1. PART 7 TOPICS FOR FURTHER STUDY

2. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. 21 The Theory of Consumer Choice

3. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. Learning Objectives ●See how a budget constraint represents consumer choices ●Learn how indifference curves can be used to represent consumer preferences ●Analyze how a consumer’s optimal choices are determined ●See how a consumer responds to  changes in income  changes in prices ●Decompose the impact of a price change into an income effect and a substitution effect ●Apply the theory of consumer choice to four questions about consumer behaviour

4. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. Questions addressed by the Theory of Consumer Choice ●In this chapter, the theory you learn will be applied to three questions about household (consumer) decisions  Do all demand curves slope downward?  How do wages affect labor supply?  How do interest rates affect household saving?

5. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. THE BUDGET CONSTRAINT: WHAT THE CONSUMER CAN AFFORD ●When choosing which goods to purchase, consumers face two constraints  their income  prices of the goods consumption bundle ●Each combination of goods purchased is called a consumption bundle budget constraint ●The budget constraint illustrates the limit on the consumption “bundles” that a consumer can afford.  People consume less than they desire because their spending is constrained.

6. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. THE BUDGET CONSTRAINT: WHAT THE CONSUMER CAN AFFORD budget constraint ●The budget constraint shows  various combinations of goods the consumer can afford  given his or her income and the prices of the two goods. budget constraintline ●Any point on the budget constraint line indicates the consumer’s combination or tradeoff between two goods.

7. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. The Consumer’s Budget Constraint (Assume income=$1000) Litres of Pepsi (Q) Number of Pizzas (Q) Spending on Pepsi (PxQ) Spending on Pizza (PxQ)Total Spending 0100$ 0$1,000 5090100 900 1,000 10080200 800 1,000 15070300 700 1,000 20060400 600 1,000 25050500 1,000 30040600 400 1,000 35030700 300 1,000 40020800 200 1,000 45010900 100 1,000 50001,000 0

8. Figure 1 The Consumer’s Budget Constraint Quantity of Pizza Quantity of Pepsi 0 Consumer’s budget constraint 500 B 100 A Copyright©2004 South-Western For example, if the consumer buys no pizzas, he can afford 500 litres of Pepsi (point B). If he buys no Pepsi, he can afford 100 pizzas (point A). For example, if the consumer buys no pizzas, he can afford 500 litres of Pepsi (point B). If he buys no Pepsi, he can afford 100 pizzas (point A).

9. Figure 1 The Consumer’s Budget Constraint Quantity of Pizza Quantity of Pepsi 0 Consumer’s budget constraint 500 B 250 50 C 100 A Copyright©2004 South-Western Alternately, the consumer can buy 50 pizzas and 250 litres of Pepsi

10. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. THE BUDGET CONSTRAINT: WHAT THE CONSUMER CAN AFFORD slope ●The slope of the budget constraint line  equals the relative price of the two goods,  that is, the price of one good compared to the price of the other.  P pizza /P Pepsi ●It measures the rate at which the consumer can trade one good for the other.

11. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. PREFERENCES: WHAT THE CONSUMER WANTS indifference curves. ●A consumer’s preference among consumption bundles may be illustrated with indifference curves.

12. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. Representing Preferences with Indifference Curves indifference curve ●An indifference curve shows consumption bundles that give the consumer the same level of satisfaction.

13. Figure 2 The Consumer’s Preferences Quantity of Pizza Quantity of Pepsi 0 Indifference curve,I1I1 I2I2 C B A D Copyright©2004 South-Western

14. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. Representing Preferences with Indifference Curves ●The Consumer’s Preferences  The consumer is indifferent, or equally happy, with the combinations shown at points A, B, and C because they are all on the same curve. ●The Marginal Rate of Substitution marginal rate of substitution  The slope at any point on an indifference curve is the marginal rate of substitution. It is the rate at which a consumer is willing to trade one good for another. It is the amount of one good that a consumer requires as compensation to give up one unit of the other good.

15. Figure 2 The Consumer’s Preferences Quantity of Pizza Quantity of Pepsi 0 Indifference curve,I1I1 I2I2 1 MRS C B A D Copyright©2004 South-Western

16. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. Four Properties of Indifference Curves ●Higher indifference curves are preferred to lower ones. ●Indifference curves are downward sloping. ●Indifference curves do not cross. ●Indifference curves are bowed inward.

17. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. Four Properties of Indifference Curves ●Property 1: Higher indifference curves are preferred to lower ones.  Consumers usually prefer more of something to less.  Higher indifference curves represent larger quantities of goods than do lower indifference curves.

18. Figure 2 The Consumer’s Preferences Quantity of Pizza Quantity of Pepsi 0 Indifference curve,I1I1 I2I2 C B A D Copyright©2004 South-Western

19. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. Four Properties of Indifference Curves ●Property 2: Indifference curves are downward sloping.  A consumer is willing to give up one good only if he or she gets more of the other good in order to remain equally happy.  If the quantity of one good is reduced, the quantity of the other good must increase.  For this reason, most indifference curves slope downward.

20. Figure 2 The Consumer’s Preferences Quantity of Pizza Quantity of Pepsi 0 Indifference curve,I1I1 Copyright©2004 South-Western

21. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. Four Properties of Indifference Curves ●Property 3: Indifference curves do not cross.  Points A and B should make the consumer equally happy.  Points B and C should make the consumer equally happy.  This implies that A and C would make the consumer equally happy. both  But C has more of both goods compared to A.

22. Figure 3 The Impossibility of Intersecting Indifference Curves Quantity of Pizza Quantity of Pepsi 0 C A B Copyright©2004 South-Western

23. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. Four Properties of Indifference Curves ●Property 4: Indifference curves are bowed inward.  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.  These differences in a consumer’s marginal substitution rates cause his or her indifference curve to bow inward.

24. Figure 4 Bowed Indifference Curves Quantity of Pizza Quantity of Pepsi 0 Indifference curve 8 3 A 3 7 B 1 MRS = 6 1 MRS = 1 4 6 14 2 Copyright©2004 South-Western

25. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. Two Extreme Examples of Indifference Curves ●Perfect substitutes ●Perfect complements

26. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. Two Extreme Examples of Indifference Curves ●Perfect Substitutes  Two goods with straight-line indifference curves are perfect substitutes.  The marginal rate of substitution is a fixed number.

27. Figure 5 Perfect Substitutes and Perfect Complements Dimes 0 Nickels (a) Perfect Substitutes I1I1 I2I2 I3I3 3 6 2 4 1 2 Copyright©2004 South-Western

28. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. Two Extreme Examples of Indifference Curves ●Perfect Complements  Two goods with right-angle indifference curves are perfect complements.

29. Figure 5 Perfect Substitutes and Perfect Complements Right Shoes 0 Left Shoes (b) Perfect Complements I1I1 I2I2 7 7 5 5 Copyright©2004 South-Western

30. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. OPTIMIZATION: What the Consumer Chooses ●Consumers want to get a combination of goods on the highest possible indifference curve. ●However, the consumer must also end up on or below his budget constraint.

31. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. The Consumer’s Optimal Choices ●Combining the indifference curve and the budget constraint determines the consumer’s optimal choice. ●Consumer optimum occurs at the point where the highest indifference curve and the budget constraint are tangent.

32. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. The Consumer’s Optimal Choice marginal rate of substitution equals the relative price ●The consumer chooses consumption of the two goods so that the marginal rate of substitution equals the relative price.

33. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. The Consumer’s Optimal Choice ●At the consumer’s optimum, the consumer’s valuation of the two goods equals the market’s valuation.

34. Figure 6 The Consumer’s Optimum Quantity of Pizza Quantity of Pepsi 0 Budget constraint I1I1 I2I2 I3I3 Optimum A B Copyright©2004 South-Western

35. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. How Changes in Income Affect Consumer’s Choices ●An increase in income shifts the budget constraint outward.  The consumer is able to choose a better combination of goods on a higher indifference curve.

36. Figure 7 An Increase in Income Quantity of Pizza Quantity of Pepsi 0 New budget constraint I1I1 I2I2 2.... raising pizza consumption... 3.... and Pepsi consumption. Initial budget constraint 1. An increase in income shifts the budget constraint outward... Initial optimum New optimum Copyright©2004 South-Western

37. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. How Changes in Income Affect Consumer’s Choices ●Normal versus Inferior Goods normal good  If a consumer buys more of a good when his or her income rises, the good is called a normal good. inferior good.  If a consumer buys less of a good when his or her income rises, the good is called an inferior good.

38. Figure 8 An Inferior Good Quantity of Pizza Quantity of Pepsi 0 Initial budget constraint New budget constraint I1I1 I2I2 1. When an increase in income shifts the budget constraint outward... 2.... pizza consumption rises, making pizza a normal good... Initial optimum New optimum Copyright©2004 South-Western 3.... But Pepsi consumption falls, because Pepsi is an inferior good

39. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. How Changes in Prices Affect Consumer’s Choices ●A fall in the price of any good rotates the budget constraint outward and changes the slope of the budget constraint.

40. Figure 9 A Change in Price Quantity of Pizza Quantity of Pepsi 0 1,000 D 500 B 100 A I1I1 I2I2 Initial optimum New budget constraint Initial budget constraint 1. A fall in the price of Pepsi rotates the budget constraint outward... 3.... and raising Pepsi consumption. 2.... reducing pizza consumption... New optimum Copyright©2004 South-Western

41. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. Income and Substitution Effects ●A price change has two effects on consumption.  An income effect  A substitution effect

42. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. Income and Substitution Effects Income Effect ●The Income Effect  the change in consumption that results when a price change moves the consumer to a higher or lower indifference curve. Substitution Effect ●The Substitution Effect  the change in consumption that results when a price change moves the consumer along an indifference curve to a point with a different marginal rate of substitution.

43. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. Income and Substitution Effects ●A Change in Price:  Substitution Effect  Substitution Effect : a price change first causes the consumer to move from one point on an indifference curve to another on the same curve. Illustrated by movement from point A to point B.  Income Effect  Income Effect : a fter moving from one point to another on the same curve, the consumer will move to another indifference curve. Illustrated by movement from point B to point C.

44. Figure 10 Income and Substitution Effects Quantity of Pizza Quantity of Pepsi 0 I1I1 I2I2 A Initial optimum New budget constraint Initial budget constraint Substitution effect Substitution effect Income effect Income effect B CNew optimum Copyright©2004 South-Western

45. Table 1 Income and Substitution Effects When the Price of Pepsi Falls

46. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. Deriving the Demand Curve ●A consumer’s demand curve can be viewed as a summary of the optimal decisions that arise from his or her budget constraint and indifference curves.

47. Figure 11 Deriving the Demand Curve Quantity of Pizza 0 Demand (a) The Consumer’s Optimum ’ Quantity of Pepsi 0 Price of Pepsi (b) The Demand Curve for Pepsi Quantity of Pepsi 250 $2 A 750 1 B I1I1 I2I2 New budget constraint Initial budget constraint 750 B 250 A Copyright©2004 South-Western

48. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. THREE APPLICATIONS ●Do all demand curves slope downward?  Demand curves can sometimes slope upward.  This happens when a consumer buys more of a good when its price rises.  Giffen goods Economists use the term Giffen good to describe a good that violates the law of demand. Giffen goods are goods for which an increase in the price raises the quantity demanded. The income effect dominates the substitution effect. They have demand curves that slope upwards.

49. Figure 12 A Giffen Good Quantity of Meat Quantity of Potatoes 0 I2I2 I1I1 Initial budget constraint New budget constraint D A B 2.... which increases potato consumption if potatoes are a Giffen good. Optimum with low price of potatoes Optimum with high price of potatoes E C 1. An increase in the price of potatoes rotates the budget constraint inward... Copyright©2004 South-Western

50. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. THREE APPLICATIONS ●How do wages affect labor supply?  If the substitution effect is greater than the income effect for the worker, he or she works more.  If income effect is greater than the substitution effect, he or she works less.

51. Figure 13 The Work-Leisure Decision Hours of Leisure 0 Consumption $5,000 100 I3I3 I2I2 I1I1 Optimum 2,000 60 Copyright©2004 South-Western

52. Figure 14 An Increase in the Wage Hours of Leisure 0 Consumption (a) For a person with these preferences... Hours of Labor Supplied 0 Wage... the labor supply curve slopes upward. I1I1 I2I2 BC 2 BC 1 2.... hours of leisure decrease... 3.... and hours of labor increase. 1. When the wage rises... Labor supply Copyright©2004 South-Western

53. Figure 14 An Increase in the Wage Hours of Leisure 0 Consumption (b) For a person with these preferences... Hours of Labor Supplied 0 Wage...the labor supply curve slopes backward. I1I1 I2I2 BC 2 BC 1 1. When the wage rises... 2.... hours of leisure increase...3.... and hours of labor decrease. Labor supply Copyright©2004 South-Western

54. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. THREE APPLICATIONS ●How do interest rates affect household saving?  If the substitution effect of a higher interest rate is greater than the income effect, households save more.  If the income effect of a higher interest rate is greater than the substitution effect, households save less.  Thus, an increase in the interest rate could either encourage or discourage saving

55. Figure 15 The Consumption-Saving Decision Consumption when Young 0 Consumption when Old $110,000 100,000 I3I3 I2I2 I1I1 Budget constraint 55,000 $50,000 Optimum Copyright©2004 South-Western

56. Figure 16 An Increase in the Interest Rate 0 (a) Higher Interest Rate Raises Saving(b) Higher Interest Rate Lowers Saving Consumption when Old I1I1 I2I2 BC 1 BC 2 0 I1I1 I2I2 BC 1 BC 2 Consumption when Old Consumption when Young 1. A higher interest rate rotates the budget constraint outward... 1. A higher interest rate rotates the budget constraint outward... 2.... resulting in lower consumption when young and, thus, higher saving. 2.... resulting in higher consumption when young and, thus, lower saving. Consumption when Young Copyright©2004 South-Western

57. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. Summary budget constraint ●A consumer’s budget constraint shows the possible combinations of different goods he can buy given his income and the prices of the goods. slope of the budget constraint ●The slope of the budget constraint equals the relative price of the goods. indifference curves ●The consumer’s indifference curves represent his preferences.

58. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. Summary ●Points on higher indifference curves are preferred to points on lower indifference curves. marginal rate of substitution ●The slope of an indifference curve at any point is the consumer’s marginal rate of substitution. ●The consumer optimizes by choosing the point on his budget constraint that lies on the highest indifference curve.

59. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. Summary income effectsubstitution effect. ●When the price of a good falls, the impact on the consumer’s choices can be broken down into an income effect and a substitution effect. income effect  The income effect is the change in consumption that arises because a lower price makes the consumer better off.  The income effect is reflected by the movement from a lower to a higher indifference curve.

60. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. Summary substitution effect ●The substitution effect is the change in consumption that arises because a price change encourages greater consumption of the good that has become relatively cheaper. ●The substitution effect is reflected by a movement along an indifference curve to a point with a different slope.

61. Copyright © 2006 Nelson, a division of Thomson Canada Ltd. Summary ●The theory of consumer choice can explain:  Why demand curves can potentially slope upward.  How wages affect labor supply.  How interest rates affect household saving.