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The Theory of Consumer Choice
PowerPoint Slides prepared by:
Andreea CHIRITESCU
Eastern Illinois University
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1
Budget Constraint
• Budget constraint
– Limit on the consumption bundles that a
consumer can afford
– It shows the trade-off between goods
• Slope of the budget constraint
– Rate at which the consumer can trade one
good for the other
– Relative price of the two goods
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Figure 1
The Consumer’s Budget Constraint
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 her income is $1,000, the price
of pizza is $10, and the price of Pepsi is $2.
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Figure 1
The Consumer’s Budget Constraint
Quantity
of Pepsi
B
500
C
250
Consumer’s
budget constraint
A
0
50
100
Quantity of Pizza
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 her income is $1,000, the price
of pizza is $10, and the price of Pepsi is $2.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
4
Preferences
• 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
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Figure 2
The Consumer’s Preferences
Quantity
of Pepsi
C
B
D
MRS
A
1
0
I2
Indifference curve, I1
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.
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Preferences
• Four properties of indifference curves
1. Higher indifference curves are preferred
to lower ones
–
Higher indifference curves – more goods
2. Indifference curves are downward sloping
3. Indifference curves do not cross
4. Indifference curves are bowed inward
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Figure 3
The Impossibility of Intersecting Indifference Curves
Quantity
of Pepsi
A
C
B
0
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.
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Figure 4
Bowed Indifference Curves
Indifference curves are usually
bowed inward. This shape
Quantity of Pepsi
implies that the marginal rate
of substitution (MRS) depends
on the quantity of the two
goods the consumer is
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consuming. At point A, the
consumer has little pizza and
much Pepsi, so she requires a
MRS=6
lot of extra Pepsi to induce her
to give up one of the pizzas:
A
8
The marginal rate of
1
substitution is 6 liters of Pepsi
per pizza. At point B, the
consumer has much pizza and
Indifference
4
B
little Pepsi, so she requires
MRS=1
3
curve
only a little extra Pepsi to
1
induce her to give up one of
the pizzas: The marginal rate
2
3
6
7
0
Quantity of Pizza of substitution is 1 liter of
Pepsi per pizza.
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Preferences
• Extreme examples of indifference curves
• Perfect substitutes
– Two goods with straight-line indifference
curves
– Marginal rate of substitution – constant
• Perfect complements
– Two goods with right-angle indifference
curves
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Figure 5
Perfect Substitutes and Perfect Complements
Nickels
(b) Perfect Complements
(a) Perfect Substitutes
Left
shoes
6
4
I2
7
5
I1
2
I1
0
1
I2
2
I3
3
0
5
7
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).
Dimes
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Optimization
• 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
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Figure 6
The Consumer’s Optimum
Quantity
of
Pepsi
Budget constraint
Optimum
B
A
I3
I2
I1
0
Quantity
of Pizza
The consumer chooses the point
on her 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 she
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.
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Optimization
• Higher income
– Consumer can afford more of both goods
– Shifts the budget constraint outward
– New optimum
• Normal good
– Good for which an increase in income
raises the quantity demanded
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Figure 7
An Increase in Income
Quantity
of Pepsi
New budget constraint
1. An increase in income shifts the
budget constraint outward . . .
3. . . . and Pepsi
consumption
New optimum
Initial
optimum
I2
I1
Initial
budget
constraint
0
2. . . . 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.
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Optimization
• Inferior good
– Good for which an increase in income
reduces the quantity demanded
• Price of one good falls
– Rotates the budget constraint outward
• Steeper slope
• Change in relative price
– Income effect
– Substitution effect
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Figure 8
An Inferior Good
Quantity
of Pepsi
New budget constraint
1. When an increase in income shifts the
budget constraint outward . . .
3. . . . but Pepsi
consumption
falls, making
Pepsi an inferior
good
Initial
optimum
New optimum
I1
Initial budget
constraint
0
I2
2. . . . pizza consumption
rises, making pizza a
normal good. . .
Quantity of Pizza
A good is inferior if the consumer buys less of it when her 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.
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Figure 9
A Change in Price
Quantity
of Pepsi
D
New budget
constraint
1,000
New optimum
B
3. . . . and
raising Pepsi
consumption
1. A fall in the price of Pepsi rotates
the budget constraint outward. . .
500
Initial
budget
constraint
I2
Initial optimum
2. . . . reducing pizza
consumption
I1
A
0
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 her
purchases of both pizza and Pepsi. In this case, the quantity of Pepsi consumed rises, and the
quantity of pizza consumed falls.
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Optimization
• Income effect
– Change in consumption
– When a price change moves the
consumer
• To a higher or lower indifference curve
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Optimization
• Substitution effect
– Change in consumption
– When a price change moves the
consumer
• Along a given indifference curve
• To a point with a new marginal rate of
substitution
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Table 1
Income and Substitution Effects When the Price of Pepsi Falls
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Figure 10
Income and Substitution Effects
Quantity
of Pepsi
New budget
constraint
C
New optimum
Income
effect
B
Substitution
effect
Initial
budget
constraint
I2
A
Initial optimum
I1
0
Substitution effect
Income effect
Quantity
of Pizza
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.
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Optimization
• 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
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Figure 11
Deriving the Demand Curve
(a) The Consumer’s Optimum
(b) The Demand Curve for Pepsi
Price of Pepsi
Quantity of Pepsi
New budget constraint
B
A
$2
750
I2
B
1
A
250
Demand
I1
0
Initial budget
constraint
Quantity
of Pizza
0
250
750 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 liters. The
demand curve in panel (b) reflects this relationship between the price and the quantity demanded.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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