Consumer Behavior

Ch. 7

The Budget Line

The budget line 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.

The Consumer’s Budget Line...

Quantityof Pizza

Quantityof Pepsi

0

250

50 100

500 B

C

A

Consumer’sBudget line

The Consumer’s Budget Line

The slope of the budget 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...

Quantityof Pizza

Quantityof Pepsi

0

C

B

A Indifferencecurve, I1

D

I2

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 Consumer’s Preferences

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 substitute 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...

Quantityof Pizza

Quantityof Pepsi

0

C

B

A

D

Indifferencecurve, I1

I21MRS

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.

Property 1: Higher indifference curves are preferred to lower ones.

Consumers usually prefer more of something to less of it.

Higher indifference curves represent larger quantities of goods than do lower indifference curves.

Property 2: Indifference curves are downward sloping.

A consumer is willing to give up one good only if he or she gets more of the other good in order to remain equally happy.

If the quantity of one good is reduced, the quantity of the other good must increase.

For this reason, most indifference curves slope downward.

Property 3: Indifference curves do not cross.

Quantityof Pizza

Quantityof Pepsi

0

C

A

B

1MRS = 1

8

3

Indifferencecurve

A

Property 4: Indifference curves are bowed inward.

Quantityof Pizza

Quantityof Pepsi

0

14

2

3

7

B

1

MRS = 6

4

6

People are more willing to trade away goods that they have in abundance and less willing to trade away goods of which they have little.

Perfect Substitutes

Dimes0

Nickels

21

4

2

I1I2

6

3

I3

Perfect Complements

Right Shoes0

LeftShoes

75

7

5 I1

I2

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 line 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 consumption…

3. …and Pepsiconsumption.

Initial optimum

New budget line

1. An increase in income shifts the budget line outward…

Initial budget line

New optimum

How Changes in Prices Affect Consumer Choices

A fall in the price of any good rotates the budget constraint outward and changes the slope of the budget line.

A Change in Price...

Quantity of Pizza100

Quantity of Pepsi

1,000

500

0

I1

New budget constraint

3. …and raising Pepsiconsumption.

Initial budget constraint

2. …reducing pizza consumption…

1. A fall in the price of Pepsi rotates the budget constraint outward…

New optimum

I2

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Income and Substitution Effects A price change has two effects on

consumption. An income effect A substitution 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 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.

X2

X1

Eb

I1

I2

xa xb

Ea

The new optimum is Eb on I2.

The Total Price Effect is xa to xb

X2

X1

I1

I2

xa xb

EaEb

Draw a line parallel to the new budget line and tangent to the old indifference curve

X2

X1

Ec I1

I2

xa xc xb

EaEb

The new optimum on I1 is at Ec. The movement from

Ea to Ec (the increase in quantity demanded from

Xa to Xc) is solely in response to a change in

relative prices

X2

X1

I1

I2

Substitution Effect

EaEb

Ec

This is the substitution effect.

Xa Xc

A Change in Price: Substitution Effect

The substituiton effect increases the quantity demanded of a good whose price has fallen and reduces the quantity demanded of a good whose price has risen.

A Change in Price: Income Effect

The income effect leads consumers to buy more of a product whose price has fallen, if it is a normal good.

Because of the combined operation of the income and substitution effects, the demand curve for any normal good will be negatively sloped.