21 The Theory of Consumer Choice

PRINCIPLES OF

M ICR O ECO NO M ICS

S IX T H EDITION

N. GREGORY MANKIW

arcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
 In this chapter, we will look for the answers
to these questions:
 How does the budget constraint represent the choices a
consumer can afford?
 How do indifference curves represent the consumer’s
preferences?
Analyze how a consumer’s optimal choices are determined
 See how a consumer responds to changes in income and
changes in prices
 Impact of a price change in an income effect and a substitution
effect
 THE BUDGET CONSTRAINT:
WHAT THE CONSUMER CAN AFFORD
 The budget constraint depicts the limit on the consumption “bundles” that a
consumer can afford.
 People consume less than they desire because their spending is constrained,
or limited, by their income.
 The consumer’s budget constraint shows the various consumption bundles
that the consumer can afford for a given income

 A “consumption bundle” is a particular combination of the goods, e.g., 40

pizzas & 300 pints of Pepsi.
Figure 1
The Consumer’s Budget Constraint

The budget constraint shows the various bundles of goods that the consumer can buy for a4 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.
 Figure 1 The Consumer’s Budget Constraint
Quantity
of Pepsi
500 B

• If the consumer
buys no pepsi, he
can afford 100
pizzas (point A). If
C
he buys no pizza, 250
he can afford 500
pints of pepsi Consumer’s
(point B). budget constraint

A
0 50 100 Quantity
of Pizza
 The slope of the preceding graph is
-5 (the price of Pepsi/the price of

Slope of the budget constraint

Pizza; 10/2; the slope is negative
indicating an inverse relationship
between quantity of pizza and price)

The slope of the budget

constraint measures the rate
at which the consumer can
trade one good for the other.
The slope equals the
relative price of the two
goods, i.e. the price of one
good compared to the price
of the other.
SLOPE = CHANGE IN Y- AXIS SLOPE = -100 = -5
CHANGE IN X-AXIS 20
 Preferences:
What the Consumer Wants
 A consumer’s preference among
consumption bundles may be illustrated
with indifference curves.
 An indifference curve is a curve that shows
consumption bundles that give the
consumer the same level of satisfaction.
 Figure 2 The Consumer’s Preferences

Quantity
of Pepsi
C

B D
MRS I2
1
Indifference
A curve, I1 Quantity
of Pizza
0
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 (I2
here) are preferred to points on a lower indifference curve (I1). 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
What does the Slope of Indifference Curves
represent ?
u The slope at any point on an indifference curve is the
marginal rate of substitution.
u It is the rate at which a consumer is willing to substitute
one good for another.
u It is the amount of one good that a consumer requires as
compensation to give up one unit of the other good.
 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
Property 1: Higher indifference curves are
preferred to lower ones.
u Consumers usually prefer more
of something to less of it. Figure 1
u Higher indifference curves
represent larger quantities of
goods than do lower indifference
curves.
u Consumers prefer to be on an
indifference curve that is as far
from the origin as possible.
Property 2: Indifference curves are downward
sloping.
u A consumer is willing to give up one
good only if he or she gets more of Figure 2
the other good in order to remain
equally happy.
u If the quantity of one good is reduced,
the quantity of the other good must
increase.
u For this reason, most indifference
curves slope downward.
 Property 3: Indifference curves do not cross.
uPoints A and B should make the
Figure 3
consumer equally happy.
uPoints B and C should make the
consumer equally happy.
uThis implies that A and C would
make the consumer equally happy.
uBut C has more of both goods
compared to A.
Property 4: Indifference curves are bowed inward.
u People are more willing to trade
away goods that they have in Figure 4
abundance and less willing to
trade away goods of which they
have little.
u These differences in a consumer’s
marginal substitution rates cause
his or her indifference curve to
bow inward.
 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
Perfect Substitutes and Perfect Complements
(a) Perfect Substitutes (b) Perfect Complements
Nickels
Left
shoes
6

4 7 I2

5 I1
2

I1 I2 I3
0 1 2 3 Dimes 0 5 7 Right
shoes
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).
OPTIMIZATION: WHAT THE CONSUMER CHOOSES
Figure 7 An Increase in Income

Quantity
of Pepsi New budget constraint

1. An increase in income shifts the

budget constraint outward . . .
New optimum
3. . . . and
Pepsi
consumption. Initial
optimum I2

Initial
budget
constraint I1
0 Quantity
2. . . . raising pizza consumption . . . of Pizza
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
A Change in Price
Quantity A fall in the price of any good will
of Pepsi New budget shift the budget constraint outward
D constraint and will change the slope of the
1,000 budget constraint.

New optimum 1. A fall in the price of Pepsi rotates

B the budget constraint outward. . .
500
3. . . . and
Initial I2
raising Pepsi
consumption budget
Initial
constraint 2. . . . reducing pizza
optimum
I1 consumption
A
0 100 Quantity of Pizza
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.
Income and Substitution Effects

The effect of a change in price

Quantity can be broken down into an
of Pepsi New budget income effect and a
constraint substitution effect. The
substitution effect—the
movement along an
indifference curve to a point
C with a different marginal rate
New optimum
Income of substitution—is shown here
effect B as the change from point A to
Initial I2 point B along indifference
Substitutio curve I1. The income
n budget A Initial effect—the shift to a higher
constraint
effect optimum indifference curve—is shown
I1 here as the change from point
B on indifference curve I1 to
0 Quantity point C on indifference curve I2.
Substitution
of Pizza
effect
Income effect
Income and Substitution Effects When
the Price of Pepsi Falls