Optimization:

What the Consumer Chooses

 Consumers would like to obtain the combination of goods on the highest possible indifference
curve. However, the budget constraint may restrict or limit the consumer to a lower
indifference curve.
 Combining the indifference curve and budget constraint determines the optimum choice.
 The point at which the indifference curve and the budget constraint touch (i.e. its tangent) is
called the optimum.
 The consumer chooses consumption of the two goods so that the marginal rate of
substitution equals the relative price.
 The consumer’s valuation of the two goods equals the market’s valuation.

Principles of Microeconomics: Ch. 21 Second Canadian Edition

 The Consumer’s Optimal Choice
Pepsi
Optimal Choice
given personal preference

.
and budget constraint.
QPepsi I3
I2
I1
Pizza
Principles of Microeconomics: Ch. 21
QPizza Second Canadian Edition
 How Changes in Income Affect the
Consumer’s Choices
The increase in income shifts the budget
constraint outward. This results in two
affects:
–A parallel shift in the budget constraint.
– Allows the consumer to choose a better
combination of goods on a higher
indifference curve.
Principles of Microeconomics: Ch. 21 Second Canadian Edition
 A Change in Income Affects Choices
Pepsi
A new optimum

.
A new choice of goods
is chosen on a higher
QNew indifference curve.

QPepsi I3
I2
I1
Pizza
Principles of Microeconomics: Ch. 21
QPizza QNew Second Canadian Edition
 Normal versus Inferior Goods
If a consumer wants more of a good
when his income rises, the good is called
a normal good.
If a consumer buys less of a good when
his income rises, the good is called an
inferior good.
Principles of Microeconomics: Ch. 21 Second Canadian Edition
 Figure 8 An Inferior Good
Quantity
of Pepsi New budget constraint

1. When an increase in income shifts the

3. . . . but budget constraint outward . . .
Pepsi Initial
consumption optimum
falls, making
Pepsi an New optimum
inferior good.

Initial
budget I1 I2
constraint
0 Quantity
2. . . . pizza consumption rises, making pizza a normal good . . . of Pizza

Principles of Microeconomics: Ch. 21 Second Canadian Edition

 A Change in Prices Affects Choices
Pepsi
A fall in the price of any good will
shift the budget constraint outward
and will change the slope of the

.
budget constraint.

QPepsi I3
I2
I1
Pizza
Principles of Microeconomics: Ch. 21
QPizza Second Canadian Edition
Income and Substitution Effects
u A price change has two effects on
consumption.
– An income effect
– A substitution effect

Principles of Microeconomics: Ch. 21 Second Canadian Edition

Income and Substitution Effects
u The Income Effect
– The income effect is the change in
consumption that results when a price
change moves the consumer to a higher or
lower indifference curve.
u The Substitution Effect
– The substitution effect is the change in
consumption that results when a price
Principles of Microeconomics: Ch. 21 Second Canadian Edition
Income and Substitution Effects
u A Change in Price: Substitution Effect
– A price change first causes the consumer to
move from one point on an indifference
curve to another on the same curve.
v Illustrated by movement from point A to point B.
u A Change in Price: Income Effect
– After moving from one point to another on
Principles of Microeconomics: Ch. 21 Second Canadian Edition
 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, In

Income and Substitution Effects...

Quantity
of Pepsi
New budget constraint

C New optimum
Income effect B
Initial optimum
Substitution
effect I2
A
Initial budget I1
constraint
0 Quantity of Pizza
Substitution effect
Principles of Microeconomics: Ch. 21 Income effect Second Canadian Edition
 Table 1 Income and Substitution Effects When the
Price of Pepsi Falls

Principles of Microeconomics: Ch. 21 Second Canadian Edition

Copyright©2004 South-Western
 Deriving the Demand Curve...
(a) The Consumer’s Optimum (b) The Demand Curve for Pepsi
Quantity of
Pepsi New budget constraint Price of
Pepsi

B $2 A
150
I2
1 B
A
50 I1
0 0
Quantity of 50 150 Quantity of
Initial budget Pizza Pepsi
constraint Ch. 21
Principles of Microeconomics: Second Canadian Edition