CHAPTE

R 21
The Theory of
Consumer Choice
Microeonomics
PRINCIPLES OF

N. Gregory
Mankiw

© 2009 South-Western, a part of Cengage Learning, all rights reserved

 The Budget Constraint:
What the Consumer Can Afford
 Example:
Hurley divides his income between two goods:
fish and mangos.
 A “consumption bundle” is a particular combination
of the goods, e.g., 40 fish & 300 mangos.
 Budget constraint: the limit on the consumption
bundles that a consumer can afford .

THE THEORY OF CONSUMER CHOICE 2

ACTIVE LEARNING 1
Budget Constraint
Hurley’s income: $1200
Prices: PF = $4 per fish, PM = $1 per mango
A. If Hurley spends all his income on fish,
how many fish does he buy?
B. If Hurley spends all his income on mangos,
how many mangos does he buy?
C. If Hurley buys 100 fish, how many mangos can
he buy?
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.
3
ACTIVE LEARNING 1
Answers D.
D. Hurley’s
Hurley’s budget
budget
Quantity
of Mangos constraint
constraint shows
shows
B the
the bundles
bundles he
he can
can
A. $1200/$4 afford.
afford.
= 300 fish
C
B. $1200/$1
= 1200
mangos
C. 100 fish
cost $400,
$800 left A
buys 800
Quantity
mangos of Fish
ACTIVE LEARNING 2
Budget constraint, continued.
Show what happens to Hurley’s budget constraint if:
A. His income falls to $800.
B. The price of mangos rises to
PM = $2 per mango

5
ACTIVE LEARNING 2
Answers, part A
Quantity A
A fall
fall in
in income
income
Now, of Mangos shifts
shifts the
the budget
budget
Hurley constraint
constraint down.
down.
can buy
$800/$4
= 200 fish
or
$800/$1
= 800 mangos
or any
combination in
between. Quantity
of Fish
ACTIVE LEARNING 2
Answers, part B
Quantity An
An increase
increase in
in the
the
Hurley of Mangos price
price of
of one
one good
good
can still buy pivots
pivots the
the budget
budget
300 fish. constraint
constraint inward.
inward.
But now he
can only buy
$1200/$2 =
600 mangos.
Notice:
slope is smaller,
relative price of
fish is now only
2 mangos. Quantity
of Fish
 Preferences: What the Consumer
Wants
Indifference curve: Quantity One of Hurley’s
of Mangos indifference curves
shows consumption
bundles that give the
consumer the same
level of satisfaction B
A, B, and all other
bundles on I1 make A
Hurley equally happy – I1
he is indifferent
between them.
Quantity
of Fish

THE THEORY OF CONSUMER CHOICE 8

 Four Properties of Indifference
Curves
Quantity One of Hurley’s
1. Indifference curves of Mangos indifference curves
are downward-
sloping.

If the quantity of
B
fish is reduced,
the quantity of A
mangos must be
I1
increased to keep
Hurley equally
happy. Quantity
of Fish

THE THEORY OF CONSUMER CHOICE 9

 Four Properties of Indifference
Curves
Quantity A few of Hurley’s
2. Higher indifference of Mangos indifference curves
curves are preferred
to lower ones.

Hurley prefers every

bundle on I2 (like C) C
D
to every bundle on I1 A I2
(like A). I1
He prefers every
bundle on I1 (like A) I0
to every bundle on I0 Quantity
of Fish
(like D).
THE THEORY OF CONSUMER CHOICE 10
 Four Properties of Indifference
Curves
Quantity Hurley’s
3. Indifference curves of Mangos indifference curves
cannot cross.
Suppose they did.
Hurley should prefer
B to C, since B has B
more of both goods.
Yet, Hurley is indifferent C A
between B and C: I1 I4
He likes C as much as A
(both are on I4).
Quantity
He likes A as much as B of Fish
(both are on I1).
THE THEORY OF CONSUMER CHOICE 11
 Four Properties of Indifference
Curves
Quantity
4. Indifference curves of Mangos
are bowed inward.
A
Hurley is willing to give
up more mangos for a 6
fish if he has few fish
1
(A) than if he has
B
many (B). 2
1 I1

Quantity
of Fish

THE THEORY OF CONSUMER CHOICE 12

 Optimization: What the Consumer
Chooses
A is the optimum: Quantity
of Mangos
The
The optimum
optimum
the point on the
is
is the
the bundle
bundle
budget constraint
Hurley
Hurley most
most
that touches the
1200 prefers
prefers outout of
of
highest possible
all
all the
the bundles
bundles
indifference curve.
he
he cancan afford.
afford.
Hurley prefers B to A, B
but he cannot afford B. 600
A

Hurley can afford C C

and D, D
but A is on a higher
indifference curve. 150 300 Quantity
of Fish
THE THEORY OF CONSUMER CHOICE 13
 The Effects of an Increase in
Income
Quantity
of Mangos
An increase in
income shifts the
budget constraint
outward.
B
If both goods are A
“normal,” Hurley
buys more of each.

Quantity
of Fish
THE THEORY OF CONSUMER CHOICE 14
ACTIVE LEARNING 3
Inferior vs. normal goods
 An increase in income increases the quantity
demanded of normal goods and reduces the
quantity demanded of inferior goods.
 Suppose fish is a normal good
but mangos are an inferior good.
 Use a diagram to show the effects of
an increase in income on Hurley’s optimal
bundle of fish and mangos.

15
ACTIVE LEARNING 3
Answers Quantity
of Mangos

If mangos are
inferior, the new
optimum will
contain fewer
mangos.
A
B

Quantity
of Fish
16
 The Effects of a Price Change
Quantity
Initially,
of Mangos
PF = $4
1200
PM = $1 initial
optimum

PF falls to $2 new
optimum
budget constraint 600
500
rotates outward,
Hurley buys
more fish and
fewer mangos.
150 300 600 Quantity
350 of Fish

THE THEORY OF CONSUMER CHOICE 17