Principles of Microeconomics: Ch. 21 Second Canadian Edition Chapter 21 The Theory of Consumer...

Principles of Microeconomics: Ch. 21 Second Canadian Edition

Chapter 21

The Theory of Consumer Choice

© 2002 by Nelson, a division of Thomson Canada Limited


Overview

The budget constraintIndifference curvesThe consumer’s optimal choiceIncome and substitution effects on

choiceDeriving the demand curve


The Theory of Consumer Choice...

... addresses the following questions and links them in understanding:– Do all demand curves slope downward?

– How do wages affect labour supply?

– How do interest rates affect household saving?

– Do the poor prefer to receive cash or in-kind transfers?


The Budget Constraint:What Consumers Can Afford

“The budget constraint depicts the consumption possibilities available to

the individual.”

People consume less than they desire because their spending is constrained, or limited, by their income.


The Budget Constraint

Shows what combination of goods the consumer can afford given his income and the prices of the two goods.


The Budget ConstraintPepsi

Pizza

Pepsi($2)

Pizza($10)



Pizza

500

100

Pepsi($2)

Pizza($10)



Pizza

500

100

B

A

Pepsi($2)

Pizza($10)



Pizza

500

250

50 100

B

C

A

Pepsi($2)

Pizza($10)



($2)

Pizza($10)

500

250

50 100

B

C

A

Any point on the constraint line equals $1,000, the income available to spend on the two products.


The Budget Constraint

The slope of the budget constraint measures the rate at which the consumer can trade one good for the other.

The slope equals the relative price of the two goods, i.e. the price of one good compared to the price of the other.


Overview

The budget constraintIndifference curvesThe consumer’s optimal choiceIncome and substitution effects on



Preferences: What the Consumer WantsA consumer’s preference (choice)

between different bundles of goods and services may be illustrated with indifference curves.

An indifference curve depicts bundles of goods that leave the consumer equally well-off. It shows the combinations of goods that give the consumer a constant level of utility.


Indifference CurvesPepsi

PizzaI1

I2



Pizza

C

B

A I1

I2

..

.


Indifference Curves

The consumer is indifferent among combinations A, B, and C, because they are all on the same curve.

The slope at any point on an indifference curve equals the rate at which the consumer is willing to substitute one good for the other.



Pizza

C

B

A I1

I2

..

. D.



Pizza

C

B

A I1

I2

..

.

Slope between points A and B.Tradeoff between the two bundles.

D.


The Marginal Rate of Substitution

The slope is called the marginal rate of substitution.– The rate at which consumers are willing

to trade one good for another.

– The amount that the consumer must receive as compensation in order to give up something else that he/she desires.


Preferences: What the Consumer Wants

The consumer prefers some indifference curves to others. – Because he prefers more consumption to

less, higher indifference curves are preferred to lower ones.

– Points on a higher indifference curve are preferred to any point on lower curves.



Pizza

C

B

A I1

I2

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.


Higher indifference curves are preferred to lower ones

Indifference curves further from the origin represent higher levels of well-being or utility.

Consumers prefer to be on an indifference curve that is as far from the origin as possible.


Indifference curves are downward sloping

The fact that the consumer is willing to give up one of the goods only if he/she is given some more of the other good results in the indifference curve being

downward sloping.


Indifference curves do not cross

In order for preference rankings to be consistent, indifference curves cannot intersect or cross.

If indifference curves were to cross the assumption that “more is preferred to less” would be violated.


Indifference curves are bowed inward

Since goods are subject to diminishing marginal utility, indifference curves are bowed inward.

We are willing to give up a lot of a good with low marginal utility to get some more of the good that has a high marginal utility.


Extreme Indifference Curves

Perfect Substitutes: The indifference curves have a constant marginal rate of substitution and the curves are straight lines.


Perfect Substitutes

DimesI1 I2 I3

Nickels6

4

2

321


Extreme Indifference Curves

Perfect Substitutes: The indifference curves have a constant marginal rate of substitution and the curves are straight lines.

Perfect Complements: The indifference curves have lines that are at right-angles to each other.


Perfect Complements

RightShoes

I1

I2

LeftShoes


Quick Quiz!

Draw some indifference curves for Pepsi and pizza.

Explain the four properties of these indifference curves.


Overview

The budget constraint Indifference curvesThe consumer’s optimal choiceIncome and substitution effects on



Optimization: What the Consumer Chooses

Consumers would like to obtain the combination of goods on the highest possible indifference curve. However, the budget constraint may restrict or limit the consumer to a lower indifference curve.

Combining the indifference curve and budget constraint determines the optimum choice.


The Consumer’s Optimal ChoicePepsi

PizzaI1

I2

Consumer’s indifference curves, based on personal

preferences.

I3



PizzaI1

I2

Consumer’s budget constraint.

I3



PizzaI1

I2

Optimal Choicegiven personal preference

and budget constraint.

I3.QPepsi

QPizza


The Consumer’s Optimal ChoiceThe point at which the indifference

curve and the budget constraint touch (i.e. its tangent) is called the optimum.

The consumer chooses consumption of the two goods so that the marginal rate of substitution equals the relative price.

The consumer’s valuation of the two goods equals the market’s valuation.


How Changes in Income Affect the Consumer’s Choices

The increase in income shifts the budget constraint outward. This results in two affects:– A parallel shift in the budget constraint.

– Allows the consumer to choose a better combination of goods on a higher indifference curve.


A Change in Income Affects ChoicesPepsi

PizzaI1

I2

I3.QPepsi

QPizza

Optimal Choicegiven personal preference

and budget constraint.



PizzaI1

I2

I3.QPepsi

QPizza

An Increase in incomeshifts the budget

constraint.



PizzaI1

I2

I3

QPepsi

QPizza

A new choice of goodsis chosen on a higher

indifference curve..QNew

QNew



PizzaI1

I2

I3

QPepsi

QPizza

A new optimum

.QNew

QNew


Normal versus Inferior Goods

If a consumer wants more of a good when his income rises, the good is called a normal good.

If a consumer buys less of a good when his income rises, the good is called an inferior good.


Changes in Prices Affect Consumer’s Choices

A fall in the price of any good will shift the budget constraint outward and will change the slope of the budget constraint.


A Change in Prices Affects ChoicesPepsi

PizzaI1

I2

I3.QPepsi

QPizza

A decrease in price changes the slope of the

budget constraint.


Overview

The budget constraint Indifference curvesThe consumer’s optimal choiceIncome and substitution effects on



Income and Substitution Effects

A price change will have two effects upon the consumer:

–an income effect

–a substitution effect



The substitution effect is the change in consumption that results from being at a point on an indifference curve with a different marginal rate of substitution.

When the price of a good increases, the amount of other goods that have to be given up increases.


Substitution EffectPepsi

PizzaI1

I2

.Initial optimum

A


Substitution EffectPepsi

PizzaI1

I2

. New optimum

substitution effect

substi-tution effect

A

B



The income effect is the change in consumption that results from the movement to a higher or lower indifference curve because of the price change of one good.

The consumer is:– worse off when prices increase

– better off when prices decrease


Income EffectPepsi

PizzaI1

I2

. Inital optimum

A

B


Income EffectPepsi

PizzaI1

I2

.A

B

New optimumC

income effect

income effect



A price change first causes the consumer to move from one point on a indifference curve to another point on the same curve, a substitution effect (A to B).

After moving from one point to another on the same curve, the consumer will move to another indifference curve, the income effect (B to C).


Income and Substitution EffectsPepsi

PizzaI1

I2

. A

B

C


Quick Quiz!Draw a budget constraint

and indifference curves for Pepsi and pizza.

Show what happens to the budget constraint and the consumer’s optimum when the price of pizza rises.

Identify income and substitution effects.


Overview

The budget constraint Indifference curvesThe consumer’s optimal choice Income and substitution effects on



Deriving the Demand Curve

A consumer’s demand curve is a summary of the optimal decisions that arise from his budget constraint and

indifference curves.


Do all demand curves slope downward?

Demand curves can sometimes slope upward when consumers buy more of a good when the price rises.

Giffen Goods are inferior goods for which the income effect dominates the substitution effect. Therefore, they have demand curves that slope upward.


How do wages affect labour supply?If substitution effect is greater than the

income effect for the consumer he/she will work more.

If income effect is greater than the substitution effect for the consumer he/she will work less.


How do interest rates affect household saving?

If the substitution effect of a higher interest rate is greater than the income effect, the consumer will save more.

If the income effect of a higher interest rate is greater than the substitution effect, the consumer will save less.

An increase in the interest rate could either encourage or discourage saving.


Do the poor prefer to receive cash or in-kind transfers?

If an in-kind transfer of a good forces the recipient to consume more of the good than he would on his own, then the recipient prefers the cash transfer.

If the recipient does not consume more of the good than he would on his own, then the cash and in-kind transfer have exactly the same effect as before the transfer.


Conclusion

Indifference curve analysis describes how individuals make decisions. It has many relevant and interesting applications.

If people behave as if they followed the model, then the model will yield accurate and useful predictions and results.


Overview

The budget constraint Indifference curvesThe consumer’s optimal choice Income and substitution effects on


Principles of Microeconomics: Ch. 21 Second Canadian Edition Chapter 21 The Theory of Consumer...

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