THEORY OF CONSUMER CHOICE

B , Burgers c 25 f 20 e 15 a d 10 b 15 25 30 Z , Pizzas per semester

Assumptions Individuals can rank their preferences Non-satiation - people prefer more to less Transitivity - rankings are consistent Individuals are willing to give up successfully smaller amounts of one good in order to get additional units of other goods

Bundles of Pizzas and Burgers a consumer might consume Indifference Curve per semester c Individuals can rank their preferences Non-satiation - people prefer more to less Transitivity - rankings are consistent Individuals are willing to give up successfully smaller amounts of one good in order to get additional units of other goods 25 f 20 e 15 a d I 10 b 15 25 30 Z , Pizzas per semester

Bundles of Pizzas and Burgers a consumer might consume Preference Map B , Burgers per semester 30 25 15 Z , Pizzas per semester 20 10 d I 1 2 e c f Indifference curve on the right means greater satisfaction

Impossible Indifference Curves Crossing B , Burgers per semester Violation of Transitivity e b I 1 a I Z , Pizzas per semester

Impossible Indifference Curves Upward Sloping B , Burgers per semester b a I Z , Pizzas per semester

Impossible Indifference Curves Thick B , Burgers per semester No two points can have same satisfaction level b a I Z , Pizzas per semester

Properties of Indifference Curves Indifference curves (IC) are downward sloping Convex to the origin do not intersect Higher IC reflect greater level of satisfaction

Slope of IC is called Marginal Rate of Substitution. It denotes rate at which an individual is willing to trade two goods/ services MUz * ΔZ = -(MUB * ΔB) ΔB/ ΔZ = -(MUz /MUB) Burgers Pizzas

Budget Constraint B , Burgers per semester a 25 = M / p b 20 L ( p 1 ( p = $1, PB = $2, M = $50) Z c 10 Opportunity set d 10 30 50 = M / p Z Z , Pizzas per semester

Slope = - PZ/PB M PZQZ + PBQB QZ = M/PZ - PB/PZ*QB BUDGET LINE M PZQZ + PBQB QZ = M/PZ - PB/PZ*QB QB = M/PB - PZ/PB*QZ Slope = - PZ/PB

Changes in the Budget Constraint , Burgers per semester Price of Pizza Doubles 25 L 1 ( p = $1) Z 50 Z , Pizzas per semester

Changes in the Budget Constraint , Burgers per semester Price of Pizza Doubles 25 L 1 ( p = $1) Z Loss L 2 ( p Z = $2) 25 50 Z , Pizzas per semester

Changes in the Budget Constraint , Burgers per semester Income Doubles 25 L 1 ( M = $50) 50 Z , Pizzas per semester

Changes in the Budget Constraint , Burgers per semester Income Doubles 50 L 3 ( M = $100) 25 Gain L 1 ( M = $50) 50 100 Z , Pizzas per semester

Consumer Equilibrium Consumer Equilibrium is attained when maximum satisfaction is obtained from given choices- Utility Maximization

Utility Maximization Budget line B , Burgers per semester g 25 c 20 B 10 d A a I 1 10 30 50 Z , Pizzas per semester

Utility Maximization Budget line B , Burgers per semester g 25 c f 20 10 I 3 d I 2 A a I 1 10 30 50 Z , Pizzas per semester

Individual’s Demand Curve A Deriving an Individual’s Demand Curve 5.2 12.0 L 3 ( p b = $4) e I B Price-consumption curve A 58.9

Individual’s Demand Curve Deriving an Individual’s Demand Curve A 12.0 As Price of B increases from $4 to $6, consumer shifts to lower IC e Price-consumption curve 3 5.2 e 2 4.3 I 3 I 2 L 2 ( p = $6) L 3 ( p = $4) b b 44.5 58.9 B

Individual’s Demand Curve 4.3 5.2 12.0 2.8 L 1 ( p b = $12) 2 = $6) 3 = $4) e I B Price-consumption curve A 26.7 44.5 58.9 Deriving an Individual’s Demand Curve

Individual’s Demand Curve (a) Indifference Curves and Budget Constraints Deriving an Individual’s Demand Curve A 12.0 e Price-consumption curve 3 5.2 e 2 4.3 e I 3 1 2.8 I 2 L 1 ( p = $12) I 1 L 2 ( p = $6) L 3 ( p = $4) b b b 26.7 44.5 58.9 B (b) Demand Curve p , $ per unit b 12.0 E 1 E 6.0 2 E 4.0 3 B 26.7 44.5 58.9

Individual’s Demand Curve (a) Indifference Curves and Budget Constraints A Deriving an Individual’s Demand Curve 12.0 e Price-consumption curve 3 5.2 e 2 4.3 e I 3 1 2.8 I 2 L 1 ( p = $12) I 1 L 2 ( p = $6) L 3 ( p = $4) b b b 26.7 44.5 58.9 B (b) Demand Curve p b , $ per unit 12.0 E 1 E 6.0 2 E D , Demand for B 4.0 3 1 B 26.7 44.5 58.9

CONSUMER CHOICE AND CHANGE IN DEMAND Y E O X SUBSTITUTION EFFECT

CONSUMER CHOICE AND CHANGE IN DEMAND Y Y E O X X SUBSTITUTION EFFECT

CONSUMER CHOICE AND CHANGE IN DEMAND On the same IC, consumer shifts up & down by substituting one in place of another Y Y E O O` F X X SUBSTITUTION EFFECT

INCOME EFFECT Y G N F X

INCOME EFFECT Consumer shifts to higher IC Y G’ G M N F F’ X

Price Effect with Normal Goods Y 12.0 L 1 e 1 20 30

Price Effect with Normal Goods Y 12.0 L 2 L 1 e 3 e 1 e 2 I 1 I 2 20 30 75 X Price effect