THEORY OF CONSUMER

CHOICE
 Budget constraints and consumer choice;
 Indifference Curves (IC) and consumer
preferences;
 Principles of resource allocation between goods
 Consumer choice and decision-making e.g.
supply of labor
(Reproduced /Adapted from N. G Mankiw)

THE THEORY CONSUMER CHOICE 1

THE THEORY OF CONSUMER CHOICE 6
 UTILITY
Utility refers to the amount of satisfaction that a consumer gains from a
particular good or service (Eating a burger, drinking a can of Pepsi, wearing a
shirt, listening to a music, reading a novel…… chatting with a friend).
Cardinal and ordinal measurement of utility
Total utility refers to the complete amount of satisfaction gained.
Marginal utility refers to the satisfaction gained from an extra unit consumed.
Law of Diminishing Marginal Utility

THE THEORY OF CONSUMER CHOICE 7

THE THEORY OF CONSUMER CHOICE 8
Characteristics of Utility
Utility is that invisible quality of anything which resorts to satisfying any
human want. The utility may neither be seen, i.e. it is invisible, nor may it
be touched. It is there in the things in abstract or invisible form.
Utility is not concerned with the ‘morality’. Whether the consumption of a
thing is useful or harmful, if it serves to fulfill the wants of anyone, it
possesses ‘utility’.
Utility emerges out of the human needs or wants. Thus it is Individual and
relative in nature. It is a subjective concept, not objective or concrete
which could be uniformly applicable in all cases.

THE THEORY OF CONSUMER CHOICE 9

THE THEORY OF CONSUMER CHOICE 10
THE THEORY OF CONSUMER CHOICE 11
THE THEORY OF CONSUMER CHOICE 12
THE THEORY OF CONSUMER CHOICE 13
 Recall one of the Ten Principles 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 lecture explores how consumers make choices like these.

THE THEORY OF CONSUMER CHOICE 14

 The Budget Constraint:
What the Consumer Can Afford
 Example:
Umar 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 15

Budget Constraint
Umar’s income: $1200
Prices: PF = $4 per fish, PM = $1 per mango
A. If Umar spends all his income on fish,
how many fish does he buy?
B. If Umar spends all his income on mangos,
how many mangos does he buy?
C. If Umar 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.
16
 D.
D. Umar’s
Umar’s budget
budget
Quantity
of Mangos constraint
constraint shows
shows
B the
the bundles
bundles he
he can
can
A. $1200/$4 afford.
afford.
= 300 fish
C
B. $1200/$1
= 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
Umar must
give up
4 mangos
to get one fish.
Quantity
of Fish
THE THEORY OF CONSUMER CHOICE 18
 The Slope of the Budget
Constraint
The slope of the budget constraint equals
 the rate at which Umar
can trade mangos for fish
 the opportunity cost of fish in terms of mangos
 the relative price of fish:

THE THEORY OF CONSUMER CHOICE 19

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

20
ACTIVE LEARNING 2
Answers, part A
Quantity A
A fall
fall in
in income
income
Now, of Mangos shifts
shifts the
the budget
budget
Umar constraint
constraint down.
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
An increase
increase in
in the
the
Umar of Mangos price
price of
of one
one good
good
can still buy pivots
pivots the
the budget
budget
300 fish. constraint
constraint inward.
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 Umar’s
of Mangos indifference curves
shows consumption
bundles that give the
consumer the same
level of satisfaction B
A, B, and all other
bundles on I1 make A
Umar equally happy – I1
he is indifferent
between them.
Quantity
of Fish

THE THEORY OF CONSUMER CHOICE 23

 Four Properties of Indifference
Curves
Quantity One of Umar’s
1. Indifference curves of Mangos indifference curves
are downward-
sloping.

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

THE THEORY OF CONSUMER CHOICE 24

 Four Properties of Indifference
Curves
Quantity A few of Umar’s
2. Higher indifference of Mangos indifference curves
curves are preferred
to lower ones.

Umar 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
of Fish
(like D).
THE THEORY OF CONSUMER CHOICE 25
 Four Properties of Indifference
Curves
Quantity Umar’s indifference
3. Indifference curves of Mangos curves
cannot cross.
Suppose they did.
Umar should prefer
B to C, since B has B
more of both goods.
Yet, Umar is indifferent C A
between B and C: I1 I4
He likes C as much as A
(both are on I4).
Quantity
He likes A as much as B of Fish
(both are on I1).
THE THEORY OF CONSUMER CHOICE 26
 Four Properties of Indifference
Curves
Quantity
4. Indifference curves of Mangos
are bowed inward.
A
Umar 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 27

 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
Umar’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 28

 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 29

 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 30

 Less Extreme Cases:
Close Substitutes and Close
Complements
Quantity Indifference
Indifference Quantity Indifference
Indifference
curves of hot curves
curves for
of Pepsi curves for
for close
close dog buns
for
substitutes
substitutes are
are close
close
not
not very
very bowed
bowed complements
complements
are
are very
very
bowed
bowed

Quantity Quantity
of Coke of hot dogs
 Optimization: What the Consumer
Chooses
A is the optimum: Quantity
of Mangos
The
The optimum
optimum
the point on the
is
is the
the bundle
bundle
budget constraint
Umar
Umar most
most
that touches the
1200 prefers
prefers outout of
of
highest possible
all
all the
the bundles
bundles
indifference curve.
he
he cancan afford.
afford.
Umar prefers B to A, B
but he cannot afford B. 600
A
Umar 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 32
 Optimization: What the Consumer
Chooses
Quantity
At the optimum, of Mangos Consumer
Consumer
slope of the optimization
optimization isis
indifference curve another
another example
example
equals 1200 of
of “thinking
“thinking at
at the
the
slope of the budget margin.”
margin.”
constraint:
MRS = PF/PM A
600

marginal
price of fish
value of fish
(in terms of
mangos)
(in terms of 150 300 Quantity
mangos) of Fish
THE THEORY OF CONSUMER CHOICE 33
 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,” Umar
buys more of each.

Quantity
of Fish
THE THEORY OF CONSUMER CHOICE 34
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 Umar’s optimal bundle
of fish and mangos.

35
 Quantity
of Mangos

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

Quantity
of Fish
36
 The Effects of a Price Change
Quantity
Initially,
of Mangos
PF = $4
1200
PM = $1 initial
optimum

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

THE THEORY OF CONSUMER CHOICE 37

 The Income and Substitution
Effects
A fall in the price of fish has two effects on
Umar’s optimal consumption of both goods.
 Income effect
A fall in PF boosts the purchasing power of Umar’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 Umar to buy fewer mangos & more
fish.
Notice: The net effect on mangos is ambiguous.
THE THEORY OF CONSUMER CHOICE 38
 The Income and Substitution
Effects
Initial Quantity
In
In this
this example,
example,
optimum at A. of Mangos
the
the net
net effect
effect
PF falls. on
on mangos
mangos isis
negative.
negative.
Substitution effect:
from A to B,
buy more fish and A
C
fewer mangos.
B
Income effect:
from B to C,
buy more of both Quantity
goods.
of Fish
THE THEORY OF CONSUMER CHOICE 39
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).

40
 ACTIVE LEARNING 4
Answers
But
ButInthe
Inthe substitution
both graphs,
graphs, the
substitution
both effect
effect
the is
is bigger
relative
relative pricefor
price
bigger substitutes
changes
for substitutes
changes
bythan
by the
than complements.
the same amount.
complements.
same amount.
Quantity
of Pepsi Quantity of
hot dog buns

A
B B

Quantity Quantity
of Coke of hot dogs
Deriving Umar’s Demand Curve for
Fish
A: When
B: $4, Hurley
WhenPPF F==$2, 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
42
 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: buy less potatoes
 income effect: buy more potatoes
 If income effect > substitution effect,
then potatoes are a Giffen good, a good for which
an increase in price raises the quantity demanded.

THE THEORY OF CONSUMER CHOICE 43

 Application
1:
Giffen
Goods

THE THEORY OF CONSUMER CHOICE 44

 Application 2: Wages and Labor
Supply
Budget constraint
 Shows a person’s tradeoff between consumption
and leisure.
 Depends on how much time she has to divide
between leisure and working.
 The relative price of an hour of leisure is the amount
of consumption she could buy with an hour’s wages.
Indifference curve
 Shows “bundles” of consumption and leisure
that give her the same level of satisfaction.

THE THEORY OF CONSUMER CHOICE 45

 Application 2: Wages and Labor
Supply
At
At the
the optimum,
optimum,
the
the MRS
MRS between
between
leisure
leisure and
and
consumption
consumption
equals
equals thethe wage.
wage.

THE THEORY OF CONSUMER CHOICE 46

 Application 2: Wages and Labor
Supply
An increase in the wage has two effects
on the optimal quantity of labor supplied.
 Substitution effect (SE): A higher wage makes
leisure more expensive relative to consumption.
The person chooses less leisure,
i.e., increases quantity of labor supplied.
 Income effect (IE): With a higher wage,
she can afford more of both “goods.”
She chooses more leisure,
i.e., reduces quantity of labor supplied.

THE THEORY OF CONSUMER CHOICE 47

 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

THE THEORY OF CONSUMER CHOICE 48

 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

THE THEORY OF CONSUMER CHOICE 49

 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 50

 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 relative price of consumption when young
in terms of consumption when old.

THE THEORY OF CONSUMER CHOICE 51

 Application 3: Interest Rates
and Saving
Budget constraint shown is for 10% interest rate.

At
At the
the optimum,
optimum,
the
the MRS
MRS between
between
current
current and
and future
future
consumption
consumption equals
equals
the
the interest
interest rate.
rate.

THE THEORY OF CONSUMER CHOICE 52

 Effects of a change in the
interest
Suppose therate
interest rate rises.
 Describe the income and substitution effects on
current and future consumption, and on saving.

53
The interest rate rises.
Substitution effect
 Current consumption becomes more expensive
relative to future consumption.
 Current consumption falls, saving rises,
future consumption rises.
Income effect
 Can afford more consumption in both the
present and the future. Saving falls.

54
 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 55

 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 5656

 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 57
CHAPTER 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.

58
CHAPTER 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.
59
CHAPTER 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.

60
CHAPTER 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.
61
CHAPTER 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.

62