Chapter 21: Consumer Choice (Principles of Microeconomics 7th Edition) PDF

Chapter 21 The Theory of Consumer Choice W hen you walk into a store, you are confronted with thousands of goods that you might buy. Because your financial resources are limited, however, you cannot buy everything that you want. You therefore consider the prices of the various goods offered for sale and buy a bundle of goods that, given your resources, best suits your needs and desires. In this chapter, we develop a theory that describes how consumers make decisions about what to buy. Thus far in this book, we have summarized consumers’ decisions with the demand curve. As we have seen, the demand curve for a good reflects consumers’ willingness to pay for it. When the price of a good rises, consumers are willing to pay for fewer units, so the quantity demanded falls. We now look more deeply at the decisions that lie behind the demand curve. The theory of consumer choice presented in this chapter provides a more complete understanding of demand, just as the theory of the competi- tive firm in Chapter 14 provides a more complete understanding of supply. 435 Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 436 PART VII TOPICS FOR FURTHER STUDY One of the Ten Principles of Economics discussed in Chapter 1 is that people face trade-offs. The theory of consumer choice examines the trade-offs that people face in their role as consumers. When a consumer buys more of one good, she can afford less of other goods. When she spends more time enjoying leisure and less time working, she has lower income and can afford less consumption. When she spends more of her income in the present and saves less of it, she must accept a lower level of consumption in the future. The theory of consumer choice examines how consumers facing these trade-offs make decisions and how they respond to changes in their environment. After developing the basic theory of consumer choice, we apply it to three questions about household decisions. In particular, we ask: Do all demand curves slope downward? How do wages affect labor supply? How do interest rates affect household saving? At first, these questions might seem unrelated. But as we will see, we can use the theory of consumer choice to address each of them. 21-1 The Budget Constraint: What the Consumer Can Afford Most people would like to increase the quantity or quality of the goods they consume—to take longer vacations, drive fancier cars, or eat at better restaurants. People consume less than they desire because their spending is constrained, or limited, by their income. We begin our study of consumer choice by examining this link between income and spending. To keep things simple, we examine the decision facing a consumer who buys only two goods: pizza and Pepsi. Of course, real people buy thousands of different kinds of goods. Assuming there are only two goods greatly simplifies the problem without altering the basic insights about consumer choice. We first consider how the consumer ’s income constrains the amount she spends on pizza and Pepsi. Suppose the consumer has an income of $1,000 per month and she spends her entire income on pizza and Pepsi. The price of a pizza is $10, and the price of a liter of Pepsi is $2. The table in Figure 1 shows some of the many combinations of pizza and Pepsi that the consumer can buy. The first row in the table shows that if the consumer spends all her income on pizza, she can eat 100 pizzas during the month, but she would not be able to buy any Pepsi at all. The second row shows another possible consumption bundle: 90 pizzas and 50 liters of Pepsi. And so on. Each consumption bundle in the table costs exactly $1,000. The graph in Figure 1 illustrates the consumption bundles that the consumer can choose. The vertical axis measures the number of liters of Pepsi, and the horizontal axis measures the number of pizzas. Three points are marked on this figure. At point A, the consumer buys no Pepsi and consumes 100 pizzas. At point B, the consumer buys no pizza and consumes 500 liters of Pepsi. At point C, the budget constraint consumer buys 50 pizzas and 250 liters of Pepsi. Point C, which is exactly at the the limit on the middle of the line from A to B, is the point at which the consumer spends an equal consumption bundles amount ($500) on pizza and Pepsi. These are only three of the many combinations that a consumer can of pizza and Pepsi that the consumer can choose. All the points on the line from A afford to B are possible. This line, called the budget constraint, shows the consumption Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. CHAPTER 21 THE THEORY OF CONSUMER CHOICE 437 The budget constraint shows the various bundles of goods that the consumer can buy for a given income. Here the consumer buys bundles of pizza and Pepsi. The table and graph show FIGURE 1 what the consumer can afford if her income is $1,000, the price of pizza is $10, and the The Consumer’s Budget price of Pepsi is $2. Constraint Number Liters Spending Spending Total Quantity of Pizzas of Pepsi on Pizza on Pepsi Spending of Pepsi 100 0 $1,000 $ 0 $1,000 B 500 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 C 250 30 350 300 700 1,000 20 400 200 800 1,000 Consumer’s 10 450 100 900 1,000 budget constraint 0 500 0 1,000 1,000 A 0 50 100 Quantity of Pizza bundles that the consumer can afford. In this case, it shows the trade-off between pizza and Pepsi that the consumer faces. The slope of the budget constraint measures the rate at which the consumer can trade one good for the other. Recall that the slope between two points is calculated as the change in the vertical distance divided by the change in the horizontal distance (“rise over run”). From point A to point B, the vertical distance is 500 liters, and the horizontal distance is 100 pizzas. Thus, the slope is 5 liters per pizza. (Actually, because the budget constraint slopes downward, the slope is a negative number. But for our purposes we can ignore the minus sign.) Notice that the slope of the budget constraint equals the relative price of the two goods—the price of one good compared to the price of the other. A pizza costs five times as much as a liter of Pepsi, so the opportunity cost of a pizza is 5 liters of Pepsi. The budget constraint’s slope of 5 reflects the trade-off the market is offer- ing the consumer: 1 pizza for 5 liters of Pepsi. Quick Quiz Draw the budget constraint for a person with income of $1,000 if the price of Pepsi is $5 and the price of pizza is $10. What is the slope of this budget constraint? 21-2 Preferences: What the Consumer Wants Our goal in this chapter is to see how consumers make choices. The budget constraint is one piece of the analysis: It shows the combinations of goods the consumer can afford given her income and the prices of the goods. The consumer’s Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 438 PART VII TOPICS FOR FURTHER STUDY choices, however, depend not only on her budget constraint but also on her preferences regarding the two goods. Therefore, the consumer’s preferences are the next piece of our analysis. 21-2a Representing Preferences with Indifference Curves The consumer’s preferences allow her to choose among different bundles of pizza and Pepsi. If you offer the consumer two different bundles, she chooses the bundle that best suits her tastes. If the two bundles suit her tastes equally well, we say that the consumer is indifferent between the two bundles. Just as we have represented the consumer’s budget constraint graphically, we can also represent her preferences graphically. We do this with indifference indifference curve curves. An indifference curve shows the various bundles of consumption that a curve that shows make the consumer equally happy. In this case, the indifference curves show the consumption bundles combinations of pizza and Pepsi with which the consumer is equally satisfied. that give the consumer Figure 2 shows two of the consumer’s many indifference curves. The consumer the same level of is indifferent among combinations A, B, and C because they are all on the same satisfaction curve. Not surprisingly, if the consumer’s consumption of pizza is reduced, say, from point A to point B, consumption of Pepsi must increase to keep her equally happy. If consumption of pizza is reduced again, from point B to point C, the amount of Pepsi consumed must increase yet again. The slope at any point on an indifference curve equals the rate at which the consumer is willing to substitute one good for the other. This rate is called the marginal rate of marginal rate of substitution (MRS). In this case, the marginal rate of substitution substitution measures how much Pepsi the consumer requires to be compensated for a one- the rate at which a unit reduction in pizza consumption. Notice that because the indifference curves consumer is willing are not straight lines, the marginal rate of substitution is not the same at all points to trade one good for on a given indifference curve. The rate at which a consumer is willing to trade another one good for the other depends on the amounts of the goods she is already consuming. That is, the rate at which a consumer is willing to trade pizza for Pepsi depends on whether she is hungrier or thirstier, which in turn depends on how much pizza and Pepsi she is consuming. The consumer is equally happy at all points on any given indifference curve, but she prefers some indifference curves to others. Because she prefers more FIGURE 2 Quantity of Pepsi The Consumer’s Preferences C The consumer’s preferences are represented with indifference curves, which show the combinations of pizza and Pepsi that make the consumer equally satisfied. Because the consumer prefers more of a good, points on a higher indifference curve (I2 B D here) are preferred to points on a lower indiffer- MRS I2 ence curve (I1). The marginal rate of substitution 1 (MRS) shows the rate at which the consumer is Indifference A willing to trade Pepsi for pizza. It measures the curve, I 1 quantity of Pepsi the consumer must be given in 0 Quantity exchange for 1 pizza. of Pizza Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. CHAPTER 21 THE THEORY OF CONSUMER CHOICE 439 consumption to less, higher indifference curves are preferred to lower ones. In Figure 2, any point on curve I2 is preferred to any point on curve I1. A consumer ’s set of indifference curves gives a complete ranking of the consumer’s preferences. That is, we can use the indifference curves to rank any two bundles of goods. For example, the indifference curves tell us that point D is preferred to point A because point D is on a higher indifference curve than point A. (That conclusion may be obvious, however, because point D offers the consumer both more pizza and more Pepsi.) The indifference curves also tell us that point D is preferred to point C because point D is on a higher indifference curve. Even though point D has less Pepsi than point C, it has more than enough extra pizza to make the consumer prefer it. By seeing which point is on the higher indifference curve, we can use the set of indifference curves to rank any combination of pizza and Pepsi. 21-2b Four Properties of Indifference Curves Because indifference curves represent a consumer’s preferences, they have certain properties that reflect those preferences. Here we consider four properties that describe most indifference curves: Property 1: Higher indifference curves are preferred to lower ones. People usually prefer to consume more goods rather than less. This preference for greater quantities is reflected in the indifference curves. As Figure 2 shows, higher indifference curves represent larger quantities of goods than lower indifference curves. Thus, the consumer prefers being on higher indifference curves. Property 2: Indifference curves are downward sloping. The slope of an indifference curve reflects the rate at which the consumer is willing to substitute one good for the other. In most cases, the consumer likes both goods. Therefore, if the quantity of one good is reduced, the quantity of the other good must increase for the consumer to be equally happy. For this reason, most indifference curves slope downward. Property 3: Indifference curves do not cross. To see why this is true, suppose that two indifference curves did cross, as in Figure 3. Then, because point A is on the same indifference curve as point B, the two points would make the consumer equally happy. In addition, because point B is on the same Quantity of Pepsi FIGURE 3 The Impossibility of Intersecting C Indifference Curves A situation like this can A never happen. According to these indifference curves, the consumer would be equally B satisfied at points A, B, and C, even though point C has more of both goods than point A. 0 Quantity of Pizza Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 440 PART VII TOPICS FOR FURTHER STUDY i ndifference curve as point C, these two points would make the consumer equally happy. But these conclusions imply that points A and C would also make the consumer equally happy, even though point C has more of both goods. This contradicts our assumption that the consumer always prefers more of both goods to less. Thus, indifference curves cannot cross. Property 4: Indifference curves are bowed inward. The slope of an indifference curve is the marginal rate of substitution—the rate at which the consumer is willing to trade off one good for the other. The marginal rate of substitution usually depends on the amount of each good the consumer is currently consuming. In particular, because 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, the indifference curves are bowed inward. As an example, consider Figure 4. At point A, because the consumer has a lot of Pepsi and only a little pizza, she is very hungry but not very thirsty. To induce the consumer to give up 1 pizza, she has to be given 6 liters of Pepsi: The marginal rate of substitution is 6 liters per pizza. By contrast, at point B, the consumer has little Pepsi and a lot of pizza, so she is very thirsty but not very hungry. At this point, she would be willing to give up 1 pizza to get 1 liter of Pepsi: The marginal rate of substitution is 1 liter per pizza. Thus, the bowed shape of the indifference curve reflects the consumer’s greater willingness to give up a good that she already has in large quantity. 21-2c Two Extreme Examples of Indifference Curves The shape of an indifference curve tells us about the consumer’s willingness to trade one good for the other. When the goods are easy to substitute for each other, the indifference curves are less bowed; when the goods are hard to substitute, the indifference curves are very bowed. To see why this is true, let’s consider the extreme cases. FIGURE 4 Quantity of Pepsi Bowed Indifference Curves 14 Indifference curves are usually bowed inward. This shape implies that the marginal rate of MRS = 6 substitution (MRS) depends on the quantity of the two goods the consumer is consuming. At point A, A 8 the consumer has little pizza and 1 much Pepsi, so she requires a lot of extra Pepsi to induce her to give up one of the pizzas: The marginal rate of substitution is 6 liters of Pepsi 4 MRS = 1 B per pizza. At point B, the consumer 3 1 has much pizza and little Pepsi, so Indifference she requires only a little extra Pepsi curve to induce her to give up one of the pizzas: The marginal rate of substi- 0 2 3 6 7 Quantity tution is 1 liter of Pepsi per pizza. of Pizza Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. CHAPTER 21 THE THEORY OF CONSUMER CHOICE 441 Perfect Substitutes Suppose that someone offered you bundles of nickels and dimes. How would you rank the different bundles? Most likely, you would care only about the total monetary value of each bundle. If so, you would always be willing to trade 2 nickels for 1 dime, regardless of the number of nickels and dimes in the bundle. Your marginal rate of substitution between nickels and dimes would be a fixed number—2. We can represent your preferences over nickels and dimes with the indifference curves in panel (a) of Figure 5. Because the marginal rate of substitution is constant, the indifference curves are straight lines. In this extreme case of straight indifference curves, we say that the two goods are perfect substitutes. perfect substitutes two goods with straight- Perfect Complements Suppose now that someone offered you bundles of shoes. line indifference curves Some of the shoes fit your left foot, others your right foot. How would you rank these different bundles? In this case, you might care only about the number of pairs of shoes. In other words, you would judge a bundle based on the number of pairs you could assem- ble from it. A bundle of 5 left shoes and 7 right shoes yields only 5 pairs. Getting 1 more right shoe has no value if there is no left shoe to go with it. We can represent your preferences for right and left shoes with the indifference curves in panel (b) of Figure 5. In this case, a bundle with 5 left shoes and 5 right shoes is just as good as a bundle with 5 left shoes and 7 right shoes. It is also just as good as a bundle with 7 left shoes and 5 right shoes. The indifference curves, therefore, are right angles. In this extreme case of right-angle indifference curves, we say that the two goods are perfect complements. perfect complements In the real world, of course, most goods are neither perfect substitutes (like two goods with right- nickels and dimes) nor perfect complements (like right shoes and left shoes). angle indifference curves More typically, the indifference curves are bowed inward, but not so bowed that they become right angles. When two goods are easily substitutable, such as nickels and dimes, the indifference curves are straight lines, as shown in panel (a). When two goods are strongly complementary, such FIGURE 5 as left shoes and right shoes, the indifference curves are right angles, as shown in panel (b). Perfect Substitutes and Perfect Complements (a) Perfect Substitutes (b) Perfect Complements Nickels Left Shoes 6 4 I2 7 5 I1 2 I1 I2 I3 0 1 2 3 Dimes 0 5 7 Right Shoes Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 442 PART VII TOPICS FOR FURTHER STUDY Quick Quiz Draw some indifference curves for pizza and Pepsi. Explain the four properties of these indifference curves. 21-3 Optimization: What the Consumer Chooses The goal of this chapter is to understand how a consumer makes choices. We have the two pieces necessary for this analysis: the consumer’s budget constraint (how much she can afford to spend) and the consumer’s preferences (what she wants to spend it on). Now we put these two pieces together and consider the consumer’s decision about what to buy. 21-3a The Consumer’s Optimal Choices Consider once again our pizza and Pepsi example. The consumer would like to end up with the best possible combination of pizza and Pepsi for her—that is, the combination on her highest possible indifference curve. But the consumer must also end up on or below her budget constraint, which measures the total resources available to her. Figure 6 shows the consumer’s budget constraint and three of her many indifference curves. The highest indifference curve that the consumer can reach (I2 in the figure) is the one that just barely touches her budget constraint. The point at which this indifference curve and the budget constraint touch is called the optimum. The consumer would prefer point A, but she cannot afford that point because it lies above her budget constraint. The consumer can afford point B, but that point is on a lower indifference curve and, therefore, provides the consumer less satisfaction. The optimum represents the best combination of pizza and Pepsi available to the consumer. Notice that, at the optimum, the slope of the indifference curve equals the slope of the budget constraint. We say that the indifference curve is tangent to the budget constraint. The slope of the indifference curve is the marginal rate of FIGURE 6 Quantity of Pepsi The Consumer’s Optimum The consumer chooses the point on her budget constraint that lies on the Optimum highest indifference curve. At this point, B called the optimum, the marginal rate of A substitution equals the relative price of the two goods. Here the highest indiffer- I3 ence curve the consumer can reach is I2. I2 The consumer prefers point A, which lies I1 on indifference curve I3, but she cannot afford this bundle of pizza and Pepsi. Budget constraint By contrast, point B is affordable, but 0 Quantity because it lies on a lower indifference of Pizza curve, the consumer does not prefer it. Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. CHAPTER 21 THE THEORY OF CONSUMER CHOICE 443 substitution between pizza and Pepsi, and the slope of the budget constraint is the relative price of pizza and Pepsi. Thus, the consumer chooses consumption of the two goods so that the marginal rate of substitution equals the relative price. In Chapter 7, we saw how market prices reflect the marginal value that consumers place on goods. This analysis of consumer choice shows the same result in another way. In making her consumption choices, the consumer takes as given the relative price of the two goods and then chooses an optimum at which her marginal rate of substitution equals this relative price. The relative price is the rate at which the market is willing to trade one good for the other, whereas the marginal rate of substitution is the rate at which the consumer is willing to trade one good for the other. At the consumer’s optimum, the consumer’s valuation of the two goods (as measured by the marginal rate of substitution) equals the market’s valuation (as measured by the relative price). As a result of this consumer optimization, market prices of different goods reflect the value that consumers place on those goods. F YI Utility: An Alternative Way to Describe Preferences and Optimization W e have used indifference curves to represent the consumer’s preferences. Another common way to represent preferences is with the concept of utility. Utility is an abstract measure of the satisfaction or substitution equals the ratio of prices. That is, MRS = PX / PY. happiness that a consumer receives from a bundle of goods. Econo- mists say that a consumer prefers one bundle of goods to another if one Because the marginal rate of substitution equals the ratio of marginal provides more utility than the other. utilities, we can write this condition for optimization as Indifference curves and utility are closely related. Because the con- MUX / MUY = PX / PY. sumer prefers points on higher indifference curves, bundles of goods on higher indifference curves provide higher utility. Because the consumer Now rearrange this expression to become is equally happy with all points on the same indifference curve, all MUX / PX = MUY / PY. these bundles provide the same utility. You can think of an indifference curve as an “equal-utility” curve. This equation has a simple interpretation: At the optimum, the marginal The marginal utility of any good is the increase in utility that the utility per dollar spent on good X equals the marginal utility per dol- consumer gets from an additional unit of that good. Most goods are lar spent on good Y. (Why? If this equality did not hold, the consumer assumed to exhibit diminishing marginal utility: The more of the good could increase utility by spending less on the good that provided lower the consumer already has, the lower the marginal utility provided by an marginal utility per dollar and more on the good that provided higher extra unit of that good. marginal utility per dollar.) The marginal rate of substitution between two goods depends on When economists discuss the theory of consumer choice, they some- their marginal utilities. For example, if the marginal utility of good X is times express the theory using different words. One economist might twice the marginal utility of good Y, then a person would need 2 units of say that the goal of the consumer is to maximize utility. Another econo- good Y to compensate for losing 1 unit of good X, and the marginal rate mist might say that the goal of the consumer is to end up on the high- of substitution equals 2. More generally, the marginal rate of substitu- est possible indifference curve. The first economist would conclude that tion (and thus the slope of the indifference curve) equals the marginal at the consumer’s optimum, the marginal utility per dollar is the same utility of one good divided by the marginal utility of the other good. for all goods, whereas the second would conclude that the indifference Utility analysis provides another way to describe consumer optimi- curve is tangent to the budget constraint. In essence, these are two zation. Recall that, at the consumer’s optimum, the marginal rate of ways of saying the same thing. Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 444 PART VII TOPICS FOR FURTHER STUDY 21-3b How Changes in Income Affect the Consumer’s Choices Now that we have seen how the consumer makes a consumption decision, let’s examine how this decision responds to changes in the consumer’s income. To be specific, suppose that income increases. With higher income, the consumer can afford more of both goods. The increase in income, therefore, shifts the budget constraint outward, as in Figure 7. Because the relative price of the two goods has not changed, the slope of the new budget constraint is the same as the slope of the initial budget constraint. That is, an increase in income leads to a parallel shift in the budget constraint. The expanded budget constraint allows the consumer to choose a better combination of pizza and Pepsi, one that is on a higher indifference curve. Given the shift in the budget constraint and the consumer’s preferences as represented by her indifference curves, the consumer’s optimum moves from the point labeled “initial optimum” to the point labeled “new optimum.” Notice that, in Figure 7, the consumer chooses to consume more Pepsi and more pizza. The logic of the model does not require increased consumption of both normal good goods in response to increased income, but this situation is the most common. a good for which an As you may recall from Chapter 4, if a consumer wants more of a good when her increase in income raises income rises, economists call it a normal good. The indifference curves in Figure 7 the quantity demanded are drawn under the assumption that both pizza and Pepsi are normal goods. Figure 8 shows an example in which an increase in income induces the con- inferior good sumer to buy more pizza but less Pepsi. If a consumer buys less of a good when a good for which an her income rises, economists call it an inferior good. Figure 8 is drawn under the increase in income assumption that pizza is a normal good and Pepsi is an inferior good. reduces the quantity Although most goods are normal goods, there are some inferior goods in the demanded world. One example is bus rides. As income increases, consumers are more likely FIGURE 7 Quantity of Pepsi New budget constraint An Increase in Income When the consumer’s income rises, the budget 1. An increase in income shifts the constraint shifts outward. budget constraint outward... If both goods are normal goods, the consumer New optimum responds to the increase in income by buying more 3.... and of both of them. Here the raising Pepsi consumption. Initial consumer buys more pizza optimum I2 and more Pepsi. Initial budget I1 constraint 0 Quantity of Pizza 2.... raising pizza consumption... Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. CHAPTER 21 THE THEORY OF CONSUMER CHOICE 445 Quantity of Pepsi New budget constraint FIGURE 8 An Inferior Good A good is inferior if the consumer buys less of it when her income rises. Here Pepsi is an inferior good: 1. When an increase in income shifts the When the consumer’s income 3.... but budget constraint outward... Initial increases and the budget Pepsi consumption optimum constraint shifts outward, falls, making the consumer buys more New optimum pizza but less Pepsi. Pepsi an inferior good. Initial budget I1 I2 constraint 0 Quantity of Pizza 2.... pizza consumption rises, making pizza a normal good... to own cars or take taxis and less likely to ride the bus. Bus rides, therefore, are an inferior good. 21-3c How Changes in Prices Affect the Consumer’s Choices Let’s now use this model of consumer choice to consider how a change in the price of one of the goods alters the consumer’s choices. Suppose, in particular, that the price of Pepsi falls from $2 to $1 per liter. It is no surprise that the lower price expands the consumer’s set of buying opportunities. In other words, a fall in the price of any good shifts the budget constraint outward. Figure 9 considers more specifically how the fall in price affects the budget constraint. If the consumer spends her entire $1,000 income on pizza, then the price of Pepsi is irrelevant. Thus, point A in the figure stays the same. Yet if the consumer spends her entire income of $1,000 on Pepsi, she can now buy 1,000 rather than only 500 liters. Thus, the end point of the budget constraint moves from point B to point D. Notice that in this case the outward shift in the budget constraint changes its slope. (This differs from what happened previously when prices stayed the same but the consumer’s income changed.) As we have discussed, the slope of the budget constraint reflects the relative price of pizza and Pepsi. Because the price of Pepsi has fallen to $1 from $2, while the price of pizza has remained $10, the consumer can now trade a pizza for 10 rather than 5 liters of Pepsi. As a result, the new budget constraint has a steeper slope. How such a change in the budget constraint alters the consumption of both goods depends on the consumer’s preferences. For the indifference curves drawn in this figure, the consumer buys more Pepsi and less pizza. Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 446 PART VII TOPICS FOR FURTHER STUDY FIGURE 9 Quantity of Pepsi A Change in Price D New budget constraint When the price of Pepsi 1,000 falls, the consumer’s budget constraint shifts outward and changes slope. The consumer moves from the initial optimum to the new New optimum optimum, which changes B 1. A fall in the price of Pepsi rotates her purchases of both pizza 500 the budget constraint outward... and Pepsi. In this case, the 3.... and quantity of Pepsi consumed raising Pepsi Initial optimum rises, and the quantity of consumption. pizza consumed falls. Initial I2 budget I1 constraint A 0 100 Quantity of Pizza 2.... reducing pizza consumption... 21-3d Income and Substitution Effects The impact of a change in the price of a good on consumption can be decomposed income effect into two effects: an income effect and a substitution effect. To see what these two the change in effects are, consider how our consumer might respond when she learns that the consumption that results price of Pepsi has fallen. She might reason in the following ways: when a price change moves the consumer “Great news! Now that Pepsi is cheaper, my income has greater purchasing to a higher or lower power. I am, in effect, richer than I was. Because I am richer, I can buy both indifference curve more pizza and more Pepsi.” (This is the income effect.) “Now that the price of Pepsi has fallen, I get more liters of Pepsi for every pizza that I give up. Because pizza is now relatively more expensive, I should substitution effect buy less pizza and more Pepsi.” (This is the substitution effect.) the change in consumption that results Which statement do you find more compelling? when a price change In fact, both of these statements make sense. The decrease in the price of Pepsi moves the consumer makes the consumer better off. If pizza and Pepsi are both normal goods, the along a given indifference consumer will want to spread this improvement in her purchasing power over curve to a point with both goods. This income effect tends to make the consumer buy more pizza and a new marginal rate of more Pepsi. Yet at the same time, consumption of Pepsi has become less expensive substitution relative to consumption of pizza. This substitution effect tends to make the consumer choose less pizza and more Pepsi. Now consider the result of these two effects working at the same time. The consumer certainly buys more Pepsi because the income and substitution effects both act to increase purchases of Pepsi. But it is ambiguous whether the consumer buys more pizza, because the income and substitution effects work in opposite directions. This conclusion is summarized in Table 1. Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. CHAPTER 21 THE THEORY OF CONSUMER CHOICE 447 Good Income Effect Substitution Effect Total Effect Table 1 Pepsi Consumer is Pepsi is relatively Income and substitution Income and Substitution richer, so she buys cheaper, so effects act in the same Effects When the Price more Pepsi. consumer buys direction, so consumer buys of Pepsi Falls more Pepsi. more Pepsi. Pizza Consumer is Pizza is relatively Income and substitution richer, so she buys more expensive, effects act in opposite more pizza. so consumer buys directions, so the total effect less pizza. on pizza consumption is ambiguous. We can interpret the income and substitution effects using indifference curves. The income effect is the change in consumption that results from the movement to a higher indifference curve. The substitution effect is the change in consumption that results from being at a point on an indifference curve with a different marginal rate of substitution. Figure 10 shows graphically how to decompose the change in the consumer’s decision into the income effect and the substitution effect. When the price of Pepsi falls, the consumer moves from the initial optimum, point A, to the new optimum, point C. We can view this change as occurring in two steps. First, the consumer moves along the initial indifference curve, I1, from point A to point B. The consumer is equally happy at these two points, but at point B, the marginal Quantity of Pepsi FIGURE 10 Income and Substitution Effects New budget constraint The effect of a change in price can be broken down into an income effect and a substitution effect. The substitution effect—the movement along an C New optimum indifference curve to a point Income with a different marginal rate of effect B substitution—is shown here as Initial optimum the change from point A to point Substitution Initial budget B along indifference curve I1. effect The income effect—the shift to constraint A I2 a higher indifference curve—is shown here as the change from I1 point B on indifference curve I1 to point C on indifference 0 Quantity curve I2. Substitution effect of Pizza Income effect Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 448 PART VII TOPICS FOR FURTHER STUDY rate of substitution reflects the new relative price. (The dashed line through point B is parallel to the new budget constraint and thus reflects the new relative price.) Next, the consumer shifts to the higher indifference curve, I2, by moving from point B to point C. Even though point B and point C are on different indifference curves, they have the same marginal rate of substitution. That is, the slope of the indifference curve I1 at point B equals the slope of the indifference curve I2 at point C. The consumer never actually chooses point B, but this hypothetical point is useful to clarify the two effects that determine the consumer’s decision. Notice that the change from point A to point B represents a pure change in the marginal rate of substitution without any change in the consumer’s welfare. Similarly, the change from point B to point C represents a pure change in welfare without any change in the marginal rate of substitution. Thus, the movement from A to B shows the substitution effect, and the movement from B to C shows the income effect. 21-3e Deriving the Demand Curve We have just seen how changes in the price of a good alter the consumer’s budget constraint and, therefore, the quantities of the two goods that she chooses to buy. The demand curve for any good reflects these consumption decisions. Recall that a demand curve shows the quantity demanded of a good for any given price. We can view a consumer’s demand curve as a summary of the optimal decisions that arise from her budget constraint and indifference curves. For example, Figure 11 considers the demand for Pepsi. Panel (a) shows that when the price of a liter falls from $2 to $1, the consumer’s budget constraint shifts outward. Because of both income and substitution effects, the consumer increases FIGURE 11 Panel (a) shows that when the price of Pepsi falls from $2 to $1, the consumer’s optimum moves from point A to point B, and the quantity of Pepsi consumed rises from Deriving the Demand Curve 250 to 750 liters. The demand curve in panel (b) reflects this relationship between the price and the quantity demanded. (a) The Consumer’s Optimum (b) The Demand Curve for Pepsi Quantity Price of of Pepsi Pepsi New budget constraint B A 750 $2 I2 B 1 A 250 Demand I1 0 Quantity 0 250 750 Quantity Initial budget of Pizza of Pepsi constraint Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. CHAPTER 21 THE THEORY OF CONSUMER CHOICE 449 her purchases of Pepsi from 250 to 750 liters. Panel (b) shows the demand curve that results from this consumer’s decisions. In this way, the theory of consumer choice provides the theoretical foundation for the consumer’s demand curve. It may be comforting to know that the demand curve arises naturally from the theory of consumer choice, but this exercise by itself does not justify developing the theory. There is no need for a rigorous, analytic framework just to establish that people respond to changes in prices. The theory of consumer choice is, however, useful in studying various decisions that people make as they go about their lives, as we see in the next section. Quick Quiz Draw a budget constraint and indifference curves for pizza and Pepsi. Show what happens to the budget constraint and the consumer’s optimum when the price of pizza rises. In your diagram, decompose the change into an income effect and a substitution effect. 21-4 Three Applications Now that we have developed the basic theory of consumer choice, let’s use it to shed light on three questions about how the economy works. These three questions might at first seem unrelated. But because each question involves household decision making, we can address it with the model of consumer behavior we have just developed. 21-4a Do All Demand Curves Slope Downward? Normally, when the price of a good rises, people buy less of it. This usual behavior, called the law of demand, is reflected in the downward slope of the demand curve. As a matter of economic theory, however, demand curves can sometimes slope upward. In other words, consumers can sometimes violate the law of demand and buy more of a good when the price rises. To see how this can happen, consider Figure 12. In this example, the consumer buys two goods—meat and potatoes. Initially, the consumer’s budget constraint is the line from point A to point B. The optimum is point C. When the price of potatoes rises, the budget constraint shifts inward and is now the line from point A to point D. The optimum is now point E. Notice that a rise in the price of potatoes has led the consumer to buy a larger quantity of potatoes. Why is the consumer responding in a seemingly perverse way? In this example, potatoes are a strongly inferior good. When the price of potatoes rises, the consumer is poorer. The income effect makes the consumer want to buy less meat and more potatoes. At the same time, because the potatoes have become more expensive relative to meat, the substitution effect makes the consumer want to buy more meat and fewer potatoes. In this particular case, however, the income effect is so strong that it exceeds the substitution effect. In the end, the consumer responds to the higher price of potatoes by buying less meat and more potatoes. Economists use the term Giffen good to describe a good that violates the law Giffen good of demand. (The term is named for economist Robert Giffen, who first noted this a good for which an possibility.) In this example, potatoes are a Giffen good. Giffen goods are inferior increase in the price goods for which the income effect dominates the substitution effect. Therefore, raises the quantity they have demand curves that slope upward. demanded Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 450 PART VII TOPICS FOR FURTHER STUDY FIGURE 12 Quantity of Potatoes Initial budget constraint A Giffen Good B In this example, when the price of potatoes rises, the consumer’s optimum shifts from point C to point E. In this Optimum with high case, the consumer responds price of potatoes to a higher price of potatoes Optimum with low by buying less meat and more D price of potatoes 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 case The Search for Giffen Goods study Have any actual Giffen goods ever been observed? Some historians suggest that potatoes were a Giffen good during the Irish potato famine of the 19th century. Potatoes were such a large part of people’s diet that when the price of potatoes rose, it had a large income effect. People responded to their reduced living standard by cutting back on the luxury of meat and buying more of the staple food of potatoes. Thus, it is argued that a higher price of potatoes actually raised the quantity of potatoes demanded. A recent study by Robert Jensen and Nolan Miller has produced similar but more concrete evidence for the existence of Giffen goods. These two economists conducted a field experiment for five months in the Chinese province of Hunan. They gave randomly selected households vouchers that subsidized the purchase of rice, a staple in local diets, and used surveys to measure how consumption of rice responded to changes in the price. They found strong evidence that poor households exhibited Giffen behavior. Lowering the price of rice with the subsidy voucher caused households to reduce their consumption of rice, and removing the subsidy had the opposite effect. Jensen and Miller wrote, “To the best of our knowledge, this is the first rigorous empirical evidence of Giffen behavior.” Thus, the theory of consumer choice allows demand curves to slope upward, and sometimes that strange phenomenon actually occurs. As a result, the law of demand we first saw in Chapter 4 is not completely reliable. It is safe to say, however, that Giffen goods are very rare. 21-4b How Do Wages Affect Labor Supply? So far, we have used the theory of consumer choice to analyze how a person allocates income between two goods. We can use the same theory to analyze how a person allocates time. People

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