Economics Consumer Choice and Budget Constraints

Opportunity Costs

• The real cost of a good or service is its opportunity cost
• Opportunity cost is determined by relative prices
• The real cost of a good is the value of other goods and services that could've been purchased with the same amount of money

Budget Constraints

• A household's budget constraint is limited by available income
• Prices and income affect the budget constraint
• A decrease in prices, keeping income the same, expands the opportunity set and makes the household better off
• Real income reduces if money income increases but prices increase more

Theory of Consumer Choice: Utility and Preferences

• Theory of consumer choice examines trade-offs faced by consumers
• Utility is the property of a good that helps satisfy human needs
• Total Utility (TU) is the overall satisfaction from consuming a certain quantity of a good
• Marginal Utility (MU) is the extra utility from consuming one additional unit of a good, while holding other commodities constant
• The Law of Diminishing Marginal Utility states that each additional unit of a good consumed eventually gives less and less extra utility
• Cardinal utility assigns specific numerical values to utility
• Ordinal utility ranks the utility received from various amounts of a good

Utility-Maximizing Rule

• Consumers maximize utility by equating the ratio of the marginal utility of a good to its price for all goods
• The consumer will increase utility by spending more on a good with higher MU relative to price, and less on goods with lower MU relative to price
• This rule ensures the consumer's marginal utility per dollar spent is equal across all goods

The Budget Constraint Equation

• The budget constraint equation is PxX + PyY = I
  • Px is the price of good X
  • X is the quantity of good X consumed
  • Py is the price of good Y
  • Y is the quantity of good Y consumed
  • I is household income

Budget Constraint Changes

• A decrease in the price of a good shifts the budget constraint outwards, expanding the opportunity set
• Changes in income also affect the budget constraint.
• Budget constraint shifts outwards with an increase in income, indicating improved purchasing power

Indifference Curves

• Indifference curves show combinations of goods giving a consumer equal levels of satisfaction
• Higher indifference curves represent greater satisfaction
• Indifference curves are typically downward sloping, reflecting tradeoffs between goods to maintain the same utility level
• Indifference curves cannot cross, as this would imply a contradiction in preference rankings
• Indifference curves are bowed inward, or convex to the origin, reflecting the diminishing marginal rate of substitution (MRS) - the consumer is willing to give up less of one good to gain an additional unit of another good as they have more of the latter
• Perfect substitutes have linear indifference curves, implying a constant MRS
• Perfect complements have right-angle indifference curves, representing goods that must be consumed in fixed proportions

Consumer Optimization: Attaining the Highest Utility Level

• Consumers choose the bundle of goods on the highest indifference curve that they can afford
• At the optimum, the slope of the indifference curve equals the slope of the budget constraint
• This occurs where MRS = Price Ratio (Px/Py)

Income and Substitution Effects

• A decrease in the price of a good has both an income effect and a substitution effect
• The Income Effect: The consumer has more purchasing power, leading to increased consumption of both goods if they are normal goods
• The Substitution Effect: The price difference makes the good relatively cheaper, encouraging greater consumption of that good

Applications in Intertemporal Consumption

• The interest rate acts as the relative price of consumption in period 1 versus consumption in period 2.
• A higher interest rate encourages saving and increases the relative price of consumption in the current period.

This quiz explores key concepts in economics such as opportunity costs, budget constraints, and the theory of consumer choice. Understand how these principles influence consumer decisions and the satisfaction derived from goods and services. Test your knowledge on utility and preferences as well as how income and prices interact.