Consumer Choice Theory PDF

7 TOPICS FOR FURTHER STUDY  The Theory of Consumer Choice 21 Copyright©2004 South-Western  The theory of consumer choice addresses the following questions: Do all demand curves slope downward? How do wages affect labor supply? How do interes...

7 TOPICS FOR FURTHER STUDY  The Theory of Consumer Choice 21 Copyright©2004 South-Western  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? Copyright©2004 South-Western  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. Copyright©2004 South-Western  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. Copyright©2004 South-Western The Consumer’s Budget Constraint Copyright©2004 South-Western  THE BUDGET CONSTRAINT: WHAT THE CONSUMER CAN AFFORD 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). Copyright©2004 South-Western Figure 1 The Consumer’s Budget Constraint Quantity of Pepsi B 500 Consumer’s budget constraint A 0 100 Quantity of Pizza Copyright©2004 South-Western  THE BUDGET CONSTRAINT: WHAT THE CONSUMER CAN AFFORD The Consumer’s Budget Constraint Alternately, the consumer can buy 50 pizzas and 250 pints of Pepsi. Copyright©2004 South-Western 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. Copyright©2004 South-Western  PREFERENCES: WHAT THE CONSUMER WANTS A consumer’s preference among consumption bundles may be illustrated with indifference curves. Copyright©2004 South-Western Representing Preferences with Indifference Curves An indifference curve is a curve that shows consumption bundles that give the consumer the same level of satisfaction. Copyright©2004 South-Western  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. Copyright©2004 South-Western  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. Copyright©2004 South-Western 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. Copyright©2004 South-Western  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. Copyright©2004 South-Western  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. Copyright©2004 South-Western  Figure 3 The Impossibility of Intersecting Indifference Curves Quantity of Pepsi C A B 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. Copyright©2004 South-Western  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 Two Extreme Examples of Indifference Curves Perfect substitutes Perfect complements Copyright©2004 South-Western 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. Copyright©2004 South-Western Figure 5 Perfect Substitutes and Perfect Complements (a) Perfect Substitutes Nickels 6 4 2 I1 I2 I3 0 1 2 3 Dimes Copyright©2004 South-Western Two Extreme Examples of Indifference Curves Perfect Complements Two goods with right-angle indifference curves are perfect complements. Copyright©2004 South-Western Figure 5 Perfect Substitutes and Perfect Complements (b) Perfect Complements Left Shoes I2 7 5 I1 0 5 7 Right Shoes Copyright©2004 South-Western  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. Copyright©2004 South-Western 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. Copyright©2004 South-Western The Consumer’s Optimal Choice The consumer chooses consumption of the two goods so that the marginal rate of substitution equals the relative price. Copyright©2004 South-Western The Consumer’s Optimal Choice At the consumer’s optimum, the consumer’s valuation of the two goods equals the market’s valuation. Copyright©2004 South-Western  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. Copyright©2004 South-Western 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... Copyright©2004 South-Western 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. Copyright©2004 South-Western 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... Copyright©2004 South-Western 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. Copyright©2004 South-Western 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 Copyright©2004 South-Western 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. Copyright©2004 South-Western 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. Copyright©2004 South-Western  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 Table 1 Income and Substitution Effects When the Price of Pepsi Falls Copyright©2004 South-Western 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. Copyright©2004 South-Western  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 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. Copyright©2004 South-Western 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 Copyright©2004 South-Western  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. Copyright©2004 South-Western  Figure 13 The Work-Leisure Decision Consumption $5,000 Optimum I3 2,000 I2 I1 0 60 100 Hours of Leisure Copyright©2004 South-Western  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 Copyright©2004 South-Western  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 Copyright©2004 South-Western  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. Copyright©2004 South-Western  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 Copyright©2004 South-Western  Figure 16 An Increase in the Interest Rate (a) Higher Interest Rate Raises Saving (b) Higher Interest Rate Lowers Saving Consumption Consumption when Old BC when Old BC 2 2 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. Copyright©2004 South-Western  THREE APPLICATIONS Thus, an increase in the interest rate could either encourage or discourage saving. Copyright©2004 South-Western  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. Copyright©2004 South-Western  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. Copyright©2004 South-Western  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. Copyright©2004 South-Western  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. Copyright©2004 South-Western  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. Copyright©2004 South-Western