1. Principles of Microeconomics Chapter 21
Theory of Consumer Choice and Deriving the demand curve

2. Understanding Consumer Choice
To understand how consumers make decisions we need two factors:
Budget Constraint - what a consumer can buy
Indifference Curves - what a consumer wants to buy
Combination of income and preferences determines consumer choices

3. Budget Constraint
A consumer’s budget constraint determines what they can afford to buy
All consumers have income
Use income to purchase goods they need and want
Constrained in their choices based on how much income they have

4. Budget Constraint Example
Suppose Charlie has $100/month to spend on two goods – pizza and soda. The price of pizza is $10 and the price of soda is $2.
How much pizza would he buy if he spent all his money on pizza?
How much soda would he buy if he spent all his money on soda?
If he wants to consume more pizza, how much soda does he have to give up?

5. Budget Constraint Example Cont.
To consume one more pizza, he needs to give up 5 sodas.
Slope of the budget constraint: rate at which a consumer can trade one good for another
Yields relative price of good X in terms of good Y
Slope: ΔY / ΔX = -50 / 10 = 5
Px = $10
Py = $2
Slope = Px/Py = 10/2 = 5
Budget Constraint: limits the consumption bundles a consumer can afford

6. Budget Constraint Example Cont.
To consume one more pizza, he needs to give up 5 sodas.
Slope of the budget constraint: rate at which a consumer can trade one good for another
Yields relative price of good X in terms of good Y
Slope: ΔY / ΔX = -50 / 10 = 5
Px = $10
Py = $2
Slope = Px/Py = 10/2 = 5
Budget Constraint: limits the consumption bundles a consumer can afford

7. Budget Constraint Example Cont.
To consume one more pizza, he needs to give up 5 sodas.
Slope of the budget constraint: rate at which a consumer can trade one good for another
Yields relative price of good X in terms of good Y
Slope: ΔY / ΔX = -50 / 10 = 5
Px = $10
Py = $2
Slope = Px/Py = 10/2 = 5
Budget Constraint: limits the consumption bundles a consumer can afford

8. Budget Constraint Example Cont.
To consume one more pizza, he needs to give up 5 sodas.
Slope of the budget constraint: rate at which a consumer can trade one good for another
Yields relative price of good X in terms of good Y
Slope: ΔY / ΔX = -50 / 10 = 5
Px = $10
Py = $2
Slope = Px/Py = 10/2 = 5
Budget Constraint: limits the consumption bundles a consumer can afford

9. Changes in the Budget Constraint
If a consumer’s income changes: can afford more or less
If the price of one good changes: trade-offs between the two goods change – different slope
Consumer can consume only ON B.C. not past it

10. Budget Constraint Example Cont.
To consume one more pizza, he needs to give up 5 sodas.
Slope of the budget constraint: rate at which a consumer can trade one good for another
Yields relative price of good X in terms of good Y
Slope: ΔY / ΔX = -50 / 10 = 5
Px = $10
Py = $2
Slope = Px/Py = 10/2 = 5
Budget Constraint: limits the consumption bundles a consumer can afford

11. Changes in the Budget Constraint
If a consumer’s income changes: can afford more or less
If the price of one good changes: trade-offs between the two goods change – different slope
Consumer can consume only ON B.C. not past it

12. Change in a Consumer’s Income
What if Charlie’s income falls to $500/month?
Must consume less of both goods
Budget Constraint shifts in
No change in relative prices = no change in slope of B.C.

13. Changes in the Budget Constraint
If a consumer’s income changes: can afford more or less
If the price of one good changes: trade-offs between the two goods change – different slope
Consumer can consume only ON B.C. not past it

14. Change in the Price of a Good
What if the price of pizza rises to $12.50?
Can consume only 8 pies/month at max
Still can consume 50 sodas/month at max
Relative price of pizza to soda has changed = change in slope!
New slope = 12.50/2 = 6.25
Now pizza is more expensive in terms of soda – give up more soda for same amount of pizza – bigger trade-off!

15. Consumer Preferences
Income is not the only factor that influences consumer choice
Each consumer has different preferences in what they want to consume
Capture consumer preferences by Indifference Curves
Consumers will be indifferent between two bundles goods if the bundles equally satisfy his needs/wants

16. Indifference Curves
A consumer is indifferent – or equally satisfied – between consumption bundles along the same indifference curve
Always prefer: D > B > A
Indifferent between B and C
Always prefer any point on a higher indifference curve

17. Four Properties of Indifference Curves
Higher indifference curves preferred to lower ones
Indifference curves are downward sloping
Indifference curves never cross
Indifference curves are bowed inward

18. Marginal Rate of Substitution
Rate at which consumer is willing to trade one good for another
MRS = slope at each point on indifference curve
Not constant!
Depends on how much of each good already consuming
More abundant good – more willing to trade
Less abundant good – less willing to trade

19. Marginal Rate of Substitution
Rate at which consumer is willing to trade one good for another
MRS = slope at each point on indifference curve
Not constant!
Depends on how much of each good already consuming
More abundant good – more willing to trade
Less abundant good – less willing to trade

20. Marginal Rate of Substitution
Rate at which consumer is willing to trade one good for another
MRS = slope at each point on indifference curve
Not constant!
Depends on how much of each good already consuming
More abundant good – more willing to trade
Less abundant good – less willing to trade

21. Marginal Rate of Substitution
Rate at which consumer is willing to trade one good for another
MRS = slope at each point on indifference curve
Not constant!
Depends on how much of each good already consuming
More abundant good – more willing to trade
Less abundant good – less willing to trade

22. Consumer’s Optimal Choice
Optimal point of consumption – where the ability to buy meets the willingness to buy Where budget constraint meets HIGHEST indifference curve

23. Changes in the Optimal Choice
What happens when the price of Good A falls? What happens to the optimal consumption point?
Good A is cheaper: Consume more of Good A
What about Good B?
Same budget can buy more of both goods: More of Good B
Good B now more expensive in relative terms than Good A: Less of Good B

24. Changes in the Optimal Choice
What happens when the price of Good A falls? What happens to the optimal consumption point?
Good A is cheaper: Consume more of Good A
What about Good B?
Same budget can buy more of both goods: More of Good B
Good B now more expensive in relative terms than Good A: Less of Good B

25. Changes in the Optimal Choice
What happens when the price of Good A falls? What happens to the optimal consumption point?
Good A is cheaper: Consume more of Good A
What about Good B?
Same budget can buy more of both goods: More of Good B
Good B now more expensive in relative terms than Good A: Less of Good B

26. Changes in the Optimal Choice
What happens when the price of Good A falls? What happens to the optimal consumption point?
Good A is cheaper: Consume more of Good A
What about Good B?
Same budget can buy more of both goods: More of Good B
Good B now more expensive in relative terms: Less of Good B

27. Income and Substitution Effects
Income Effect: The change in consumption that results when a price change moves the consumer to a higher or lower indifference curve
When the price of Good X falls, income does not change but we “feel wealthier” because each dollar in our pocket can buy more of Good X and more of Good Y
With a price fall in Good X  move to a new consumption bundle on a higher indifference curve
Substitution Effect: The change in consumption that results when a price change moves the consumer along the same indifference curve to a point with a new MRS
When the price of Good X falls, Good X is now cheaper in terms of Good Y. The relative price of Good X has changed.
In other words – Good Y has become more expensive in terms of good Good X
Consume more of Good X and less of Good Y

28. Income and Substitution Effects
Income Effect: The change in consumption that results when a price change moves the consumer to a higher or lower indifference curve
When the price of Good X falls, income does not change but we “feel wealthier” because each dollar in our pocket can buy more of Good X and more of Good Y
With a price fall in Good X  move to a new consumption bundle on a higher indifference curve
Substitution Effect: The change in consumption that results when a price change moves the consumer along the same indifference curve to a point with a new MRS
When the price of Good X falls, Good X is now cheaper in terms of Good Y. The relative price of Good X has changed.
In other words – Good Y has become more expensive in terms of good Good X
Consume more of Good X and less of Good Y

29. Income and Substitution Effect
Assume that the Price of Good X falls A
Good Y
IC.1
BC.1
Good X

30. Income and Substitution Effect
Budget constraint shifts out on a bias
Good Y
IC.1
BC.1
BC.2
Good X

31. Income and Substitution Effect
Good Y
With the substitution effect  Good Y is now more expensive in terms of Good X
Move to a new point of consumption on the existing IC.1 A A’
IC.1
BC.1
BC.2
Good X

32. Income and Substitution Effect
Good Y
With the income effect  We can buy more of both!
Move to a new point of consumption on the new IC
A’’ A
IC.2
IC.1
BC.1
BC.2
Good X

33. Income and Substitution Effect
Good Y
In reality:
Both Income and Substitution Effect occur simultaneously!
Consumer moves from Point A to Point B
Which dominates?
A’’ A B A’
IC.2
IC.1
BC.1
BC.2
Good X

34. Application 1
Jennifer divides her income between coffee and croissants (both of which are normal goods). An early frost in Brazil causes a large increase in the price of coffee in the United States.
Show the effect of the frost on Jennifer's budget constraint.
Show the effect of the frost on Jennifer's optimal consumption bundle assuming that the substitution effect outweighs the income effect for croissants.
Show the effect of the frost on Jennifer's optimal consumption bundle assuming that the income effect outweighs the substitution effect for croissants

35. Application Reflection
Why does this matter?
This example allows us to merge the supply and demand model with how consumers make decisions – a frost in Brazil decreases the number of coffee sellers and increases the price of coffee
When Jennifer observes this change, she adjusts her consumption behavior
It affects both her consumption of coffee AND her consumption of croissants
By how much her consumption of croissants changes depends on the strength of the income effect or the substitution effect
What’s the most important takeaway?
Changes in the price on one good will affect a consumer’s optimal consumption point
If the price of coffee rises, we know definitively Jennifer consumes less coffee
If the income effect dominates, she also consumes less croissants
If the substitution effect dominates, she consumes more croissants as a result
MUDDIEST POINT?

36. Application 2
Consider once again Jennifer’s love of coffee and croissants. Assume that she has $100 per month allotted to the consumption of these goods. Assume that the price of coffee remains constant at $5 a cup.
Assume the price of croissants is $2 and she prefers to splits her income evenly between the consumption of coffee and croissants. Draw her BC and Indifference curve, labeling all points.
What happens if the price of croissants increases to $2.50? Then to $4? On the same graph, illustrate the changes in the budget constraint and optimal consumption points, once again assuming she prefers to split her income evenly between coffee and croissants.
Based on the prices changes in croissants, determine Jennifer’s demand for croissants.

37. Application Reflection
Why does this matter?
As the price of croissants changes, Jennifer’s demand for croissants also changes.
Since we are assuming she always leaves $50 for coffee and $50 for croissants each month, regardless of the price, the income and substitution effects cancel each other out in terms of how of a price change in croissants affects Jen’s coffee consumption.
Since we see how much her consumption of croissants changes when the price of croissants changes – we have Jen’s demand schedule for croissants and we can derive her demand curve for croissants
What’s the most important takeaway?
By finding the optimal consumption point when prices change, we can derive an individual consumer’s demand curve
When we add all of the individual demand curves together, we have the market demand curve
Demand is a direct reflection of finding the optimal consumption points
MUDDIEST POINT?

38. Key Takeaways
Consumer’s optimal choice depend on both how much they can afford (budget constraint) and what the prefer (indifference curves)
Changes in a consumer’s income as well as changes in the price of goods will affect the optimal consumption choice
How consumers respond to the change in the price of a good will determine the demand curve