1. PowerPoint Slides prepared by: Andreea CHIRITESCU Eastern Illinois University The Theory of Consumer Choice 1 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2. Budget Constraint Budget constraint –Limit on the consumption bundles that a consumer can afford –It shows the trade-off between goods Slope of the budget constraint –Rate at which the consumer can trade one good for the other –Relative price of the two goods 2 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3. Figure 1 3 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Consumer’s Budget Constraint The budget constraint shows the various bundles of goods that the consumer can buy for a given income. Here the consumer buys bundles of pizza and Pepsi. The table and graph show what the consumer can afford if his income is $1,000, the price of pizza is $10, and the price of Pepsi is $2.

4. Figure 1 4 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Consumer’s Budget Constraint The budget constraint shows the various bundles of goods that the consumer can buy for a given income. Here the consumer buys bundles of pizza and Pepsi. The table and graph show what the consumer can afford if his income is $1,000, the price of pizza is $10, and the price of Pepsi is $2. Quantity of Pepsi Quantity of Pizza 0 Consumer’s budget constraint 50 500 100 250 C B A

5. Preferences Indifference curve –Shows consumption bundles that give the consumer the same level of satisfaction –Combinations of goods on the same curve Same satisfaction Slope of indifference curve –Marginal rate of substitution Rate at which a consumer is willing to trade one good for another –Not the same at all points 5 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

6. Figure 2 6 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Consumer’s Preferences The consumer’s preferences are represented with indifference curves, which show the combinations of pizza and Pepsi that make the consumer equally satisfied. Because the consumer prefers more of a good, points on a higher indifference curve (I 2 here) are preferred to points on a lower indifference curve (I 1 ). The marginal rate of substitution (MRS) shows the rate at which the consumer is willing to trade Pepsi for pizza. It measures the quantity of Pepsi the consumer must be given in exchange for 1 pizza. Quantity of Pepsi Quantity of Pizza 0 Indifference curve, I 1 I2I2 C B A D 1 MRS

7. Preferences Four properties of indifference curves 1.Higher indifference curves are preferred to lower ones – Higher indifference curves – more goods 2.Indifference curves are downward sloping 3.Indifference curves do not cross 4.Indifference curves are bowed inward 7 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

8. Figure 3 8 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Impossibility of Intersecting Indifference Curves Quantity of Pepsi Quantity of Pizza 0 C B A A situation like this can never happen. According to these indifference curves, the consumer would be equally satisfied at points A, B, and C, even though point C has more of both goods than point A.

9. Figure 4 9 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Bowed Indifference Curves Indifference curves are usually bowed inward. This shape implies that the marginal rate of substitution (MRS) depends on the quantity of the two goods the consumer is consuming. At point A, the consumer has little pizza and much Pepsi, so he requires a lot of extra Pepsi to induce him to give up one of the pizzas: The marginal rate of substitution is 6 pints of Pepsi per pizza. At point B, the consumer has much pizza and little Pepsi, so he requires only a little extra Pepsi to induce him to give up one of the pizzas: The marginal rate of substitution is 1 pint of Pepsi per pizza. Quantity of Pepsi Quantity of Pizza 0 Indifference curve 2 3 6 7 3 4 8 14 1 MRS=1 1 MRS=6 B A

10. Preferences Extreme examples of indifference curves Perfect substitutes –Two goods with straight-line indifference curves –Marginal rate of substitution – constant Perfect complements –Two goods with right-angle indifference curves 10 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

11. Figure 5 11 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Perfect Substitutes and Perfect Complements Nickels 6 2 4 When two goods are easily substitutable, such as nickels and dimes, the indifference curves are straight lines, as shown in panel (a). When two goods are strongly complementary, such as left shoes and right shoes, the indifference curves are right angles, as shown in panel (b). (a) Perfect Substitutes Dimes 0 1 3 2 I1I1 I2I2 I3I3 Left shoes (b) Perfect Complements Right shoes 0 5 7 5 7 I2I2 I1I1

12. Optimization Optimum –Point where indifference curve and budget constraint touch –Best combination of goods available to the consumer –Slope of indifference curve Equals slope of budget constraint Marginal rate of substitution = Relative price 12 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

13. Figure 6 13 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Consumer’s Optimum The consumer chooses the point on his budget constraint that lies on the highest indifference curve. At this point, called the optimum, the marginal rate of substitution equals the relative price of the two goods. Here the highest indifference curve the consumer can reach is I 2. The consumer prefers point A, which lies on indifference curve I 3, but the consumer cannot afford this bundle of pizza and Pepsi. By contrast, point B is affordable, but because it lies on a lower indifference curve, the consumer does not prefer it. Quantity of Pepsi Quantity of Pizza 0 Budget constraint I2I2 I1I1 I3I3 A B Optimum

14. Optimization Higher income –Consumer can afford more of both goods –Shifts the budget constraint outward –New optimum Normal good –Good for which an increase in income raises the quantity demanded 14 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

15. Figure 7 15 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. An Increase in Income When the consumer’s income rises, the budget constraint shifts out. If both goods are normal goods, the consumer responds to the increase in income by buying more of both of them. Here the consumer buys more pizza and more Pepsi. Quantity of Pepsi Quantity of Pizza 0 New budget constraint I2I2 I1I1 New optimum Initial budget constraint Initial optimum 1. An increase in income shifts the budget constraint outward... 2.... raising pizza consumption... 3.... and Pepsi consumption

16. Optimization Inferior good –Good for which an increase in income reduces the quantity demanded Price of one good falls –Rotates the budget constraint outward Steeper slope Change in relative price –Income effect –Substitution effect 16 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

17. Figure 8 17 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. An Inferior Good A good is an inferior good if the consumer buys less of it when his income rises. Here Pepsi is an inferior good: When the consumer’s income increases and the budget constraint shifts outward, the consumer buys more pizza but less Pepsi. Quantity of Pepsi Quantity of Pizza 0 New budget constraint I2I2 I1I1 New optimum Initial budget constraint Initial optimum 1. When an increase in income shifts the budget constraint outward... 2.... pizza consumption rises, making pizza a normal good... 3.... but Pepsi consumption falls, making Pepsi an inferior good

18. Figure 9 18 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. A Change in Price When the price of Pepsi falls, the consumer’s budget constraint shifts outward and changes slope. The consumer moves from the initial optimum to the new optimum, which changes his purchases of both pizza and Pepsi. In this case, the quantity of Pepsi consumed rises, and the quantity of pizza consumed falls. Quantity of Pepsi Quantity of Pizza 0 I2I2 I1I1 Initial budget constraint 1. A fall in the price of Pepsi rotates the budget constraint outward... 2.... reducing pizza consumption 3.... and raising Pepsi consumption New budget constraint New optimum Initial optimum A 100 B 500 D 1,000

19. Optimization Income effect –Change in consumption –When a price change moves the consumer To a higher or lower indifference curve 19 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

20. Optimization Substitution effect –Change in consumption –When a price change moves the consumer Along a given indifference curve To a point with a new marginal rate of substitution 20 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

21. Table 1 21 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Income and Substitution Effects When the Price of Pepsi Falls

22. Figure 10 22 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Income and Substitution Effects The effect of a change in price can be broken down into an income effect and a substitution effect. The substitution effect—the movement along an indifference curve to a point with a different marginal rate of substitution—is shown here as the change from point A to point B along indifference curve I 1. The income effect—the shift to a higher indifference curve—is shown here as the change from point B on indifference curve I 1 to point C on indifference curve I 2. Quantity of Pepsi Quantity of Pizza 0 I2I2 I1I1 Initial budget constraint New budget constraint Initial optimum A New optimum C B Substitution effect Substitution effect Income effect Income effect

23. Optimization Deriving the demand curve –Quantity demanded of a good for any given price –Initial optimum point Initial price of the good Initial quantity of the good –A change in price of the good (new price) New optimum New optimum quantity 23 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

24. Figure 11 24 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Deriving the Demand Curve Quantity of Pepsi Panel (a) shows that when the price of Pepsi falls from $2 to $1, the consumer’s optimum moves from point A to point B, and the quantity of Pepsi consumed rises from 250 to 750 pints. Demand curve in panel (b) reflects this relationship between the price and the quantity demanded. (a) The Consumer’s Optimum Quantity of Pizza 0 Price of Pepsi (b) The Demand Curve for Pepsi Quantity of Pepsi 0 250 750 Demand I2I2 I1I1 250 750 Initial budget constraint New budget constraint B A 1 $2 B A

25. Three Applications 1.Do all demand curves slope downward? –Law of demand When the price of a good rises, people buy less of it –Downward slope of the demand curve –Giffen good An increase in the price of the good raises the quantity demanded –Income effect dominates the substitution effect –Demand curve – slopes upward 25 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

26. Figure 12 26 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. A Giffen Good In this example, when the price of potatoes rises, the consumer’s optimum shifts from point C to point E. In this case, the consumer responds to a higher price of potatoes by buying less meat and more potatoes. Quantity of Potatoes Quantity of Meat 0 I1I1 New budget constraint 1. An increase in the price of potatoes rotates the budget constraint inward... 2.... which increases potato consumption if potatoes are a Giffen good. Initial budget constraint A D B Optimum with low price of potatoes C I2I2 Optimum with high price of potatoes E

27. The search for Giffen goods Potatoes - Giffen good during the Irish potato famine of the 19th century –Price of potatoes rose Large income effect People – cut back on the luxury of meat Buy more of the staple food of potatoes 27 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

28. The search for Giffen goods Chinese province of Hunan, rice –Poor households exhibited Giffen behavior Lower price of rice (with subsidy voucher) –Households - reduce their consumption of rice Higher price of rice (remove the subsidy) –Households – increase consumption of rice 28 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

29. Three Applications 2.How do wages affect labor supply? –Trade-off between leisure and consumption –Bundle of goods: leisure and work Given wage Budget constraint Optimum 29 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

30. Figure 13 30 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Work-Leisure Decision This figure shows Sally’s budget constraint for deciding how much to work, her indifference curves for consumption and leisure, and her optimum. Consumption Hours of leisure 0 I2I2 I1I1 I3I3 $5,000 100 Optimum 60 2,000

31. Three Applications 2.How do wages affect labor supply? –Increase in wage - budget constraint shifts outward: Steeper If enjoy less leisure –Work more –Upward-sloping labor supply curve –Substitution effect dominates If enjoy more leisure –Work less –Backward-sloping labor supply curve –Income effect dominates 31 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

32. Figure 14 32 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. An Increase in the Wage (a) Consumption The two panels of this figure show how a person might respond to an increase in the wage. The graphs on the left show the consumer’s initial budget constraint, BC 1, and new budget constraint, BC 2, as well as the consumer’s optimal choices over consumption and leisure. The graphs on the right show the resulting labor- supply curve. Because hours worked equal total hours available minus hours of leisure, any change in leisure implies an opposite change in the quantity of labor supplied. In panel (a), when the wage rises, consumption rises and leisure falls, resulting in a labor-supply curve that slopes upward. (a) For a person with these preferences... Hours of Leisure 0 Wage... the labor supply curve slopes upward. Hours of Labor Supplied 0 Labor supply I2I2 I1I1 BC 2 BC 1 A B 1. When the wage rises... 2.... hours of leisure decrease... 3.... and hours of labor increase

33. Figure 14 33 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. An Increase in the Wage (b) Consumption The two panels of this figure show how a person might respond to an increase in the wage. The graphs on the left show the consumer’s initial budget constraint, BC 1, and new budget constraint, BC 2, as well as the consumer’s optimal choices over consumption and leisure. The graphs on the right show the resulting labor- supply curve. Because hours worked equal total hours available minus hours of leisure, any change in leisure implies an opposite change in the quantity of labor supplied. In panel (b), when the wage rises, both consumption and leisure rise, resulting in a labor-supply curve that slopes backward. (b) For a person with these preferences... Hours of Leisure 0 Wage... the labor supply curve slopes backward Hours of Labor Supplied 0 Labor supply I2I2 I1I1 BC 2 BC 1 1. When the wage rises... 2.... hours of leisure increase... 3.... and hours of labor decrease

34. Income effects on labor supply Labor- supply curve, over long periods –Slope backward A hundred years ago –People worked six days a week Today –Five-day workweeks –Length of the workweek has been falling –Wage of the typical worker (adjusted for inflation) has been rising 34 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

35. Income effects on labor supply Explanation: Advances in technology –Higher worker productivity –Increase in demand for labor Higher equilibrium wages Greater reward for working Income effect dominates substitution effect More leisure Less work 35 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

36. Income effects on labor supply Winners of lotteries –Large increase in incomes –Large outward shifts in budget constraints Same slope No substitution effect –Income effect on labor supply Substantial People who win the lottery – tend to quit their jobs 36 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

37. Income effects on labor supply Andrew Carnegie, 19 th century –“The parent who leaves his son enormous wealth generally deadens the talents and energies of the son, and tempts him to lead a less useful and less worthy life than he otherwise would” –Income effect on labor supply – substantial 37 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

38. Three Applications 3.How do interest rates affect household saving? –Income decision Consume today or save for future –Bundle of goods Consumption today and Consumption in the future Relative price = interest rates Optimum: Budget constraint & Indifference curves 38 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

39. Figure 15 39 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Consumption-Saving Decision This figure shows the budget constraint for a person deciding how much to consume in the two periods of his life, the indifference curves representing his preferences, and the optimum. Consumption when Old Consumption when Young 0 I2I2 I1I1 I3I3 $110,00 0 100,000 Optimum $50,000 55,000

40. Three Applications 3.How do interest rates affect household saving? –Increase in interest rates Budget constraint – shifts outward –Steeper Consumption in the future – rises If consume less today –Substitution effect dominates; Save more If consume more today –Income effect dominates; Save less 40 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

41. Figure 16 41 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. An Increase in the Interest Rate Consumption when old (a) Higher Interest Rate Raises Saving Consumption when Young 0 I2I2 I1I1 BC 2 BC 1 1. A higher interest rate rotates the budget constraint outward... Consumption when old In both panels, an increase in the interest rate shifts the budget constraint outward. In panel (a), consumption when young falls, and consumption when old rises. The result is an increase in saving when young. In panel (b), consumption in both periods rises. The result is a decrease in saving when young. (b) Higher Interest Rate Lowers Saving Consumption when Young 0 I2I2 I1I1 BC 2 BC 1 2.... resulting in lower consumption when young and, thus, higher saving. 1. A higher interest rate rotates the budget constraint outward... 2.... resulting in higher consumption when young and, thus, lower saving.