The Theory of

Consumer Choice
21
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 Theory of Consumer Choice
• When entering a store, you want to buy a multiple of desirable
things, but can not
• Why?
• What do you focus on then
• What combination you finally buy
• Theory of consumer choice helps understand how consumers
decide what to buy
• So far, consumers’ decisions summarised by demand curve
• Now we look at what lies behind the demand curve
• Principle of Economics: People face trade-offs
• When you buy more of one good, you can buy less of another good
• Example: leisure vs. consumption
• Present consumption vs. future consumption
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Budget Constraint

• What the consumer can afford

• We all want more and of better quality
• But spending is constrained
• Link between income and spending
• We model this constraint or link through a budget constraint
• The budget constraint shows all the combinations of different goods
which are affordable given the prices and income

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Budget Constraint

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 Budget Constraint
Quantity
of Pepsi

B
500

Consumer’s
budget constraint

A
0 100 Quantity
of Pizza

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 Slope of the Budget 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

can trade one good for the other.

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Consumer Preferences: Indifference Curves

• Goal: to understand how consumers choose from amongst

different bundles of good
• 1st Step: What different bundle of goods they can afford given
income and prices i.e. what are the available choices
• This information is represented by the budget constraint
• 2nd Step: From within the available choices and combinations,
which does the consumer most prefer
• Now we develop a framework to analyse consumer preferences

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 Consumer Preferences: Indifference Curves

• A consumer’s preference among consumption bundles may be

illustrated with indifference curves
• Consumers’ preferences allow them to choose from amongst
different options of consumption bundles
• 2Pizza 2Pepsi 4Pizza 1Pepsi ½Pizza 3Pepsi
• There must be some consumption bundles (combinations of
Pepsi and Pizza) amongst which the consumer is indifferent
• 2Pizza 2Pepsi: If I take away 1Pizza, there must be some amount of
additional Pepsi that will make you indifferent (i.e. equally happy)
• An Indifference curve represents all those combinations of
Pizza and Pepsi that a consumer values equally

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 Indifference curve

Quantity
of Pepsi
Remember: Every point on the
IC represents equal satisfaction

Indifference
curve

0 Quantity
of Pizza
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Slope of the IC

• Marginal Rate of Substitution (MRS): Rate at which the

consumer is willing to substitute one good for another, in order
to still have the same level of satisfaction

• It is the amount of one good that a consumer requires as

compensation to give up one unit of the other good.

• MRS / Slope Changes:

• The rate at which consumer is willing to trade between goods to maintain
overall same level of satisfaction depends on how much of the particular
good he already has

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Four Properties of ICs

• Higher indifference curves are preferred to

lower ones.
• Indifference curves are downward sloping.
• Indifference curves do not cross.
• Indifference curves are bowed inward.

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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.
• Higher IC always represent more satisfaction than a
lower IC does

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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.

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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.

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 Figure 3 The Impossibility of Intersecting Indifference
Curves

Quantity
of Pepsi

0 Quantity
of Pizza
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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.

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 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
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Two Extreme Examples of Indifference
Curves
• Perfect substitutes
• Two goods with straight-line indifference curves are perfect
substitutes.
• The marginal rate of substitution is a fixed number.
• Perfect complements
• Two goods with right-angle indifference curves are perfect
complements.

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Figure 5 Perfect Substitutes and Perfect Complements

(a) Perfect Substitutes

Nickels

I1 I2 I3
0 1 2 3 Dimes

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Figure 5 Perfect Substitutes and Perfect Complements

(b) Perfect Complements

Left
Shoes

I2
7

5 I1

0 5 7 Right Shoes

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 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.

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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.

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The Consumer’s Optimal Choice

• The consumer chooses consumption of the two

goods so that the marginal rate of substitution
equals the relative price.

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The Consumer’s Optimal Choice

• At the consumer’s optimum, the consumer’s

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

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 Figure 6 The Consumer’s Optimum

Quantity
of Pepsi

Optimum

B
A

I3
I2
I1

Budget constraint
0 Quantity
of Pizza
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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.

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Figure 7 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
consumption. Initial
optimum I2

Initial
budget
I1
constraint

0 Quantity
of Pizza
2. . . . raising pizza consumption . . .

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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.

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Figure 8 An Inferior Good

Quantity
of Pepsi New budget constraint

1. When an increase in income shifts the

3. . . . but budget constraint outward . . .
Initial
Pepsi
optimum
consumption
falls, making
New optimum
Pepsi an
inferior good.

Initial
budget I1 I2
constraint
0 Quantity
of Pizza
2. . . . pizza consumption rises, making pizza a normal good . . .

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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.

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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 . . .

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Income and Substitution Effects

• A price change has two effects on consumption.

• An income effect
• A substitution effect

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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.

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 Figure 9 A Change in Price

Quantity
of Pepsi

1,000

B 500

C Initial optimum

I1
A

0 100 Quantity
of Pizza

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 Figure 10 Income and Substitution Effects

Quantity
of Pepsi

New budget constraint

C New optimum
Income
effect B
Initial optimum
Substitution Initial
effect budget
constraint A
I2

I1
0 Quantity
Substitution effect of Pizza
Income effect Copyright©2004 South-Western
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Table 1 Income and Substitution Effects When the
Price of Pepsi Falls

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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.

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 Figure 11 Deriving the Demand Curve

(a) The Consumer’s Optimum (b) The Demand Curve for Pepsi

Quantity Price of
of Pepsi New budget constraint Pepsi

B A
750 $2

I2
B
1
A
250 Demand
I1

0 Initial budget Quantity 0 250 750 Quantity

constraint of Pizza of Pepsi

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 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.
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Figure 12 A Giffen Good

Quantity of
Potatoes Initial budget constraint
B

Optimum with high

price of potatoes
Optimum with low
D price of potatoes
E
2. . . . which 1. An increase in the price of
increases C potatoes rotates the budget
potato constraint inward . . .
consumption
if potatoes I1
are a Giffen New budget I2
good. constraint
0 A Quantity
of Meat
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 THREE APPLICATIONS
• 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.

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 Figure 15 The Consumption-Saving Decision

Consumption Budget
when Old constraint

$110,000

55,000 Optimum

I3

I2

I1
0 $50,000 100,000 Consumption
when Young

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 Figure 16 An Increase in the Interest Rate

(a) Higher Interest Rate Raises Saving (b) Higher Interest Rate Lowers Saving

Consumption Consumption
when Old BC2 when Old BC2
1. A higher interest rate rotates
1. A higher interest rate rotates the budget constraint outward . . .
the budget constraint outward . . .

BC1 BC1

I2

I1 I2
I1
0 Consumption 0 Consumption
2. . . . resulting in lower when Young 2. . . . resulting in higher when Young
consumption when young consumption when young
and, thus, higher saving. and, thus, lower saving.

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 THREE APPLICATIONS
• Thus, an increase in the interest rate could
either encourage or discourage saving.

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 THREE APPLICATIONS
• 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.

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 Figure 13 The Work-Leisure Decision

Consumption

$5,000

Optimum

I3
2,000
I2

I1

0 60 100 Hours of Leisure

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 Figure 14 An Increase in the Wage

(a) For a person with these preferences. . . . . . the labor supply curve slopes upward.

Consumption Wage

Labor
supply

1. When the wage rises . . .

BC1

BC2 I2

I1
0 Hours of 0 Hours of Labor
2. . . . hours of leisure decrease . . . Leisure 3. . . . and hours of labor increase. Supplied

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 Figure 14 An Increase in the Wage

(b) For a person with these preferences. . . . . . the labor supply curve slopes backward.

Consumption Wage

BC2
1. When the wage rises . . .

Labor
BC1 supply

I2
I1

0 Hours of 0 Hours of Labor

2. . . . hours of leisure increase . . . Leisure 3. . . . and hours of labor decrease. Supplied

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