Chapter 21

nt
oi
The Theory of
Consumer
Choice
aP
rth
A
In this chapter,
look for the answers to these questions:

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▪ How does the budget constraint represent the
choices a consumer can afford?

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▪ How do indifference curves represent the

aP
consumer’s preferences?
rth
▪ What determines how a consumer divides her
resources between two goods?
A

▪ How does the theory of consumer choice explain

decisions such as how much a consumer saves,
or how much labor she supplies?
 Introduction
▪ Recall one of the Ten Principles from Chapter 1:
People face tradeoffs.
▪ Buying more of one good leaves

nt
less income to buy other goods.

oi
▪ Working more hours means more income and

aP
more consumption, but less leisure time.
▪ Reducing saving allows more consumption today
rth
but reduces future consumption.
▪ This chapter explores how consumers make
A

choices like these.

 The Budget Constraint:
What the Consumer Can Afford
▪ Example:
Hurley divides his income between two goods:

nt
fish and mangos.

oi
▪ A “consumption bundle” is a particular combination

aP
of the goods, e.g., 40 fish & 300 mangos.
▪ Budget constraint: the limit on the consumption
rth
bundles that a consumer can afford
A
ACTIVE LEARNING 1
Budget Constraint
Hurley’s income: $1200
Prices: PF = $4 per fish, PM = $1 per mango

nt
A. If Hurley spends all his income on fish,

oi
how many fish does he buy?

aP
B. If Hurley spends all his income on mangos,
how many mangos does he buy?
rth
C. If Hurley buys 100 fish, how many mangos can
he buy?
A

D. Plot each of the bundles from parts A – C on a

graph that measures fish on the horizontal axis
and mangos on the vertical, connect the dots.
4
ACTIVE LEARNING 1
Answers D. Hurley’s budget
Quantity
of Mangos constraint shows
B the bundles he can

nt
A. $1200/$4 afford.
= 300 fish

oi
B. $1200/$1 C

aP
= 1200
mangos
rth
C. 100 fish
A
cost $400,
$800 left
A
buys 800
Quantity
mangos of Fish
 The Slope of the Budget Constraint
From C to D, Quantity
of Mangos
“rise” =

nt
–200 mangos

oi
“run” =
+50 fish C

aP
Slope = – 4 rth D
Hurley must
give up
4 mangos
A

to get one fish.

Quantity
of Fish
 The Slope of the Budget Constraint
The slope of the budget constraint equals
▪ the rate at which Hurley

nt
can trade mangos for fish IMPORTANT
▪ the opportunity cost of fish in terms of mangos

oi
▪ the relative price of fish:

aP
price of fish $4
rth
= = 4 mangos per fish
price of mangos $1
A
ACTIVE LEARNING 2
Budget constraint, continued.
Show what happens to Hurley’s budget constraint if:

nt
A. His income falls to $800.

oi
B. The price of mangos rises to

aP
PM = $2 per mango
rth
A

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ACTIVE LEARNING 2
Answers, part A
Quantity A fall in income
Now, of Mangos shifts the budget
Hurley constraint down.

nt
can buy

oi
$800/$4
= 200 fish

aP
or
rth
$800/$1
= 800 mangos
A
or any
combination in
between. Quantity
of Fish
ACTIVE LEARNING 2
Answers, part B
Quantity An increase in the
Hurley
of Mangos price of one good
can still buy
pivots the budget

nt
300 fish. constraint inward.

oi
But now he
can only buy

aP
$1200/$2 =
600 mangos.
rth
Notice:
slope is smaller,
A

relative price of
fish is now only
2 mangos. Quantity
of Fish
 Preferences: What the Consumer Wants

Indifference curve: Quantity One of Hurley’s

shows consumption of Mangos indifference curves

nt
bundles that give the
consumer the same

oi
level of satisfaction

aP
B
A, B, and all other
bundles on I1 make
rth
A
Hurley equally happy –
I1
he is indifferent
A
between them.
Quantity
of Fish
 Four Properties of Indifference Curves

Quantity One of Hurley’s

1. Indifference curves of Mangos indifference curves
are downward-

nt
sloping.

oi
If the quantity of

aP
fish is reduced, B

the quantity of
rth
A
mangos must be
I1
increased to keep
A
Hurley equally
happy. Quantity
of Fish
 Four Properties of Indifference Curves

Quantity A few of Hurley’s

2. Higher indifference of Mangos indifference curves
curves are preferred

nt
to lower ones.

oi
Hurley prefers every

aP
bundle on I2 (like C) C
D
to every bundle on I1
I2
rth
A
(like A).
I1
He prefers every
A
bundle on I1 (like A) I0
to every bundle on I0 Quantity
(like D). of Fish
 Four Properties of Indifference Curves

Quantity Hurley’s
3. Indifference curves of Mangos indifference curves
cannot cross.

nt
Suppose they did.

oi
Hurley should prefer

aP
B to C, since B has B
more of both goods.
C
rth
Yet, Hurley is indifferent A
between B and C: I1 I4
He likes C as much as A
A

(both are on I4).

He likes A as much as B Quantity
of Fish
(both are on I1).
 Four Properties of Indifference Curves

Quantity
4. Indifference curves of Mangos
are bowed inward.

nt
A

oi
Hurley is willing to give
up more mangos for a 6

aP
fish if he has few fish
1
(A) than if he has
rth
B
many (B). 2
1 I1
A

Quantity
of Fish
 The Marginal Rate of Substitution

Marginal rate of Quantity MRS = slope of

substitution (MRS): of Mangos indifference curve

nt
the rate at which a consumer
is willing to trade one good for A

oi
another.
MRS = 6

aP
Hurley’s MRS is the
amount of mangos he 1
rth
would substitute for B
MRS = 2
another fish. 1 I1
A
MRS falls as you move
down along an Quantity
indifference curve. of Fish
One Extreme Case: Perfect Substitutes
Perfect substitutes: two goods with
straight-line indifference curves,

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constant MRS

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Example: nickels & dimes
Consumer is always willing to trade

aP
two nickels for one dime.
rth
A
Another Extreme Case: Perfect Complements
Perfect complements: two goods with
right-angle indifference curves
Example: Left shoes, right shoes

nt
{7 left shoes, 5 right shoes}

oi
is just as good as

aP
rth {5 left shoes, 5 right shoes}
A
 Less Extreme Cases:
Close Substitutes and Close Complements

Quantity Indifference Quantity Indifference

nt
of Pepsi curves for close of hot curves for
dog buns close
substitutes are

oi
not very bowed complements
are very

aP
rth bowed
A

Quantity Quantity
of Coke of hot dogs
Optimization: What the Consumer Chooses
A is the optimum: Quantity
The optimum
the point on the of Mangos
is the bundle
budget constraint

nt
Hurley most
that touches the
1200 prefers out of

oi
highest possible
all the bundles
indifference curve.
he can afford.

aP
Hurley prefers B to A, B
but he cannot afford B. A
rth
600
Hurley can afford C C
A
and D, D
but A is on a higher
indifference curve. 150 300 Quantity
of Fish
Optimization: What the Consumer Chooses
Quantity
At the optimum, of Mangos Consumer
slope of the optimization is

nt
indifference curve another example
equals 1200 of “thinking at the

oi
slope of the budget margin.”

aP
constraint:
MRS = PF/PM A
rth
600

marginal
price of fish
A
value of fish
(in terms of
(in terms of
mangos)
mangos) 150 300 Quantity
of Fish
 The Effects of an Increase in Income
Quantity
of Mangos
An increase in

nt
income shifts the

oi
budget constraint
outward.

aP
B
If both goods are
A
rth
“normal,” Hurley
buys more of each.
A

Quantity
of Fish
ACTIVE LEARNING 3
Inferior vs. normal goods
▪ An increase in income increases the quantity

nt
demanded of normal goods and reduces the
quantity demanded of inferior goods.

oi
▪ Suppose fish is a normal good

aP
but mangos are an inferior good.
rth
▪ Use a diagram to show the effects of
an increase in income on Hurley’s optimal
A
bundle of fish and mangos.

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ACTIVE LEARNING 3
Answers Quantity
of Mangos

nt
If mangos are
inferior, the new

oi
optimum will

aP
contain fewer
mangos.
A
rth
B
A

Quantity
of Fish
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 The Effects of a Price Change

Initially, Quantity
of Mangos
PF = $4

nt
1200
PM = $1 initial
optimum

oi
PF falls to $2 new

aP
optimum
budget constraint 600
rotates outward, 500
rth
Hurley buys
more fish and
A

fewer mangos.
150 300 600 Quantity
350 of Fish
 The Income and Substitution Effects
A fall in the price of fish has two effects on
Hurley’s optimal consumption of both goods.

nt
▪ Income effect
A fall in PF boosts the purchasing power of Hurley’s

oi
income, allows him to buy more mangos and more

aP
fish.
▪ Substitution effect
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A fall in PF makes mangos more expensive relative
to fish, causes Hurley to buy fewer mangos & more
A

fish.
Notice: The net effect on mangos is ambiguous.
 The Income and Substitution Effects
Initial Quantity In this example,
optimum at A. of Mangos
the net effect

nt
PF falls. on mangos is
negative.

oi
Substitution effect:
from A to B,

aP
buy more fish and A
fewer mangos. C
rth
Income effect: B
from B to C,
A

buy more of both

Quantity
goods.
of Fish
 Deriving Hurley’s Demand Curve for Fish
A: When PF = $4, Hurley demands 150 fish.
B: When PF = $2, Hurley demands 350 fish.
Quantity Price of

nt
of Mangos Fish

oi
aP
A
$4
A
rth
B
B
$2
DFish
A

150 350 Quantity 150 350 Quantity

of Fish of Fish
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 Application 1: Giffen Goods
▪ Do all goods obey the Law of Demand?
▪ Suppose the goods are potatoes and meat,

nt
and potatoes are an inferior good.

oi
▪ If price of potatoes rises,
▪ substitution effect: buy less potatoes

aP
▪ income effect: buy more potatoes
rth
▪ If income effect > substitution effect,
then potatoes are a Giffen good, a good for which
A

an increase in price raises the quantity demanded.

Giffen goods are those inferior goods whose income effect >
substitution effect
 Application 1:
Giffen Goods

nt
oi
aP
rth
A
Application 2: Wages and Labor Supply
Budget constraint
▪ Shows a person’s tradeoff between consumption

nt
and leisure.
▪ Depends on how much time she has to divide

oi
between leisure and working.

aP
▪ The relative price of an hour of leisure is the amount
of consumption she could buy with an hour’s wages.
rth
Indifference curve
▪ Shows “bundles” of consumption and leisure
A

that give her the same level of satisfaction.

Application 2: Wages and Labor Supply
At the optimum,
the MRS between

nt
leisure and
consumption

oi
equals the wage.

aP
rth
A
Application 2: Wages and Labor Supply
An increase in the wage has two effects
on the optimal quantity of labor supplied.

nt
▪ Substitution effect (SE): A higher wage makes

oi
leisure more expensive relative to consumption.
The person chooses less leisure,

aP
i.e., increases quantity of labor supplied.
▪ Income effect (IE): With a higher wage,
rth
she can afford more of both “goods.”
A
She chooses more leisure,
i.e., reduces quantity of labor supplied.
Application 2: Wages and Labor Supply
For this person, So her labor supply
SE > IE increases with the wage

nt
oi
aP
rth
A
Application 2: Wages and Labor Supply
For this person, So his labor supply falls
SE < IE when the wage rises

nt
oi
aP
rth
A
Could This Happen in the Real World???
Cases where the income effect on labor supply is
very strong:

nt
▪ Over last 100 years, technological progress has
increased labor demand and real wages.

oi
The average workweek fell from 6 to 5 days.

aP
▪ When a person wins the lottery or receives an
inheritance, his wage is unchanged – hence no
rth
substitution effect.
A
But such persons are more likely to work fewer
hours, indicating a strong income effect.
Application 3: Interest Rates and Saving
▪ A person lives for two periods.
▪ Period 1: young, works, earns $100,000

nt
consumption = $100,000 minus amount saved
▪ Period 2: old, retired

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consumption = saving from Period 1

aP
plus interest earned on saving
▪ The interest rate determines
rth
the relative price of consumption when young
A
in terms of consumption when old.
Application 3: Interest Rates and Saving
Budget constraint shown is for 10% interest rate.

At the optimum,

nt
the MRS between

oi
current and future

aP
consumption equals
the interest rate.
rth
A
ACTIVE LEARNING 5
Effects of a change in the interest rate
▪ Suppose the interest rate rises.

nt
▪ Describe the income and substitution effects on

oi
current and future consumption, and on saving.

aP
rth
A

39
ACTIVE LEARNING 5
Answers
The interest rate rises.

nt
Substitution effect
▪ Current consumption becomes more expensive

oi
relative to future consumption.

aP
▪ Current consumption falls, saving rises,
future consumption rises.
rth
Income effect
A
▪ Can afford more consumption in both the
present and the future. Saving falls.

40
Application 3: Interest Rates and Saving
In this case,
SE > IE and

nt
saving rises

oi
aP
rth
A
Application 3: Interest Rates and Saving
In this case,
SE < IE and

nt
saving falls

oi
aP
rth
A

42
 CONCLUSION:
Do People Really Think This Way?
▪ People do not make spending decisions
by writing down their budget constraints and

nt
indifference curves.

oi
▪ Yet, they try to make the choices that maximize

aP
their satisfaction given their limited resources.
▪ The theory in this chapter is only intended as a
rth
metaphor for how consumers make decisions.
▪ It explains consumer behavior fairly well in many
A

situations and provides the basis for more

advanced economic analysis.
CHAPTER SUMMARY

▪ A consumer’s budget constraint shows the possible

combinations of different goods she can buy given

nt
her income and the prices of the goods. The slope

oi
of the budget constraint equals the relative price of
the goods.

aP
▪ An increase in income shifts the budget constraint
rth
outward. A change in the price of one of the goods
pivots the budget constraint.
A

44
CHAPTER SUMMARY

▪ A consumer’s indifference curves represent her

nt
preferences. An indifference curve shows all the
bundles that give the consumer a certain level of

oi
happiness. The consumer prefers points on higher

aP
indifference curves to points on lower ones.
▪ The slope of an indifference curve at any point is
rth
the marginal rate of substitution – the rate at which
the consumer is willing to trade one good for the
A

other.

45
CHAPTER SUMMARY

▪ The consumer optimizes by choosing the point on

nt
her budget constraint that lies on the highest
indifference curve. At this point, the marginal rate

oi
of substitution equals the relative price of the two

aP
goods.
▪ When the price of a good falls, the impact on the
rth
consumer’s choices can be broken down into two
effects, an income effect and a substitution effect.
A

46
CHAPTER SUMMARY

▪ The income effect is the change in consumption

that arises because a lower price makes the

nt
consumer better off. It is represented by a

oi
movement from a lower indifference curve to a
higher one.

aP
▪ The substitution effect is the change that arises
rth
because a price change encourages greater
consumption of the good that has become
A
relatively cheaper. It is represented by a
movement along an indifference curve.

47
CHAPTER SUMMARY

▪ The theory of consumer choice can be applied in

many situations. It can explain why demand

nt
curves can potentially slope upward, why higher

oi
wages could either increase or decrease labor
supply, and why higher interest rates could either

aP
increase or decrease saving.
rth
A

48