1. The Theory of Consumer Choice21
The Theory of Consumer Choice

2. Budget Constraint: What the Consumer can Afford
Limit on the consumption bundles that a consumer can afford
Trade-off between goods
Slope of the budget constraint
Rate at which the consumer can trade one good for the other
Change in the vertical distance
Divided by the change in the horizontal distance
Relative price of the two goods

3. The consumer’s budget constraint (table)1
The consumer’s budget constraint (table)
Number
of Pizzas
Pints
of Pepsi
Spending
on Pizza
on Pepsi
Total
spending
100 90 80 70 60 50 40 30 20 10
150
200
300
350
400
450
500
$1,000
900
800
700
600 $0
1,000
The budget constraint shows the various bundles of goods that the consumer can buy for a given income. Here the consumer buys bundles of pizza and Pepsi. The table and graph show what the consumer can afford if his income is $1,000, the price of pizza is $10, and the price of Pepsi is $2.

4. The consumer’s budget constraint (graph)1
The consumer’s budget constraint (graph)
Quantity of
Pepsi B
500
Consumer’s
budget constraint C
250 50 A
Quantity of Pizza
100
The budget constraint shows the various bundles of goods that the consumer can buy for a given income. Here the consumer buys bundles of pizza and Pepsi. The table and graph show what the consumer can afford if his income is $1,000, the price of pizza is $10, and the price of Pepsi is $2.

5. Preferences: What the Consumer Wants
Indifference curve
Shows consumption bundles that give the consumer the same level of satisfaction
Combinations of goods on the same curve
Same satisfaction
Slope of indifference curve
Marginal rate of substitution
Rate at which a consumer is willing to trade one good for another
Not the same at all points

6. The consumer’s preferences2
The consumer’s preferences
Quantity
Of Pepsi I2
Indifference
curve, I1 C B D
MRS A 1
Quantity of Pizza
The consumer’s preferences are represented with indifference curves, which show the combinations of pizza and Pepsi that make the consumer equally satisfied. Because the consumer prefers more of a good, points on a higher indifference curve (I2 here) are preferred to points on a lower indifference curve (I1). The marginal rate of substitution (MRS) shows the rate at which the consumer is willing to trade Pepsi for pizza. It measures the quantity of Pepsi the consumer must be given in exchange for 1 pizza.

7. Preferences: What the Consumer Wants
Four properties of indifference curves
Higher indifference curves are preferred to lower ones
Higher indifference curves – more goods
Indifference curves are downward sloping
Indifference curves do not cross
Indifference curves are bowed inward

8. The impossibility of intersecting indifference curves3
The impossibility of intersecting indifference curves
Quantity
Of Pepsi C A B
Quantity of Pizza
A situation like this can never happen. According to these indifference curves, the consumer would be equally satisfied at points A, B, and C, even though point C has more of both goods than point A.

9. Bowed indifference curves4
Bowed indifference curves
Indifference curves are usually bowed inward. This shape implies that the marginal rate of substitution (MRS) depends on the quantity of the two goods the consumer is consuming. At point A, the consumer has little pizza and much Pepsi, so he requires a lot of extra Pepsi to induce him to give up one of the pizzas: The marginal rate of substitution is 6 pints of Pepsi per pizza. At point B, the consumer has much pizza and little Pepsi, so he requires only a little extra Pepsi to induce him to give up one of the pizzas: The marginal rate of substitution is 1 pint of Pepsi per pizza.
Quantity
Of Pepsi
Indifference
curve 14
MRS=8 2 A 8 1 3 4 B
MRS=1 6 3 1 7
Quantity of Pizza

10. Preferences: What the Consumer Wants
Two extreme examples of indifference curves
Perfect substitutes
Two goods with straight-line indifference curves
Marginal rate of substitution – constant
E.g.: nickels and dimes bundles
Perfect complements
Two goods with right-angle indifference curves
E.g.: right shoe and left shoe bundle

11. Perfect substitutes and perfect complements5
Perfect substitutes and perfect complements
(a) Perfect Substitutes
(b) Perfect Complements
Nickels 6 2 4
Left
shoes I2 I1 I3 7 I2 5 5 7 I1
Dimes 1 3 2
Right
shoes
When two goods are easily substitutable, such as nickels and dimes, the indifference curves are straight lines, as shown in panel (a). When two goods are strongly complementary, such as left shoes and right shoes, the indifference curves are right angles, as shown in panel (b).

12. Optimization: What the Consumer Chooses
The consumer’s optimal choices
Optimum
Point where indifference curve and budget constraint touch
Best combination of goods available to the consumer
Slope of indifference curve
Equals slope of budget constraint
Marginal rate of substitution = relative price

13. The consumer’s optimum6
The consumer’s optimum
Quantity of
Pepsi
Budget constraint I3
Optimum I2 I1 A B
Quantity of Pizza
The consumer chooses the point on his budget constraint that lies on the highest indifference curve. At this point, called the optimum, the marginal rate of substitution equals the relative price of the two goods. Here the highest indifference curve the consumer can reach is I2. The consumer prefers point A, which lies on indifference curve I3, but the consumer cannot afford this bundle of pizza and Pepsi. By contrast, point B is affordable, but because it lies on a lower indifference curve, the consumer does not prefer it.

14. Optimization: What the Consumer Chooses
How changes in income affect the consumer’s choices
Higher income
Consumer can afford more of both goods
Shifts the budget constraint outward
New optimum

15. 7 An Increase in Income Quantity of New budget constraint Pepsi
1. An increase in income shifts the
budget constraint outward . . . I2
and
Pepsi
consumption I1
New optimum
Initial
budget
constraint
Initial optimum
raising
pizza
consumption . . .
Quantity of Pizza
When the consumer’s income rises, the budget constraint shifts out. If both goods are normal goods, the consumer responds to the increase in income by buying more of both of them. Here the consumer buys more pizza and more Pepsi.

16. Optimization: What the Consumer Chooses
How changes in income affect the consumer’s choices
Normal good
Good for which an increase in income raises the quantity demanded
Inferior good
Good for which an increase in income reduces the quantity demanded

17. 8 An inferior good Quantity of New budget constraint Pepsi
1. When an increase in income shifts the
budget constraint outward . . . I2
but Pepsi
consumption falls,
making Pepsi an
inferior good I1
Initial budget
constraint
Initial optimum
New optimum
pizza consumption rises,
making pizza a normal good. . .
Quantity of Pizza
A good is an inferior good if the consumer buys less of it when his income rises. Here Pepsi is an inferior good: When the consumer’s income increases and the budget constraint shifts outward, the consumer buys more pizza but less Pepsi.

18. Optimization: What the Consumer Chooses
How changes in prices affect the consumer’s choices
Price of one good falls
Rotates the budget constraint outward
Steeper slope
Change in relative price
Income effect
Substitution effect

19. 9 A change in price Quantity of Pepsi New budget constraint I2 D 1,000
New optimum
1. A fall in the price of Pepsi rotates
the budget constraint outward. . .
and
raising Pepsi
consumption B
500
Initial
budget
constraint
Initial optimum
reducing pizza consumption A
100
Quantity of Pizza
When the price of Pepsi falls, the consumer’s budget constraint shifts outward and changes slope. The consumer moves from the initial optimum to the new optimum, which changes his purchases of both pizza and Pepsi. In this case, the quantity of Pepsi consumed rises, and the quantity of pizza consumed falls.

20. Optimization: What the Consumer Chooses
Income effect
Change in consumption
When a price change moves the consumer
To a higher or lower indifference curve
Substitution effect
Along a given indifference curve
To a point with a new marginal rate of substitution

21. Income and substitution effects when the price of Pepsi falls1
Income and substitution effects when the price of Pepsi falls
Good
Income effect
Substitution effect
Total effect
Pepsi Pizza
Consumer is richer,
so he buys more Pepsi
so he buys more pizza
Pepsi is relatively
cheaper, so consumer
buys more Pepsi
Pizza is relatively
More expensive,
so consumer buys
less pizza.
Income and substitution
effects act in same
direction, so consumer
effects act in opposite
directions, so the
total effect on pizza
consumption is
ambiguous.

22. Income and substitution effects10
Income and substitution effects
Quantity
of Pepsi
The effect of a change in price can be broken down into an income effect and a substitution effect. The substitution effect—the movement along an indifference curve to a point with a different marginal rate of substitution—is shown here as the change from point A to point B along indifference curve I1. The income effect—the shift to a higher indifference curve—is shown here as the change from point B on indifference curve I1 to point C on indifference curve I2.
New budget
constraint I2 I1
New optimum C
Income
effect B
Initial
budget
constraint
Substitution
effect
Initial optimum A
Quantity
of Pizza
Substitution effect
Income effect

23. Optimization: What the Consumer Chooses
Deriving the demand curve
Quantity demanded of a good for any given price
Initial optimum point
Initial price of the good
Initial quantity of the good
A change in price of the good (new price)
New optimum
New optimum quantity

24. Deriving the demand curve11
Deriving the demand curve
(a) The Consumer’s Optimum
(b) The Demand Curve for Pepsi
Quantity
of Pepsi
Price of
Pepsi
New budget constraint I2 B A $2
Demand
750
250 I1 B
Initial budget
constraint 1 A
750
250
Quantity
of Pizza
Quantity
of Pepsi
Panel (a) shows that when the price of Pepsi falls from $2 to $1, the consumer’s optimum moves from point A to point B, and the quantity of Pepsi consumed rises from 250 to 750 pints. Demand curve in panel (b) reflects this relationship between the price and the quantity demanded.

25. Three Applications Do all demand curves slope downward? Law of demand
When the price of a good rises, people buy less of it
Downward slope of the demand curve
Giffen good
An increase in the price of the good raises the quantity demanded
Income effect dominates the substitution effect
Demand curve – slopes upward

26. 12 A Giffen good Quantity of Potatoes
Initial budget
constraint
1. An increase in the price of potatoes rotates the budget constraint inward . . . B D I2
Optimum with high
price of potatoes E
New
budget
constraint I1
which
increases
potato
consumption
if potatoes
are a Giffen
good.
Optimum with low
price of potatoes C A
Quantity of Meat
In this example, when the price of potatoes rises, the consumer’s optimum shifts from point C to point E. In this case, the consumer responds to a higher price of potatoes by buying less meat and more potatoes.

27. The search for Giffen goods
Potatoes - Giffen good during the Irish potato famine of the 19th century
Price of potatoes rose
Large income effect
People – cut back on the luxury of meat
Buy more of the staple food of potatoes
Chinese province of Hunan, rice
Poor households exhibited Giffen behavior
Lower price of rice (with subsidy voucher)
Households - reduce their consumption of rice
Higher price of rice (remove the subsidy)
Households – increase consumption of rice

28. Three Applications How do wages affect labor supply?
Trade-off between leisure and consumption
Bundle of goods: leisure and work
Given wage
Budget constraint
Optimum

29. The work-leisure decision13
The work-leisure decision
Consumption
$5,000 I1 I2 I3
Optimum
2,000 60
Hours of leisure
100
This figure shows Sally’s budget constraint for deciding how much to work, her indifference curves for consumption and leisure, and her optimum.

30. Three Applications How do wages affect labor supply? Increase in wage
Budget constraint shifts outward
Steeper
New optimum
If enjoy less leisure
Work more
Upward-sloping labor supply curve
Substitution effect dominates

31. Three Applications How do wages affect labor supply? Increase in wage
Budget constraint shifts outward
Steeper
New optimum
If enjoy more leisure
Work less
Backward-sloping labor supply curve
Income effect dominates

32. An increase in the wage (a)14
An increase in the wage (a)
(a) For a person with these preferences . . .
. . . the labor supply curve slopes upward.
Consumption
Wage
BC2 I2
Labor supply B
1. When the wage rises . . . I1
BC1 A
Hours of Leisure
Hours of Labor
Supplied
hours of leisure decrease . . .
and hours of labor increase
The two panels of this figure show how a person might respond to an increase in the wage. The graphs on the left show the consumer’s initial budget constraint, BC1, and new budget constraint, BC2, as well as the consumer’s optimal choices over consumption and leisure. The graphs on the right show the resulting labor-supply curve. Because hours worked equal total hours available minus hours of leisure, any change in leisure implies an opposite change in the quantity of labor supplied. In panel (a), when the wage rises, consumption rises and leisure falls, resulting in a labor-supply curve that slopes upward.

33. An increase in the wage (b)14
An increase in the wage (b)
(b) For a person with these preferences . . .
. . . the labor supply curve slopes backward
Consumption
Wage
BC2 I2 I1
1. When the wage rises . . .
Labor supply
BC1
Hours of Leisure
Hours of Labor
Supplied
hours of leisure increase . . .
and hours of labor decrease
The two panels of this figure show how a person might respond to an increase in the wage. The graphs on the left show the consumer’s initial budget constraint, BC1, and new budget constraint, BC2, as well as the consumer’s optimal choices over consumption and leisure. The graphs on the right show the resulting labor-supply curve. Because hours worked equal total hours available minus hours of leisure, any change in leisure implies an opposite change in the quantity of labor supplied. In panel (b), when the wage rises, both consumption and leisure rise, resulting in a labor-supply curve that slopes backward.

34. Labor- supply curve, over long periods A hundred years ago Today
Income effects on labor supply: historical trends, lottery winners,& Carnegie conjecture
Labor- supply curve, over long periods
Slope backward
A hundred years ago
People worked six days a week
Today
Five-day workweeks
Length of the workweek has been falling
Wage of the typical worker (adjusted for inflation) has been rising

35. Explanation: Advances in technology
Income effects on labor supply: historical trends, lottery winners,& Carnegie conjecture
Explanation: Advances in technology
Higher worker productivity
Increase in demand for labor
Higher equilibrium wages
Greater reward for working
Income effect dominates substitution effect
More leisure
Less work

36. Winners of lotteries Large increase in incomes
Income effects on labor supply: historical trends, lottery winners,& Carnegie conjecture
Winners of lotteries
Large increase in incomes
Large outward shifts in budget constraints
Same slope
No substitution effect
Income effect on labor supply
Substantial
People who win the lottery – tend to quit their jobs

37. Andrew Carnegie, 19th century
Income effects on labor supply: historical trends, lottery winners,& Carnegie conjecture
Andrew Carnegie, 19th century
“The parent who leaves his son enormous wealth generally deadens the talents and energies of the son, and tempts him to lead a less useful and less worthy life than he otherwise would”
Income effect on labor supply – substantial

38. Three Applications How do interest rates affect household saving?
Income decision
Consume today or Save for future
Bundle of goods
Consumption today and Consumption in the future
Relative price = interest rates
Optimum: Budget constraint & Indifference curves

39. The consumption-saving decision15
The consumption-saving decision
Consumption
when Old
$110,000 I1 I2 I3
Optimum
55,000
$50,000
Consumption
when Young
100,000
This figure shows the budget constraint for a person deciding how much to consume in the two periods of his life, the indifference curves representing his preferences, and the optimum.

40. Three Applications How do interest rates affect household saving?
Increase in interest rates
Budget constraint – shifts outward
Steeper
Consumption in the future – rises
If consume less today
Substitution effect dominates; Save more
If consume more today
Income effect dominates; Save less

41. An increase in the interest rate16
An increase in the interest rate
(a) Higher Interest Rate Raises Saving
(b) Higher Interest Rate Lowers Saving
Consumption
When
old
Consumption
When
old
BC2
1. A higher interest rate rotates
the budget constraint outward . . .
1. A higher interest rate rotates
the budget constraint outward . . .
BC2 I2 I2 I1
BC1 I1
BC1
Consumption
when Young
Consumption
when Young
resulting in lower consumption when young and, thus, higher saving.
resulting in higher consumption when young and, thus, lower saving.
In both panels, an increase in the interest rate shifts the budget constraint outward. In panel (a), consumption when young falls, and consumption when old rises. The result is an increase in saving when young. In panel (b), consumption in both periods rises. The result is a decrease in saving when young.