The Theory of
Consumer Choice
Chapter 21
The Theory of Consumer Choice
The theory of consumer choice addresses
the following questions:
– Do all demand curves slope downward?
– How do wages affect labor supply?
– How do interest rates affect household saving?
The Budget Constraint
The budget constraint depicts the
consumption,bundles” that a consumer
can afford.
– People consume less than they desire because
their spending is constrained,or limited,by
their income.
It shows the various combinations of
goods the consumer can afford given his
or her income and the prices of the two
goods.
The Budget Constraint
Quantity
of Pizza
Quantity
of Pepsi
0
250
50 100
500 B
C
A
Consumer’s
budget constraint
The Consumer’s Budget Constraint
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),
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 will
trade one good for the other.
Preferences,
What the Consumer Wants
A consumer’s preference among
consumption bundles may be
illustrated with indifference curves.
An indifference curve shows bundles
of goods that make the consumer
equally happy.
The Consumer’s Preferences
Quantity
of Pizza
Quantity
of Pepsi
0
C
B
A Indifferencecurve,I
1
D
I2
Preferences,
What the Consumer Wants
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.
The Consumer’s Preferences
Quantity
of Pizza
Quantity
of Pepsi
0
Indifference
curve,I1
I21MRS
C
B
A
D
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.
Quantity
of Pizza
Quantity
of Pepsi
0
C
B
A
D
Indifference
curve,I1
I2
Property 1,Higher indifference
curves are preferred to lower ones.
Quantity
of Pizza
Quantity
of Pepsi
0
Indifference
curve,I1
Property 2,Indifference curves are
downward sloping.
Quantity
of Pizza
Quantity
of Pepsi
0
C
A
B
Property 3,Indifference curves do
not cross.
1
MRS = 1
8
3
Indifference
curve
A
Quantity
of Pizza
Quantity
of Pepsi
0
14
2
3
7
B
1
MRS = 6
4
6
Property 4,Indifference curves are
bowed inward.
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,
Perfect complements:
Two goods with right-angle indifference
curves are perfect complements.
Dimes0
Nickels
21
4
2
I1 I2
6
3
I3
Perfect Substitutes
Perfect Complements
Right Shoes0
Left
Shoes
75
7
5 I1
I2
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.
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 Optimum...
Quantityof Pizza
Quantityof Pepsi
0
I1
I2
I3
Budget constraint
AB
Optimum
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.
An Increase in Income...
Quantityof Pizza
Quantityof Pepsi
0
I1
I2
2,…raising pizza onsumption…
3,…and Pepsi
consumption,Initial optimum
New budget constraint
1,An increase in income shifts
the budget constraint outward…
Initial budget
constraint
New optimum
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.
An Inferior Good...
New budget constraint
1,When an increase in income shifts the
budget constraint outward...
Quantityof Pizza
Quantityof Pepsi
0
Initial
optimum
I1
New optimum
I2
2.,.,pizza consumption rises,
making pizza a normal good..,
3.,.,but Pepsi
consumption
falls,making
Pepsi an
inferior good.
Initial
budget
constraint
How Changes in Prices Affect
Consumer Choices
Quantity of Pizza100
Quantity of
Pepsi
1,000
500
0
I1
New budget constraint
3,…and
raising Pepsi
consumption.
Initial budget constraint
2,…reducing pizza consumption…
1,A fall in the price of Pepsi
rotates the budget constraint
outward…
New optimum
I2
Income and Substitution Effects
A price change has two effects on consumption:
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...
Quantity of Pizza
Quantityof Pepsi
0
A
Initial optimum
I1
New budget constraint
Initial budget
constraint
I2
C New optimum
Income effect
Income effect
Substitution
effect
B
Substitution effect
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.
Deriving the Demand Curve
Quantity
of Pizza
0
Demand
(a) The Consumer ’s Optimum
Quantity
of Pepsi
0
Price of
Pepsi
(b) The Demand Curve for Pepsi
Quantity
of Pepsi
250
$2 A
750
1
B
I1
I2
New budget constraint
Initial budget
constraint
750 B
250 A
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.
Quantity
of Meat
A
Quantity of
Potatoes
0
E
C
I2
I1
Initial budget constraint
New budget
constraint
D
B
Optimum with low
price of potatoes
Optimum with high
price of potatoes
1,An increase in the price of
potatoes rotates the budget...
2...which
increases potato
consumption if
potatoes are a
Giffen good.
A Giffen Good...
THREE APPLICATIONS
How do wages affect labor 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.
The Work-Leisure Decision
Hours of Leisure0
Consumption
$5,000
100
I3
I2
I1
Optimum
2,000
60
An Increase in the Wage
Hours of
Leisure
0
Consumption
(a) For a person with these preferences,,,
Hours of Labor
Supplied
0
Wage
.,,the labor supply curve slopes upward.
I1
I2BC2
BC1
2.,,,hours of leisure decrease,,,3.,,,and hours of labor increase.
1,When the wage rises,,,
Labor
supply
An Increase in the Wage
Hours of
Leisure
0
Consumption
(b) For a person with these preferences,,,
Hours of Labor
Supplied
0
Wage
.,,the labor supply curve slopes backward.
I1
I2
BC2
BC1
1,When the wage rises,,,
2.,,,hours of leisure increase,,,3.,,,and hours of labor decrease.
Labor
supply
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.
Thus,an increase in the interest rate could
either encourage or discourage saving.
The Consumption-Saving Decision
Consumption
when Young
0
Consumption
when Old
$110,000
100,000
I3
I2
I1
Budget
constraint
55,000
$50,000
Optimum
An Increase in the Interest Rate
0
(a) Higher Interest Rate Raises Saving (b) Higher Interest Rate Lowers Saving
Consumption
when Old
I1
I2
BC1
BC2
0
I1 I2
BC1
BC2
Consumption
when Old
Consumption
when Young
1,A higher interest rate rotates
the budget constraint outward,,,
1,A higher interest rate rotates
the budget constraint outward,,,
2.,,,resulting in lower
consumption when young
and,thus,higher saving.
2.,,,resulting in higher
consumption when young
and,thus,lower saving.
Consumption
when Young
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
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
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
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.
The theory of consumer choice can explain:
– Why demand curves can potentially slope upward.
– How wages affect labor supply.
– How interest rates affect household saving.
Consumer Choice
Chapter 21
The Theory of Consumer Choice
The theory of consumer choice addresses
the following questions:
– Do all demand curves slope downward?
– How do wages affect labor supply?
– How do interest rates affect household saving?
The Budget Constraint
The budget constraint depicts the
consumption,bundles” that a consumer
can afford.
– People consume less than they desire because
their spending is constrained,or limited,by
their income.
It shows the various combinations of
goods the consumer can afford given his
or her income and the prices of the two
goods.
The Budget Constraint
Quantity
of Pizza
Quantity
of Pepsi
0
250
50 100
500 B
C
A
Consumer’s
budget constraint
The Consumer’s Budget Constraint
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),
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 will
trade one good for the other.
Preferences,
What the Consumer Wants
A consumer’s preference among
consumption bundles may be
illustrated with indifference curves.
An indifference curve shows bundles
of goods that make the consumer
equally happy.
The Consumer’s Preferences
Quantity
of Pizza
Quantity
of Pepsi
0
C
B
A Indifferencecurve,I
1
D
I2
Preferences,
What the Consumer Wants
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.
The Consumer’s Preferences
Quantity
of Pizza
Quantity
of Pepsi
0
Indifference
curve,I1
I21MRS
C
B
A
D
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.
Quantity
of Pizza
Quantity
of Pepsi
0
C
B
A
D
Indifference
curve,I1
I2
Property 1,Higher indifference
curves are preferred to lower ones.
Quantity
of Pizza
Quantity
of Pepsi
0
Indifference
curve,I1
Property 2,Indifference curves are
downward sloping.
Quantity
of Pizza
Quantity
of Pepsi
0
C
A
B
Property 3,Indifference curves do
not cross.
1
MRS = 1
8
3
Indifference
curve
A
Quantity
of Pizza
Quantity
of Pepsi
0
14
2
3
7
B
1
MRS = 6
4
6
Property 4,Indifference curves are
bowed inward.
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,
Perfect complements:
Two goods with right-angle indifference
curves are perfect complements.
Dimes0
Nickels
21
4
2
I1 I2
6
3
I3
Perfect Substitutes
Perfect Complements
Right Shoes0
Left
Shoes
75
7
5 I1
I2
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.
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 Optimum...
Quantityof Pizza
Quantityof Pepsi
0
I1
I2
I3
Budget constraint
AB
Optimum
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.
An Increase in Income...
Quantityof Pizza
Quantityof Pepsi
0
I1
I2
2,…raising pizza onsumption…
3,…and Pepsi
consumption,Initial optimum
New budget constraint
1,An increase in income shifts
the budget constraint outward…
Initial budget
constraint
New optimum
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.
An Inferior Good...
New budget constraint
1,When an increase in income shifts the
budget constraint outward...
Quantityof Pizza
Quantityof Pepsi
0
Initial
optimum
I1
New optimum
I2
2.,.,pizza consumption rises,
making pizza a normal good..,
3.,.,but Pepsi
consumption
falls,making
Pepsi an
inferior good.
Initial
budget
constraint
How Changes in Prices Affect
Consumer Choices
Quantity of Pizza100
Quantity of
Pepsi
1,000
500
0
I1
New budget constraint
3,…and
raising Pepsi
consumption.
Initial budget constraint
2,…reducing pizza consumption…
1,A fall in the price of Pepsi
rotates the budget constraint
outward…
New optimum
I2
Income and Substitution Effects
A price change has two effects on consumption:
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...
Quantity of Pizza
Quantityof Pepsi
0
A
Initial optimum
I1
New budget constraint
Initial budget
constraint
I2
C New optimum
Income effect
Income effect
Substitution
effect
B
Substitution effect
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.
Deriving the Demand Curve
Quantity
of Pizza
0
Demand
(a) The Consumer ’s Optimum
Quantity
of Pepsi
0
Price of
Pepsi
(b) The Demand Curve for Pepsi
Quantity
of Pepsi
250
$2 A
750
1
B
I1
I2
New budget constraint
Initial budget
constraint
750 B
250 A
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.
Quantity
of Meat
A
Quantity of
Potatoes
0
E
C
I2
I1
Initial budget constraint
New budget
constraint
D
B
Optimum with low
price of potatoes
Optimum with high
price of potatoes
1,An increase in the price of
potatoes rotates the budget...
2...which
increases potato
consumption if
potatoes are a
Giffen good.
A Giffen Good...
THREE APPLICATIONS
How do wages affect labor 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.
The Work-Leisure Decision
Hours of Leisure0
Consumption
$5,000
100
I3
I2
I1
Optimum
2,000
60
An Increase in the Wage
Hours of
Leisure
0
Consumption
(a) For a person with these preferences,,,
Hours of Labor
Supplied
0
Wage
.,,the labor supply curve slopes upward.
I1
I2BC2
BC1
2.,,,hours of leisure decrease,,,3.,,,and hours of labor increase.
1,When the wage rises,,,
Labor
supply
An Increase in the Wage
Hours of
Leisure
0
Consumption
(b) For a person with these preferences,,,
Hours of Labor
Supplied
0
Wage
.,,the labor supply curve slopes backward.
I1
I2
BC2
BC1
1,When the wage rises,,,
2.,,,hours of leisure increase,,,3.,,,and hours of labor decrease.
Labor
supply
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.
Thus,an increase in the interest rate could
either encourage or discourage saving.
The Consumption-Saving Decision
Consumption
when Young
0
Consumption
when Old
$110,000
100,000
I3
I2
I1
Budget
constraint
55,000
$50,000
Optimum
An Increase in the Interest Rate
0
(a) Higher Interest Rate Raises Saving (b) Higher Interest Rate Lowers Saving
Consumption
when Old
I1
I2
BC1
BC2
0
I1 I2
BC1
BC2
Consumption
when Old
Consumption
when Young
1,A higher interest rate rotates
the budget constraint outward,,,
1,A higher interest rate rotates
the budget constraint outward,,,
2.,,,resulting in lower
consumption when young
and,thus,higher saving.
2.,,,resulting in higher
consumption when young
and,thus,lower saving.
Consumption
when Young
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
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
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
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.
The theory of consumer choice can explain:
– Why demand curves can potentially slope upward.
– How wages affect labor supply.
– How interest rates affect household saving.
