The Theory of Consumer Choice

The Theory of
Consumer Choice
Chapter 21
Copyright © 2001 by Harcourt, Inc.
All rights reserved. Requests for permission to make copies of any part of
the
work should be mailed to:
Permissions Department, Harcourt College Publishers,
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?
◆ Do the poor prefer to receive cash or
in-kind transfers?
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
The Budget Constraint
◆ The budget constraint 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 Budget Constraint
It shows the various combinations of

goods the consumer can afford given
his or her income and the prices of
the two goods.
Copyright © 2001 by Harcourt, Inc. All rights reserved
The Consumer’s Opportunities

Pints of Number of Spending Spending Total
Pepsi Pizzas on Pepsi on Pizza Spending
0 100 $ 0 $1,000 $1,000
50 90 100 900 1,000
100 80 200 800 1,000
150 70 300 700 1,000
200 60 400 600 1,000
250 50 500 500 1,000
300 40 600 400 1,000
350 30 700 300 1,000
400 20 800 200 1,000
450 10 900 100 1,000
500 0 1,000 0 1,000
The Consumer’s Budget
Constraint
◆ Any point on the budget constraint line

indicates the consumer’s combination or
tradeoff between two goods.
◆ For example, if the consumer buys no
pizzas, he can afford 500 pints of Pepsi
(point B). If he buys no Pepsi, he can
afford 100 pizzas (point A).
Constraint...
Quantity
of Pepsi
500 B
Consumer’s
budget constraint
A
0 100 Quantity
of Pizza
Constraint
◆ Alternately, the consumer can buy

50 pizzas and 250 pints of Pepsi.
Constraint...
Quantity
of Pepsi
B
500
C
250
Consumer’s
budget constraint
A
0 50 100 Quantity
of Pizza
Constraint
◆ 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 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.
Representing Preferences with
Indifference Curves
An indifference curve shows

bundles of goods that make the
consumer equally happy.
The Consumer’s Preferences...
Quantity
of Pepsi
B D
I2
A Indifference
curve, I1
0 Quantity
of Pizza
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 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...
Quantity
of Pepsi
B D
MRS 1 I2
A Indifference
curve, I1
0 Quantity
of Pizza
Properties of Indifference Curves
❶ Higher indifference curves are

preferred to lower ones.
❷ Indifference curves are downward
sloping.
❸ Indifference curves do not cross.
❹ 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 1: Higher indifference curves
are preferred to lower ones.
Quantity
of Pepsi
B D
I2
A Indifference
curve, I1
0 Quantity
of Pizza
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.
downward sloping.
Quantity
of Pepsi
Indifference
curve, I1
0 Quantity
of Pizza
Property 3: Indifference curves do not
cross.
◆ Points A and B should make the

◆ Points B and C should make the
◆ This implies that A and C would make
the consumer equally happy.
◆ But C has more of both goods compared
to A.
Property 3: Indifference curves do not
cross.
Quantity
of Pepsi
0 Quantity
of Pizza
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.
bowed inward.
Quantity
of Pepsi
14
MRS = 6
8 A
1
4 MRS = 1 B
3 Indifference
1
curve
0 2 3 6 7 Quantity
of Pizza
Two Extreme Examples of
Indifference Curves
◆ Perfect substitutes
◆ Perfect complements
Perfect Substitutes
◆ Two goods with straight-line indifference curves are perfect

substitutes.
◆ The marginal rate of substitution is a fixed number.
Perfect Substitutes
Nickels
I1 I2 I3
0 1 2 3 Dimes
Perfect Complements
Two goods with right-angle

indifference curves are perfect
complements.
Perfect Complements
Left
Shoes
I2
7
5 I1
0 5 7 Right Shoes
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.
Optimization: What the Consumer
Chooses
◆ 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.
The Consumer’s Optimal Choice
At the consumer’s optimum, the

consumer’s valuation of the two goods
equals the market’s valuation.
The Consumer’s Optimum...
Quantity
of Pepsi
Optimum
B
A
I3
I2
I1
Budget constraint
0 Quantity
of Pizza
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.
An Increase in Income...
Quantity
of Pepsi New budget constraint
1. An increase in income shifts

the budget constraint outward…
New optimum
3. …and Pepsi Initial

consumption. optimum
I2
Initial
budget
constraint I1
0 Quantity
of Pizza
2. …raising pizza
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.
An Inferior Good...
Quantity
of Pepsi New budget constraint
1. When an increase in income

3. ... but shifts the budget constraint
Pepsi Initial outward...
consumption optimum
falls, making
Pepsi an New optimum
inferior
good.
Initial
budget
constraint I1 I2
0 Quantity
2. ... pizza consumption rises, of Pizza
making pizza a normal good...
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 constraint.
A Change in Price...
Quantity
of Pepsi
1,000 New budget constraint
New optimum1. A fall in the price of

Pepsi rotates the budget
500 constraint outward…
3. …and
raising Pepsi
consumptio I2
n.
Initial budget I1
constraint
0 100 Quantity of Pizza
2. …reducing pizza
Income and Substitution Effects
◆A price change has two effects on consumption.

◆ An income effect
◆ A substitution effect
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.
A Change in Price:
Substitution Effect
A price change first causes the

consumer to move from one point
on a 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.
Income and Substitution Effects...

Quantity
of Pepsi
New budget constraint
CNew optimum
Income effect B
Initial optimum
Substitutio
n effect
I2
A
Initial I1
budget
constraint 0 Quantity of Pizza
Substitution effect
Income effect
Income and Substitution Effects When
the Price of Pepsi Falls
Good I ncome Effect Substitution Effect Total Effect

Pepsi Consumer is richer, Pepsi is relatively Income and
so he buys more Pepsi. cheaper, so consumer substitution
buys more Pepsi. effects act in
same direction,
so consumer buys
more Pepsi.
Pizza Consumer is richer, Pizza is relatively Income and
so he buys more pizza. more expensive, substitution
so consumer buys effects act in
less pizza. opposite directions,
so the total effect
on pizza consumption
is ambiguous.
Deriving the Demand Curve
A consumer’s demand curve can be

viewed as a summary of the optimal
decisions that arise from his or her
budget constraint and indifference
curves.
Deriving the Demand Curve...
(a) The Consumer’s Optimum (b) The Demand Curve for Pepsi
Quantity
of Pepsi Price of
New budget
constraint Pepsi
B A
$2
150
I2
1
B
A
50 I1
0 0
Quantity 50 150 Quantity
Initial budget of Pizza of Pepsi
constraint
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 inferior goods for which
the income effect dominates the
substitution effect.
◆ They have demand curves that slope
upwards.
Quantity of
A Giffen Good...
Potatoes Initial budget constraint
B
Optimum with high

price of potatoes
2...which Optimum with low
D price of potatoes
increases
E
potato
C 1. An increase in the price
consumptio
of potatoes rotates the
n if
budget...
potatoes I1
are a Giffen New budget I2
good. constraint
0 A Quantity
of Meat
How do wages affect labor
supply?
◆ If the substitution effect is greater than
the income effect for the worker, he or
she works more.
◆ If income effect is greater than the
substitution effect, he or she works less.
The Work-Leisure Decision...
Consumption
$5,000
Optimum
I3
2,000
I2
I1
0 60 100 Hours of
Leisure
An Increase in the Wage...
(a) For a person with these . . . the labor supply curve slop
Consumption
preferences… upward.
Wage
1. When the
wage rises…
I2
BC1
BC2
I1
0
Hours of 0 Hours of
2. …hours of leisure Leisure Labor
decrease… 3. ...and hours of laborSupplied
increase.
An Increase in the Wage...
(b) For a person with these . . . the labor supply curve slop
Consumption
preferences… backward.
Wage
BC2
1. When the
wage rises…
BC1 I2
I1
0 0
Hours of Hours of
Leisure Labor
2. …hours of leisure 3. ...and hours of laborSupplied
decrease.
increase…
How do interest rates affect
household saving?
◆ If the substitution effect of a higher

interest rate is greater than the income
effect, households save more.
◆ If the income effect of a higher interest
rate is greater than the substitution effect,
households save less.
The Consumption-Saving Decision...
Consumption
when Old Budget
constraint
$110,000
55,000 Optimum
I3
I2
I1
0 $50,000 100,000 Consumption
when Young
An Increase in the Interest Rate...

Consumption
Consumption
(a) Higher Interest (b) Higher Interest Rate
BC2 Rate Raises Saving Lowers Saving
when Old
when Old
BC2
1. A higher
1. A higher
interest rate
interest rate
rotates the
rotates the
budget constraint
budget constraint
outward...
outward...
BC1 I2
BC1 I2
I1
I1
0 0
Consumption Hours of
2. …resulting in lower
when Young 2. …resulting in higherLeisure
consumption when young consumption when young
and, thus, higher saving. and, thus, lower saving.
How do interest rates affect
household saving?
Thus, 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.
Do the poor prefer to receive cash
or in-kind transfers?
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 on his
consumption and welfare.
Cash versus In-Kind Transfers...
(a) The Constraint Is Not Binding
Food Cash Transfer Food In-Kind Transfer
BC(with $1,000 cash) BC(with $1,000 food stamps)

2 2
BC1 BC1
B B
I2 I2
$1,000 $1,000
A A
I1 I1
0 0
Nonfood Nonfood
Consumption Consumption
Cash versus In-Kind Transfers...
(b) The Constraint Is Binding
Food Cash Transfer Food In-Kind Transfer
BC(with $1,000 cash) BC(with $1,000 food stamps)

2 2
BC1 BC1
C
$1,000 $1,000
B B
I2
A I2 A I1
I1 I3
0 0
Nonfood Nonfood
Consumption Consumption
Summary
◆ A consumer’s budget constraint shows the possible

combinations of different goods he can buy given his
income and the prices of the goods.
◆ The slope of the budget constraint equals the relative
price of the goods.
◆ The consumer’s indifference curves represent his
preferences.
Summary
◆ Points on higher indifference curves are preferred to points
on lower indifference curves.
◆ The slope of an indifference curve at any point is the
consumer’s marginal rate of substitution.
◆ The consumer optimizes by choosing the point on his
budget constraint that lies on the highest indifference
curve.
Summary
◆ When the price of a good falls, the impact on the
consumer’s choices can be broken down into an income
effect and a substitution effect.
◆ The income effect is the change in consumption that
arises because a lower price makes the consumer better
off.
◆ The income effect is reflected by the movement from a
lower to a higher indifference curve.
Summary
◆ The substitution effect is the change in consumption that
arises because a price change encourages greater
consumption of the good that has become relatively cheaper.
◆ The substitution effect is reflected by a movement along an
indifference curve to a point with a different slope.
Summary
◆ The theory of consumer choice can explain:

◆ Why demand curves can potentially slope upward.
◆ How wages affect labor supply.
◆ How interest rates affect household saving.
◆ Whether the poor prefer to receive cash or in-kind transfers.

The Theory of Consumer Choice

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The Theory of Consumer Choice

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Copyright © 2001 by Harcourt, Inc.

◆ Do all demand curves slope

◆ How do interest rates affect household

◆ The budget constraint depicts the consumption

It shows the various combinations of

The Consumer’s Opportunities

◆ Any point on the budget constraint line

◆ Alternately, the consumer can buy

◆ The slope of the budget constraint line

A consumer’s preference among

An indifference curve shows

◆ The consumer is indifferent, or equally

❶ Higher indifference curves are

◆ Consumers usually prefer more of

◆ A consumer is willing to give up one good

◆ Points A and B should make the

◆ People are more willing to trade away

◆ Two goods with straight-line indifference curves are perfect

Two goods with right-angle

◆ Consumers want to get the

◆ Combining the indifference curve and

The consumer chooses consumption of

At the consumer’s optimum, the

◆ An increase in income shifts the budget constraint outward.

1. An increase in income shifts

3. …and Pepsi Initial

◆ If a consumer buys more of a good

1. When an increase in income

A fall in the price of any good

New optimum1. A fall in the price of

◆A price change has two effects on consumption.

The income effect is the change in

The substitution effect is the change in

A price change first causes the

After moving from one point to

Income and Substitution Effects...

New budget constraint

Good I ncome Effect Substitution Effect Total Effect

A consumer’s demand curve can be

◆ Demand curves can sometimes slope

◆ Economists use the term Giffen good to

Optimum with high

◆ If the substitution effect of a higher

An Increase in the Interest Rate...

Thus, an increase in the interest

If an in-kind transfer of a good forces

If the recipient does not consume more

Food Cash Transfer Food In-Kind Transfer

BC(with $1,000 cash) BC(with $1,000 food stamps)

Food Cash Transfer Food In-Kind Transfer

BC(with $1,000 cash) BC(with $1,000 food stamps)

◆ A consumer’s budget constraint shows the possible

◆ The theory of consumer choice can explain:

◆ How interest rates affect household saving.

◆ Whether the poor prefer to receive cash or in-kind transfers.

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