1. Economic Analysis for Business Session XV: Theory of Consumer Choice (Chapter 21)
Instructor Sandeep Basnyat

2. A C T I V E L E A R N I N G 1: Budget constraint
The consumer’s income: $ Prices: $10 per pizza, $2 per pint of Pepsi
A. If the consumer spends all his income on pizza, how many pizzas does he buy?
B. If the consumer spends all his income on Pepsi, how many pints of Pepsi does he buy?
C. If the consumer spends $400 on pizza, how many pizzas and Pepsis does he buy?
D. Plot each of the bundles from parts A-C on a diagram that measures the quantity of pizza on the horizontal axis and quantity of Pepsi on the vertical axis, then connect the dots. 2

3. A C T I V E L E A R N I N G 1: Answers
D. The budget constraint shows the various combinations of goods the consumer can afford given his or her income and the prices of the two goods.
Pepsis
A. $1000/$10 = 100 pizzas
B. $1000/$2 = 500 Pepsis
C. $400/$10 = 40 pizzas $600/$2 = 300 Pepsis B C A
Pizzas 3

4. The Slope of the Budget Constraint
Pepsis
From C to D,
“rise” = –100 Pepsis
“run” = +20 pizzas
Slope = –5
Consumer must give up 5 Pepsis to get another pizza. C D
Pizzas
CHAPTER THE THEORY OF CONSUMER CHOICE

5. The Slope of the Budget Constraint
The slope of the budget constraint equals
the rate at which the consumer can trade Pepsi for pizza: the opportunity cost of pizza in terms of Pepsi
the relative price of pizza: price of one good compared to the other
CHAPTER THE THEORY OF CONSUMER CHOICE

6. A C T I V E L E A R N I N G 2: Exercise
Pepsis
What happens to the budget constraint if:
A. Income falls to $800
Pizzas 6

7. A C T I V E L E A R N I N G 2A: Answers
Pepsis
A fall in income shifts the budget constraint inward.
Consumer can buy $800/$10 = 80 pizzas
or $800/$2 = 400 Pepsis
or any combination in between.
Pizzas 7

8. A C T I V E L E A R N I N G 2: Exercise
Pepsis
What happens to the budget constraint if:
B. The price of Pepsi rises to $4/pint.
Pizzas 8

9. A C T I V E L E A R N I N G 2B: Answers
An increase in the price of one good pivots the budget constraint inward.
Pepsis
Consumer can still buy 100 pizzas.
But now, can only buy $1000/$4 = 250 Pepsis.
Notice: slope is smaller, relative price of pizza now only 2.5 Pepsis.
Pizzas 9

10. PREFERENCES: WHAT THE CONSUMER WANT
The consumer’s preferences allow him to choose among different bundles of the same goods he wants, for example Pepsi and Pizza, that best suits his tastes.
If the two bundles suit his tastes equally well, the consumer is indifferent between two bundles.
A graphical representation of the bundles of consumption that make the consumer equally happy is called the indifference curve.

11. The Consumer’s Preferences
Quantity
An indifference curve is a curve that shows consumption bundles that give the consumer the same level of satisfaction, such as in points A, B or C
Indifference
curve, I1
of Pepsi C B A
Quantity
If the consumption of pizza is reduced, consumption of Pepsi must increase to keep him equally happy.
of Pizza

12. The Consumer’s Preferences-MRS
The slope at any point on an indifference curve is the
Marginal Rate of Substitution MRS
Quantity
Indifference
curve, I1
of Pepsi
MRS is the rate at which a consumer is willing to trade 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. C
200 B 5
MRS
100 A 30 50
Quantity
MRS tells how much Pepsi the consumer requires to be compensated for a one unit increase in pizza consumption
of Pizza

13. Higher and Lower Indifference Curves: Indifference Map
Quantity
Indifference
curve, I1
Higher indifference curves represent higher level of satisfaction
of Pepsi C I3 E B D 5
MRS A
Quantity
of Pizza

14. Four 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.

15. Four Properties of Indifference Curves
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.

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

17. Four Properties of Indifference Curves
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.

18. The Consumer’s Preferences
Quantity
Indifference
curve, I1
of Pepsi
Quantity
of Pizza

19. Four Properties of Indifference Curves
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.

20. The Impossibility of Intersecting Indifference Curves
Quantity
of Pepsi C A B
Quantity
of Pizza

21. Four Properties of Indifference Curves
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.

22. Bowed Indifference Curves
Quantity
of Pepsi
Indifference
curve 14 2 1
MRS
= 6 8 3 A 4 6 3 7 B 1
MRS
= 1
Quantity
of Pizza

23. Two Extreme Examples of Indifference Curves
Perfect substitutes
Goods that can be exactly substitutable
Consumers value both goods exactly equal
Perfect complements
Goods that need exact combination to form a product
Consumers benefit extra unit of good A only if he/she has extra unit of good B

24. Perfect Substitutes and Perfect Complements
(a) Perfect Substitutes
50 cents
Perfect Substitutes
Because the MRS is constant, two goods with straight-line indifference curves are perfect substitutes.
The marginal rate of substitution is a constant number. 3 6 I3 2 4 I2 1 2 I1
$ amount

25. Perfect Substitutes and Perfect Complements
(b) Perfect Complements
Perfect Complements
Two goods with right-angle indifference curves are perfect complements.
Left
Shoes I1 I2 9 7 5
Right Shoes

26. OPTIMIZATION: HOW THE CONSUMER CHOOSES?
Step 1:
Consumer chooses to buy on or below his budget constraint.
Step 2:
He get the combination of goods on the highest possible indifference curve.

27. The Consumer’s Optimum
Consumer optimum occurs at the point where the highest indifference curve and the budget constraint are tangent (slope of budget constraint and indifference curve is equal).
Quantity I3
of Pepsi I2
Budget constraint I1
Optimum B A
Note:
Slop of ID curve: MRS
Slop of BC: Relative price of Pepsi and Pizza
Quantity
of Pizza

28. The Consumer’s Optimal Choice
The consumer chooses consumption of the two goods so that the marginal rate of substitution equals the relative price.
At the consumer’s optimum, the consumer’s valuation of the two goods equals the market’s valuation.
Consumer takes as given the relative price of the two goods and then chooses an optimum at which his MRS equals the relative price.
The relative price is the rate at which market is willing to trade one good for another, whereas the MRS is the rate at which the consumer is willing to trade one good for another.

29. Cases: Income effect and Price Effect
What happens when consumer’s income level increases? (Income effect)
A) Normal good: consumption increases, and,
B) Inferior good: consumption decreases

30. An Increase in Income-Normal goods: Pepsi and Pizza
Quantity
of Pepsi
New budget constraint I2 I1
Which Indifference curve would the consumer chose? I3
Initial
optimum I4
Initial
budget
constraint
Quantity
of Pizza

31. An Increase in Income-Normal goods case
Quantity
of Pepsi
New budget constraint I3 I1
New optimum
Initial
optimum
Initial
budget
constraint
Quantity
of Pizza

32. Increase in Income- An Inferior Good case (Pepsi)
Quantity
of Pepsi
New budget constraint I2 I1
Initial
optimum
New optimum
Initial
budget
constraint
Quantity
of Pizza

33. Cases What happens when consumer’s income level increase or decreases?
Normal good and inferior good cases
What happens when price of the good(s) increases or decreases? (Price effect)
Assume that price of Pepsi decreases from $2 to $1 per pint.

34. Price Effect Effect 1 Substitution effect Interaction Effect
Pepsi is relatively cheaper
Opportunity cost of buying Pizza is higher
Buy more Pepsi and less Pizza
Effect 1
Pizza is relatively expensive
Moves to another combination of Indifference curve
Substitution effect

35. Price Effect Effect I1 Income effect Interaction Effect Normal Good -
Buy more goods
Pepsi is relatively cheaper
Income level increased
Effect I1
Can buy more goods with extra money
Jumps to higher indifference curve
Inferior Good - Buy less of inferior goods
Income effect

36. Price Effect
Total Price Effect =
Substitution effect + Income Effect

37. A Change in Price- Price of Pepsi decreases from $2 to $1
Quantity
of Pepsi I2 I1
New budget constraint
Total effect
Income effect
Substitution effect C
New optimum B A
Initial optimum
Initial
budget
constraint
Quantity
of Pizza

38. Total effect of Price decrease of Good X on Quantity demanded of Good X=
Substitution effect +
Income effect 9 5 4
Total effect of price decrease =
Substitution effect +
Income effect 3 5
(-2)

39. Generalization: Income and Substitution Effects
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
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.

40. THREE APPLICATIONS Do all demand curves slope downward?
How do wages affect labour supply?
How do interest rates affect household savings?

41. THREE APPLICATIONS 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.
Giffen goods
Economists use the term Giffen good to describe a good that violates the law of demand.
Giffen goods are goods for which an increase in the price raises the quantity demanded.
The income effect dominates the substitution effect.
They have demand curves that slope upwards.

42. Application I: A Giffen Good
Reasons:
Potatoes are a strongly inferior good. When the price of potatoes rises, the consumer is poorer. The income effect makes the consumer want to buy less meat and more potatoes
Because potatoes are more expensive, substitution effect makes the consumer want to buy more meat but income effect is so strong that it exceeds the substitution effects
Quantity of
Potatoes
Initial budget constraint A B I1
Optimum with high
price of potatoes I2
Optimum with low
price of potatoes D E
which
increases
potato
consumption
if potatoes
are a Giffen
good.
1. An increase in the price of
potatoes rotates the budget
constraint inward . . . C
New budget
constraint
Quantity
of Meat

43. What happens when the wage rate increases?
When wage rate increases,
a) If people find that spending more time on leisure activity incur higher opportunity costs, the substitution effect is greater than the income effect for them and they work more.
b) If people find that increase in wage rate is an increase in their income level, income effect is greater than the substitution effect for them and they spend more time on leisure and works less or the same amount.

44. Application II: The Work-Leisure Decision
Consumption I3
What happens when the wage increases? I2
$5,000
100 I1
Optimum
2,000 60
Hours of Leisure

45. An Increase in the Wage: Substitution effect-Income effect
(a) For a person with substitution effect
. . .
Hours of work
(b) For a person with Income effect
. . .
Hours of work I2 I1
BC2
1. When the wage rises . . . I2 I1
1. When the wage rises . . .
BC1
BC1
BC2
Hours of
hours of leisure decrease . . .
Hours of
Leisure
hours of leisure increase . . .
Leisure

46. 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 spend more and save less or remain constant.

47. Application III: The Consumption-Saving Decision
Budget
constraint
when Old I3
What happens when the bank interest rate increases?
$110,000
100,000 I2 I1
55,000
$50,000
Optimum
Consumption
when Young

48. An Increase in the Interest Rate-Substitution and Income Effect
(a) Higher Interest Rate Raises Saving
(b) Higher Interest Rate Lowers Saving
Consumption
Consumption
when Old
when Old
BC2
BC2
1. A higher interest rate rotates
the budget constraint outward . . .
1. A higher interest rate rotates
the budget constraint outward . . . I2 I1 I1 I2
BC1
BC1
Consumption
Consumption
resulting in lower
consumption when young
and, thus, higher saving.
resulting in higher
consumption when young
and, thus, lower saving.
when Young
when Young
Thus, an increase in the interest rate could either encourage or
discourage saving.

49. Thank you