1. Consumer Choice CHAPTER
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2. The Budget Constraint Budget constraint Budget line
Different combinations of goods
A consumer can afford with a limited budget
At given prices
Budget line
Graphical representation of a budget constraint
Maximum affordable quantity of one good, for given amounts of another good
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3. The Budget Constraint Max Relative price
Total entertainment budget = $100 per month
Price of a movie = $10
Price of a concert = $20
Relative price
Price of one good relative to the price of another
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4. 1
The Budget Constraint
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5. 1
The Budget Constraint
With $100 per month, Max can afford 10 movies and no concerts, . . .
Number of Concerts per Month
Number of Movies per Month A 10 5
8 movies and 1 concert or any other combination on the budget line. B 8 1 C
But not points above the line. 6 H 2 D 4 G
Points below the line are also affordable. 3 E 2 4 F
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6. The Budget Constraint If Then, Px/Py is
Py: price of the good on the vertical axis
Px: price of the good on the horizontal axis
Then, Px/Py is
The relative price of good X
The opportunity cost of one more unit of good X
The absolute value of the slope of the consumer’s budget line
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7. Changes in the Budget Line
Changes in income
An increase in income will shift the budget line upward (and rightward)
A decrease in income will shift the budget line downward (and leftward)
These shifts are parallel
Changes in income do not affect the budget line’s slope
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8. Changes in the Budget Line
Changes in price
The budget line rotates
The slope of the budget line changes
One of the intercepts of the budget line changes
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9. 2 Changes in the Budget Line Number of Concerts per Month
Number of movies per month
(a)
Number of
Concerts per Month
Number of movies per month
(b)
Number of
Concerts per Month
Number of movies per month
(c)
1. An increase in income shifts the budget line rightward, with no change in slope. 10 20 20
2. A decrease in the price of movies rotates the budget line upward . . .
3. While a decrease in the price of concerts rotates it rightward 5 10 5 10 5 10 10
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10. Preferences Rational preferences satisfy two conditions:
Any two alternatives can be compared, and one is preferred or else the two are valued equally
The comparisons are logically consistent or transitive
More is better
Always choose a point on the budget line, rather than a point below it
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11. The Marginal Utility Approach
Quantitative measure of pleasure/ satisfaction obtained from consuming goods and services
Marginal utility
Change in total utility
From consuming an additional unit of a good or service
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12. 3 Total and Marginal Utility
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13. 3 Total and Marginal Utility Ice cream cones per week Utils 10 20 3040 50 60 70 1 2 3 4 5 6
Total Utility
1. The change in total utility from one more ice cream cone . . .
Ice cream cones per week
Utils 10 20 30 1 2 3 4 5 6
2. Is called the marginal utility of an additional cone.
3. Marginal utility falls as more cones are consumed.
Marginal Utility
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14. The Marginal Utility Approach
Law of diminishing marginal utility
As consumption of a good or service increases, marginal utility decreases
Marginal utility
Can be zero
Assumption
Marginal utility for every good is positive
‘More is better’
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15. The Marginal Utility Approach
Utility maximization
Consumer will choose the point on the budget line
Where marginal utility per dollar is the same for both goods: MUx/Px = MUy/Py
There is no further gain from reallocating expenditures in either direction
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16. 1 Total and Marginal Utility of Concerts and Movies
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17. 4 Consumer Decision Making
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18. 4 Consumer Decision Making Number of Concerts per Month Number of
Movies
per Month 8 1 2 6 4 3 10 5 A B C D G E F
The budget line shows the maximum number of movies Max could attend for each number of concerts he attends. He would never choose an interior point like G because there are affordable points—on the line—that make him better off. Max will choose the point on the budget line at which the marginal utilities per dollar spent on movies and concerts are equal. From the table, this occurs at point D.
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19. The Marginal Utility Approach
A rise in income
With no change in prices
A new quantity demanded for each good
Individual preferences (marginal utility)
Normal good – quantity demanded increases
Inferior good – quantity demanded decreases
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20. 5 Effects of an Increase in Income
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21. 5 Effects of an Increase in Income Number of Concerts per Month
Number of Movies per Month 20 10 G H J K L
1. When Max's income rises to $200, his budget line shifts outward. 14 16 18
2. If his preferences are as given in the table, he'll choose point K. 12 A B C D E F 10 5 8 1 6 6 2 7 4 3 8 9 2 4
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22. 6 Normal and Inferior Goods Number of Concerts per Month
Number of Movies per Month 8 1 2 6 4 3 7 9 14 16 18 12 5 10 20
If income rises and concerts are inferior, Max moves to a point like K″ (fewer concerts). K” K K’ A B C D E F
If income rises and movies are inferior, Max moves to a point like K′ (fewer movies).
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23. The Marginal Utility Approach
Change in prices
Decrease in the price of one good
Other things constant
Rotates the budget line rightward
Individual demand curve
Quantity of a good a consumer demands at each different price
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24. 7 Deriving the Demand Curve
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25. 7 Deriving the Demand Curve Number of Concerts per month
Number of Movies per Month 4 5 6 10 3 8 20
1. When the price of concerts is $20, point D is best for Max.
2. If the price falls to $10, Max's budget line rotates rightward, and he chooses point R. T R
3. And if the price drops to $5, he chooses point T. D
Number of Concerts per month
Price per Concert $5
$10
$20 3 5 8 D
4. The demand curve shows the quantity Max chooses at each price R T
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26. Income and Substitution Effects
As the price of a good falls, the consumer substitutes that good in place of other goods whose prices have not changed
Arises from a change in the relative price of a good
It moves quantity demanded in the opposite direction to the price change
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27. Income and Substitution Effects
Income effect
As the price of a good decreases, the consumer’s purchasing power increases
Causing a change in quantity demanded for the good
Arises from a change in purchasing power over both goods
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28. Income and Substitution Effects
Normal goods
Substitution and income effects work together
Quantity demanded - moves in the opposite direction of the price
Always obey the law of demand
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29. Income and Substitution Effects
Inferior goods
Substitution and income effects work against each other
Substitution effect virtually always dominates
Virtually always obey the law of demand
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30. 8 Income and Substitution Effects
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31. Consumers in Markets Market demand curve
Horizontally summing the individual demand curves of every consumer in the market
Obeys the law of demand
Downward sloping
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32. 9 From Individual to Market Demand (a) Price Jerry Price George Price
Number of Bottles
per Week
Price
Jerry
Number of Bottles
per Week
Price
George
Number of Bottles
per Week
Price
Elaine $4 3 2 $4 3 2 $4 3 2 C C’ C” 4 6 1 1 1 8 12 9 12 10 20
The individual demand curves show how much bottled water will be demanded by Jerry, George, and Elaine at different prices. As the price falls, each demands more.
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33. 9 From Individual to Market Demand (b) Number of Bottles per Week
Price A $4 3
Market Demand Curve B 3 C 2 10 D 1 27 E 44
The market demand curve in panel (b) is obtained by adding up the total quantity demanded by all market participants at different prices.
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34. Consumer Theory in Perspective
Extensions of the model
Incorporate choices among many goods
Recognize saving and borrowing
Incorporate uncertainty and imperfect information
Behavioral economics
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35. Consumer Theory in Perspective
Behavioral economics
Subfield of economics
Decision-making patterns that deviate from those predicted by traditional consumer theory
Salience of a particular outcome
The extent to which it “jumps out at them”
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36. Consumer Theory in Perspective
Preference for defaults
People tend to stick to the default choice
Decision-making environment
Environment in which a decision is made - can exert a strong and surprising influence
Self-binding
To a narrower set of choices - long-run good
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37. Consumer Theory in Perspective
Behavioral economics and policy
Financial incentive for firms to make “automatic contribution” by employees the default choice
People with gambling problems - voluntarily put themselves on a list that bans them from any casino
Industry-wide “vanilla” versions of mortgages, student loans, credit card agreements
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38. Consumer Theory in Perspective
Behavioral economics and traditional theory
Traditional economic theory: assumes that consumers have rational preferences
Behavioral economics: analyzes decisions that violate rational preferences
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39. Model of consumer choice
Improving Education
Model of consumer choice
Student’s time allocation problem
Only two activities: studying economics and studying French
Each of these activities costs time
Students “buy” points on their exams with hours spent studying
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40. Student’s time allocation problem
Improving Education
Student’s time allocation problem
Opportunity cost of scoring better in French
Scoring lower in economics
Slope of budget line = -PF/PE = -2
Each additional point in French: sacrifice 2 points in economics
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41. New computer-assisted technique in French class
Improving Education
New computer-assisted technique in French class
Learn more French with the same study time or to study less and learn the same amount
A decrease in the price of French points
Budget line rotates outward
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42. 10 Time Allocation French score Economics score 90 70 80 75 (a)
(b) F E C D C
Panel (a) shows combinations of French and economics test scores that can be obtained for a given amount of study time. The slope of −2 indicates that each additional point in French
requires a sacrifice of 2 points in economics. The student chooses point C. Panel (b) shows
that computer-assisted French instruction causes the budget line to rotate outward; French points are now less expensive. The student might move to point D, attaining a higher French score. Or she might choose F, using all of the time freed up in French to study economics. Or she might choose an intermediate point, such as E.
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43. The Indifference Curve Approach
Assumptions
Rational preferences: an individual can compare any two options and decide which is best
Makes choices that are logically consistent
An individual prefers more of every good to less
Consumer - choose to be on budget line, rather than below it
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44. Marginal rate of substitution, MRSy,x
An Indifference Curve
An indifference curve
All combinations of two goods that make the consumer equally well off
Slopes downward
Marginal rate of substitution, MRSy,x
Of good y for good x along any segment of an indifference curve
Is the maximum rate at which a consumer would willingly trade units of y for units of x
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45. Number of Concerts per Month
A.1
An Indifference Curve
Number of Concerts per Month
Number of Movies per Month 6 3 4 11 20 1 2 5
If Max gets another concert . . . +1 G -9
He could give up 9 movies and be just as satisfied. +1 H -5 +1 J -2 +1 K -1 L
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46. MRS at any point on the indifference curve
An Indifference Curve
MRS at any point on the indifference curve
The (absolute value of) the slope of the curve at that point
Maximum rate at which a consumer would willingly trade good y for a tiny bit more of good x
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47. The Indifference Map Indifference map
A set of indifference curves that describe one persons’ preferences
Any point on a higher indifference curve is preferred to any point on a lower one
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48. Number of Concerts per Month
A.2
An Indifference Map
Number of Concerts per Month
Number of Movies per Month 6 11 20 1 2 3
1.Max prefers any point on this indifference curve… G H J R S
2.to any point on this one.
3.And any point on this curve is preferred to any point on the other two.
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49. Consumer Decision Making
Optimal combination of goods
The point on the budget line where an indifference curve is tangent to the budget line
That combination on the budget line for which MRSy,x = Px/Py
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50. A.3 Consumer Decision Making with Indifference Curves
Number of Movies per Month
Number of Concerts
per Month 6 10 1 2 3 4 5 8 A B
2. But point D (also affordable) is preferred because it is on a higher indifference curve.
1. Points B and E are affordable . . . D E
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51. What Happens When Things Change?
A rise in income
With no change in prices
Leads to a new quantity demanded for each good
Quantity demanded increases (normal good)
Quantity demanded decreases (inferior good)
Depends on the individual’s preferences
Indifference map
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52. A.4 An Increase in Income Number of Concerts per Month
Number of Movies
per Month 8 4 3 6 5 10 20
1. When Max's income rises to $200, his budget line shifts outward.
2. With the preferences represented by these indifference curves, he'll choose point H.
3. In this case, both movies and concerts are normal goods for Max. H D
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53. A.4 An Increase in Income Number of Concerts per Month
Number of Movies
per Month 2 4 3 9 5 10 20 8 6
5. Concerts would be normal for Max, but movies would be inferior.
4. But if Max instead had these indifference curves, he would choose point H’ . . . D H’
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54. What Happens When Things Change?
Changes in price
Budget line rotates
Quantity demanded changes
Downward sloping demand curve
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55. A.5 Deriving the Demand Curve with Indifference Curves
Number of Concerts per Month
Number of Movies per Month 5 4 3 8 10 6 20
1. When the price of concerts is $20, MRSm,c = Pc /Pm at Point D. K
2. But when the price of concerts falls to $10, this condition is satisfied at point J. J D
Number of Concerts per Month
Price per concert $5 3 8 5
$20
$10 D
3. The demand curve shows the quantity of concerts Max chooses at each price for concerts. J K
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