Chapter 5

Wojciech Gerson (1831-1901)

The Theory of
Consumer Choice

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 Introduction
 Recall from Lecture 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.

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

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 The budget constraint
Vicky’s income: $1200
Prices: PB = $4 per loaf, PM = $1 per mango
A. If Vicky spends all his income on breads,
how many breads does he buy?
B. If Vicky spends all his income on mangos,
how many mangos does he buy?
C. If Vicky buys 100 breads, how many mangos
can he buy?
D. Plot each of the bundles from parts A – C on a
graph that measures breads on the horizontal
axis and mangos on the vertical, connect the
dots.
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 Answers
D. Vicky’s budget
Quantity constraint shows
of Mangos the bundles he can
B
A. $1200/$4 afford.
= 300
breads
C
B. $1200/$1
= 1200
mangos
C. 100 breads
cost $400,
$800 left
A
buys 800
mangos Quantity
of breads
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 The Slope of the Budget Constraint
From C to D, Quantity The slope of the
of Mangos budget constraint
“rise” =
equals the relative
–200 mangos
price of the good
“run” = on the X axis.
+50 breads C

Slope = – 4 D
Vicky must
give up
4 mangos
to get one bread.

Quantity
of
Breads
 Budget constraint, continued
Show what happens to Vicky’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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 Answers, part A
Quantity A fall in income
Now, of Mangos shifts the budget
Vicky constraint down.
can buy
$800/$4
= 200 breads
or
$800/$1
= 800 mangos
or any
combination in
between. Quantity
of
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 Answers, part B
Vicky Quantity An increase in the
of Mangos price of one good
can still buy
300 breads. pivots the budget
constraint inward.
But now he
can only buy
$1200/$2 =
600 mangos.
Notice:
slope is smaller,
relative price of
breads is now
only 2 mangos. Quantity
of
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 Utility Function
A utility function is…
A function that measures the level of satisfaction a
consumer receives from any basket of goods and
services.

Written as U = u(y)

It is an ordinal concept, that means

-The precise magnitude of the number that the
function assigns has no significance.

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 Marginal Utility

 Marginal Utility of a good y is the additional utility

that the consumer gets from consuming a little
more of y
 In other words, the rate at which total utility
changes as the level of consumption of good y
rises
∆𝑈
 𝑀𝑈𝑦 =
∆𝑦

 It is the slope of the utility function with respect

to y
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 Marginal Utility
 Law of diminishing marginal utility: The
principle of diminishing marginal utility states
that the marginal utility falls as the consumer
consumes more of a good.

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 Marginal Utility Example

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 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

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 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

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 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

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 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).
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 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

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 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

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

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 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}

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 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 dogs21
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 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
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 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
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 Lets consider Julie’s preferences for clothing C
and food F. Her utility function was U(C,F) = CF.

Suppose that clothing costs $2 a unit and that food

costs $1 a unit. Julie has $12 to spend on food and
clothing.

1. Find the optimal choice of food and clothing.

2. What is the marginal rate of substitution of

clothing for food at her optimal basket?

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 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
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 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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 Answers
Quantity
of Mangos

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

Quantity
of Fish
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 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

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 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 and
more fish.
Notice: The net effect on mangos is ambiguous.
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 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

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 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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Answers
ButInthe substitution
both graphs, theeffect is bigger
relative pricefor substitutes
changes
bythan
the complements.
same amount.
Quantity
of Pepsi Quantity of
hot dog buns

A
B B

Quantity Quantity
of Coke of hot dogs
 Deriving Hurley’s Demand Curve for Fish
A: When
B: WhenPPFF== $2,
$4, Hurley
Hurley demands
demands 350
150 fish.
fish.

Quantity Price of
of Mangos Fish

A
$4
A
B
B
$2
DFish

150 350 Quantity 150 350 Quantity

of Fish of Fish
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 Summary
• A consumer’s budget constraint shows the
possible combinations of different goods she can
buy given her income and the prices of the
goods. The slope of the budget constraint
equals the relative price of the goods.
• An increase in income shifts the budget
constraint outward. A change in the price of one
of the goods pivots the budget constraint.

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 Summary
• A consumer’s indifference curves represent her
preferences. An indifference curve shows all the
bundles that give the consumer a certain level of
happiness. The consumer prefers points on
higher indifference curves to points on lower
ones.
• The slope of an indifference curve at any point is
the marginal rate of substitution—the rate at
which the consumer is willing to trade one good
for the other.

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 Summary
• The consumer optimizes by choosing the point
on her budget constraint that lies on the highest
indifference curve. At this point, the marginal
rate of substitution equals the relative price of
the two goods.
• When the price of a good falls, the impact on the
consumer’s choices can be broken down into
two effects, an income effect and a substitution
effect.

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 Summary
• The income effect is the change in consumption
that arises because a lower price makes the
consumer better off. It is represented by a
movement from a lower indifference curve to a
higher one.
• The substitution effect is the change that arises
because a price change encourages greater
consumption of the good that has become
relatively cheaper. It is represented by a
movement along an indifference curve.

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 Summary
• The theory of consumer choice can be applied in
many situations. It can explain why demand
curves can potentially slope upward, why higher
wages could either increase or decrease labor
supply, and why higher interest rates could
either increase or decrease saving.

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