer Decisions Utility - quantitative measure of pleasure or satisfaction obtained from consuming goods and services Consumers - maximize utility Marginal utility –Additional utility from consuming an additional unit of a good The Law of Diminishing Marginal Utility –As consumption of a good or service increases, marginal utility decreases

12 Total And Marginal Utility Total Utility Marginal Utility Utils Ice Cream Cones per Week Utils Ice Cream Cones per Week The change in total utility from one more ice cream cone is called the marginal utility of an additional cone Figure 3 Total And Marginal Utility 3.Marginal utility falls as more cones are consumed

13 Budget Constraint and Preferences Maximize utility: MU x /P x =MU y /P y no gain from reallocating expenditures If MU x /P x >MU y /P y –move away from y toward x If MUx/Px<MUy/Py –move away from x toward y

14 Budget Constraint and Preferences A B C D E G F Number of Concerts per Month Number of Movies per Month Figure 4 Consumer Decision Making