Chapter 6

PowerPoint Slides prepared by:

Andreea CHIRITESCU

Eastern Illinois University

PowerPoint Slides prepared by:

Andreea CHIRITESCU

Eastern Illinois University

Consumer Choice

CHAPTER

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The Budget Constraint

• Budget constraint

– Different combinations of goods

– A consumer can afford with a limited

budget

– At given prices

• Budget line

– Graphical representation of a budget

constraint

• Maximum affordable quantity of one good, for

given amounts of another good




• Max

– Total entertainment budget = $100 per

month

– Price of a movie = $10

– Price of a concert = $20

• Relative price

– Price of one good relative to the price of

another



FigureThe Budget Constraint



1

FigureThe Budget Constraint



1

Number of Concerts per Month

Number of

Movies per

Month

8

1 2

With $100 per month, Max can afford

10 movies and no concerts, . . .

6

4

2

3 4

10

5

A

B

C

D

E

F

H

G

8 movies and 1 concert or any other

combination on the budget line.

Points below the line are

also affordable.

But not points above the line.


• If

– Py: price of the good on the vertical axis

– Px: price of the good on the horizontal axis

• Then, Px/Py is

– The relative price of good X

– The opportunity cost of one more unit of

good X

– The absolute value of the slope of the

consumer’s budget line



Changes in the Budget Line

• Changes in income

– An increase in income will shift the budget

line upward (and rightward)

– A decrease in income will shift the budget

line downward (and leftward)

– These shifts are parallel

• Changes in income do not affect the budget

line’s slope



Changes in the Budget Line

• Changes in price

– The budget line rotates

– The slope of the budget line changes

– One of the intercepts of the budget line

changes



FigureChanges in the Budget Line



2

Number of

Concerts per Month

Number of

movies per

month

(a)

5

10

10

201. An increase in

income shifts the

budget line

rightward, with no

change in slope.

Number of

Concerts per Month

Number of

movies per

month

(b)

5

10

20

2. A decrease in

the price of movies

rotates the budget

line upward . . .

Number of

Concerts per Month

Number of

movies per

month

(c)

5

10

10

3. While a

decrease in the

price of concerts

rotates it rightward

Preferences

• Rational preferences satisfy two

conditions:

1. Any two alternatives can be compared,

and one is preferred or else the two are

valued equally

2. The comparisons are logically consistent

or transitive

• More is better

– Always choose a point on the budget line,

rather than a point below it



The Marginal Utility Approach

• Utility

– Quantitative measure of pleasure/

satisfaction obtained from consuming

goods and services

• Marginal utility

– Change in total utility

– From consuming an additional unit of a

good or service



FigureTotal and Marginal Utility



3

FigureTotal and Marginal Utility



3

Ice cream cones per week

Utils

10

20

30

40

50

60

70

1 2 3 4 5 6

Ice cream cones per week

Utils

10

20

30

1 2 3 4 5 6

Total Utility

Marginal Utility

1. The change in total

utility from one more ice

cream cone . . .

2. Is called the marginal utility of

an additional cone.3. Marginal utility

falls as more cones

are consumed.


• Law of diminishing marginal utility

– As consumption of a good or service

increases, marginal utility decreases

• Marginal utility

– Can be zero

• Assumption

– Marginal utility for every good is positive

– ‘More is better’




• Utility maximization

– Consumer will choose the point on the

budget line

– Where marginal utility per dollar is the

same for both goods: MUx/Px = MUy/Py

– There is no further gain from reallocating

expenditures in either direction



TableTotal and Marginal Utility of Concerts and Movies



1

FigureConsumer Decision Making



4

Figure

The budget line shows the maximum number of movies Max could attend for each number of concerts

he attends. He would never choose an interior point like G because there are affordable points—on

the line—that make him better off. Max will choose the point on the budget line at which the marginal

utilities per dollar spent on movies and concerts are equal. From the table, this occurs at point D.

Consumer Decision Making



4


Number of

Movies

per Month8

1 2

6

4

2

3 4

10

5

A

D

F

G

B

C

E

40, 20c m

c m

MU MU

P P

30, 30c m

c m

MU MU

P P

20, 45c m

c m

MU MU

P P


• A rise in income

– With no change in prices

– A new quantity demanded for each good

– Individual preferences (marginal utility)

• Normal good – quantity demanded increases

• Inferior good – quantity demanded decreases



FigureEffects of an Increase in Income



5

FigureEffects of an Increase in Income



5


Number of

Movies per

Month

8

1 2

1. When Max's income rises to $200,

his budget line shifts outward.

6

4

2

3 4

A

B

C

D

E

F

10

5 6 7 8 9

14

16

18

12

20

10

G

H

J

K

L

2. If his preferences are as given

in the table, he'll choose point K.

FigureNormal and Inferior Goods



6


Number of

Movies per

Month

8

1 2

6

4

2

3 4 6 7 8 9

14

16

18

12

5 10

20

10

If income rises and concerts are

inferior, Max moves to a point like K″

(fewer concerts).

A

B

C

D

E

F

K”

K

K’

If income rises and movies are

inferior, Max moves to a point like

K′ (fewer movies).


• Change in prices

– Decrease in the price of one good

• Other things constant

• Rotates the budget line rightward

• Individual demand curve

– Quantity of a good a consumer demands

at each different price



FigureDeriving the Demand Curve



7

FigureDeriving the Demand Curve



7

Number of Concerts per month

Price per

Concert

$5

$10

$20

3 5 8

Number of Concerts

per month

Number of

Movies per

Month

45

6

10

3 5 108 20

1. When the price of concerts is $20,

point D is best for Max.

T

D

R 3. And if the price drops to $5,

he chooses point T.

4. The demand curve shows the

quantity Max chooses at each priceT

D

R

2. If the price falls to $10, Max's

budget line rotates rightward,

and he chooses point R.

Income and Substitution Effects

• Substitution effect

– As the price of a good falls, the consumer

substitutes that good in place of other

goods whose prices have not changed

– Arises from a change in the relative price

of a good

– It moves quantity demanded in the

opposite direction to the price change




• Income effect

– As the price of a good decreases, the

consumer’s purchasing power increases

• Causing a change in quantity demanded for

the good

– Arises from a change in purchasing power

over both goods




• Normal goods

– Substitution and income effects work

together

– Quantity demanded - moves in the

opposite direction of the price

– Always obey the law of demand




• Inferior goods

– Substitution and income effects work

against each other

– Substitution effect virtually always

dominates

– Virtually always obey the law of demand



FigureIncome and Substitution Effects



8

Consumers in Markets

• Market demand curve

– Horizontally summing the individual

demand curves of every consumer in the

market

– Obeys the law of demand

– Downward sloping



Figure

The individual demand curves show how much bottled water will be demanded by Jerry,

George, and Elaine at different prices. As the price falls, each demands more.

From Individual to Market Demand (a)



9

Number of Bottles

per Week

Price

Jerry $4

3

2

1

8 124

C

Number of Bottles

per Week

Price

George $4

3

2

1

9 126

C’

Number of Bottles

per Week

Price

Elaine$4

3

2

1

2010

C”

Figure

The market demand curve in panel (b) is obtained by adding up the total quantity demanded by

all market participants at different prices.

From Individual to Market Demand (b)



9

Number of Bottles per Week

Price

1

4410

2

$4

3

3 27

A

B

C

D

E

Market Demand Curve

Consumer Theory in Perspective

• Extensions of the model

– Incorporate choices among many goods

– Recognize saving and borrowing

– Incorporate uncertainty and imperfect

information

– Behavioral economics




• Behavioral economics

– Subfield of economics

– Decision-making patterns that deviate from

those predicted by traditional consumer

theory

• Salience of a particular outcome

– The extent to which it “jumps out at them”




• Preference for defaults

– People tend to stick to the default choice

• Decision-making environment

– Environment in which a decision is made -

can exert a strong and surprising influence

• Self-binding

– To a narrower set of choices - long-run

good




• Behavioral economics and policy

– Financial incentive for firms to make

“automatic contribution” by employees the

default choice

– People with gambling problems -

voluntarily put themselves on a list that

bans them from any casino

– Industry-wide “vanilla” versions of

mortgages, student loans, credit card

agreements




• Behavioral economics and traditional

theory

– Traditional economic theory: assumes that

consumers have rational preferences

– Behavioral economics: analyzes decisions

that violate rational preferences



Improving Education

• Model of consumer choice

– Student’s time allocation problem

– Only two activities: studying economics

and studying French

– Each of these activities costs time

– Students “buy” points on their exams with

hours spent studying



Improving Education

• Student’s time allocation problem

– Opportunity cost of scoring better in

French

• Scoring lower in economics

– Slope of budget line = -PF/PE = -2

• Each additional point in French: sacrifice 2

points in economics



Improving Education

• New computer-assisted technique in

French class

– Learn more French with the same study

time or to study less and learn the same

amount

– A decrease in the price of French points

– Budget line rotates outward



Figure

Panel (a) shows combinations of French and economics test scores that can be obtained for a

given amount of study time. The slope of −2 indicates that each additional point in French

requires a sacrifice of 2 points in economics. The student chooses point C. Panel (b) shows

that computer-assisted French instruction causes the budget line to rotate outward; French

points are now less expensive. The student might move to point D, attaining a higher French

score. Or she might choose F, using all of the time freed up in French to study economics. Or

she might choose an intermediate point, such as E.

Time Allocation



10

French score

Economics

score

90

70

80

75 80

(a)

C

French score

Economics

score

90

70

80

9075 80

(b)

CD

E

F

The Indifference Curve Approach

• Assumptions

– Rational preferences: an individual can

compare any two options and decide

which is best

• Makes choices that are logically consistent

– An individual prefers more of every good to

less

• Consumer - choose to be on budget line,

rather than below it



An Indifference Curve

• An indifference curve

– All combinations of two goods that make

the consumer equally well off

– Slopes downward

• Marginal rate of substitution, MRSy,x

– Of good y for good x along any segment of

an indifference curve

– Is the maximum rate at which a consumer

would willingly trade units of y for units of x



FigureAn Indifference Curve



A.1


Number of Movies

per Month

6

3

4

11

20

1 2 3 4 5

If Max gets another concert . . .

G

H

J

K

L

+1

+1

+1

+1

-9

-5

-2

-1

He could give up 9 movies

and be just as satisfied.

An Indifference Curve

• MRS at any point on the indifference

curve

– The (absolute value of) the slope of the

curve at that point

– Maximum rate at which a consumer would

willingly trade good y for a tiny bit more of

good x



The Indifference Map

• Indifference map

– A set of indifference curves that describe

one persons’ preferences

– Any point on a higher indifference curve is

preferred to any point on a lower one



FigureAn Indifference Map



A.2


Number of Movies

per Month

6

11

20

1 2 3

1.Max prefers any point on

this indifference curve…G

H

J

2.to any point on this one.R

S

3.And any point on this

curve is preferred to any

point on the other two.

Consumer Decision Making

• Optimal combination of goods

– The point on the budget line where an

indifference curve is tangent to the budget

line

– That combination on the budget line for

which MRSy,x = Px/Py



FigureConsumer Decision Making with Indifference Curves



A.3

Number of Movies

per Month

Number of Concerts

per Month

6

10

1 2 3 4 5

8

4

2

2. But point D (also affordable) is

preferred because it is on a higher

indifference curve.

A

B

D

E

1. Points B

and E are

affordable . . .

What Happens When Things Change?

• A rise in income

– With no change in prices

– Leads to a new quantity demanded for

each good

– Quantity demanded increases (normal

good)

– Quantity demanded decreases (inferior

good)

– Depends on the individual’s preferences

• Indifference map



FigureAn Increase in Income



A.4


Number of

Movies

per Month

8

4

3 65 10

20

10

1. When Max's income rises to $200, his

budget line shifts outward.

2. With the preferences represented

by these indifference curves, he'll

choose point H.

D

H

3. In this case, both

movies and concerts are

normal goods for Max.

Figure


Number of

Movies

per Month

2

4

3 95 10

20

10

8

6

An Increase in Income



A.4

D

H’

4. But if Max instead had

these indifference curves, he

would choose point H’ . . .

5. Concerts would be

normal for Max, but

movies would be inferior.

What Happens When Things Change?

• Changes in price

– Budget line rotates

– Quantity demanded changes

– Downward sloping demand curve



FigureDeriving the Demand Curve with Indifference Curves



A.5


Number of

Movies

per Month

5

4

3 85 10

10

6

20

D

K

J

1. When the price of concerts is

$20, MRSm,c = Pc /Pm at Point D.

2. But when the price of

concerts falls to $10, this

condition is satisfied at point J.


Price per

concert

$5

3 85

$20

$10

D

K

J

3. The demand curve shows the

quantity of concerts Max chooses

at each price for concerts.

Chapter 6

Economy & Finance

Transcript of Chapter 6