CHAPTER

21
The Theory of
Consumer Choice
Economics
PRINCIPLES OF

N. Gregory Mankiw

Dr. Nanda R. Nurdianto

© 2009 South-Western, a part of Cengage Learning, all rights reserved

 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 1

 The Budget Constraint:
What the Consumer Can Afford
▪ Example:
Hurley divides his income between two goods:
fish and mangos.
▪ A “consumption bundle” is a particular combination
of the goods, e.g., 40 fish & 300 mangos.
▪ Budget constraint: the limit on the consumption
bundles that a consumer can afford

THE THEORY OF CONSUMER CHOICE 2

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.
3
ACTIVE LEARNING 1
Answers D. Hurley’s budget
Quantity
of Mangos constraint shows
B the bundles he can
A. $1200/$4 afford.
= 300 fish
B. $1200/$1 C
= 1200
mangos
C. 100 fish
cost $400,
$800 left
A
buys 800
Quantity
mangos of Fish
 The Slope of the Budget Constraint
From C to D, Quantity
of Mangos
“rise” =
–200 mangos
“run” =
+50 fish C

Slope = – 4 D
Hurley must
give up
4 mangos
to get one fish.

Quantity
of Fish
THE THEORY OF CONSUMER CHOICE 5
 The Slope of the Budget Constraint
The slope of the budget constraint equals
▪ the rate at which Hurley
can trade mangos for fish
▪ the opportunity cost of fish in terms of mangos
▪ the relative price of fish:
price of fish $4
= = 4 mangos per fish
price of mangos $1

THE THEORY OF CONSUMER CHOICE 6

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

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ACTIVE LEARNING 2
Answers, part A
Quantity A fall in income
Now, of Mangos shifts the budget
Hurley constraint down.
can buy
$800/$4
= 200 fish
or
$800/$1
= 800 mangos
or any
combination in
between. Quantity
of Fish
ACTIVE LEARNING 2
Answers, part B
Quantity An increase in the
Hurley
of Mangos price of one good
can still buy
pivots the budget
300 fish. constraint inward.
But now he
can only buy
$1200/$2 =
600 mangos.
Notice:
slope is smaller,
relative price of
fish is now only
2 mangos. Quantity
of Fish
 Preferences: What the Consumer Wants

Indifference curve: Quantity One of Hurley’s

shows consumption of Mangos indifference curves
bundles that give the
consumer the same
level of satisfaction
B
A, B, and all other
bundles on I1 make A
Hurley equally happy –
I1
he is indifferent
between them.
Quantity
of Fish

THE THEORY OF CONSUMER CHOICE 10

 Four Properties of Indifference Curves

Quantity One of Hurley’s

1. Indifference curves of Mangos indifference curves
are downward-
sloping.

If the quantity of
fish is reduced, B

the quantity of
A
mangos must be
I1
increased to keep
Hurley equally
happy. Quantity
of Fish

THE THEORY OF CONSUMER CHOICE 11

 Four Properties of Indifference Curves

Quantity A few of Hurley’s

2. Higher indifference of Mangos indifference curves
curves are preferred
to lower ones.

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 12

 Four Properties of Indifference Curves

Quantity Hurley’s
3. Indifference curves of Mangos indifference curves
cannot cross.
Suppose they did.
Hurley should prefer
B to C, since B has B
more of both goods.
Yet, Hurley is indifferent C A
between B and C: I1 I4
He likes C as much as A
(both are on I4).
He likes A as much as B Quantity
of Fish
(both are on I1).
THE THEORY OF CONSUMER CHOICE 13
 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 6
fish if he has few fish
1
(A) than if he has
B
many (B). 2
1 I1

Quantity
of Fish

THE THEORY OF CONSUMER CHOICE 14

 The Marginal Rate of Substitution

Marginal rate of Quantity MRS = slope of

substitution (MRS): of Mangos indifference curve
the rate at which a consumer
is willing to trade one good for A
another.
MRS = 6
Hurley’s MRS is the
amount of mangos he 1
would substitute for B
MRS = 2
another fish. 1 I1
MRS falls as you move
down along an Quantity
indifference curve. of Fish

THE THEORY OF CONSUMER CHOICE 15

 One Extreme Case: Perfect Substitutes
Perfect substitutes: two goods with
straight-line indifference curves,
constant MRS
Example: nickels & dimes
Consumer is always willing to trade
two nickels for one dime.

THE THEORY OF CONSUMER CHOICE 16

Another Extreme Case: Perfect Complements
Perfect complements: two goods with
right-angle indifference curves
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 17

 Less Extreme Cases:
Close Substitutes and Close Complements

Quantity Indifference Quantity Indifference

of Pepsi curves for close of hot curves for
dog buns close
substitutes are
not very bowed complements
are very
bowed

Quantity Quantity
of Coke of hot dogs
Optimization: What the Consumer Chooses
A is the optimum: Quantity
The optimum
the point on the of Mangos
is the bundle
budget constraint
Hurley most
that touches the
1200 prefers out of
highest possible
all the bundles
indifference curve.
he can afford.
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 19
Optimization: What the Consumer Chooses
Quantity
At the optimum, of Mangos Consumer
slope of the optimization is
indifference curve another example
equals 1200 of “thinking at the
slope of the budget margin.”
constraint:
MRS = PF/PM A
600

marginal
price of fish
value of fish
(in terms of
(in terms of
mangos)
mangos) 150 300 Quantity
of Fish
THE THEORY OF CONSUMER CHOICE 20
 The Effects of an Increase in Income
Quantity
of Mangos
An increase in
income shifts the
budget constraint
outward.
B
If both goods are
A
“normal,” Hurley
buys more of each.

Quantity
of Fish
THE THEORY OF CONSUMER CHOICE 21
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.

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ACTIVE LEARNING 3
Answers Quantity
of Mangos

If mangos are
inferior, the new
optimum will
contain fewer
mangos.
A
B

Quantity
of Fish
23
 The Effects of a Price Change

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

PF falls to $2 new
optimum
budget constraint 600
rotates outward, 500
Hurley buys
more fish and
fewer mangos.
150 300 600 Quantity
350 of Fish

THE THEORY OF CONSUMER CHOICE 24

 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
A fall in PF boosts the purchasing power of Hurley’s
income, allows him to buy more mangos and more
fish.
▪ Substitution effect
A fall in PF makes mangos more expensive relative
to fish, causes Hurley to buy fewer mangos & more
fish.
Notice: The net effect on mangos is ambiguous.
THE THEORY OF CONSUMER CHOICE 25
 The Income and Substitution Effects
Initial Quantity In this example,
optimum at A. of Mangos
the net effect
PF falls. on mangos is
negative.
Substitution effect:
from A to B,
buy more fish and A
fewer mangos. C

Income effect: B
from B to C,
buy more of both
Quantity
goods.
of Fish

THE THEORY OF CONSUMER CHOICE 26

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).

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