The Theory of

Consumer Choice
Chapter

21
• The theory of consumer choice addresses the
following questions:

– Do all demand curves slope downward?

– How do wages affect labor supply?
– How do interest rates affect household saving?
 THE BUDGET CONSTRAINT: WHAT
THE CONSUMER CAN AFFORD
• The budget constraint depicts the limit on 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 BUDGET CONSTRAINT: WHAT
THE CONSUMER CAN AFFORD

• The budget constraint shows the various

combinations of goods the consumer can afford
given his or her income and the prices of the two
goods.
Figure 1 The Consumer’s Budget Constraint

Quantity
of Pepsi
B
500

C
250

Consumer’s
budget constraint

A
0 50 100 Quantity
of Pizza
Copyright©2004 South-Western
THE BUDGET CONSTRAINT: WHAT
THE CONSUMER CAN AFFORD

• The slope of the budget constraint 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 can
trade one good for the other.
 PREFERENCES: WHAT THE
CONSUMER WANTS

• A consumer’s preference among consumption

bundles may be illustrated with indifference
curves.
 Representing Preferences with
Indifference Curves

• An indifference curve is a curve that shows

consumption bundles that give the consumer the
same level of satisfaction.
 Figure 2 The Consumer’s Preferences

Quantity
of Pepsi
C

B D
I2
Indifference
A
curve, I1

0 Quantity
of Pizza
Copyright©2004 South-Western
Representing Preferences with Indifference
Curves
• The Consumer’s Preferences
– 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 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
trade 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.
 Figure 2 The Consumer’s Preferences

Quantity
of Pepsi
C

B D
MRS I2
1
Indifference
A
curve, I1

0 Quantity
of Pizza
Copyright©2004 South-Western
 Four 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.
 Four Properties of Indifference
Curves
• 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.
 Figure 2 The Consumer’s Preferences

Quantity
of Pepsi
C

B D
I2
Indifference
A
curve, I1

0 Quantity
of Pizza
Copyright©2004 South-Western
 Four Properties of 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.
 Figure 2 The Consumer’s Preferences

Quantity
of Pepsi

Indifference
curve, I1

0 Quantity
of Pizza
Copyright©2004 South-Western
 Four Properties of Indifference
Curves
• Property 3: Indifference curves do not cross.
– Points A and B should make the consumer
equally happy.
– Points B and C should make the consumer
equally happy.
– This implies that A and C would make the
consumer equally happy.
– But C has more of both goods compared to A.
 Figure 3 The Impossibility of Intersecting Indifference
Curves

Quantity
of Pepsi

0 Quantity
of Pizza
Copyright©2004 South-Western
 Four Properties of Indifference
Curves
• Property 4: Indifference curves are bowed
inward.
– 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.
– These differences in a consumer’s marginal
substitution rates cause his or her indifference
curve to bow inward.
 Figure 4 Bowed Indifference Curves

Quantity
of Pepsi

14

MRS = 6

A
8
1

4 B
MRS = 1
3
1
Indifference
curve

0 2 3 6 7 Quantity
of Pizza
Copyright©2004 South-Western
 Perfect Substitutes and Perfect
Compliments
• Inputs are perfect substitutes when one
output can always be substituted for the
other on fixed terms and the MRTS is
constant.
• With perfect compliments, substitution is
impossible and the MRTS cannot be
defined for the bundle at the kink in the
isoquant.
Perfect Substitutes and Perfect
Complements
Perfect Substitutes and Perfect
Complements
 OPTIMIZATION: WHAT THE
CONSUMER CHOOSES
• Consumers want to get the combination of goods
on the highest possible indifference curve.
• However, the consumer must also end up on or
below his budget constraint.
The Consumer’s Optimal Choices

• Combining the indifference curve and the budget

constraint determines the consumer’s optimal
choice.
• Consumer optimum occurs at the point where the
highest indifference curve and the budget
constraint are tangent.
 The Consumer’s Optimal Choice

• The consumer chooses consumption of the two

goods so that the marginal rate of substitution
equals the relative price.
 Figure 6 The Consumer’s Optimum

Quantity
of Pepsi

Optimum

B
A

I3
I2
I1

Budget constraint
0 Quantity
of Pizza
Copyright©2004 South-Western
 How Changes in Income Affect
the Consumer’s Choices
• An increase in income shifts the budget
constraint outward.
– The consumer is able to choose a better
combination of goods on a higher
indifference curve.
How Changes in Income Affect the
Consumer’s Choices
• Normal versus Inferior Goods
– If a consumer buys more of a good when his or
her income rises, the good is called a
normal
– good.
If a consumer buys less of a good when his or
her income rises, the good is called an
inferior good.
 How Changes in Prices Affect
Consumer’s Choices

• A fall in the price of any good rotates the budget

constraint outward and changes the slope of the
budget constraint.
Figure 9 A Change in Price

Quantity
of Pepsi

New budget constraint

1,000 D

New optimum
B 1. A fall in the price of Pepsi rotates
500
the budget constraint outward . . .
3. . . . and
raising Pepsi Initial optimum
consumption.
Initial I2
budget I1
constraint A
0 100 Quantity
of Pizza
2. . . . reducing pizza consumption . . .

Copyright©2004 South-Western
 Income and Substitution Effects

• A price change has two effects on

consumption.
– An income effect
– A substitution effect
 Income and Substitution Effects
• The Income 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
– 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.
Income and Substitution Effects
 Income and Substitution Effects

• A Change in Price: Substitution Effect

– A price change first causes the consumer to move
from one point on an indifference curve to another
on the same curve.
• Illustrated by movement from point A to point B.
• A Change in Price: Income Effect
– After moving from one point to another on the
same curve, the consumer will move to another
indifference curve.
• Illustrated by movement from point B to point
C.
Table 1 Income and Substitution Effects When the
Price of Pepsi Falls

Copyright©2004 South-Western
 THREE APPLICATIONS
• Do all demand curves slope downward?
– Demand curves can sometimes slope upward.
– This happens when a consumer buys more of a
good when its price rises.
•Giffen goods
• Economists use the term Giffen good to describe
a good that violates the law of demand.
• Giffen goods are goods for which an increase in
the price raises the quantity demanded.
• The income effect dominates the substitution
effect.
• They have demand curves that slope upwards.
A Giffen Good
• Just to clarify: All Giffen goods are inferior goods
but not all inferior goods are Giffen goods.