CHAPTER

21
The Theory of
Consumer Choice
Economics
P RINCIP LES OF

N. Gregory Mankiw

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by Ron Cronovich
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In this chapter,
look for the answers to these questions:

§ How does the budget constraint represent the

choices a consumer can afford?
§ How do indifference curves represent the
consumer’s preferences?
§ What determines how a consumer divides her
resources between two goods?
§ How does the theory of consumer choice explain
decisions such as how much a consumer saves,
or how much labor she supplies?
1

Introduction
§ Recall one of the Ten Principles from Chapter 1:
People face tradeoffs.
§ Buying more of one good leaves
less income to buy other goods.
§ Working more hours means more income and
more consumption, but less leisure time.
§ Reducing saving allows more consumption today
but reduces future consumption.
§ This chapter explores how consumers make
choices like these.

THE THEORY OF CONSUMER CHOICE 2

1
 The Budget Constraint:
What the Consumer Can Afford
§ Example:
Hurley divides his income between two goods:
fish and mangos.
§ A “consumption bundle” is

§ Budget constraint:

THE THEORY OF CONSUMER CHOICE 3

ACTIVE LEARNING 1
Budget Constraint
Hurley’s income: $1200
Prices: PF = $4 per fish, PM = $1 per mango
A. If Hurley spends all his income on fish,
how many fish does he buy?
B. If Hurley spends all his income on mangos,
how many mangos does he buy?
C. If Hurley buys 100 fish, how many mangos can
he buy?
D. Plot each of the bundles from parts A – C on a
graph that measures fish on the horizontal axis
and mangos on the vertical, connect the dots.
4

ACTIVE LEARNING 1
Answers
Quantity
of Mangos

Quantity
of Fish

2
 The Slope of the Budget Constraint
From C to D, Quantity
of Mangos
“rise” =

“run” =
C
Slope = D
Hurley must
give up

Quantity
of Fish
THE THEORY OF CONSUMER CHOICE 6

The Slope of the Budget Constraint

The slope of the budget constraint equals

price of fish
price of mangos
THE THEORY OF CONSUMER CHOICE 7

ACTIVE LEARNING 2
Budget constraint, continued.
Show what happens to Hurley’s budget constraint if:
A. His income falls to $800.
B. The price of mangos rises to
PM = $2 per mango

3
 ACTIVE LEARNING 2
Answers, part A
Quantity
of Mangos

Quantity
of Fish

ACTIVE LEARNING 2
Answers, part B
Quantity
of Mangos

Quantity
of Fish

Preferences: What the Consumer Wants

Indifference curve: Quantity One of Hurley’s

of Mangos indifference curves

B
A, B, and all other
bundles on I1 A
I1

he is indifferent Quantity
between them. of Fish

THE THEORY OF CONSUMER CHOICE 11

4
 Four Properties of Indifference Curves

Quantity One of Hurley’s

of Mangos indifference curves

If the quantity of
fish is reduced,
the quantity of A
mangos must be
I1
increased to keep
Hurley equally
happy. Quantity
of Fish

THE THEORY OF CONSUMER CHOICE 12

Four Properties of Indifference Curves

Quantity A few of Hurley’s

of Mangos indifference curves

Hurley prefers every

bundle on I2 (like C) C
D
to every bundle on I1
A I2
(like A).
I1
He prefers every
bundle on I1 (like A) I0
to every bundle on I0 Quantity
(like D). of Fish

THE THEORY OF CONSUMER CHOICE 13

Four Properties of Indifference Curves

Quantity Hurley’s
3. Indifference curves of Mangos indifference curves
cannot cross.
Suppose they did.

C A
I1 I4

Quantity
of Fish

THE THEORY OF CONSUMER CHOICE 14

5
 Four Properties of Indifference Curves

Quantity
4. Indifference curves of Mangos
are bowed inward.
A
Hurley is willing to give
up more mangos for a
fish if
1
B

1 I1

Quantity
of Fish

THE THEORY OF CONSUMER CHOICE 15

The Marginal Rate of Substitution

Marginal rate of Quantity

of Mangos
substitution (MRS):

6
Hurley’s MRS is
1
B
2
1 I1
MRS falls as you move
down along an Quantity
of Fish
indifference curve.
THE THEORY OF CONSUMER CHOICE 16

One Extreme Case: Perfect Substitutes

Perfect substitutes:

Example: nickels & dimes

Consumer is always willing to trade
two nickels for one dime.

THE THEORY OF CONSUMER CHOICE 17

6
Another Extreme Case: Perfect Complements
Perfect complements:

Example: Left shoes, right shoes

{7 left shoes, 5 right shoes}
is just as good as
{5 left shoes, 5 right shoes}

THE THEORY OF CONSUMER CHOICE 18

Less Extreme Cases:

Close Substitutes and Close Complements

Quantity Indifference Quantity Indifference

of Pepsi curves for close of hot curves for
dog buns
substitutes close
complements

Quantity Quantity
of Coke of hot dogs

Optimization: What the Consumer Chooses

A is the optimum: Quantity
of Mangos

1200

Hurley prefers B to A, B
but he cannot afford B. 600
A

Hurley can afford C C

and D, D
but A is on a higher
indifference curve. 150 300 Quantity
of Fish
THE THEORY OF CONSUMER CHOICE 20

7
Optimization: What the Consumer Chooses
Quantity
At the optimum, of Mangos Consumer
Consumer
optimization
optimization is is
another
another example
example
1200 of
of “thinking
“thinking at
at the
the
margin.”
margin.”

MRS = PF/PM A
600

150 300 Quantity

of Fish
THE THEORY OF CONSUMER CHOICE 21

The Effects of an Increase in Income

Quantity
of Mangos
An increase in
income

If both goods are A

“normal,” Hurley

Quantity
of Fish
THE THEORY OF CONSUMER CHOICE 22

ACTIVE LEARNING 3
Inferior vs. normal goods
§ An increase in income increases the quantity
demanded of normal goods and reduces the
quantity demanded of inferior goods.
§ Suppose fish is a normal good
but mangos are an inferior good.
§ Use a diagram to show the effects of
an increase in income on Hurley’s optimal
bundle of fish and mangos.

23

8
 ACTIVE LEARNING 3
Answers Quantity
of Mangos

Quantity
of Fish
24

The Effects of a Price Change

Quantity
Initially,
of Mangos
PF = $4
1200
PM = $1 initial
optimum

PF falls to $2
600

150 300 Quantity

of Fish

THE THEORY OF CONSUMER CHOICE 25

The Income and Substitution Effects

A fall in the price of fish has two effects on
Hurley’s optimal consumption of both goods.
§ Income effect

§ Substitution effect

Notice:
THE THEORY OF CONSUMER CHOICE 26

9
 The Income and Substitution Effects
Initial Quantity
optimum at A. of Mangos

PF falls.
Substitution effect:
from A to B,
buy more fish and A
fewer mangos.
Income effect:
from B to C,
buy more of both
Quantity
goods. of Fish

THE THEORY OF CONSUMER CHOICE 27

ACTIVE LEARNING 4
The substitution effect in two cases
Do you think the substitution effect would be
bigger for substitutes or complements?
§ Draw an indifference curve for Coke and Pepsi,
and, on a separate graph, one for hot dogs and
hot dog buns.
§ On each graph, show the effects of a relative
price change (keeping the consumer on the initial
indifference curve).

28

ACTIVE LEARNING 4
Answers

Quantity
of Pepsi Quantity of
hot dog buns

Quantity Quantity
of Coke of hot dogs

10
 Deriving Hurley’s Demand Curve for Fish

Quantity Price of
of Mangos Fish

A
$4
A

150 Quantity 150 Quantity

of Fish of Fish
30

Application 1: Giffen Goods

§ Do all goods obey the Law of Demand?
§ Suppose the goods are potatoes and meat,
and potatoes are an inferior good.
§ If price of potatoes rises,
§ substitution effect:
§ income effect:
§ If
then potatoes are a Giffen good,

THE THEORY OF CONSUMER CHOICE 31

Application 1:
Giffen Goods

THE THEORY OF CONSUMER CHOICE 32

11
 Application 2: Wages and Labor Supply
Budget constraint

§ The relative price of an hour of leisure

Indifference curve
§ Shows “bundles” of

THE THEORY OF CONSUMER CHOICE 33

Application 2: Wages and Labor Supply

THE THEORY OF CONSUMER CHOICE 34

Application 2: Wages and Labor Supply

An increase in the wage has two effects
on the optimal quantity of labor supplied.
§ Substitution effect (SE):

§ Income effect (IE):

THE THEORY OF CONSUMER CHOICE 35

12
 Application 2: Wages and Labor Supply
For
For this
this person,
person, So
So her
her labor
labor supply
supply
SE
SE >> IE
IE increases
increases with
with the
the wage
wage

24729_2114

THE THEORY OF CONSUMER CHOICE 36

Application 2: Wages and Labor Supply

For
For this
this person,
person, So
So his
his labor
labor supply
supply falls
falls
SE
SE << IE
IE when
when thethe wage
wage rises
rises

24729_2114

THE THEORY OF CONSUMER CHOICE 37

Could This Happen in the Real World???

Cases where the income effect on labor supply is
very strong:
§ Over last 100 years, technological progress has
increased labor demand and real wages.
The average workweek fell from 6 to 5 days.
§ When a person wins the lottery or receives an
inheritance, his wage is unchanged – hence no
substitution effect.
But such persons are more likely to work fewer
hours, indicating a strong income effect.

THE THEORY OF CONSUMER CHOICE 38

13
 Application 3: Interest Rates and Saving
§ A person lives for two periods.
§ Period 1: young, works, earns $100,000
consumption = $100,000 minus amount saved
§ Period 2: old, retired
consumption = saving from Period 1
plus interest earned on saving
§ The interest rate determines

THE THEORY OF CONSUMER CHOICE 39

Application 3: Interest Rates and Saving

Budget constraint shown is for 10% interest rate.

At the optimum,

THE THEORY OF CONSUMER CHOICE 40

ACTIVE LEARNING 5
Effects
Effects of a change in the interest rate
§ Suppose the interest rate rises.
§ Describe the income and substitution effects on
current and future consumption, and on saving.

41

14
 Application 3: Interest Rates and Saving
In
In this
this case,
case,
SE
SE >> IEIE and
and
saving
saving rises
rises

THE THEORY OF CONSUMER CHOICE 43

Application 3: Interest Rates and Saving

In
In this
this case,
case,
SE
SE << IEIE and
and
saving
saving falls
falls

THE THEORY OF CONSUMER CHOICE 44

44

CONCLUSION:
Do People Really Think This Way?
§ People do not make spending decisions
by writing down their budget constraints and
indifference curves.
§ Yet, they try to make the choices that maximize
their satisfaction given their limited resources.
§ The theory in this chapter is only intended as a
metaphor for how consumers make decisions.
§ It explains consumer behavior fairly well in many
situations and provides the basis for more
advanced economic analysis.
THE THEORY OF CONSUMER CHOICE 45

15