Consumer Choice Theory PDF

## The Theory of Consumer Choice ### Introduction - Consumers face Trade offs - Theory of consumer choice examines trade-offs consumers face - Ex: Buy more of one good = buy less of others, Spend more time on leisure = less income = less consumption - Analyzes how consumers make decisions and r...

## The Theory of Consumer Choice ### Introduction - Consumers face Trade offs - Theory of consumer choice examines trade-offs consumers face - Ex: Buy more of one good = buy less of others, Spend more time on leisure = less income = less consumption - Analyzes how consumers make decisions and respond to changes in their environment. - Applies theory to three key household decisions: - Do all demand curves slope downward? - How do wages affect labor supply? - How interest rates affect household saving? - These questions seemingly unrelated - Theory of consumer choice can be used to address all of them ### 21-1 The Budget Constraint: What the Consumer Can Afford - **Budget constraint** is the limit on consumption bundles a consumer can afford. - Consumers often desire more goods, but income limits how much they can buy. - Simple model: Consumer buys only Pizza and Pepsi (represents all goods and services) - Income = $1,000, Pizza Price = $10, Pepsi Price = $2 - Table and graph show possible combinations of Pizza and Pepsi **Figure 1: The Consumer's Budget Constraint** | Number of Pizzas | Liters of Pepsi | Spending on Pizza | Spending on Pepsi | Total Spending | |---|---|---|---|---| | 100 | 0 | $1,000 | $0 | $1,000 | | 90 | 50 | $900 | $100 | $1,000 | | 80 | 100 | $800 | $200 | $1,000 | | 70 | 150 | $700 | $300 | $1,000 | | 60 | 200 | $600 | $400 | $1,000 | | 50 | 250 | $500 | $500 | $1,000 | | 40 | 300 | $400 | $600 | $1,000 | | 30 | 350 | $300 | $700 | $1,000 | | 20 | 400 | $200 | $800 | $1,000 | | 10 | 450 | $100 | $900 | $1,000 | | 0 | 500 | $0 | $1,000 | $1,000 | - **Budget Constraint** is a line that shows all possible consumption bundles a consumer can afford. - **Slope** of the Budget Constraint reflects the relative price of the goods. - Pizza costs 5 times as much as Pepsi, so one pizza can be traded for 5 liters of Pepsi. - **Slope** of the Budget Constraint is 5 liters per pizza. ### 21-2 Preferences: What the Consumer Wants - Budget Constraint shows what the consumer can afford. - Preferences show the consumer's desires. - **Indifference Curves** show combinations of goods that give the consumer the same level of satisfaction. - The consumer is equally happy with any point on the same Indifference Curve. **Figure 2: The Consumer's Preferences** - Higher Indifference Curves are preferred to lower ones. - **Marginal Rate of Substitution (MRS)** shows the rate at which the consumer is willing to trade one good for another. - Ex: How much Pepsi is the consumer willing to give up to get one extra pizza. - The MRS depends on how much of each good the consumer is already consuming. #### 21-2a Representing Preferences with Indifference Curves - **Properties of Indifference Curves** - Higher indifference curves are preferred: Consumers prefer more goods to less. - They are downward sloping: If the quantity of one good decreases, the quantity of the other must increase to maintain the same level of satisfaction. - They do not cross: Crossing would mean that the consumer is equally happy with two bundles, even though one bundle has more of both goods, contradicting the preference for more. - They are bowed inwards: Reflects the diminishing MRS, meaning the consumer is willing to trade a smaller quantity of the good they have more of to get one more of the good they have less of (ex: willing to give up larger amounts of Pepsi for the first few pizzas than for later pizzas). #### 21-2b Four Properties of Indifference Curves - **Perfect substitutes:** Goods that are easily interchangeable (Ex: Nickels & Dimes). Indifference curves are straight lines, showing a constant MRS. - **Perfect complements:** Goods that must be consumed in a fixed ratio (Ex: Left & Right Shoes). Indifference curves are right angles, showing that additional units of one good have no value without the other. #### 21-2c Two Extreme Examples of Indifference Curves - Most goods are neither perfect substitutes or complements, but have indifference curves that are bowed inward. ### 21-3 Optimization: What the Consumer Chooses - Goal: Find the best combination of goods within the consumer's budget. - Highest Indifference Curve the consumer can reach is tangent (touching) to the Budget Constraint at the **optimum**. **Figure 6: The Consumer's Optimum** - The point where the indifference curve and the budget constraint touch is the optimum. - The slope of the Indifference Curve (MRS) equals the slope of the Budget Constraint (Relative Price). - The consumer values the goods at the same rate as the market. #### 21-3a The Consumer's Optimal Choices - **Utility** is an alternate way to represent preferences. - Utility is the satisfaction a consumer gets from a bundle of goods. - Higher Indifference Curves = Higher Utility - **Marginal Utility:** The extra satisfaction a consumer gets from consuming one more unit of the good. - The MRS equals the ratio of marginal utilities of the two goods. - At the optimum, the marginal utility per dollar is the same for all goods. #### 21-3b How Changes in Income Affect the Consumer's Choices - **Normal good:** A good for which the quantity demanded increases as income increases. - **Inferior good:** A good for which the quantity demanded decreases as income increases. **Figure 7: An Increase in Income** - Increase in income shifts the budget constraint outward, allowing the consumer to buy more of both goods (assuming both goods are normal). - The new optimum is on a higher indifference curve, showing increased satisfaction. **Figure 8: An Inferior Good** - Increase in income shifts the budget constraint outward, leading the consumer to consume more of a normal good (pizza) but less of an inferior good (Pepsi). #### 21-3c How Changes in Price Affect the Consumer's Choices - **Price change** shifts the budget constraint outward and changes its slope. **Figure 9: A Change in Price** - Lower price of Pepsi shifts the budget constraint outward and becomes steeper, meaning the consumer can trade a pizza for a higher quantity of Pepsi. - The new optimum is on a higher indifference curve showing increased satisfaction. #### 21-3d Income and Substitution Effects - **Income Effect:** Change in consumption due to a price change moving the consumer to a higher or lower indifference curve. - **Substitution Effect:** Change in consumption due to a price change, moving the consumer along the same indifference curve to a point with a new MRS. **Table 1: Income and Substitution Effects When the Price of Pepsi Falls** | Good | Income Effect | Substitution Effect | Total Effect | |---|---|---|---| | Pepsi | Consumer is richer, so she buys more Pepsi | Pepsi is relatively cheaper, so consumer buys more Pepsi | Income and substitution effects act in the same direction, so consumer buys more Pepsi. | | Pizza | Consumer is richer, so she buys more pizza | Pizza is relatively more expensive, so consumer buys less pizza. | Income and substitution effects act in opposite directions, so the total effect on pizza consumption is ambiguous. | **Figure 10: Income and Substitution Effects** - When the price of Pepsi falls, the consumer moves from the initial optimum to the new optimum. This change can be broken down into two steps: 1. **Substitution Effect:** The consumer moves along the initial indifference curve to a point with the new MRS, where the indifference curve's slope matches the new relative price. 2. **Income Effect:** Consumer shifts to a higher indifference curve, reflecting the increase in purchasing power due to the price change. - Shows that the consumer will always buy more of the good whose price has fallen, but the impact on the demand for the other good is uncertain. #### 21-3e Deriving the Demand Curve - **Demand Curve:** Shows quantity demanded of a good at different prices. - Arises from the consumer's optimization of their preferences within their budget constraint. **Figure 11: Deriving the Demand Curve** - Panel (a) shows a fall in the price of Pepsi moving the consumer to a new optimum with a higher quantity demanded. - Panel (b) shows the corresponding demand curve reflecting the relationship between price and quantity demanded. ### 21-4 Three Applications The theory of consumer choice can be used to explain: - **Downward sloping demand curves:** When the price of a good decreases, the consumer substitutes the now relatively cheaper good for more expensive goods. - **Labor supply decisions:** Higher wages can lead to both a substitution effect (more earnings = more leisure) and an income effect (more earnings = less need for work). - **Saving and borrowing decisions:** Higher interest rates can lead to a substitution effect (more rewards for saving) and an income effect (more rewards for saving = less need to save). ### Conclusion The Theory of Consumer Choice is a valuable tool for understanding how individuals make decisions given their limited resources, preferences, and changes in prices and income. It provides a framework for analyzing various economic questions and demonstrates the importance of optimizing choices to maximize consumer satisfaction and welfare.