Theory of Consumer Choice

APPENDIX
⎮ We will develop a more advanced

set of tools using indifference
curves and budget lines to aid in
our understanding the theory of
consumer choice.
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APPENDIX
⎮ A consumer’s indifference curve

contains various combinations of two
commodities and each combination of
goods (like points A, B, and C) on the
indifference curve will yield the same
level of total utility to this consumer.
⎮ The consumer is said to be
indifferent between any combination
of the two goods along an individual
indifference curve, because the
consumer receives the same level of
satisfaction from each bundle.
APPENDIX
An Indifference Curve
APPENDIX
⎮ Three properties of indifference

curves:
• higher indifference curves represent
greater satisfaction
• they are negatively sloped
• they are convex from the origin
APPENDIX
⎮ Higher indifference curves

represent greater satisfaction.
⎮ Although equally happy with any
bundle of goods along the
indifference curve, consumers
prefer to be on the highest
indifference curve possible.
APPENDIX
Indifference Curves
APPENDIX
⎮ Consumer would prefer I2 to I1.

• Bundle D gives the consumer more of
both goods than bundle C, which is
on a lower indifference curve.
• Bundle D is also preferred to bundle A
because there is more than enough
extra food to compensate the
consumer for the loss of clothing; his
total utility has risen.
APPENDIX
⎮ Indifference curves are negatively

sloped.
• Must slope downward from left to
right
• If both goods are desirable and the
quantity of one good is reduced, the
quantity of the other good must be
increased to maintain the same level
of total satisfaction.
APPENDIX
⎮ Indifference curves are convex

from the origin.
⎮ The slope of the indifference curve
reflects the marginal rate of
substitution.
⎮ The rate at which a consumer is
willing to trade one good to gain
one more unit of another good.
APPENDIX
⎮ If the indifference curve is steep,

the marginal rate of substitution is
high.
⎮ The consumer would be willing to
give up a large amount of A for a
small amount of B.
APPENDIX
APPENDIX
⎮ If the indifference curve is flatter, the

marginal rate of substitution is low.
⎮ The consumer is only willing to give
up a small amount of A in exchange
for an additional unit of B to remain
indifferent.
⎮ If you have lots of something, you
will not value the prospect of getting
even more of it more highly; this is
just the law of demand, which is
based on the law of diminishing
marginal utility.
APPENDIX
⎮ Complements – the use of more units

of one encourages the acquisition of
additional units of the other.
• gasoline and automobiles
• baseballs and baseball bats
• snow skis and bindings
• bread and butter
• coffee and cream
⎮ When goods are complements, units

of one good cannot be acquired
without affecting the want-satisfying
power of other goods.
APPENDIX
⎮ Substitutes-the more you have of

one, the less your desire the other.
• coffee and tea
• sweaters and jackets
• home-cooked and restaurant meals
APPENDIX
⎮ The degree of convexity of an

indifference curve—that is, the
extent to which the curve deviates
from a straight line—depends on
how easily the two goods can be
substituted for each other.
• Perfect substitutes, the indifference
curve is a straight line (in this case of
slope –1).
APPENDIX
⎮ Perfect complements, goods are

never used separately but are
consumed only together.
• left and right shoes
⎮ Since it is impossible to replace
units of one with units of the other
and maintain satisfaction, the
marginal rate of substitution is
undefined; thus, the indifference
curve is a right angle.
APPENDIX
APPENDIX
⎮ If two commodities can easily be

substituted for one another, the
nearer the indifference curves will
approach a straight line.
⎮ The greater the complementarily
between the two goods, the nearer
the indifference curves will
approach a right angle.
APPENDIX
⎮ A budget line represents the

various combinations of two goods
that a consumer can buy with a
given income, holding the prices of
the two goods constant.
• The horizontal axis measures the
quantity of food.
• The vertical axis measures the
quantity of clothing.
APPENDIX
⎮ Moving along the budget line, we

can see the various combinations of
food and clothing the consumer can
purchase with her income.
⎮ Any combination of goods beyond
the budget line is not feasible.
APPENDIX
APPENDIX
⎮ The intercept can easily be found

by dividing the total income
available for expenditures by the
price of the good in question.
APPENDIX
APPENDIX
⎮ The slope of the budget line is

equal to -PX/PY.
⎮ The negative coefficient of the
slope indicates that the budget line
is negatively sloped (downward
sloping), reflecting the fact that you
must give up some of one good to
get more of the other.
APPENDIX
⎮ Given the consumer’s indifference

curves for two goods, together with
the budget line showing the various
quantities of the two that can be
purchased with a given money
income for expenditure, the
optimal (or best) quantities of each
good to be purchased can be
determined.
APPENDIX
Point of Tangency—The Consumer’s Optimum
APPENDIX
⎮ The optimum occurs where the

budget line is tangent to
indifference curve I2, at point A.
• To maximize satisfaction, the
consumer must acquire the most
preferred attainable bundle, that is,
reach the highest indifference curve
that can be reached with a given level
of income.
• The highest curve that can be reached
is the one to which the budget line is
tangent, at point A.
APPENDIX
⎮ The position of the budget line if

income rises
• An increase in income, holding
relative prices constant, will cause the
curve to shift out parallel to the old
curve.
– A richer person can afford more of both
goods than a poorer person because of
the higher budget line.
• The change in income, holding
relative prices constant, is called the
income effect and it causes this
parallel shift in the budget line.
APPENDIX
⎮ Income-consumption curve (ICC)

• A curve that connects the various
optimum combinations of two goods
as a consumer’s income changes
APPENDIX
APPENDIX
⎮ With a given pattern of

indifference curves, larger amounts
available for spending will result in
an income consumption curve (ICC)
connecting the best consumption
points (tangencies) at each income
level.
APPENDIX
⎮ The rise in income shifts the

budget line outward.
• If both goods are normal goods in this
range, then the consumer will buy
more of both goods
• If income rises and the consumer
buys less of one good, we say that
good is an inferior good.
APPENDIX
APPENDIX
⎮ Purchases depend on relative

prices as well as income level.
⎮ When the price of one good
changes, holding income and the
price of the other good constant, it
causes a relative price effect.
⎮ Relative prices affect the way the
consumers allocates their income
among different goods.
APPENDIX
⎮ A price change of the good on

either the Y- or X-axis causes the
budget line to rotate inward or
outward from the intercept on the
other axis.
⎮ This fall in price expands
consumers’ buying opportunities—
rotating the budget line outward.
APPENDIX
APPENDIX
⎮ The tangency relationship between

the budget line and the indifference
curve indicates the optimal
amounts of each of the two goods
the consumer will purchase, given
• the prices of both goods
• the consumer’s total available income
for expenditures
APPENDIX
⎮ At different possible prices for one

of the goods, given the price of the
other and given total income, a
consumer would optimally
purchase different quantities of the
two goods.
⎮ A change in the price of one of the
goods will alter the slope of the
budget line because a different
amount of the good can be
purchased with a given level of
income.
APPENDIX
APPENDIX
⎮ The point of tangency moves from

A to B as a result of the decline in
price of food from $10 to $5; the
equilibrium quantity of food
purchased increases from two to
five units.
APPENDIX
⎮ Price-consumption curve (PCC)-a

curve consisting of the various
optimum combinations of two
goods as the relative price of one
good changes
⎮ The price-consumption curve (PCC)
may be drawn through these points
of tangency, indicating the
optimum quantities at various
possible prices of food (given the
price of clothing).
APPENDIX
⎮ From this price-consumption curve

can be derived the usual demand
curve for the good.
⎮ Essentially, the demand curve is
made up of various price and
quantity optimum points.
APPENDIX
⎮ When the price of a good falls, the

income effect enables the person to
buy more of this good (or other
goods) with a given income.
⎮ The price reduction has the same
effect as an increase in money
income.
⎮ That is, the consumer can now
move onto a higher indifference
curve.
APPENDIX
⎮ Substitution effect – The lower

price encourages the consumer to
buy larger quantities of this good.
⎮ The substitution effect is always
negative.
⎮ That is, price and quantity
demanded are negatively
correlated; lower prices mean
higher quantities demanded, and
vice versa.
APPENDIX
Income and Substitution Effects

APPENDIX
⎮ Because the relative price of pizza

increases, the budget line rotates
inward.
⎮ The total effect of the increase in
the price of pizza is indicated by
point c, that is; a reduction in the
quantity of pizza from 7 slices of
pizza to 3 slices of pizza.
APPENDIX
⎮ Within the total effect are the

substitution effect and the income
effect.
⎮ The consumer is compensated for the
loss of welfare associated with the
price rise by enough income to return
to the original indifference curve, I1.
⎮ The movement from b to c results
from the decrease in real income
because of the higher price of pizza
while all other prices remain
constant—the income effect.
APPENDIX
⎮ By shifting the new budget line

next to the old indifference curve,
we can see the change that took
place holding real income
(measured by utility) constant.
⎮ When we make the parallel shift,
we see that the change in income,
because the size of the parallel
shift measures only the amount of
real income change, with relative
prices remaining constant.
APPENDIX
Cash Grant versus Food

Stamp Income Subsidy
APPENDIX
⎮ Using the indifference curve

approach, it can be seen that the poor
would be at least equally as well off
receiving cash rather than a subsidy
like food stamps.
⎮ The reason is that the shaded triangle
(Exhibit 13) is unobtainable to the
recipient of food stamps but not to
those receiving a cash payment.
Unless the individual intended to
spend all of the next $100 of
additional income on food, he or she
would be better off with a choice.
APPENDIX
⎮ Similarly, subsidizing the price of

a good (like education, postal
services, mass transportation, or
medical services) is usually not the
best method to assure that
society’s scarce resources are
properly allocated.
⎮ If the price of a good is
subsidized, it distorts market
signals and results in output levels
of the subsidized good that are
inefficiently large.
APPENDIX
⎮ In other words, the opportunity cost of

forgone other goods that could have been
produced with those resources is greater
than the (marginal) value of the
subsidized good.
⎮ Because reaching the highest

indifference curve subject to the budget
constraint maximizes consumer
satisfaction, it is better to subsidize
income (parallel shift) than to subsidize
price (altering the slope), if one is
interested in making some group better
off.
APPENDIX
Cash Grants versus Price Subsidies
APPENDIX
⎮ If you want certain groups (say,

the poor) to consume more of
particular goods (housing or food),
rather than just raising their utility
you may not wish to give
unconstrained income subsidies.

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APPENDIX

⎮ We will develop a more advanced

⎮ A consumer’s indifference curve

⎮ Three properties of indifference

⎮ Higher indifference curves

⎮ Consumer would prefer I2 to I1.

⎮ Indifference curves are negatively

⎮ Indifference curves are convex

⎮ If the indifference curve is steep,

⎮ If the indifference curve is flatter, the

⎮ Complements – the use of more units

⎮ When goods are complements, units

⎮ Substitutes-the more you have of

⎮ The degree of convexity of an

⎮ Perfect complements, goods are

⎮ If two commodities can easily be

⎮ A budget line represents the

⎮ Moving along the budget line, we

⎮ The intercept can easily be found

⎮ The slope of the budget line is

⎮ Given the consumer’s indifference

Point of Tangency—The Consumer’s Optimum

⎮ The optimum occurs where the

⎮ The position of the budget line if

⎮ Income-consumption curve (ICC)

⎮ With a given pattern of

⎮ The rise in income shifts the

⎮ Purchases depend on relative

⎮ A price change of the good on

⎮ The tangency relationship between

⎮ At different possible prices for one

⎮ The point of tangency moves from

⎮ Price-consumption curve (PCC)-a

⎮ From this price-consumption curve

⎮ When the price of a good falls, the

⎮ Substitution effect – The lower

Income and Substitution Effects

⎮ Because the relative price of pizza

⎮ Within the total effect are the

⎮ By shifting the new budget line

Cash Grant versus Food

⎮ Using the indifference curve

⎮ Similarly, subsidizing the price of

⎮ In other words, the opportunity cost of

⎮ Because reaching the highest

Cash Grants versus Price Subsidies

⎮ If you want certain groups (say,

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