D.N.TIWARIPGT (ECO) : dntjnv@yahoo.co.in D.N.TIWARIPGT (ECO) The Theory of Consumer Choice
In this chapter you will… : dntjnv@yahoo.co.in See how a budget constraint represents the choices of consumers.
Learn how indifference curves can be used to represent a consumer’s preferences.
Analyze how a consumer’s optimal choices are determined.
See how a consumer responds to changes in income and changes in prices.
Decompose the impact of a price change into an income effect and a substitution effect.
Apply the theory of consumer choice to four questions about household behaviour. In this chapter you will…
The Theory of Consumer Choice : dntjnv@yahoo.co.in The Theory of Consumer Choice The theory of consumer choice addresses the following questions:
Do all demand curves slope downward?
How do wages affect labour supply?
How do interest rates affect household saving?
THE BUDGET CONSTRAINT: WHAT THE CONSUMER CAN AFFORD : dntjnv@yahoo.co.in THE BUDGET CONSTRAINT: WHAT THE CONSUMER CAN AFFORD The budget constraint depicts the limit on the consumption “bundles” that a consumer can afford.
People consume less than they desire because their spending is constrained, or limited, by their income.
THE BUDGET CONSTRAINT: WHAT THE CONSUMER CAN AFFORD : dntjnv@yahoo.co.in THE BUDGET CONSTRAINT: WHAT THE CONSUMER CAN AFFORD 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.
The Consumer’s Budget Constraint : dntjnv@yahoo.co.in The Consumer’s Budget Constraint
THE BUDGET CONSTRAINT: WHAT THE CONSUMER CAN AFFORD : dntjnv@yahoo.co.in THE BUDGET CONSTRAINT: WHAT THE CONSUMER CAN AFFORD 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).
Figure 21-1. The Consumer’s Budget Constraint : Figure 21-1. The Consumer’s Budget Constraint Quantity of Pizza Quantity of Pepsi 0
THE BUDGET CONSTRAINT: WHAT THE CONSUMER CAN AFFORD : dntjnv@yahoo.co.in THE BUDGET CONSTRAINT: WHAT THE CONSUMER CAN AFFORD The Consumer’s Budget Constraint
Alternately, the consumer can buy 50 pizzas and 250 pints of Pepsi.
Figure 21-1. The Consumer’s Budget Constraint : Quantity of Pizza Quantity of Pepsi 0 Figure 21-1. The Consumer’s Budget Constraint
THE BUDGET CONSTRAINT: WHAT THE CONSUMER CAN AFFORD : dntjnv@yahoo.co.in THE BUDGET CONSTRAINT: WHAT THE CONSUMER CAN AFFORD 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 can trade one good for the other.
PREFERENCES: WHAT THE CONSUMER WANTS : dntjnv@yahoo.co.in PREFERENCES: WHAT THE CONSUMER WANTS A consumer’s preference among consumption bundles may be illustrated with indifference curves.
Representing Preferences with Indifference Curves : dntjnv@yahoo.co.in Representing Preferences with Indifference Curves An indifference curve is a curve that shows consumption bundles that give the consumer the same level of satisfaction.
Figure 21-2. The Consumer’s Preferences : Figure 21-2. The Consumer’s Preferences Quantity of Pizza Quantity of Pepsi 0
Representing Preferences with Indifference Curves : dntjnv@yahoo.co.in Representing Preferences with Indifference Curves 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.
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 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.
Figure 21-2. The Consumer’s Preferences : Quantity of Pizza Quantity of Pepsi 0 Figure 21-2. The Consumer’s Preferences
Four Properties of Indifference Curves : dntjnv@yahoo.co.in 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.
Four Properties of Indifference Curves : dntjnv@yahoo.co.in 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.
Figure 21-2. The Consumer’s Preferences : Quantity of Pizza Quantity of Pepsi 0 Figure 21-2. The Consumer’s Preferences
Four Properties of Indifference Curves : dntjnv@yahoo.co.in 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.
Figure 21-2. The Consumer’s Preferences : Quantity of Pizza Quantity of Pepsi 0 Figure 21-2. The Consumer’s Preferences
Four Properties of Indifference Curves : dntjnv@yahoo.co.in 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.
Figure 21-3. The Impossibility of Intersecting Indifference Curves : Figure 21-3. The Impossibility of Intersecting Indifference Curves Quantity of Pizza Quantity of Pepsi 0
Four Properties of Indifference Curves : dntjnv@yahoo.co.in 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.
Figure 21-4. Bowed Indifference Curves : Figure 21-4. Bowed Indifference Curves Quantity of Pizza Quantity of Pepsi 0
Two Extreme Examples of Indifference Curves : dntjnv@yahoo.co.in Two Extreme Examples of Indifference Curves Perfect substitutes
Perfect complements
Two Extreme Examples of Indifference Curves : dntjnv@yahoo.co.in Two Extreme Examples of Indifference Curves Perfect Substitutes
Two goods with straight-line indifference curves are perfect substitutes.
The marginal rate of substitution is a fixed number.
Figure 21-5. Perfect Substitutes and Perfect Complements : Figure 21-5. Perfect Substitutes and Perfect Complements Dimes 0 Nickels (a) Perfect Substitutes
Two Extreme Examples of Indifference Curves : dntjnv@yahoo.co.in Two Extreme Examples of Indifference Curves Perfect Complements
Two goods with right-angle indifference curves are perfect complements.
Figure 21-5. Perfect Substitutes and Perfect Complements : Figure 21-5. Perfect Substitutes and Perfect Complements Right Shoes 0 Left Shoes (b) Perfect Complements
OPTIMIZATION: WHAT THE CONSUMER CHOOSES : dntjnv@yahoo.co.in 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.
The Consumer’s Optimal Choices : dntjnv@yahoo.co.in The Consumer’s Optimal Choices 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.
The Consumer’s Optimal Choice : dntjnv@yahoo.co.in 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.
Figure 21-6. The Consumer’s Optimum : Figure 21-6. The Consumer’s Optimum Quantity of Pizza Quantity of Pepsi 0
How Changes in Income Affect the Consumer’s Choices : dntjnv@yahoo.co.in 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.
Figure 21-7. An Increase in Income : Figure 21-7. An Increase in Income Quantity of Pizza Quantity of Pepsi 0
How Changes in Income Affect the Consumer’s Choices : dntjnv@yahoo.co.in How Changes in Income Affect the Consumer’s Choices 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.
Figure 21-8. An Inferior Good : Figure 21-8. An Inferior Good Quantity of Pizza Quantity of Pepsi 0
How Changes in Prices Affect Consumer’s Choices : dntjnv@yahoo.co.in How Changes in Prices Affect Consumer’s Choices A fall in the price of any good rotates the budget constraint outward and changes the slope of the budget constraint.
Figure 21-9. A Change in Price : Figure 21-9. A Change in Price Quantity of Pizza Quantity of Pepsi 0
Income and Substitution Effects : dntjnv@yahoo.co.in Income and Substitution Effects A price change has two effects on consumption.
An income effect
A substitution effect
Income and Substitution Effects : dntjnv@yahoo.co.in 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.
Income and Substitution Effects : dntjnv@yahoo.co.in Income and Substitution Effects A Change in Price: Substitution Effect
A price change first causes the consumer to move from one point on an indifference curve to another on the same curve.
Illustrated by movement from point A to point B.
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.
Figure 21-10. Income and Substitution Effects : Figure 21-10. Income and Substitution Effects Quantity of Pizza Quantity of Pepsi 0
Table 21-1. Income and Substitution Effects When the Price of Pepsi Falls : Table 21-1. Income and Substitution Effects When the Price of Pepsi Falls
Deriving the Demand Curve : dntjnv@yahoo.co.in 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.
Figure 21-11. Deriving the Demand Curve : Figure 21-11. Deriving the Demand Curve Quantity of Pizza 0 (a) The Consumer ’ s Optimum Quantity of Pepsi 0 Price of Pepsi (b) The Demand Curve for Pepsi Quantity of Pepsi
THREE APPLICATIONS : dntjnv@yahoo.co.in 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.
Figure 21-12. A Giffen Good : Figure 21-12. A Giffen Good Quantity of Meat Quantity of Potatoes 0
THREE APPLICATIONS : dntjnv@yahoo.co.in THREE APPLICATIONS How do wages affect labour 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.
Figure 21-13. The Work-Leisure Decision : Figure 21-13. The Work-Leisure Decision Hours of Leisure 0 Consumption
Figure 21-14. An Increase in the Wage : Figure 21-14. An Increase in the Wage Hours of Leisure 0 Consumption (a) For a person with these preferences . . . Hours of labour Supplied 0 Wage . . . the labour supply curve slopes upward.
Figure 21-14. An Increase in the Wage : Figure 21-14. An Increase in the Wage Hours of Leisure 0 Consumption (b) For a person with these preferences . . . Hours of labour Supplied 0 Wage . . . the labour supply curve slopes backward.
THREE APPLICATIONS : dntjnv@yahoo.co.in THREE APPLICATIONS 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.
Figure 21-15. The Consumption-Saving Decision : Figure 21-15. The Consumption-Saving Decision Consumption when Young 0 Consumption when Old
Figure 21-16. An Increase in the Interest Rate : Figure 21-16. An Increase in the Interest Rate 0 (a) Higher Interest Rate Raises Saving (b) Higher Interest Rate Lowers Saving Consumption when Old 0 Consumption when Old Consumption when Young Consumption when Young
THREE APPLICATIONS : dntjnv@yahoo.co.in THREE APPLICATIONS Thus, an increase in the interest rate could either encourage or discourage saving.
Summary : dntjnv@yahoo.co.in 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.
Summary : dntjnv@yahoo.co.in 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.
Summary : dntjnv@yahoo.co.in 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.
Summary : dntjnv@yahoo.co.in 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.
Summary : dntjnv@yahoo.co.in Summary The theory of consumer choice can explain:
Why demand curves can potentially slope upward.
How wages affect labour supply.
How interest rates affect household saving.
The End : dntjnv@yahoo.co.in The End