Overview
The
budget constraint
Indifference curves
The consumer’s optimal choice
Income and substitution effects on
choice
Deriving the demand curve
Principles of Microeconomics: Ch. 21
First Canadian Edition
The Budget Constraint:
What Consumers Can Afford
“The budget constraint depicts the
consumption possibilities available to
the individual.”
People
consume less than they desire
because their spending is constrained,
or limited, by their income.
Principles of Microeconomics: Ch. 21
First Canadian Edition
The Budget Constraint
Pepsi
($2)
500
Pizza
100
Principles of Microeconomics: Ch. 21
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First Canadian Edition
The Budget Constraint
Pepsi
($2)
500
B
250
Any point on the constraint
line equals $1,000, the
income available to spend
on the two products.
C
A
Pizza
50
Principles of Microeconomics: Ch. 21
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($10)
First Canadian Edition
The Budget Constraint
The
slope of the budget constraint
measures the rate at which the
consumer can trade one good for the
other.
The slope equals the relative price of
the two goods, i.e. the price of one
good compared to the price of the
other.
Principles of Microeconomics: Ch. 21
First Canadian Edition
Indifference Curves
Pepsi
C
.
B
.
.
A
I2
I1
Pizza
Principles of Microeconomics: Ch. 21
First Canadian Edition
Indifference Curves
The
consumer is indifferent among
combinations A, B, and C, because
they are all on the same curve.
The slope at any point on an
indifference curve equals the rate at
which the consumer is willing to
substitute one good for the other.
Principles of Microeconomics: Ch. 21
First Canadian Edition
Indifference Curves
Pepsi
C
Slope between
points A and B.
Tradeoff between
the two bundles.
.
B
.
.
.
D
A
I2
I1
Pizza
Principles of Microeconomics: Ch. 21
First Canadian Edition
The Marginal Rate of Substitution
The
slope is called the marginal rate of
substitution.
The rate at which consumers are willing
to trade one good for another.
– The amount that the consumer must
receive as compensation in order to give
up something else that he/she desires.
–
Principles of Microeconomics: Ch. 21
First Canadian Edition
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.
Principles of Microeconomics: Ch. 21
First Canadian Edition
Optimization:
What the Consumer Chooses
Consumers
would like to obtain the
combination of goods on the highest
possible indifference curve. However,
the budget constraint may restrict or
limit the consumer to a lower
indifference curve.
Combining the indifference curve and
budget constraint determines the
optimum choice.
Principles of Microeconomics: Ch. 21
First Canadian Edition
The Consumer’s Optimal Choice
Pepsi
Consumer’s indifference
curves, based on personal
preferences.
I3
I2
I1
Pizza
Principles of Microeconomics: Ch. 21
First Canadian Edition
The Consumer’s Optimal Choice
Pepsi
Consumer’s budget
constraint.
I3
I2
I1
Pizza
Principles of Microeconomics: Ch. 21
First Canadian Edition
The Consumer’s Optimal Choice
The
point at which the indifference
curve and the budget constraint touch
(i.e. its tangent) is called the optimum.
The consumer chooses consumption
of the two goods so that the marginal
rate of substitution equals the relative
price.
Principles of Microeconomics: Ch. 21
First Canadian Edition
A Change in Income Affects Choices
Pepsi
QPepsi
.
An Increase in income
shifts the budget
constraint.
I3
I2
I1
QPizza
Principles of Microeconomics: Ch. 21
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First Canadian Edition
A Change in Income Affects Choices
Pepsi
A new optimum
QNew
QPepsi
.
I3
I2
I1
QPizza QNew
Principles of Microeconomics: Ch. 21
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First Canadian Edition
Changes in Prices Affect Consumer’s
Choices
A
fall in the price of any good will shift
the budget constraint outward and will
change the slope of the budget
constraint.
Principles of Microeconomics: Ch. 21
First Canadian Edition
Deriving the Demand Curve
A consumer’s demand curve is a
summary of the optimal decisions that
arise from his budget constraint and
indifference curves.
Principles of Microeconomics: Ch. 21
First Canadian Edition
Conclusion
Indifference
curve analysis describes
how individuals make decisions. It
has many relevant applications.
If people behave AS IF they followed
the model, then the model will yield
accurate and useful predictions and
results.
Principles of Microeconomics: Ch. 21
First Canadian Edition