1. Consumer Choices and Economic Behavior
Chapter 5:
Consumer Choices and Economic Behavior

2. Key Topics The budget constraint Utility
Definition, equation, graph, opportunity cost
Impact of ΔI, ΔPx, ΔPy
Utility
Total and marginal
Indifference curve: definition, slope
Utility maximization

3. Key Topics 3. Downward-sloping demand factors
Diminishing marginal utility
Income effect
Substitution effect
4. Other consumer decisions
Work or leisure
Save or borrow

4. Questions What does it mean if you have a ‘budget constraint’?
How can your attainable consumption choices be shown mathematically and graphically?

5. Budget Constraint
The maximum Q combinations of goods
that can be purchased given one’s income and the prices of the goods.

6. Budget Constraint Variables
I (or M) = the amount of income or money that a consumer has to spend on specified goods and services.
X = the quantity of one specific good or one specific bundle of goods
Y = the quantity of a second specific good or second specific bundle of goods
Px = the price or per unit cost of X
PY = the price or per unit cost of Y

7. Budget Line Equation
Income = expenses
I = PxX+PYY
Y = l/PY – (Px/PY)X
 straight line equation

8. The Opportunity Set

9. Budget Line: Axis Intercepts & Slope
Vertical Axis Intercept
= I/PY
= max Y (X = 0)
Horizontal Axis Intercept
= I/PX
= max X (Y = 0)
- Slope
= PX/PY
= ‘inverse’ P ratio
= X axis good P/Y axis good P
= Y/X

10. Changes in the Budget Line
Changes in Income
- Increases lead to a parallel,
outward shift in the budget line.
- Decreases lead to a parallel,
downward shift.

11. Changes in the Budget Line
Changes in Price
- A decrease in the price of good X rotates the budget line counter-clockwise.
- An increase rotates the budget line clockwise. Y
New budget line for
a price decrease X

12. Q. What Are Your Preferences?
Lunch
A: 1 drink, 1 pizza slice
B: 1 drink, 2 pizza slices
C: 2 drinks, 1 pizza slice
Entertainment
A: 1 movie, 1 dinner
B: 1 movie, 2 dinners
C: 2 movies, 1 dinner
For each, indicate which of the following you prefer:
A vs B, B vs C, or A vs C

13. Utility Concepts Utility: satisfaction received from consuming goods
Cardinal utility:
satisfaction levels that can be measured or specified with numbers (units = ‘utils’)
Ordinal utility:
satisfaction levels that can be ordered or ranked
Marginal utility:
the additional utility received per unit of additional unit of an item consumed (ΔU/ ΔX)

14. Utility Assumptions
Complete (or continuous)  can rank all bundles of goods
Consistent (or transitive)  preference orderings are logical and consistent
Consumptive (nonsatiation)  more of a ‘normal’ good is preferred to less

15. More of a Good is Preferred to Less
The shaded area represents those combinations of X and Y that are unambiguously preferred to the combination X*, Y*. Ceteris paribus, individuals prefer more of any good rather than less. Combinations identified by “?” involve ambiguous changes in welfare since they contain more of one good and less of the other.

16. Indifference Curve Indifference Curve A curve that defines the
combinations of 2 or more
goods that give a consumer
the same level of satisfaction.
Curves further from origin represent higher utility levels

17. A ‘bad’ good, or an economic ‘bad’ is an item that a consumer does not like or enjoy, which means their total satisfaction level is lower the more of the item they have. This also means the marginal utility of the item is negative.

18. MRS & MU MRS = - slope of indifference curve = -Y/ X
= the rate at which a consumer is willing to exchange Y for 1more (or less) unit of X
U = 0 along given indiff curve
= MUx(X)+MUY(Y) = 0
= - Y/ X = MUx/MUY
= - slope = inverse MU ratio

19. Consumer Equilibrium (U Max)
The equilibrium
consumption
bundle is the
affordable bundle
that yields the
highest level of satisfaction.

20. Equal Slopes Condition (for consumer equilibrium)
MUX/MUY = PX/PY
MUX/PX = MUY/PY

21. Individual Demand Curve
An individual’s demand curve is derived from each new equilibrium point found on the indifference curve as the price of good X is varied.

22. Diminishing Marginal Utility
The law of diminishing marginal utility:
The more of one good consumed in a given period, the less satisfaction (utility) generated by consuming each additional (marginal) unit of the same good.

23. Diminishing Marginal Utility and Downward-Sloping Demand
Diminishing marginal utility helps to explain why demand slopes down.
Marginal utility falls with each additional unit consumed, so people are not willing to pay as much. 40
Price per meal ($) 25 15 D 5 10 25
Thai meals per month

24. Income and Substitution Effects of a Price Change (for normal goods)
Price of a
good or
service
Household is
better off
(higher real income)
Income
effect
Household
buys more
FALLS
Opportunity
cost of the
good falls
Substitution
effect
Household
buys more
Household is
worse off
(lower real income)
Income
effect
Household
buys less
RISES
Opportunity
cost of the
good rises.
Substitution
effect
Household
buys less

25. Household Choices in Labor Markets
As in output markets, households face constrained choices in input markets. They must decide:
Whether to work
How much to work
What kind of a job to work at
These decisions are affected by:
The availability of jobs
Market wage rates
The skill possessed by the household

26. The Price of Leisure
W = wage rate
= the price (or the opportunity cost or lost benefits) of either unpaid work or leisure.

27. Work vs. Leisure Constraint
Income
24W
Leisure (hrs/day) 24

28. The Labor Supply Curve
The labor supply curve is a diagram that shows the quantity of labor supplied at different wage rates.

29. Saving and Borrowing: Present Versus Future Consumption
Households can use present income to finance future spending (i.e., save), or they can use future funds to finance present spending (i.e., borrow).
In deciding how much to save and how much to spend today, interest rates define the opportunity cost of present consumption in terms of foregone future consumption.

30. Q1
(next yr)
save
I1/P
borrow
Q0 (this yr)
I0/P