1. The Theory of Consumer Choice
Chapter 21
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2. The theory of consumer choice addresses the following questions:
Do all demand curves slope downward?
How do wages affect labor supply?
How do interest rates affect household saving?
Do the poor prefer to receive cash or in-kind transfers? 2

3. The Budget Constraint
The budget constraint 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

4. The Budget Constraint
It shows the various combinations of goods the consumer can afford given his or her income and the prices of the two goods. 4

5. The Consumer’s Opportunities
Copyright © 2001 by Harcourt, Inc. All rights reserved
Pints of
Pepsi
Number of
Pizzas
Spending
on Pepsi
on Pizza
Total
100
$ 0
$1,000 50 90
900
1,000 80
200
800
150 70
300
700 60
400
600
250
500 40
350 30 20
450 10

6. The Consumer’s Budget Constraint
Any point on the budget constraint line indicates the consumer’s combination or tradeoff between two goods.
For example, if the consumer buys no pizzas, he can afford 500 pints of Pepsi (point B). If he buys no Pepsi, he can afford 100 pizzas (point A).

7. The Consumer’s Budget Constraint...
Quantity
of Pepsi
500 B
Consumer’s
budget constraint
100 A
Quantity
of Pizza

8. The Consumer’s Budget Constraint
Alternately, the consumer can buy 50 pizzas and 250 pints of Pepsi.

9. The Consumer’s Budget Constraint...
Quantity
of Pepsi B
500 C
250 50
Consumer’s
budget constraint A
100
Quantity
of Pizza

10. The Consumer’s Budget Constraint
The slope of the budget constraint 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

11. Preferences: What the Consumer Wants
A consumer’s preference among consumption bundles may be illustrated with indifference curves. 11

12. Representing Preferences with Indifference Curves
An indifference curve shows bundles of goods that make the consumer equally happy.

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

14. 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

15. 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

16. The Consumer’s Preferences...
Quantity
of Pepsi C B D 1
MRS I2 A
Indifference
curve, I1
Quantity
of Pizza

17. 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.

18. 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.

19. Property 1: Higher indifference curves are preferred to lower ones.
Quantity
of Pepsi C B D I2 A
Indifference
curve, I1
Quantity
of Pizza

20. 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

21. Property 2: Indifference curves are downward sloping.
Quantity
of Pepsi
Indifference
curve, I1
Quantity
of Pizza

22. Property 3: Indifference curves do not cross.
Points A and B should make the consumer equally happy.
Points B and C should make the consumer equally happy.
This implies that A and C would make the consumer equally happy.
But C has more of both goods compared to A. 23

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

24. 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.
These differences in a consumer’s marginal substitution rates cause his or her indifference curve to bow inward. 24

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

26. Two Extreme Examples of Indifference Curves
Perfect substitutes
Perfect complements 25

27. Perfect Substitutes
Two goods with straight-line indifference curves are perfect substitutes.
The marginal rate of substitution is a fixed number. 26

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

29. Perfect Complements
Two goods with right-angle indifference curves are perfect complements. 27

30. Perfect Complements
Left
Shoes 7 5 I1 I2
Right Shoes

31. Optimization: What the Consumer Chooses
Consumers want to get the combination of goods on the highest possible indifference curve.
However, the consumer must also end up on or below his budget constraint. 30

32. Optimization: What the Consumer Chooses
Combining the indifference curve and the budget constraint determines the consumer’s optimal choice.
Consumer optimum occurs at the point where the highest indifference curve and the budget constraint are tangent.

33. The Consumer’s Optimal Choice
The consumer chooses consumption of the two goods so that the marginal rate of substitution equals the relative price. 34

34. The Consumer’s Optimal Choice
At the consumer’s optimum, the consumer’s valuation of the two goods equals the market’s valuation. 34

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

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

37. An Increase in Income... Quantity New budget constraint of Pepsi
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An Increase in Income...
Quantity
of Pepsi
New budget constraint I2
1. An increase in income shifts
the budget constraint outward…
New optimum
3. …and Pepsi
consumption.
Initial optimum
Initial budget constraint I1
2. …raising pizza consumption…
Quantity
of Pizza

38. Normal versus Inferior Goods
If a consumer buys more of a good when his or her income rises, the good is called a normal good.
If a consumer buys less of a good when his or her income rises, the good is called an inferior good.

39. An Inferior Good... Quantity New budget constraint of Pepsi
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Quantity
New budget constraint
1. When an increase in income shifts the budget constraint outward...
of Pepsi
New optimum I2
but Pepsi consumption falls, making Pepsi an inferior good.
Initial optimum
Initial budget constraint I1
pizza consumption rises,
making pizza a normal good...
Quantity
of Pizza

40. 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 constraint. 41

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

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

43. The Income 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. 48

44. The Substitution Effect
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. 45

45. A Change in Price: Substitution Effect
A price change first causes the consumer to move from one point on a indifference curve to another on the same curve.
Illustrated by movement from point A to point B. 51

46. A Change in Price: Income Effect
After moving from one point to another on the same curve, the consumer will move to another indifference curve.
Illustrated by movement from point B to point C.

47. Income and Substitution Effects...
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Income and Substitution Effects...
Quantity
of Pepsi I2 C
New optimum
Income effect
New budget constraint
Substitution effect B
Initial optimum A
Initial budget constraint I1
Quantity of Pizza

48. Income and Substitution Effects When the Price of Pepsi Falls

49. Deriving the Demand Curve
A consumer’s demand curve can be viewed as a summary of the optimal decisions that arise from his or her budget constraint and indifference curves. 54

50. Deriving the Demand Curve...
(a) The Consumer’s Optimum
(b) The Demand Curve for Pepsi
Quantity of Pepsi
Price of Pepsi
New budget constraint A B $2
150 I2 B 1 A 50 I1
Quantity of Pizza 50
150
Quantity of Pepsi
Initial budget constraint

51. Do all demand curves slope downward?
Demand curves can sometimes slope upward.
This happens when a consumer buys more of a good when its price rises. 55

52. Giffen Goods
Economists use the term Giffen good to describe a good that violates the law of demand.
Giffen goods are inferior goods for which the income effect dominates the substitution effect.
They have demand curves that slope upwards. 55

53. A Giffen Good... Quantity of Potatoes Initial budget constraint B
Optimum with high
price of potatoes
2...which increases potato consumption if potatoes are a Giffen good.
Optimum with low D
price of potatoes E
1. An increase in the price of potatoes rotates the budget... C I1
New budget I2
constraint A
Quantity
of Meat

54. How do wages affect labor supply?
If the substitution effect is greater than the income effect for the worker, he or she works more.
If income effect is greater than the substitution effect, he or she works less.

55. The Work-Leisure Decision...
Consumption
$5,000
Optimum I3
2,000 I2 I1 60
100
Hours of Leisure

56. An Increase in the Wage... I2 BC1 BC2 I1
(a) For a person with these preferences…
. . . the labor supply curve slopes upward.
Wage
Consumption
1. When the wage rises… I2
BC1
BC2 I1
Hours of
Leisure
Hours of Labor
Supplied
2. …hours of leisure decrease…
3. ...and hours of labor increase.

57. An Increase in the Wage... BC2 I2 BC1 I1
(b) For a person with these preferences…
. . . the labor supply curve slopes backward.
Wage
Consumption
BC2
1. When the wage rises… I2
BC1 I1
Hours of
Leisure
Hours of Labor
Supplied
2. …hours of leisure increase…
3. ...and hours of labor decrease.

58. How do interest rates affect household saving?
If the substitution effect of a higher interest rate is greater than the income effect, households save more.
If the income effect of a higher interest rate is greater than the substitution effect, households save less. 57

59. The Consumption-Saving Decision...
when Old
Budget
constraint
$110,000
Optimum
55,000 I3 I2 I1
$50,000
100,000
Consumption
when Young

60. An Increase in the Interest Rate...
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(a) Higher Interest Rate Raises Saving
(b) Higher Interest Rate Lowers Saving
Consumption when Old
BC2
Consumption when Old
BC2
1. A higher interest rate rotates the budget constraint outward...
1. A higher interest rate rotates the budget constraint outward...
BC1 I2 I2
BC1 I1 I1
Consumption when Young
Hours of
Leisure
2. …resulting in lower consumption when young and, thus, higher saving.
2. …resulting in higher consumption when young and, thus, lower saving.

61. How do interest rates affect household saving?
Thus, an increase in the interest rate could either encourage or discourage saving. 57

62. Do the poor prefer to receive cash or in-kind transfers?
If an in-kind transfer of a good forces the recipient to consume more of the good than he would on his own, then the recipient prefers the cash transfer. 58

63. Do the poor prefer to receive cash or in-kind transfers?
If the recipient does not consume more of the good than he would on his own, then the cash and in-kind transfer have exactly the same effect on his consumption and welfare. 58

64. Cash versus In-Kind Transfers...
(a) The Constraint Is Not Binding
Cash Transfer
Food
Food
In-Kind Transfer
BC2
(with $1,000 cash)
BC2
(with $1,000 food stamps)
BC1
BC1 B B I2 I2
$1,000
$1,000 A A I1 I1
Nonfood
Nonfood
Consumption
Consumption

65. Cash versus In-Kind Transfers...
(b) The Constraint Is Binding
Cash Transfer
Food
Food
In-Kind Transfer
BC2
(with $1,000 cash)
BC2
(with $1,000 food stamps)
BC1
BC1 C
$1,000
$1,000 B B I2 A A I2 I1 I1 I3
Nonfood
Nonfood
Consumption
Consumption

66. Summary
A consumer’s budget constraint shows the possible combinations of different goods he can buy given his income and the prices of the goods.
The slope of the budget constraint equals the relative price of the goods.
The consumer’s indifference curves represent his preferences.

67. Summary
Points on higher indifference curves are preferred to points on lower indifference curves.
The slope of an indifference curve at any point is the consumer’s marginal rate of substitution.
The consumer optimizes by choosing the point on his budget constraint that lies on the highest indifference curve.

68. Summary
When the price of a good falls, the impact on the consumer’s choices can be broken down into an income effect and a substitution effect.
The income effect is the change in consumption that arises because a lower price makes the consumer better off.
The income effect is reflected by the movement from a lower to a higher indifference curve.

69. Summary
The substitution effect is the change in consumption that arises because a price change encourages greater consumption of the good that has become relatively cheaper.
The substitution effect is reflected by a movement along an indifference curve to a point with a different slope.

70. Summary The theory of consumer choice can explain:
Why demand curves can potentially slope upward.
How wages affect labor supply.
How interest rates affect household saving.
Whether the poor prefer to receive cash or in-kind transfers.

71. Graphical Review

72. The Consumer’s Budget Constraint...
Quantity
of Pizza
of Pepsi
Consumer’s
budget constraint
500 B
100 A

73. The Consumer’s Budget Constraint...
Quantity
of Pizza
of Pepsi
250 50
100
500 B C A
Consumer’s
budget constraint

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

75. The Consumer’s Preferences...
Quantity
of Pizza
of Pepsi C B A D
Indifference
curve, I1 I2 1
MRS

76. Property 1: Higher indifference curves are preferred to lower ones.
Quantity
of Pizza
of Pepsi C B A D
Indifference
curve, I1 I2

77. Property 2: Indifference curves are downward sloping.
Quantity
of Pizza
of Pepsi
Indifference
curve, I1

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

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

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

81. Perfect Complements
Right Shoes
Left
Shoes 7 5 I1 I2

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

83. An Increase in Income... New budget constraint of Pepsi
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
An Increase in Income...
Quantity
of Pizza
of Pepsi I1 I2
2. …raising pizza consumption…
3. …and Pepsi
consumption.
Initial optimum
New budget constraint
1. An increase in income shifts
the budget constraint outward…
Initial budget constraint
New optimum

84. An Inferior Good... New budget constraint of Pepsi
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New budget constraint
1. When an increase in income shifts the budget constraint outward...
Quantity
of Pizza
of Pepsi
Initial optimum I1
New optimum I2
pizza consumption rises,
making pizza a normal good...
but Pepsi consumption falls, making Pepsi an inferior good.
Initial budget constraint

85. Initial budget constraint
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A Change in Price...
Quantity of Pizza
100
Quantity of Pepsi
1,000
500 I1
New budget constraint
3. …and raising Pepsi
consumption.
Initial budget constraint
2. …reducing pizza consumption…
1. A fall in the price of Pepsi rotates the budget constraint outward…
New optimum I2

86. Income and Substitution Effects...
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Income and Substitution Effects...
Quantity of Pizza
Quantity
of Pepsi A
Initial optimum I1
New budget constraint
Initial budget constraint I2 C
New optimum
Income effect
Substitution effect B

87. Deriving the Demand Curve...
(a) The Consumer’s Optimum
(b) The Demand Curve for Pepsi I1 I2 A B
Initial budget constraint
New budget constraint 50
150
Quantity of Pizza
Quantity of Pepsi 1 $2
Price of Pepsi

88. A Giffen Good... Quantity of Potatoes Initial budget constraint B
of Meat A
Quantity of
Potatoes E C I2 I1
Initial budget constraint
New budget
constraint D B
Optimum with low
price of potatoes
Optimum with high
1. An increase in the price of potatoes rotates the budget...
2...which increases potato consumption if potatoes are a Giffen good.

89. The Work-Leisure Decision...
Hours of Leisure
2,000
$5,000 60
Consumption
100
Optimum I3 I2 I1

90. An Increase in the Wage... I2 BC1 BC2 I1 Hours of Labor Supplied Wage
Wage
. . . the labor supply curve slopes upward.
Hours of
Leisure
Consumption
(a) For a person with these preferences… I2 I1
BC2
BC1
2. …hours of leisure decrease…
3. ...and hours of labor increase.
1. When the wage rises…

91. An Increase in the Wage... BC2 I2 BC1 I1 Hours of Labor Supplied Wage
Wage
. . . the labor supply curve slopes backward.
Hours of
Leisure
Consumption
(b) For a person with these preferences… I2 I1
BC2
BC1
1. When the wage rises…
2. …hours of leisure increase…
3. ...and hours of labor decrease.

92. The Consumption-Saving Decision...
when Young
55,000
$110,000
$50,000
when Old
100,000
Optimum I3 I2 I1
Budget
constraint

93. An Increase in the Interest Rate...
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Consumption when Old
1. A higher interest rate rotates the budget constraint outward... I2 I1
BC2
BC1
2. …resulting in lower consumption when young and, thus, higher saving.
Consumption when Young
Hours of
Leisure
2. …resulting in higher consumption when young and, thus, lower saving.
(a) Higher Interest Rate Raises Saving
(b) Higher Interest Rate Lowers Saving

94. Cash versus In-Kind Transfers...
Cash Transfer
In-Kind Transfer
(a) The Constraint Is Not Binding
Nonfood
Consumption
$1,000
Food A B I2 I1
BC1
BC2
(with $1,000 cash)
(with $1,000 food stamps)

95. Cash versus In-Kind Transfers...
Cash Transfer
In-Kind Transfer
(b) The Constraint Is Binding
Nonfood
Consumption
$1,000
Food A B I2 I1
BC1
BC2
(with $1,000 cash)
(with $1,000 food stamps) C I3